Heterodox
131-429: Microfoundations are an effort to understand macroeconomic phenomena in terms of economic agents' behaviors and their interactions. Research in microfoundations explores the link between macroeconomic and microeconomic principles in order to explore the aggregate relationships in macroeconomic models. During recent decades, macroeconomists have attempted to combine microeconomic models of individual behaviour to derive
262-400: A cul-de-sac (Hansen's term was "leakage"); the only culs-de-sac he acknowledged were imports and hoarding, although he also said that a rise in prices might dilute the multiplier effect. Jens Warming recognised that personal saving had to be considered, treating it as a "leakage" (p. 214) while recognising on p. 217 that it might in fact be invested. The textbook multiplier gives
393-690: A fixed exchange rate regime, aligning their currency with one or more foreign currencies, typically the US dollar or the euro . Conventional monetary policy can be ineffective in situations such as a liquidity trap . When nominal interest rates are near zero, central banks cannot loosen monetary policy through conventional means. In that situation, they may use unconventional monetary policy such as quantitative easing to help stabilize output. Quantity easing can be implemented by buying not only government bonds, but also other assets such as corporate bonds, stocks, and other securities. This allows lower interest rates for
524-623: A fixed exchange rate system or even a currency union like the Economic and Monetary Union of the European Union , drawing on the research literature on optimum currency areas . Macroeconomics as a separate field of research and study is generally recognized to start with the publication of John Maynard Keynes ' The General Theory of Employment, Interest, and Money in 1936. The terms "macrodynamics" and "macroanalysis" were introduced by Ragnar Frisch in 1933, and Lawrence Klein in 1946 used
655-409: A market economy often experiences inefficient macroeconomic outcomes, including recessions when demand is too low and inflation when demand is too high. Further, they argue that these economic fluctuations can be mitigated by economic policy responses coordinated between government and central bank . In particular, fiscal policy actions taken by the government and monetary policy actions taken by
786-501: A 1928 Treasury memorandum ("with imports as the only leakage"), but the idea was discarded in his own subsequent writings. Soon afterwards the Australian economist Lyndhurst Giblin published a multiplier analysis in a 1930 lecture (again with imports as the only leakage). The idea itself was much older. Some Dutch mercantilists had believed in an infinite multiplier for military expenditure (assuming no import "leakage"), since ... ...
917-436: A 2% inflation rate just because that has been the average the past few years; they will look at current monetary policy and economic conditions to make an informed forecast. In the new classical models with rational expectations, monetary policy only had a limited impact. Lucas also made an influential critique of Keynesian empirical models. He argued that forecasting models based on empirical relationships would keep producing
1048-468: A 3% increase in output would lead to a 1% decrease in unemployment. The structural or natural rate of unemployment is the level of unemployment that will occur in a medium-run equilibrium, i.e. a situation with a cyclical unemployment rate of zero. There may be several reasons why there is some positive unemployment level even in a cyclically neutral situation, which all have their foundation in some kind of market failure : A general price increase across
1179-799: A basis for making economic forecasting . Well-known specific theoretical models include short-term models like the Keynesian cross , the IS–LM model and the Mundell–Fleming model , medium-term models like the AD–AS model , building upon a Phillips curve , and long-term growth models like the Solow–Swan model, the Ramsey–Cass–Koopmans model and Peter Diamond 's overlapping generations model . Quantitative models include early large-scale macroeconometric model ,
1310-610: A broader class of assets beyond government bonds. A similar strategy is to lower long-term interest rates by buying long-term bonds and selling short-term bonds to create a flat yield curve , known in the US as Operation Twist . Fiscal policy is the use of government's revenue ( taxes ) and expenditure as instruments to influence the economy. For example, if the economy is producing less than potential output , government spending can be used to employ idle resources and boost output, or taxes could be lowered to boost private consumption which has
1441-564: A core part of contemporary macroeconomics. The 2007–2008 financial crisis , which led to the Great Recession , led to major reassessment of macroeconomics, which as a field generally had neglected the potential role of financial institutions in the economy. After the crisis, macroeconomic researchers have turned their attention in several new directions: Research in the economics of the determinants behind long-run economic growth has followed its own course. The Harrod-Domar model from
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#17328548107631572-412: A culprit as Kahn and Samuelson, wrote that ... ... in connection with the multiplier (and indeed most of the time) what Keynes is referring to as "investment" really means any addition to spending for any purpose ... The word "investment" is being used in a Pickwickian, or Keynesian, sense. Kahn envisaged money as being passed from hand to hand, creating employment at each step, until it came to rest in
1703-475: A demand to hoard, is not admitted by the simplified liquidity preference model of the General Theory . Once he rejects the classical theory that unemployment is due to excessive wages, Keynes proposes an alternative based on the relationship between saving and investment. In his view, unemployment arises whenever entrepreneurs' incentive to invest fails to keep pace with society's propensity to save ( propensity
1834-750: A divide between "macro" and "micro" areas. Research in macro management mainly focuses on the organizational or firm level, while research in micro areas mainly examines individual and group levels within organizations. For example, macro research domains typically include strategic management and organization theory, whereas micro includes areas such as organizational behaviour and human resource management. Most early macroeconomic models, including early Keynesian models, were based on hypotheses about relationships between aggregate quantities, such as aggregate production , employment , consumption , and investment . Critics and proponents of these models disagreed as to whether these aggregate relationships were consistent with
1965-447: A free market policy would. Under the classical theory, the wage rate is determined by the marginal productivity of labour , and as many people are employed as are willing to work at that rate. Unemployment may arise through friction or may be "voluntary", in the sense that it arises from a refusal to accept employment owing to "legislation or social practices ... or mere human obstinacy", but "...the classical postulates do not admit of
