CHAPTER ONE

The State of Macroeconomics

After studying this chapter, students will be able to:
Define the term macroeconomics
Discuss the difference between macroeconomics and microeconomics
Explain the focus areas of macroeconomics
Identify the reasons for the development of macroeconomics as a separate subject.
Differentiate between different classes of macroeconomics
Discuss the goals and instruments of macroeconomics
1. Introduction

Macroeconomics is concerned with the behavior of the economy as a whole- with booms and
recessions, the economy’s total output of goods and services and the growth of output, the rates of
inflation and unemployment, the balance of payments and the exchange rates.
The difference between microeconomics and macroeconomics is primarily one of emphasis and
exposition. In studying price determination in a single industry, it is convenient for
microeconomics to assume that prices in other industries are given. In macroeconomics, in which
we study the average price level, it is for the most part sensible to ignore changes in relative
prices of goods among different industries. In microeconomics, it is convenient to assume that
the total income of all consumers is given and then to ask how consumers divide their spending of
that income among different goods. In macroeconomics, by contrast, the aggregate level of
income or spending is among the key variables to be studied.
The most helpful circumstance for the rapid propagation of a new revolutionary theory is the
existence of an established orthodoxy, which is clearly inconsistent with the most salient
facts of reality. The inability of the classical model to account adequately for the collapse of
output and employment in the 1930s paved the way for the Keynesian revolution. During the
1950s and 1960s, the neoclassical synthesis became the accepted wisdom for the majority of
economists.

1.1 Definition of Macroeconomics

Macroeconomics is concerned with the structure, performance and behaviour of the economy as a
whole. It explains the overall level of a nation’s output, employment, prices, and foreign trade.
The prime concern of macroeconomists is to analyse and attempt to understand the
underlying determinants of the main aggregate trends in the economy with respect to the total
output of goods and services (GDP), unemployment, inflation and international transactions.

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In particular, macroeconomic analysis seeks to explain the cause and impact of short-run
fluctuations in GDP (the business cycle), and the major determinants of the long-run path of GDP
(economic growth). Obviously the subject matter of macroeconomics is of crucial importance
because in one way or another macroeconomic events have an important influence on the
lives and welfare of all of us.
Traditionally, economics is divided into microeconomics, which studies the behaviour of
individuals and organizations (consumers, firms and the like) at a disaggregated level, and
macroeconomics, which studies the overall or aggregate behaviour of the economy. Since our
interest here is with macroeconomics, we seek to explain phenomena such as inflation,
unemployment, and economic growth and we are not concerned with, say, the demand for or
supply of a specific commodity. Macroeconomics is concerned with the behaviour of the
economy as a whole- with booms and recessions, the economy’s total output of goods and
services and the growth of output, the rate of inflation and unemployment, the balance of
payments, and exchange rates. Macroeconomics focuses on the economic behaviour and policies
that affect consumption and investment, trade balance, the determinants of changes in wages and
prices, monetary and fiscal policies, the money stock, government budget, interest rate, and
national debt. In macroeconomics, we do two things. First, we seek to understand the economic
functioning of the world we live in; and, second, we ask if we can do anything to improve the
performance of the economy.
1.2 Macroeconomic Goal and Instruments
In macroeconomics we deal with the market for goods as a whole, treating all the markets for
different goods as a single market. Similarly, we deal with the labour market and the asset market
as a whole.
An economy that has successful macroeconomic management should experience low
unemployment and inflation, and steady and sustained economic growth. In contrast, in a country
where there is macroeconomic mismanagement, we will observe an adverse impact on the living
standards and employment opportunities of the citizens of that country. In extreme circumstances,
the consequences of macroeconomic instability have been devastating. For example, the
catastrophic political and economic consequences of failing to maintain macroeconomic
stability among the major industrial nations during the period 1918–33 ignited a chain of events
that contributed to the outbreak of the Second World War, with disastrous consequences for both
humanity and the world economy .
Macroeconomics deals with such major issues
Economic growth
Inflation

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 Unemployment
Foreign trade

Based on those problems the objectives of macroeconomics are:

 Generating a high level of production of economic goods and services for the population.
 High employment - providing jobs
 A stable or gently rising level of price level with prices and wages are determined by
free markets.
 Foreign economic relations marked by a stable foreign exchange rate and exports
more or less balancing imports.

