Heterodox
104-441: New classical macroeconomics , sometimes simply called new classical economics , is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics , especially rational expectations . New classical macroeconomics strives to provide neoclassical microeconomic foundations for macroeconomic analysis. This
208-490: A countercyclical variable has a negative correlation. An acyclical variable, with correlation close to zero, implies no systematic relationship to the business cycle. We find that productivity is slightly procyclical. This implies workers and capital are more productive when the economy is experiencing a boom. They are not quite as productive when the economy is experiencing a slowdown. Similar explanations follow for consumption and investment, which are strongly procyclical. Labor
312-690: 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
416-623: 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
520-436: 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
624-468: 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
728-799: 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 ,
832-610: 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
936-399: A consensus on the best way to explain short-run fluctuations in the economy. The new synthesis took elements from both schools. New classical economics contributed the methodology behind real business cycle theory and new Keynesian economics contributed nominal rigidities (slow moving and periodic, rather than continuous, price changes also called sticky prices ). The new synthesis provides
1040-564: 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
1144-495: A failure of markets to clear but rather reflect the most efficient possible operation of the economy, given the structure of the economy. RBC theory is associated with freshwater economics (the Chicago School of Economics in the neoclassical tradition). If we were to take snapshots of an economy at different points in time, no two photos would look alike. This occurs for two reasons: A common way to observe such behavior
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#17328513013501248-442: 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
1352-459: A model which only achieves a coefficient of 80% really is. The real business cycle theory relies on three assumptions which according to economists such as Greg Mankiw and Larry Summers are unrealistic: 1. The model is driven by large and sudden changes in available production technology. 2. Unemployment reflects changes in the amount people want to work. 3. Monetary policy is irrelevant for economic fluctuations. Another major criticism
1456-420: 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
1560-543: A positive but temporary shock to productivity. This momentarily increases the effectiveness of workers and capital, allowing a given level of capital and labor to produce more output. Individuals face two types of tradeoffs. One is the consumption-investment decision. Since productivity is higher, people have more output to consume. An individual might choose to consume all of it today. But if he values future consumption, all that extra output might not be worth consuming in its entirety today. Instead, he may consume some but invest
1664-498: 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
1768-449: A similar story for investment, the relationship with capital in Figure 6 departs from the story. We need a way to pin down a better story; one way is to look at some statistics. By eyeballing the data, we can infer several regularities, sometimes called stylized facts . One is persistence. For example, if we take any point in the series above the trend (the x-axis in figure 3), the probability
1872-459: A smoother growth trend. A common method to obtain this trend is the Hodrick–Prescott filter . The basic idea is to find a balance between the extent to which general growth trend follows the cyclical movement (since long term growth rate is not likely to be perfectly constant) and how smooth it is. The HP filter identifies the longer term fluctuations as part of the growth trend while classifying
1976-541: 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
2080-403: 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
2184-514: 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
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#17328513013502288-414: Is a slump, people are choosing to be in that slump because given the situation, it is the best solution. This suggests laissez-faire (non-intervention) is the best policy of government towards the economy but given the abstract nature of the model, this has been debated. A precursor to RBC theory was developed by monetary economists Milton Friedman and Robert Lucas in the early 1970s. They envisioned
2392-547: 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
2496-401: Is also procyclical while capital stock appears acyclical. Observing these similarities yet seemingly non-deterministic fluctuations about trend, the question arises as to why any of this occurs. Since people prefer economic booms over recessions, it follows that if all people in the economy make optimal decisions, these fluctuations are caused by something outside the decision-making process. So
2600-486: Is based on Walrasian assumptions . All agents are assumed to maximize utility on the basis of rational expectations . At any one time, the economy is assumed to have a unique equilibrium at full employment or potential output achieved through price and wage adjustment. In other words, the market clears at all times. New classical economics has also pioneered the use of representative agent models. Such models have received severe neoclassical criticism, pointing to
2704-548: Is by looking at a time series of an economy's output, more specifically gross national product (GNP). This is just the value of the goods and services produced by a country's businesses and workers. Figure 1 shows the time series of real GNP for the United States from 1954–2005. While we see continuous growth of output, it is not a steady increase. There are times of faster growth and times of slower growth. Figure 2 transforms these levels into growth rates of real GNP and extracts