2096-554: A general glut was possible. Keynes argued that when a glut occurred, it was the over-reaction of producers and the laying off of workers that led to a fall in demand and perpetuated the problem. Keynesians therefore advocate an active stabilization policy to reduce the amplitude of the business cycle, which they rank among the most serious of economic problems. According to the theory, government spending can be used to increase aggregate demand, thus increasing economic activity, reducing unemployment and deflation . The Liberal Party fought
2227-412: A marginal propensity to consume of 2/3, they will now spend $ 666.67 on new consumption goods. The producers of these goods will now have extra incomes... they in turn will spend $ 444.44 ... Thus an endless chain of secondary consumption respending is set in motion by my primary investment of $ 1000. Samuelson's treatment closely follows Joan Robinson 's account of 1937 and is the main channel by which
2358-442: A medium-run equilibrium (or "potential") level, the process would be slow at best. Keynes coined the term liquidity preference (his preferred name for what is also known as money demand ) and explained how monetary policy might affect aggregate demand, at the same time offering clear policy recommendations for an active role of fiscal policy in stabilizing aggregate demand and hence output and employment. In addition, he explained how
2489-450: A newly created Committee of Economists, Keynes tried to use Kahn's emerging multiplier theory to argue for public works, "but Pigou's and Henderson's objections ensured that there was no sign of this in the final product". In 1933 he gave wider publicity to his support for Kahn's multiplier in a series of articles titled "The road to prosperity" in The Times newspaper. A. C. Pigou was at
2620-420: A parallel division of macroeconomic policies into short-run policies aimed at mitigating the harmful consequences of business cycles (known as stabilization policy ) and medium- and long-run policies targeted at improving the structural levels of macroeconomic variables. Stabilization policy is usually implemented through two sets of tools: fiscal and monetary policy. Both forms of policy are used to stabilize
2751-504: A political pamphlet seeking to "provide academically respectable economic arguments" for Lloyd George's policies. It was titled Can Lloyd George do it? and endorsed the claim that "greater trade activity would make for greater trade activity ... with a cumulative effect". This became the mechanism of the "ratio" published by Richard Kahn in his 1931 paper "The relation of home investment to unemployment", described by Alvin Hansen as "one of
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#17328548107632882-498: A similar effect. Government spending or tax cuts do not have to make up for the entire output gap . There is a multiplier effect that affects the impact of government spending. For instance, when the government pays for a bridge, the project not only adds the value of the bridge to output, but also allows the bridge workers to increase their consumption and investment, which helps to close the output gap. The effects of fiscal policy can be limited by partial or full crowding out . When
3013-430: A single 'representative agent'. Thus, he suggests that proper micro-foundations should be based not on studies of individuals in isolation but on studies of aggregate activity resulting from the direct interaction between different individuals. Similarly to Kirman, Robert Solow has argued that the issue with the microfoundation project is the demand that it must be built on Walrasian foundations. According to him, there
3144-428: A somewhat lesser extent. Keynes adds that "this psychological law was of the utmost importance in the development of my own thought". Keynes viewed the money supply as one of the main determinants of the state of the real economy. The significance he attributed to it is one of the innovative features of his work, and was influential on the politically hostile monetarist school . Money supply comes into play through
3275-541: A special case of the more general Ramsey growth model , where households' savings rates are not constant as in the Solow model, but derived from an explicit intertemporal utility function . In the 1980s and 1990s endogenous growth theory arose to challenge the neoclassical growth theory of Ramsey and Solow. This group of models explains economic growth through factors such as increasing returns to scale for capital and learning-by-doing that are endogenously determined instead of
3406-520: A war could support itself for an unlimited period if only money remained in the country ... For if money itself is "consumed", this simply means that it passes into someone else's possession, and this process may continue indefinitely. Multiplier doctrines had subsequently been expressed in more theoretical terms by the Dane Julius Wulff (1896), the Australian Alfred de Lissa (late 1890s),
3537-403: A whole intellectural framework - a novel theory of economics that explained why markets might not clear, which would evolve into a school of thought known as Keynesian economics , also called Keynesianism or Keynesian theory. In Keynes' theory, aggregate demand - by Keynes called "effective demand" - was key to determining output. Even if Keynes conceded that output might eventually return to
3668-514: Is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies . Macroeconomists study topics such as output / GDP (gross domestic product) and national income , unemployment (including unemployment rates ), price indices and inflation , consumption , saving , investment , energy , international trade , and international finance . Macroeconomics and microeconomics are
3799-547: Is affected. Expansionary monetary policy lowers interest rates, increasing economic activity, whereas contractionary monetary policy raises interest rates. In the case of a fixed exchange rate system, interest rate decisions together with direct intervention by central banks on exchange rate dynamics are major tools to control the exchange rate. In developed countries, most central banks follow inflation targeting , focusing on keeping medium-term inflation close to an explicit target, say 2%, or within an explicit range. This includes
3930-434: Is associated with the individual behaviours of households and firms, "microfoundations was taken to be the demand that macroeconomic models have microeconomic foundations". Therefore, microfoundations research focuses on the influences of individual actions and interactions on firm heterogeneity. As stated by Felin and Foss (2005), "organizations are made up of individuals, and there is no organization without individuals". Thus,
4061-493: Is gaining popularity even outside the field of economics, recent development includes operation management and project studies. The microfoundations project originated in the post-Second World War neoclassical synthesis where it is generally believed that neoclassical microeconomics fused with Keynesian macroeconomics. The 'neoclassical microeconomics' in mention is the Marshallian partial-equilibrium approach , which emerged from
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4192-510: Is however no reason to believe that the world (and thus our microfoundations) should be Walrasian. Although sympathetic to microfoundations overall, Solow points out that the demand for micro-foundations might be exaggerated; the harder sciences do not necessarily describe their objects of interest down to e.g. a molecular level. S. Abu Turab Rizvi has similarly offered critique against the microfoundation project in general equilibrium theory. Macroeconomics Heterodox Macroeconomics