1.3. THE STATE OF MACROECONOMICS: EVOLUTION AND RECENT

DEVELOPMENTS

1. INTRODUCTION

Macroeconomic thought has evolved considerably over time. We cannot hope to understand fully
our modern theories and debates if we do not understand the history of our thoughts and how they
have evolved. To understand our present we have to know and understand our past; because there
is a high thread of unity in human thinking: current ideas are old ideas but with some changes in
form or shape. In other words, to understand present theories well we have to be clear with
theories in the past since the later contributed a lot for the development of the former. This can
clearly be understood from the following statement by one of the giant scientists, Isaac Newton:
If I have seen further than others, it is because I was standing on the shoulders of the giants
(cited in Jones, 2002:101).

Exploring the evolution of macroeconomic thought will also provide several other benefits as you
will learn a lot of economics in the process, you will learn some important historical knowledge,
and you will understand better the policy debates that occur between our political parties. The
theoretical framework we will tend to use is the IS-LM/AS-AD model that we will develop later
in chapter three.

As we defined earlier, macroeconomics is concerned with the structure, performance and

behaviour of the economy as a whole. The prime concern of macroeconomists is to analyze and
attempt to understand the underlying determinants of the main aggregate trends in the economy

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with respect to the total output of goods and services (GDP), unemployment, inflation, and
international transactions. In particular, macroeconomic analysis seeks to explain the cause and
impact of short-run fluctuations in GDP (the business cycle), and the major determinants of the
long-run path of GDP (economic growth). Obviously the subject matter of macroeconomics is of
crucial importance because in one way or another macroeconomic events have an important
influence on the lives and welfare of all of us.

In general, in almost all countries of the world there are about four main objectives at the macro
economy level as we discussed earlier. To recite them: steady and sustainable growth, stable
price level (avoid unpredictability in price level), avoid involuntary unemployment or high
employment (create job opportunity to all those who are willing and able to work at a reasonable
pay), and maintain reasonable/manageable balances in government budget as well as the balance
of payment of the economy in its transaction with the rest of the world.

Almost all macroeconomists agree that the above mentioned are the major objectives of the macro
economy and hence macroeconomists. However, macroeconomists disagree on how the economy
can achieve these goals as well as whether these objectives are compatible or not (that is whether
these objectives can be achieved simultaneously or not). One of the prominent economist, Milton
Friedman, explained this issue as follows:

There is wide agreement about the major goals of economic policy [at the macro level]:
high employment, stable prices, and rapid growth. There is less agreement that these
goals are mutually compatible or, among those who regard them as incompatible, about
the terms at which they can and should be substituted for one another. There is least
agreement about the role that various instruments of policy can and should play in
achieving the several goals.(Friedman 1968; cited in Snowdon and Vane, 2005: 7;
emphasis added)

The quotation attempts to generalize that the points of disagreements among economists
(macroeconomists) are mainly theoretical issues, empirical evidence, and the choice of policy
instruments than the ultimate objectives of policy. The choice of appropriate instruments in order
to achieve the ‘major goals’ of economic policy will depend on a detailed analysis of the causes
of specific macroeconomic problems. To make such detailed analysis of the economy we need to
have a model or theoretical/conceptual framework of what the economy looks like and how it
operates. However, economists significantly disagree on what they consider to be the ‘correct’

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model of the economy. Based on this difference we can categorize the intellectual traditions in
macroeconomics into two broad groups: the classical and the Keynesian approaches. All the other
schools of macroeconomic thought are the outgrowths of these two approaches in one way or
another. It is when we examine how policy objectives are interconnected and how different
economists view the role and effectiveness of markets in coordinating economic activity that we
find the fundamental question that underlies disagreements between economists on matters of
policy, namely, what is the proper role of government in the economy?

In the following sections we will try to discuss the main schools of macroeconomic thought
emphasizing the historical backgrounds, the basic tenets and the policy implications of each tenet
as well as the failures of the tenets, in case they failed.