2808-468: 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
2912-411: Is in contrast with its rival new Keynesian school that uses microfoundations , such as price stickiness and imperfect competition , to generate macroeconomic models similar to earlier, Keynesian ones. Classical economics is the term used for the first modern school of economics. The publication of Adam Smith 's The Wealth of Nations in 1776 is considered to be the birth of the school. Perhaps
3016-427: Is known as neoclassical economics . This neoclassical formulation had also been formalized by Alfred Marshall . However, it was the general equilibrium of Walras that helped solidify the research in economic science as a mathematical and deductive enterprise, the essence of which is still neoclassical and makes up what is currently found in mainstream economics textbooks to this day. The neoclassical school dominated
3120-409: 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
3224-416: 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
New classical macroeconomics - Misplaced Pages Continue
3328-460: Is that individuals and firms respond optimally over the long run. It follows that business cycles exhibited in an economy are chosen in preference to no business cycles at all. This is not to say that people like to be in a recession. Slumps are preceded by an undesirable productivity shock which constrains the situation. But given these new constraints, people will still achieve the best outcomes possible and markets will react efficiently. So when there
3432-464: 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
3536-420: Is the labor-leisure tradeoff. Higher productivity encourages substitution of current work for future work since workers will earn more per hour today compared to tomorrow. More labor and less leisure results in greater output, consumption, and investment today. On the other hand, there is an opposing effect: since workers are earning more, they may not want to work as much today and in future periods. However, given
3640-408: Is the least volatile of the indicators. Yet another regularity is the co-movement between output and the other macroeconomic variables. Figures 4 – 6 illustrated such relationship. We can measure this in more detail using correlations as listed in column B of Table 1. A procyclical variable has a positive correlation since it usually increases during booms and decreases during recessions. Vice versa,
3744-470: 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
3848-406: The 1973–75 recession which was largely triggered by the 1973 oil crisis . The nascent classical economists ignored the broader global economic conditions of the time in favor of targeting Keynesian policy responses for continued unemployment , high inflation and stagnant economic growth— stagflation . Conversely, the emerging global markets left traditional Keynesian schools struggling to reconcile
3952-592: 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
4056-833: The Lucas critique primarily as a means to cast doubt on the Keynesian model. This strengthened the case for macro models to be based on microeconomics. After the 1970s, the New Classical school for a while became the dominant school in Macroeconomics. Prior to the late 1990s, macroeconomics was split between new Keynesian work on market imperfections demonstrated with small models and new classical work on real business cycle theory that used fully specified general equilibrium models and used changes in technology to explain fluctuations in economic output. The new neoclassical synthesis developed as
4160-501: The Phillips curve with the current economic conditions, which ruled out concurrent high inflation and high unemployment. The New Classical school emerged in the 1970s as a response to what were perceived as failures of Keynesian economics to explain stagflation. New Classical and monetarist criticisms led by Robert Lucas, Jr. and Milton Friedman respectively forced a labored rethinking of Keynesian economics. In particular, Lucas designed
4264-468: 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
New classical macroeconomics - Misplaced Pages Continue
4368-435: The pro-cyclical nature of labor, it seems that the above substitution effect dominates this income effect . Overall, the basic RBC model predicts that given a temporary shock, output, consumption, investment and labor all rise above their long-term trends and hence formulate into a positive deviation. Furthermore, since more investment means more capital is available for the future, a short-lived shock may have an impact in
4472-702: The 0 axis) peaks. We call relatively large negative deviations (those below the 0 axis) troughs. A series of positive deviations leading to peaks are booms and a series of negative deviations leading to troughs are recessions . At a glance, the deviations just look like a string of waves bunched together—nothing about it appears consistent. To explain causes of such fluctuations may appear rather difficult given these irregularities. However, if we consider other macroeconomic variables, we will observe patterns in these irregularities. For example, consider Figure 4 which depicts fluctuations in output and consumption spending, i.e. what people buy and use at any given period. Observe how
4576-411: 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
4680-491: 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
4784-418: 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
4888-1169: 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
4992-546: The business cycle, RBC theory sees business cycle fluctuations as the efficient response to exogenous changes in the real economic environment. That is, the level of national output necessarily maximizes expected utility , and governments should therefore concentrate on long-run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to actively smooth out economic short-term fluctuations. According to RBC theory, business cycles are therefore " real " in that they do not represent