4323-468: Is implemented through automatic stabilizers without any active decisions by politicians. Automatic stabilizers do not suffer from the policy lags of discretionary fiscal policy . Automatic stabilizers use conventional fiscal mechanisms, but take effect as soon as the economy takes a downturn: spending on unemployment benefits automatically increases when unemployment rises, and tax revenues decrease, which shelters private income and consumption from part of
4454-409: Is measured by the unemployment rate, i.e. the percentage of persons in the labor force who do not have a job, but who are actively looking for one. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are not part of the labor force and consequently not counted as unemployed, either. Unemployment has a short-run cyclical component which depends on
4585-405: Is one of Keynes's synonyms for "demand"). The levels of saving and investment are necessarily equal, and income is therefore held down to a level where the desire to save is no greater than the incentive to invest. The incentive to invest arises from the interplay between the physical circumstances of production and psychological anticipations of future profitability; but once these things are given
4716-416: Is referred to as an "environment's source function", and this function is depleted as resources are consumed or pollution contaminates the resources. The "sink function" describes an environment's ability to absorb and render harmless waste and pollution: when waste output exceeds the limit of the sink function, long-term damage occurs. The division into various time frames of macroeconomic research leads to
4847-464: Is that of an economy's openness, economic theory distinguishing sharply between closed economies and open economies . It is usual to distinguish between three time horizons in macroeconomics, each having its own focus on e.g. the determination of output: National output is the total amount of everything a country produces in a given period of time. Everything that is produced and sold generates an equal amount of income. The total net output of
4978-567: Is the orthodox Treasury dogma, steadfastly held ... [that] very little additional employment and no permanent additional employment can, in fact, be created by State borrowing and State expenditure. Keynes pounced on a flaw in the Treasury view . Cross-examining Sir Richard Hopkins , a Second Secretary in the Treasury, before the Macmillan Committee on Finance and Industry in 1930 he referred to
5109-470: Is the product of two inputs: capital and labor. The Solow model assumes that labor and capital are used at constant rates without the fluctuations in unemployment and capital utilization commonly seen in business cycles. In this model, increases in output, i.e. economic growth, can only occur because of an increase in the capital stock, a larger population, or technological advancements that lead to higher productivity ( total factor productivity ). An increase in
5240-476: Is understood to be "an application of underlying standpoint, methodological individualism," a concept which also has ambiguity in its meaning. Nevertheless, microfoundations research only means that individual behaviour must be shown to be consistent with macro entities. While there may be various outlooks on the topic, the general consensus implies that to bridge macro and micro theories and models, microfoundations should be adopted. Alan Kirman has argued against
5371-487: The liquidity preference function, which is the demand function that corresponds to money supply. It specifies the amount of money people will seek to hold according to the state of the economy. In Keynes's first (and simplest) account – that of Chapter 13 – liquidity preference is determined solely by the interest rates r —which is seen as the earnings forgone by holding wealth in liquid form: hence liquidity preference can be written L ( r ) and in equilibrium must equal
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5502-592: The Federal Reserve and the European Central Bank , which are generally considered to follow a strategy very close to inflation targeting, even though they do not officially label themselves as inflation targeters. In practice, an official inflation targeting often leaves room for the central bank to also help stabilize output and employment, a strategy known as "flexible inflation targeting". Most emerging economies focus their monetary policy on maintaining
5633-405: The Keynesian theory of macroeconomics argued that some of Keynes' assumptions were inconsistent with standard microeconomics . For example, Milton Friedman 's microeconomic theory of consumption over time (the ' permanent income hypothesis ') suggested that the marginal propensity to consume (the increase of consumer spending with increased income) due to temporary income, which is crucial for
5764-435: The Keynesian multiplier , was likely to be much smaller than Keynesians assumed. For this reason, many empirical studies have attempted to measure the marginal propensity to consume, and macroeconomists have also studied alternative microeconomic models (such as models of credit market imperfections and precautionary saving ) that might imply a greater marginal propensity to consume. One particularly influential endorsement of
5895-501: The Quantity theory of money determining the price level and the classical theory of the interest rate . In regards to employment, the condition referred to by Keynes as the "first postulate of classical economics" stated that the wage is equal to the marginal product, which is a direct application of the marginalist principles developed during the nineteenth century (see The General Theory ). Keynes sought to supplant all three aspects of
6026-553: The Walrasian general equilibrium theory . However, the Walrasian general equilibrium theory presents another trend to the synthesis as it attempts to theorise the economy as a whole and is viewed as an alternative to macroeconomics. This approach is considered to be the trigger for exploring microfoundations, however, the notion of a gap in the "micro-macro" link has been and continues to be explored in various theories and models. Critics of
6157-466: The economy ) strongly influences economic output and inflation . In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy . It is influenced by a host of factors that sometimes behave erratically and impact production, employment, and inflation . Keynesian economists generally argue that aggregate demand is volatile and unstable and that, consequently,
6288-451: The financial crisis of 2007–2008 sparked renewed interest in Keynesian policies by governments around the world. Macroeconomics is the study of the factors applying to an economy as a whole. Important macroeconomic variables include the overall price level, the interest rate , the level of employment, and income (or equivalently output) measured in real terms . The classical tradition of partial equilibrium theory had been to split
6419-412: The multiplier effect would magnify a small decrease in consumption or investment and cause declines throughout the economy, and noted the role that uncertainty and animal spirits can play in the economy. The generation following Keynes combined the macroeconomics of the General Theory with neoclassical microeconomics to create the neoclassical synthesis . By the 1950s, most economists had accepted