1.3.1. CLASSICAL ECONOMICS

Classical economics is that body of thought, which existed prior to the publication of
Keynes’s, General Theory. For Keynes the classical school not only included Adam Smith, David
Ricardo and John Stuart Mill, but also ‘the followers of Ricardo.
In this period the distinction between micro and macro was not clear. The ruling principle was the
invisible hand coined by Alfred Marshall. The classical have made an ample contribution to the
development of economic science. With regard to the labor market, they contend that labor
demand and labor supply are brought into equilibrium by the real wage. As a result there is no
involuntary unemployment. With regard to the financial market, for classical saving and
investment are brought into equilibrium by the interest rate and investment respond to the interest
rate. In the money market, money demand is simply a transaction demand and money has no any
effect on the real economy and hence raising the money supply simply pushes up prices (i.e.
inflationary). The implication is that, government has no any role in the economy through its
monetary policy. To this end, the classicals are the proponents of laissez-faire (no government
role). In general, for this school markets (be it, commodity, factor, and money) works best if left
to themselves.
Classical economists were well aware that a capitalist market economy could deviate from its
equilibrium level of output and employment. However, they believed that such disturbances
would be temporary and very short-lived. Their collective view was that the market mechanism
would operate relatively quickly and efficiently to restore full employment equilibrium. If
the classical economic analysis was correct, then government intervention, in the form of activist
stabilization policies, would be neither necessary nor desirable. Indeed, such policies were more
than likely to create greater instability.

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Say’s Law states that the sum of the values of all commodities produced always equals the sum
of the values of all commodities bought. This definition was by Keynes, and he may have
misinterpreted what Say was actually saying! One version of what Say said is that “for every
buyer there must be a seller”, which is a much weaker version. Commonly we say that “supply
creates its own demand” and this is the interpretation we will use. Finally it should be said that
there was and is no unified Classical macroeconomic theory. In fact macroeconomics as such did
not exist before Keynes. We will look at the basic tenets of this school of economic thought and
their policy implications.

2.1. Basic tenets of the classical school

1. The economy is inherently stable and this is achieved since prices and wages are fully flexible.
According to classical economists, the economy is always at its full employment equilibrium. It is
worth mentioning that classical economists were well aware that a capitalist market economy
could deviate from its equilibrium level of output and employment. However, they believed that
such disturbances would be temporary and very short-lived. Their collective view was that the
market mechanism would operate relatively quickly and efficiently to restore full employment
equilibrium.
Implication: This tenet of the classical school has very important policy implication. That
is, there is no need for the intervention by the governments into the economy via policy
instruments since markets left to them selves can adjust quickly. Hence, the best policy is to do
nothing or follow the laissez faire principle/laissez passer principle-No need for government
intervention.

2. All economic agents (firms and households) are rational and aim to maximize their profits or
utility; furthermore, they do not suffer from money illusion.
Implication: The assumption of rationality and absence of money illusion implies that
money is super neutral. That is, changes in nominal variables (like change in money supply) will
not affect the real variables instead they affect only nominal variables like prices.

3. All markets are perfectly competitive, so that agents decide how much to buy and sell on the
basis of a given set of prices which are perfectly flexible. That is, all the assumptions underlying
perfectly competitive markets hold.

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4. All agents have perfect knowledge of market conditions and prices before engaging in trade.
That is, no economic agent will cheat any other economic agent as a result of perfect information
or absence of information imperfection or information asymmetry.
5. Trade only takes place when market-clearing prices have been established in all markets, this
being ensured by a fictional Walrasian auctioneer whose presence prevents false trading.
According to this principle, in all markets transaction will take place when equilibrium price is set
after negotiations (via fictional auctioneer).
6. Economic agents have stable expectations.

Classical aggregate supply and demand

According to classical economists, workers and firms in the labour market were thought to learn
reasonably quickly about their economic environment. Prices and wages were also thought to
adjust quickly and fully to economic changes. Firms also acted to maximize the profits of their
owners. If the price level increases, then both workers and firms learn about this reasonably
quickly. Firms increase the quantity of labour they demand and workers decrease the quantity of
labour they supply at the initial nominal wage. The nominal wage is bid up to the point where the
new real wage is exactly equal to the old real wage. The aggregate supply curve is thus vertical.
The only things that were thought by the Classical economists to change the position of the AS
curve were changes in:
– 1. The capital stock.
– 2. Technology.
– 3. The skills of the workers.
– 4. etc.

On the other hand, the classical theory of aggregate demand centres on the quantity theory of
money. The basis for this theory is the theory of exchange:
MV ≡ PT
where,
– M = the quantity of money in circulation.
– V = the transaction velocity of money.
– P = the price level.
– T = the volume of transactions.

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The equation of exchange is an identity, in that it must hold always. With further assumptions the
equation becomes a theory. In particular, Classical economists argued that:
1. Constant Short-Run Transactions Velocity of Money
The transactions velocity of money was assumed to be determined by institutional factors
involved with the payment habits and the payment technology of society such as:
◦ The average length of the pay period (e.g. shorter pay periods implied a smaller average holding
of money for any income level and hence the velocity would increase).
◦ The prevalence of trade credit among businesses.
◦ The practice of using credit cards and other money substitutes.
It was also assumed that these changed only infrequently thus the velocity could be regarded as
fixed in the short-run.