5096-447: 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
5200-459: 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
5304-453: The central idea behind it is on the ability of the market to be self-correcting as well as being the most superior institution in allocating resources. The central assumption implied is that all individuals maximize their utility. The so-called marginal revolution that occurred in Europe in the late 19th century, led by Carl Menger , William Stanley Jevons , and Léon Walras , gave rise to what
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#17328513013505408-409: 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
5512-404: 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
5616-678: 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
5720-401: The discount rate, and the rate of capital depreciation are used in the creation of simulated variable paths. These tend to be estimated from econometric studies, with 95% confidence intervals. If the full range of possible values for these variables is used, correlation coefficients between actual and simulated paths of economic variables can shift wildly, leading some to question how successful
5824-486: The disjuncture between microeconomic behavior and macroeconomic results, as indicated by Alan Kirman . The concept of rational expectations was originally used by John Muth , and was popularized by Lucas. One of the most famous new classical models is the real business cycle model, developed by Edward C. Prescott and Finn E. Kydland . It turned out that pure new classical models had low explanatory and predictive power. The models could not simultaneously explain both
5928-579: The drawing board to change the model in the face of overwhelming evidence against the model being correct; this inverts the burden of proof away from the builder of the model. In fact, simply stated, it is the process of changing the model to fit the data. Since RBC models explain data ex post, it is very difficult to falsify any one model that could be hypothesised to explain the data. RBC models are highly sample specific, leading some to believe that they have little or no predictive power. Crucial to RBC models, "plausible values" for structural variables such as
6032-425: The duration and magnitude of actual cycles. Additionally, the model's key result that only unexpected changes in money can affect the business cycle and unemployment did not stand empirical tests. The mainstream turned to the new neoclassical synthesis . Most economists, even most new classical economists, accepted the new Keynesian notion that for several reasons wages and prices do not move quickly and smoothly to
6136-440: 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
6240-529: 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
6344-454: 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),
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#17328513013506448-494: 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
6552-545: The economy would just continue following the growth trend with no business cycles. To quantitatively match the stylized facts in Table 1, Kydland and Prescott introduced calibration techniques. Using this methodology, the model closely mimics many business cycle properties. Yet current RBC models have not fully explained all behavior and neoclassical economists are still searching for better variations. The main assumption in RBC theory
6656-414: 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
6760-601: 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
6864-466: 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
6968-429: The factor that influenced people's decisions to be misperception of wages —that booms and recessions occurred when workers perceived wages higher or lower than they really were. This meant they worked and consumed more or less than otherwise. In a world of perfect information, there would be no booms or recessions. Unlike estimation, which is usually used for the construction of economic models, calibration only returns to
7072-405: 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
7176-479: The field up until the Great Depression of the 1930s. Then, however, with the publication of The General Theory of Employment, Interest and Money by John Maynard Keynes in 1936, certain neoclassical assumptions were rejected. Keynes proposed an aggregated framework to explain macroeconomic behavior, leading thus to the current distinction between micro- and macroeconomics . Of particular importance in Keynes' theories
7280-478: 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
7384-410: The future. That is, above-trend behavior may persist for some time even after the shock disappears. This capital accumulation is often referred to as an internal "propagation mechanism", since it may increase the persistence of shocks to output. A string of such productivity shocks will likely result in a boom. Similarly, recessions follow a string of bad shocks to the economy. If there were no shocks,
7488-429: 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
7592-443: 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
7696-538: 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
7800-495: The key question really is: what main factor influences and subsequently changes the decisions of all factors in an economy? Economists have come up with many ideas to answer the above question. The one which currently dominates the academic literature on real business cycle theory was introduced by Finn E. Kydland and Edward C. Prescott in their 1982 work Time to Build And Aggregate Fluctuations . They envisioned this factor to be technological shocks—i.e., random fluctuations in
7904-466: 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