6550-547: The opportunity cost of holding money (identified with inflation rather than interest) and its influence on the velocity of circulation . In 1930, he published A Treatise on Money , intended as a comprehensive treatment of its subject "which would confirm his stature as a serious academic scholar, rather than just as the author of stinging polemics", and marks a large step in the direction of his later views. In it, he attributes unemployment to wage stickiness and treats saving and investment as governed by independent decisions:
6681-517: The post-war economic expansion (1945–1973). It was developed in part to attempt to explain the Great Depression and to help economists understand future crises. It lost some influence following the oil shock and resulting stagflation of the 1970s . Keynesian economics was later redeveloped as New Keynesian economics , becoming part of the contemporary new neoclassical synthesis , that forms current-day mainstream macroeconomics . The advent of
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#17328548107636812-413: The quantity theory of money protects the classical school from the conclusion Keynes expected from it. Saving is that part of income not devoted to consumption , and consumption is that part of expenditure not allocated to investment , i.e., to durable goods. Hence saving encompasses hoarding (the accumulation of income as cash) and the purchase of durable goods. The existence of net hoarding, or of
6943-408: The "first proposition" that "schemes of capital development are of no use for reducing unemployment" and asked whether "it would be a misunderstanding of the Treasury view to say that they hold to the first proposition". Hopkins responded that "The first proposition goes much too far. The first proposition would ascribe to us an absolute and rigid dogma, would it not?" Later the same year, speaking in
7074-572: The 1929 General Election on a promise to "reduce levels of unemployment to normal within one year by utilising the stagnant labour force in vast schemes of national development". David Lloyd George launched his campaign in March with a policy document, We can cure unemployment, which tentatively claimed that, "Public works would lead to a second round of spending as the workers spent their wages." Two months later Keynes, then nearing completion of his Treatise on money , and Hubert Henderson collaborated on
7205-551: The 1930s; these accomplishments were described in a 1937 article, published in response to the 1936 General Theory, sharing the Swedish discoveries. In 1923, Keynes published his first contribution to economic theory, A Tract on Monetary Reform , whose point of view is classical but incorporates ideas that later played a part in the General Theory . In particular, looking at the hyperinflation in European economies, he drew attention to
7336-411: The 1940s attempted to build a long-run growth model inspired by Keynesian demand-driven considerations. The Solow–Swan model worked out by Robert Solow and, independently, Trevor Swan in the 1950s achieved more long-lasting success, however, and is still today a common textbook model for explaining economic growth in the long-run. The model operates with a production function where national output
7467-594: The German/American Nicholas Johannsen (same period), and the Dane Fr. Johannsen (1925/1927). Kahn himself said that the idea was given to him as a child by his father. As the 1929 election approached "Keynes was becoming a strong public advocate of capital development" as a public measure to alleviate unemployment. Winston Churchill, the Conservative Chancellor, took the opposite view: It
7598-432: The Great Depression struck, the reigning economists had difficulty explaining how goods could go unsold and workers could be left unemployed. In the prevailing neoclassical economics paradigm, prices and wages would drop until the market cleared, and all goods and labor were sold. Keynes in his main work, the General Theory , initiated what is known as the Keynesian revolution . He offered a new interpretation of events and
7729-418: The Keynesian school. A central development in new classical thought came when Robert Lucas introduced rational expectations to macroeconomics. Prior to Lucas, economists had generally used adaptive expectations where agents were assumed to look at the recent past to make expectations about the future. Under rational expectations, agents are assumed to be more sophisticated. Consumers will not simply assume
7860-1169: The Lucas critique. Like classical models, new classical models had assumed that prices would be able to adjust perfectly and monetary policy would only lead to price changes. New Keynesian models investigated sources of sticky prices and wages due to imperfect competition , which would not adjust, allowing monetary policy to impact quantities instead of prices. Stanley Fischer and John B. Taylor produced early work in this area by showing that monetary policy could be effective even in models with rational expectations when contracts locked in wages for workers. Other new Keynesian economists, including Olivier Blanchard , Janet Yellen , Julio Rotemberg , Greg Mankiw , David Romer , and Michael Woodford , expanded on this work and demonstrated other cases where various market imperfections caused inflexible prices and wages leading in turn to monetary and fiscal policy having real effects. Other researchers focused on imperferctions in labor markets, developing models of efficiency wages or search and matching (SAM) models, or imperfections in credit markets like Ben Bernanke . By
7991-420: The assumption that if a surplus of goods or services exists, they would naturally drop in price to the point where they would be consumed. Given the backdrop of high and persistent unemployment during the Great Depression, Keynes argued that there was no guarantee that the goods that individuals produce would be met with adequate effective demand, and periods of high unemployment could be expected, especially when
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#17328548107638122-459: The basis of microfoundations. It is suggested that modern mainstream economics is based entirely on DSGE models. Therefore, the importance of microfoundations lies in its synonymous relationship with DSGE. The Smets-Wouters model is one example of the importance of microfoundations as it is regarded as a benchmark model for analysing monetary and fiscal policy. The model offers three main advantages of microfoundations: While these points summarise
8253-447: The business cycle, and a more permanent structural component, which can be loosely thought of as the average unemployment rate in an economy over extended periods, and which is often termed the natural or structural rate of unemployment. Cyclical unemployment occurs when growth stagnates. Okun's law represents the empirical relationship between unemployment and short-run GDP growth. The original version of Okun's law states that
8384-473: The capacity of the producers to satisfy those needs, everything that is produced would eventually be consumed once the appropriate price was found for it. This perception is reflected in Say's law and in the writing of David Ricardo , which states that individuals produce so that they can either consume what they have manufactured or sell their output so that they can buy someone else's output. This argument rests upon
8515-459: The case of a very low interest level, the economy may be in a liquidity trap in which monetary policy becomes ineffective, which makes fiscal policy the more potent tool to stabilize the economy. Thirdly, in regimes where monetary policy is tied to fulfilling other targets, in particular fixed exchange rate regimes, the central bank cannot simultaneously adjust its interest rates to mitigate domestic business cycle fluctuations, making fiscal policy