2. Volume of Transactions Proportional to Real Output

The volume of transactions was assumed to be equivalent to the level of real output produced in
an economy and is regarded as determined by factors controlling the labour market and
production technology. This meant that we can replace T by Y, where Y is output, and that output
is fixed given the preferences of workers and firms, the level of technology, and the amount of
capital available. Note that classical economists assumed that the economy is always at its full
employment level equilibrium or at potential output level of the economy. But the potential output
level is determined by the resource endowment and states of technology which are reasonably
constant in the short run imply that the output level is also constant in the short-run. (Note that
shift in the potential output level comes as a result of growth which is a long-run concept).

3. Exogenous Money Stock

The money stock was determined by factors such as the government and taken as given. These
assumptions imply the quantity theory of money,
MV = PY
A change in the money stock feeds through into the price level, but has no impact on output. This
can be modeled as assuming a downward sloping AD curve which depends only on the stock of
money.

If the money stock increases, then AD (effectively — as the quantity theory is only an implicit
theory of aggregate demand) increases but the only thing that happens is that the price level
increases. It is a story of “too much money chasing too few goods”, so that prices increase to
restore equilibrium. This also shows the classical assertion that money is super neutral- change in

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money stock in the economy will affect only the price level (nominal variable) and not real
variables like output.
Implications of the classical model
We can sum up the important implications of the Classical model as follows:
1. Money supply changes have no influence on current output, and only affect the price level.
2. Traditional government policy tools will not affect output or employment.
3. Traditional government policy tools will in fact add instability or decrease future output.
4. Markets quickly adapt to economic changes.
5. There is a basic stability about the economic system when left to itself.
6. Given 1-4, if the economy does work this way, then letting markets work properly is the best
thing that governments can do (i.e. get rid of taxes, subsidies, price controls like minimum wages
etc).

1.3.2 ORTHODOX KEYNESIAN MACROECONOMICS

The Classical school of thought was dominant until the 1930s. During this time two separate
schools of thought also arose:
1. Marxist economics in the 1840s
2. Austrian economics in the 1870s
But they were not the dominant ways of thinking about macroeconomics, although they did
influence classical economic thinking. In the 1930s a major world event occurred that gave rise to
a new way of thinking about the operation of the macroeconomy, Keynesian economics, which
challenged the dominance of classical economics. This event also led to the formal creation of the
branch of economics that we know of as macroeconomics. Influential Keynesian economists
included: John Maynard Keynes (1883-1946), Paul Sameulson (1915-), James Tobin (1918-),
Franco Modigliani (1918-), Robert Solow (1924-), Sir John Hicks (1904-)
Keynes, through his work, created the subject of macroeconomics, which did not explicitly exist
until he came along. Oddly enough there is considerable doubt Keynes was actually a Keynesian
in the orthodox Keynesian sense! Some people argue that the work of Keynes was misinterpreted
by those we now refer to as Keynesians.

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The great depression
What challenged the theories of the Classical economists and motivated Keynes was the effects of
the Depression of 1929-1933. It seemed that even if the views of the Classical economists
accurately described the macroeconomy in the long-run, they did not seem able to explain
something like the Great Depression. Classical economists argued that markets in an economy
could experience a temporary disequilibrium but would attain equilibrium relatively quickly. This
means that economies are inherently stable and that self-correcting mechanisms exist to move an
economy back to equilibrium quickly. This prediction was contradicted by 25% unemployment,
which seems to reflect a large degree of economic disequilibrium, and since this existed for many
years it did not look as though markets adjusted very well or very quickly. It looked like the
Classical views of the economy could not explain relatively short-run fluctuations such as the
Great Depression. This weakness was what Keynes addressed.

Basic tenets of the orthodox Keynesian model and their policy implications
The main thesis of the Keynesian stream is that the economy is subjected to failure so that it may
not achieve full employment level. Thus, government intervention is inevitable. This school views
the labour market in that workers and firms bargain for a money wage, not for real wage. Money
wages adjust slowly and workers resist any drop in the money wage. Unlike the classicals, for
Keynesians saving and investment are brought into equilibrium by changes in income. Investment
is not influenced by a mere change in interest rate; rather it is affected by expectations of the
future, which is uncertain. Money demand is affected by transactions, but also by other things, in
particular fear, which may lead to a “speculative demand” for high money balances. With regard
to the role of the government, Keynes argued that the government role was needed to preserve
capitalism because without management, a modern capitalist economy is so unstable that it may
threaten the social compact that it rests on.
For the early post-war years, the central distinguishing beliefs within the orthodox Keynesian
school can be listed as follows:

1. The Economy is inherently Unstable and Is Subject to Erratic Shocks

It was believed that most of the economic shocks originated in investment plans of firms because
of changes in business confidence about the future demand for output and hence the profitability
of the relevant projects. That is, there is a lot of uncertainty (non-quantifiable) relative to risk
(quantifiable) about expected benefits from investment projects, which makes investment
inherently volatile. It was then argued that these “animal spirits” in investment plans could
produce sudden and large changes in AD and output.

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 Implication: An implication of this argument is that there is always the possibility that an
economy may get “stuck” producing less than full employment level of output. A severe example
of this type of behaviour was taken to be the Great Depression where investment dropped, and
international trade collapsed due to increased worldwide protection.
2. The Economy Can Take a Long Time to Return to Being Close To Full Equilibrium after
Being Subjected To a Shock
The economy is not rapidly self-equilibrating and could have high unemployment and low output
for long spells (i.e. because the effective demand curve was different from the notional demand
curve).
3. Need for Government Intervention
An obvious implication of the orthodox Keynesian model given 1. and 2. is that there are times
when government intervention may be required. Furthermore, given the animal spirits nature of
investment plans, governments should always be watchful and ready to “fine-tune” when
necessary. The Great Depression was seen as being such a time when the economy was demand
constrained and government action was needed to increase aggregate demand.
4. AD Is the Predominant Determinant of Output and Employment, and AD Can Be Altered
By the Authorities
The fall in investment demand and the demand for exports was used as evidence for this claim.
Government policies can affect aggregate demand and return an economy to full-employment.
5. Fiscal Policy Is Preferred To Monetary Policy in Carrying Out Stabilization
Policies
Monetary policy takes too long if it is going to have any effect and is likely to have a weak effect
if it has an effect at all. The effects of fiscal policy are immediate and strong. As a result, fiscal
policy is much better than monetary policy for fine-tuning since it is more direct, more
predictable, and faster acting on aggregate demand than is monetary policy.

Keynesian’s View of the Economy

In a very simplified form we can present Keynes’s theory of recessions. Imagine an economy that
is chugging along happily at full employment. Alongside the smoothly functioning ‘real’
economy there will be a smooth financial flows, as firms earn money from their sales, pay out
their earnings in wages and dividends, and household spend these receipts on new purchases from
the firms. But now suppose that for some reason each household and firm in this economy decides
that it would like to hold a little more cash. Keynes argued, in particular, this happens when
businessmen lose confidence and start to think of potential investments as risky, leading them to
hesitate and accumulate cash instead; today we might add the problem of nervous households who

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worry about their jobs and cut back on purchases of big-ticket consumer items.
Either way, each individual firm or household tries to increase its holdings of cash by cutting its
spending so that its receipts exceed its outlays. But as Keynes pointed out, what works for an
individual does not work for the economy as a whole, because the amount of cash in the economy
is fixed. An individual can increase her cash holding by spending less, but she does so only by
taking away cash that other people had been holding. Obviously, not everybody can do this at the
same time. So what happens when everyone tries to accumulate cash simultaneously?
The answer is that income falls along with spending. I try to accumulate cash by reducing my
purchases from you and you try to accumulate cash by reducing your purchases from me; the
result is that both of our incomes fall along with our spending, and neither of us succeeds in
increasing our cash holdings. If we remain determined to hold more cash, we will react to this
disappointment by cutting our spending still further, with the same disappointing result; and so on
and so on. Looking at the economy as a whole, you will see factories closing, workers laid off,
stores empty, as firms and households throughout the economy cut back on spending in a
collectively vain effort to accumulate more cash. The process only reaches a limit when incomes
are so shrunken that the demand for cash falls to equal the available supply.
Keynes and Economic Policy
For Keynes to do about recessions, the first and most obvious thing to do is to make it possible for
people to satisfy their demand for more cash without cutting their spending, preventing the
downward spiral of shrinking spending and shrinking income. The way to do this is simple to
print more money, and somehow get it into circulation. So the usual and basic Keynesian answer
to recessions is a monetary expansion. But Keynes worried that even this might sometimes not be
enough, particularly if a recession had been allowed to get out of hand and become a true
depression. Once the economy is deeply depressed, households and especially firms may be
unwilling to increase spending no matter how much cash they have; they may simply add any
monetary expansion to their holding. Such a situation, in which monetary policy has become
ineffective, has come to be known as a “liquidity trap”. In such a case, the government has to do
what the private sector will not: spend. When monetary expansion is ineffective, fiscal expansion
must take its place. Such a fiscal expansion can break the vicious circle of low spending and low
incomes and getting the economy moving again. Despite the "synthesis" and the "consensus",
however, Keynesian macroeconomics was subject to ongoing criticism, some of it from academic
economists who were uncomfortable with its theoretical foundations and more of it from
economists and others who did not like its political implications. By the 1970s, changing
economic circumstances and a shift in political opinion, both common to most of the developed,
industrial democracies, brought this criticism out into the open and a major attack was launched