8008-468: The line imply deviations. By using log real GNP the distance between any point and the 0 line roughly equals the percentage deviation from the long run growth trend. Also note that the Y-axis uses very small values. This indicates that the deviations in real GNP are very small comparatively, and might be attributable to measurement errors rather than real deviations. We call large positive deviations (those above
8112-417: 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
8216-434: 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
8320-420: The money market is modeled as giving equilibrium between the money supply and liquidity preference (equivalent to money demand). Real business cycle theory Heterodox Real business-cycle theory ( RBC theory ) is a class of new classical macroeconomics models in which business-cycle fluctuations are accounted for by real (in contrast to nominal) shocks . Unlike other leading theories of
8424-415: The more jumpy fluctuations as part of the cyclical component. Observe the difference between this growth component and the jerkier data. Economists refer to these cyclical movements about the trend as business cycles . Figure 3 explicitly captures such deviations. Note the horizontal axis at 0. A point on this line indicates at that year, there is no deviation from the trend. All other points above and below
8528-420: 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
8632-626: The next period is still above the trend is very high. However, this persistence wears out over time. That is, economic activity in the short run is quite predictable but due to the irregular long-term nature of fluctuations, forecasting in the long run is much more difficult if not impossible. Another regularity is cyclical variability. Column A of Table 1 lists a measure of this with standard deviations . The magnitude of fluctuations in output and hours worked are nearly equal. Consumption and productivity are similarly much smoother than output while investment fluctuates much more than output. The capital stock
8736-564: 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 ,
8840-606: 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
8944-475: 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
9048-469: The peaks and troughs align at almost the same places and how the upturns and downturns coincide. We might predict that other similar data may exhibit similar qualities. For example, (a) labor, hours worked (b) productivity, how effective firms use such capital or labor, (c) investment, amount of capital saved to help future endeavors, and (d) capital stock, value of machines, buildings and other equipment that help firms produce their goods. While Figure 5 shows
9152-465: 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
9256-449: 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
9360-518: 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
9464-659: The productivity level that shifted the constant growth trend up or down. Examples of such shocks include innovations, bad weather, imported oil price increase, stricter environmental and safety regulations, etc. The general gist is that something occurs that directly changes the effectiveness of capital and/or labour. This in turn affects the decisions of workers and firms, who in turn change what they buy and produce and thus eventually affect output. RBC models predict time sequences of allocation for consumption, investment, etc. given these shocks. But exactly how do these productivity shocks cause ups and downs in economic activity? Consider
9568-476: The rest in capital to enhance production in subsequent periods and thus increase future consumption. This explains why investment spending is more volatile than consumption. The life-cycle hypothesis argues that households base their consumption decisions on expected lifetime income and so they prefer to "smooth" consumption over time. They will thus save (and invest) in periods of high income and defer consumption of this to periods of low income. The other decision
9672-416: 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
9776-494: 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
9880-749: 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
9984-414: 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
10088-427: The theoretical foundation for much of contemporary mainstream economics. The new classical perspective takes root in three diagnostic sources of fluctuations in growth: the productivity wedge, the capital wedge, and the labor wedge. Through the neoclassical perspective and business cycle accounting one can look at the diagnostics and find the main ‘culprits’ for fluctuations in the real economy. New classical economics
10192-505: 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,
10296-419: 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
10400-475: The values needed for long-run equilibrium between quantities supplied and demanded. Therefore, they also accept the monetarist and new Keynesian view that monetary policy can have a considerable effect in the short run . The new classical macroeconomics contributed the rational expectations hypothesis and the idea of intertemporal optimisation to new Keynesian economics and the new neoclassical synthesis. Macroeconomics Heterodox Macroeconomics
10504-402: 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
10608-529: Was his explanation of economic behavior as also being led by "animal spirits". In this sense, it limited the role for the so-called rational (maximizing) agent. The Post-World War II period saw the widespread implementation of Keynesian economic policy in the United States and Western European countries. Its dominance in the field by the 1970s was best reflected by the controversial statement attributed to US President Richard Nixon and economist Milton Friedman : " We are all Keynesians now ". Problems arose during
10712-468: 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
10816-416: 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
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