8646-559: The central bank, can help stabilize economic output, inflation, and unemployment over the business cycle . Keynesian economists generally advocate a regulated market economy – predominantly private sector , but with an active role for government intervention during recessions and depressions . Keynesian economics developed during and after the Great Depression from the ideas presented by Keynes in his 1936 book, The General Theory of Employment, Interest and Money . Keynes' approach
8777-461: The claim that the effect of public works is at the expense of expenditure elsewhere, admitting that this might arise if the revenue is raised by taxation, but says that other available means have no such consequences. As an example, he suggests that the money may be raised by borrowing from banks, since ... ... it is always within the power of the banking system to advance to the Government the cost of
8908-401: The classical theory. Although Keynes's work was crystallized and given impetus by the advent of the Great Depression , it was part of a long-running debate within economics over the existence and nature of general gluts . A number of the policies Keynes advocated to address the Great Depression (notably government deficit spending at times of low private investment or consumption), and many of
9039-483: The common practice of using a representative agent as micro-foundation for macroeconomic models . First, he suggests that there's a conviction that the model of an individual as a constrained maximiser is adequate. On the basis of the Sonnenschein–Mantel–Debreu theorem , he argues that this conviction is mistaken. Second, he argues that there are multiple reasons as to why the economy cannot be described by
9170-409: The consequences of international trade in goods , financial assets and possibly factor markets like labor migration and international relocation of firms (physical capital). It explores what determines import , export , the balance of trade and over longer horizons the accumulation of net foreign assets . An important topic is the role of exchange rates and the pros and cons of maintaining
9301-446: The cost of the roads. The demonstration relies on "Mr Meade's relation" (due to James Meade ) asserting that the total amount of money that disappears into culs-de-sac is equal to the original outlay, which in Kahn's words "should bring relief and consolation to those who are worried about the monetary sources" (p. 189). A respending multiplier had been proposed earlier by Hawtrey in
9432-503: The demand side), rather than " overproduction " (which would focus on the supply side), and advocating economic interventionism . Keynes specifically discussed underconsumption (which he wrote "under-consumption") in the General Theory, in Chapter 22, Section IV and Chapter 23, Section VII . Numerous concepts were developed earlier and independently of Keynes by the Stockholm school during
9563-412: The desire to adopt DSGE models - or microfoundations - there are limitations to the model with scholars stating that their forecast performance can be poor in terms of their ability to forecast individual variables. Therefore, there is continuous debate on the microfoundations project and its efficacy with an overall lack of consensus. Specialization in the management and organizational sciences has led to
9694-404: The development of the macroeconomic research mainstream . Macroeconomics encompasses a variety of concepts and variables, but above all the three central macroeconomic variables are output, unemployment, and inflation. Besides, the time horizon varies for different types of macroeconomic topics, and this distinction is crucial for many research and policy debates. A further important dimension
9825-678: The difference may be considerable. Economists interested in long-run increases in output study economic growth. Advances in technology, accumulation of machinery and other capital , and better education and human capital , are all factors that lead to increased economic output over time. However, output does not always increase consistently over time. Business cycles can cause short-term drops in output called recessions . Economists look for macroeconomic policies that prevent economies from slipping into either recessions or overheating and that lead to higher productivity levels and standards of living . The amount of unemployment in an economy
9956-427: The direction of his subsequent work. During 1933, he wrote essays on various economic topics "all of which are cast in terms of movement of output as a whole". At the time that Keynes wrote the General Theory , it had been a tenet of mainstream economic thought that the economy would automatically revert to a state of general equilibrium: it had been assumed that, because the needs of consumers are always greater than
10087-440: The economic system is dependant upon the environment. In this case, the circular flow of income diagram may be replaced by a more complex flow diagram reflecting the input of solar energy, which sustains natural inputs and environmental services which are then used as units of production . Once consumed, natural inputs pass out of the economy as pollution and waste. The potential of an environment to provide services and materials
10218-529: The economy , i.e. limiting the effects of the business cycle by conducting expansive policy when the economy is in a recession or contractive policy in the case of overheating . Structural policies may be labor market policies which aim to change the structural unemployment rate or policies which affect long-run propensities to save, invest, or engage in education or research and development. Central banks conduct monetary policy mainly by adjusting short-term interest rates . The actual method through which
10349-492: The economy into separate markets, each of whose equilibrium conditions could be stated as a single equation determining a single variable. The theoretical apparatus of supply and demand curves developed by Fleeming Jenkin and Alfred Marshall provided a unified mathematical basis for this approach, which the Lausanne School generalized to general equilibrium theory. For macroeconomics, relevant partial theories included
10480-454: The economy is usually measured as gross domestic product (GDP). Adding net factor incomes from abroad to GDP produces gross national income (GNI), which measures total income of all residents in the economy. In most countries, the difference between GDP and GNI are modest so that GDP can approximately be treated as total income of all the inhabitants as well, but in some countries, e.g. countries with very large net foreign assets (or debt),
10611-405: The economy was contracting in size. He saw the economy as unable to maintain itself at full employment automatically, and believed that it was necessary for the government to step in and put purchasing power into the hands of the working population through government spending. Thus, according to Keynesian theory, some individually rational microeconomic-level actions such as not investing savings in
10742-436: The economy was sufficient to explain the Great Depression , and that aggregate demand oriented explanations were not necessary. Friedman also argued that monetary policy was more effective than fiscal policy; however, Friedman doubted the government's ability to "fine-tune" the economy with monetary policy. He generally favored a policy of steady growth in money supply instead of frequent intervention. Friedman also challenged
10873-460: The economy, could hardly generate the large short-run output fluctuations that we observe. In addition, there is strong empirical evidence that monetary policy does affect real economic activity, and the idea that technological regress can explain recent recessions seems implausible. Despite criticism of the realism in the RBC models, they have been very influential in economic methodology by providing
11004-574: The effect of policy changes, using the assumption that changes of macroeconomic policy do not alter the microeconomics of the macroeconomy. In terms of solutions, DSGE modelling with representative agents has been the most prevalent among literatures. This approach "makes the microeconomic and the macroeconomic level of analysis coincide: a single agent, a utility maximizing individual, represents an entire sector, which may be, for instance banks, consumers, or firms". Therefore, DSGE modelling connects both microeconomic and macroeconomic theories, thus embodying
11135-601: The entire economy is called inflation . When prices decrease, there is deflation . Economists measure these changes in prices with price indexes . Inflation will increase when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to decreasing inflation and even in some cases deflation. Central bankers conducting monetary policy usually have as a main priority to avoid too high inflation, typically by adjusting interest rates. High inflation as well as deflation can lead to increased uncertainty and other negative consequences, in particular when
11266-466: The exogenous technological improvement used to explain growth in Solow's model. Another type of endogenous growth models endogenized the process of technological progress by modelling research and development activities by profit-maximizing firms explicitly within the growth models themselves. Since the 1970s, various environmental problems have been integrated into growth and other macroeconomic models to study their implications more thoroughly. During
11397-405: The fall in market income. There is a general consensus that both monetary and fiscal instruments may affect demand and activity in the short run (i.e. over the business cycle). Economists usually favor monetary over fiscal policy to mitigate moderate fluctuations, however, because it has two major advantages. First, monetary policy is generally implemented by independent central banks instead of
11528-478: The first examples of general equilibrium models based on microeconomic foundations and a specification of underlying shocks that aim to explain the main features of macroeconomic fluctuations, not only qualitatively, but also quantitatively. In this way, they were forerunners of the later DSGE models. New Keynesian economists responded to the new classical school by adopting rational expectations and focusing on developing micro-founded models that were immune to
11659-472: The former varying positively with the interest rate, the latter negatively. The velocity of circulation is expressed as a function of the rate of interest. He interpreted his treatment of liquidity as implying a purely monetary theory of interest. Keynes's younger colleagues of the Cambridge Circus and Ralph Hawtrey believed that his arguments implicitly assumed full employment , and this influenced
11790-437: The goods and services produced by the economy, if taken collectively by a large proportion of individuals and firms, can lead to outcomes wherein the economy operates below its potential output and growth rate. Prior to Keynes, a situation in which aggregate demand for goods and services did not meet supply was referred to by classical economists as a general glut , although there was disagreement among them as to whether
11921-429: The government takes on spending projects, it limits the amount of resources available for the private sector to use. Full crowding out occurs in the extreme case when government spending simply replaces private sector output instead of adding additional output to the economy. A crowding out effect may also occur if government spending should lead to higher interest rates, which would limit investment. Some fiscal policy
12052-418: The great landmarks of economic analysis". The "ratio" was soon rechristened the "multiplier" at Keynes's suggestion. The multiplier of Kahn's paper is based on a respending mechanism familiar nowadays from textbooks. Samuelson puts it as follows: Let's suppose that I hire unemployed resources to build a $ 1000 woodshed. My carpenters and lumber producers will get an extra $ 1000 of income... If they all have
12183-498: The ideas that became the basis for Keynesian economics in his main work, The General Theory of Employment, Interest and Money (1936). It was written during the Great Depression , when unemployment rose to 25% in the United States and as high as 33% in some countries. It is almost wholly theoretical, enlivened by occasional passages of satire and social commentary. The book had a profound impact on economic thought, and ever since it
12314-452: The impression that making society richer is the easiest thing in the world: the government just needs to spend more. In Kahn's paper, it is harder. For him, the initial expenditure must not be a diversion of funds from other uses, but an increase in the total expenditure: something impossible – if understood in real terms – under the classical theory that the level of expenditure is limited by the economy's income/output. On page 174, Kahn rejects
12445-457: The incentive is independent of income and depends solely on the rate of interest r . Keynes designates its value as a function of r as the "schedule of the marginal efficiency of capital ". The propensity to save behaves quite differently. Saving is simply that part of income not devoted to consumption, and: ... the prevailing psychological law seems to be that when aggregate income increases, consumption expenditure will also increase but to
12576-493: The inflation (or deflation) is unexpected. Consequently, most central banks aim for a positive, but stable and not very high inflation level. Changes in the inflation level may be the result of several factors. Too much aggregate demand in the economy will cause an overheating , raising inflation rates via the Phillips curve because of a tight labor market leading to large wage increases which will be transmitted to increases in
12707-538: The interest rate is changed differs from central bank to central bank, but typically the implementation happens either directly via administratively changing the central bank's own offered interest rates or indirectly via open market operations . Via the monetary transmission mechanism , interest rate changes affect investment , consumption , asset prices like stock prices and house prices , and through exchange rate reactions export and import . In this way aggregate demand , employment and ultimately inflation
12838-466: The late 1990s, economists had reached a rough consensus. The market imperfections and nominal rigidities of new Keynesian theory was combined with rational expectations and the RBC methodology to produce a new and popular type of models called dynamic stochastic general equilibrium (DSGE) models. The fusion of elements from different schools of thought has been dubbed the new neoclassical synthesis . These models are now used by many central banks and are
12969-417: The macro economy. RBC models were created by combining fundamental equations from neo-classical microeconomics to make quantitative models. In order to generate macroeconomic fluctuations, RBC models explained recessions and unemployment with changes in technology instead of changes in the markets for goods or money. Critics of RBC models argue that technological changes, which typically diffuse slowly throughout
13100-434: The macro/micro divide is institutionalized in the field of economics. Most economists identify as either macro- or micro-economists. Macroeconomics is traditionally divided into topics along different time frames: the analysis of short-term fluctuations over the business cycle , the determination of structural levels of variables like inflation and unemployment in the medium (i.e. unaffected by short-term deviations) term, and
13231-437: The money market is modeled as giving equilibrium between the money supply and liquidity preference (equivalent to money demand). Keynesian economics Heterodox Keynesian economics ( / ˈ k eɪ n z i ə n / KAYN -zee-ən ; sometimes Keynesianism , named after British economist John Maynard Keynes ) are the various macroeconomic theories and models of how aggregate demand (total spending in
13362-437: The multiplier has influenced Keynesian theory. It differs significantly from Kahn's paper and even more from Keynes's book. The designation of the initial spending as "investment" and the employment-creating respending as "consumption" echoes Kahn faithfully, though he gives no reason why initial consumption or subsequent investment respending should not have exactly the same effects. Henry Hazlitt , who considered Keynes as much
13493-420: The new classical real business cycle models , microfounded computable general equilibrium (CGE) models used for medium-term (structural) questions like international trade or tax reforms, Dynamic stochastic general equilibrium (DSGE) models used to analyze business cycles, not least in many central banks, or integrated assessment models like DICE . The IS–LM model, invented by John Hicks in 1936, gives
13624-564: The oil crises of the 1970s when scarcity problems of natural resources were high on the public agenda, economists like Joseph Stiglitz and Robert Solow introduced non-renewable resources into neoclassical growth models to study the possibilities of maintaining growth in living standards under these conditions. More recently, the issue of climate change and the possibilities of a sustainable development are examined in so-called integrated assessment models , pioneered by William Nordhaus . In macroeconomic models in environmental economics ,
13755-606: The only usable tool for such countries. Macroeconomic teaching, research and informed debates normally evolve around formal ( diagrammatic or equational ) macroeconomic models to clarify assumptions and show their consequences in a precise way. Models include simple theoretical models, often containing only a few equations, used in teaching and research to highlight key basic principles, and larger applied quantitative models used by e.g. governments, central banks, think tanks and international organisations to predict effects of changes in economic policy or other exogenous factors or as
13886-475: The original simple Phillips curve relationship between inflation and unemployment. Friedman and Edmund Phelps (who was not a monetarist) proposed an "augmented" version of the Phillips curve that excluded the possibility of a stable, long-run tradeoff between inflation and unemployment. When the oil shocks of the 1970s created a high unemployment and high inflation, Friedman and Phelps were vindicated. Monetarism
14017-465: The political institutions that control fiscal policy. Independent central banks are less likely to be subject to political pressures for overly expansionary policies. Second, monetary policy may suffer shorter inside lags and outside lags than fiscal policy. There are some exceptions, however: Firstly, in the case of a major shock, monetary stabilization policy may not be sufficient and should be supplemented by active fiscal stabilization. Secondly, in
14148-408: The possibility of the third category," which Keynes defines as involuntary unemployment . Keynes raises two objections to the classical theory's assumption that "wage bargains ... determine the real wage". The first lies in the fact that "labour stipulates (within limits) for a money-wage rather than a real wage". The second is that classical theory assumes that, "The real wages of labour depend on
14279-449: The price level are directly caused by changes in the money supply . Whereas there is empirical evidence that there is a long-run positive correlation between the growth rate of the money stock and the rate of inflation, the quantity theory has proved unreliable in the short- and medium-run time horizon relevant to monetary policy and is abandoned as a practical guideline by most central banks today. Open economy macroeconomics deals with
14410-518: The price of the products of employers. Too little aggregate demand will have the opposite effect of creating more unemployment and lower wages, thereby decreasing inflation. Aggregate supply shocks will also affect inflation, e.g. the oil crises of the 1970s and the 2021–2023 global energy crisis . Changes in inflation may also impact the formation of inflation expectations , creating a self-fulfilling inflationary or deflationary spiral. The monetarist quantity theory of money holds that changes in
14541-442: The principles of microeconomics. There, bridging these two domains continues to be a topic of debate for organizational, management and strategy scholars. As a result, microfoundations has become a topic of greater interest to researchers as it explores how micro and macro areas connect. The microfoundations project was developed on the basis that if macroeconomics is associated with aggregate economic models, and microeconomics
14672-443: The relationships between macroeconomic variables. Presently, many macroeconomic models, representing different theories, are derived by aggregating microeconomic models , allowing economists to test them with both macroeconomic and microeconomic data. However, microfoundations research is still heavily debated with management, strategy and organization scholars having varying views on the "micro-macro" link. The study of microfoundations
14803-403: The roads without in any way affecting the flow of investment along the normal channels. This assumes that banks are free to create resources to answer any demand. But Kahn adds that ... ... no such hypothesis is really necessary. For it will be demonstrated later on that, pari passu with the building of roads, funds are released from various sources at precisely the rate that is required to pay
14934-416: The same predictions even as the underlying model generating the data changed. He advocated models based on fundamental economic theory (i.e. having an explicit microeconomic foundation ) that would, in principle, be structurally accurate as economies changed. Following Lucas's critique, new classical economists, led by Edward C. Prescott and Finn E. Kydland , created real business cycle (RBC) models of
15065-494: The savings rate leads to a temporary increase as the economy creates more capital, which adds to output. However, eventually the depreciation rate will limit the expansion of capital: savings will be used up replacing depreciated capital, and no savings will remain to pay for an additional expansion in capital. Solow's model suggests that economic growth in terms of output per capita depends solely on technological advances that enhance productivity. The Solow model can be interpreted as
15196-417: The specific level of the microfoundations project is the individual level as it focuses on this elementary truth. However, there are various assumptions and half-truths that have been explored by scholars within microfoundations research. There are two main assumptions that the microfoundations project rests upon: However, in addition to these assumptions, various scholars have indicated that microfoundations
15327-749: The study of long-term economic growth. It also studies the consequences of policies targeted at mitigating fluctuations like fiscal or monetary policy , using taxation and government expenditure or interest rates, respectively, and of policies that can affect living standards in the long term, e.g. by affecting growth rates. Macroeconomics as a separate field of research and study is generally recognized to start in 1936, when John Maynard Keynes published his The General Theory of Employment, Interest and Money , but its intellectual predecessors are much older. Since World War II, various macroeconomic schools of thought like Keynesians , monetarists , new classical and new Keynesian economists have made contributions to
15458-428: The study of microfoundations was Robert Lucas, Jr. 's critique of traditional macroeconometric forecasting models . After the apparent shift of the Phillips curve relationship during the 1970s, Lucas argued that the correlations between aggregate variables observed in macroeconomic data would tend to change whenever macroeconomic policy changed. This implied that microfounded models are more appropriate for predicting
15589-414: The synthesis view of the macroeconomy. Economists like Paul Samuelson , Franco Modigliani , James Tobin , and Robert Solow developed formal Keynesian models and contributed formal theories of consumption, investment, and money demand that fleshed out the Keynesian framework. Milton Friedman updated the quantity theory of money to include a role for money demand. He argued that the role of money in
15720-407: The theoretical ideas he proposed (effective demand, the multiplier, the paradox of thrift ), had been advanced by authors in the 19th and early 20th centuries. (E.g. J. M. Robertson raised the paradox of thrift in 1892 . ) Keynes's unique contribution was to provide a general theory of these, which proved acceptable to the economic establishment. An intellectual precursor of Keynesian economics
15851-502: The time the sole economics professor at Cambridge. He had a continuing interest in the subject of unemployment, having expressed the view in his popular Unemployment (1913) that it was caused by "maladjustment between wage-rates and demand" – a view Keynes may have shared prior to the years of the General Theory . Nor were his practical recommendations very different: "on many occasions in the thirties" Pigou "gave public support [...] to State action designed to stimulate employment". Where
15982-438: The two men differed is in the link between theory and practice. Keynes was seeking to build theoretical foundations to support his recommendations for public works while Pigou showed no disposition to move away from classical doctrine. Referring to him and Dennis Robertson , Keynes asked rhetorically: "Why do they insist on maintaining theories from which their own practical conclusions cannot possibly follow?" Keynes set forward
16113-505: The two most general fields in economics. The focus of macroeconomics is often on a country (or larger entities like the whole world) and how its markets interact to produce large-scale phenomena that economists refer to as aggregate variables. In microeconomics the focus of analysis is often a single market, such as whether changes in supply or demand are to blame for price increases in the oil and automotive sectors. From introductory classes in "principles of economics" through doctoral studies,
16244-419: The underpinnings of aggregate demand (itself discussed below). It answers the question "At any given price level, what is the quantity of goods demanded?" The graphic model shows combinations of interest rates and output that ensure equilibrium in both the goods and money markets under the model's assumptions. The goods market is modeled as giving equality between investment and public and private saving (IS), and
16375-426: The wage bargains which labour makes with the entrepreneurs," whereas, "If money wages change, one would have expected the classical school to argue that prices would change in almost the same proportion, leaving the real wage and the level of unemployment practically the same as before." Keynes considers his second objection the more fundamental, but most commentators concentrate on his first one: it has been argued that
16506-402: The word "macroeconomics" itself in a journal title in 1946. but naturally several of the themes which are central to macroeconomic research had been discussed by thoughtful economists and other writers long before 1936. In particular, macroeconomic questions before Keynes were the topic of the two long-standing traditions of business cycle theory and monetary theory . William Stanley Jevons
16637-525: Was underconsumption theories associated with John Law , Thomas Malthus , the Birmingham School of Thomas Attwood , and the American economists William Trufant Foster and Waddill Catchings , who were influential in the 1920s and 1930s. Underconsumptionists were, like Keynes after them, concerned with failure of aggregate demand to attain potential output, calling this "underconsumption" (focusing on
16768-414: Was a stark contrast to the aggregate supply -focused classical economics that preceded his book. Interpreting Keynes's work is a contentious topic, and several schools of economic thought claim his legacy. Keynesian economics, as part of the neoclassical synthesis , served as the standard macroeconomic model in the developed nations during the later part of the Great Depression , World War II , and
16899-468: Was one of the pioneers of the first tradition, whereas the quantity theory of money , labelled the oldest surviving theory in economics, as an example of the second was described already in the 16th century by Martín de Azpilcueta and later discussed by personalities like John Locke and David Hume . In the first decades of the 20th century monetary theory was dominated by the eminent economists Alfred Marshall , Knut Wicksell and Irving Fisher . When
17030-416: Was particularly influential in the early 1980s, but fell out of favor when central banks found the results disappointing when trying to target money supply instead of interest rates as monetarists recommended, concluding that the relationships between money growth, inflation and real GDP growth are too unstable to be useful in practical monetary policy making. New classical macroeconomics further challenged
17161-463: Was published there has been debate over its meaning. Keynes begins the General Theory with a summary of the classical theory of employment, which he encapsulates in his formulation of Say's Law as the dictum " Supply creates its own demand ". He also wrote that although his theory was explained in terms of an Anglo-Saxon laissez faire economy, his theory was also more general in the sense that it would be easier to adapt to "totalitarian states" than
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