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against the Keynesian orthodoxy. Particularly influential in this was the experience of unusually
high (for "peacetime") rates of inflation conjoined with rising levels of unemployment. One
consequence of this was a significant restatement of Keynesian principles in a model designed to
accommodate the possibility of changing price levels. This modified "Keynesian" macro model
appears in some form or other in nearly all introductory texts in economics today.

1.3.3. NEW CLASSICAL MACROECONOMICS

Keynesian economics battled it out until the early 1970s, after which a combination of two
things were to lead to their demise as the main schools of macroeconomic thought. The successor
macroeconomic way of thinking did, however, include a lot of the ideas of the monetarists.
Influential new classical economists include: Robert Lucas (1937-), Neil Wallace (1939),
Thomas Sargent (1943-), Robert Barro (1944-)

Rational expectations
Keynesians believe that there is a difference between the short-run and long-run views of the
world. The key here is the view that expectations about the price level by employees are fixed in
the short-run. This means that the labour supply schedule does not change with government
policies (that is, people don’t react to the policy changes); hence government policies can affect
employment and output. Note that in the long-run expectations adjust to the effects of the policy
action, it is in the short-run that they differ. Note also that in the orthodox Keynesian world that
expectations are effectively static, that is they never change (except for those formed by
businesses about future profit levels!). Expectations are backward looking in the Keynesian
worlds and so they change slowly with people making systematic predictable mistakes. In the
early 1960s an economist called John Muth developed a model where agents had forward looking
expectations. He argued that:
1. People Would Look To the Future
People do not just look to the past, but would also look to the future. In doing so they would use
every piece of information they had available to predict what was going to happen in the future.
2. People Would Use Information Intelligently
People would form expectations using the relevant economic theory. That is, people would
understand the way in which the economic variables they observe affect the variable they are
forming expectations about (or trying to predict).

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3. People Would Not Make Systematic Errors
When forming expectations people would not keep getting it wrong. This is in contrast to the
Keynesian theory of expectation formation people make systematic errors. The thing to notice is
that these systematic errors make people worse off than if they had made no errors when forming
their expectations. This means that people have an incentive to avoid making systematic errors
and therefore will not make such errors. John Muth argued that expectations are formed
rationally.
– Rational Expectations are forecasts that use all of the relevant information available about past
and present events, and that have the least possible errors.
People who form rational expectations do make mistakes, but they do not make systematic
mistakes. That is, people’s expectations are correct on average. This development had obvious
differences compared to the previous schools of thought:
1. Different From Classical Economics
The New Classical view is different from that of the Classical economists who believed that
except in the very short-run that people had perfect information.
2. Keynesian Economists Argue That Expectations Are Not Formed Rationally
Information is costly to obtain and it is unlikely that people will have all the information
necessary. There are situations where asymmetric information occurs between sellers and buyers.
People are not machines and are not perfect at processing what information they have, they tend
to use “rules of thumbs”. We do not even agree upon a “right theory” of the macroeconomy, so
why should we assume that people behave as though there is only right theory.

Basic tents of New Classical economics and their implications

• The position of New Classical economists and what they tend to believe about how economies
work can be summarised as follows:
The central working assumptions of the new classical school are three:
• Economic agents maximize. Households and firms make optimal decisions given all available
information in reaching decisions and that those decisions are the best possible in the
circumstances in which they find themselves.
• Expectations are rational, which means they are statistically the best predictions of the future
that can be made using the available information. Rational expectations imply that people will
eventually come to understand whatever government policy used, and thus that it is not possible
to fool most of the people all the time or even most of the time.
• Markets clear. There is no reason why firms or workers would not adjust wages or prices if that
would make them better off. Accordingly prices and wages adjust in order to equate supply and

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demand; in other words, market clear. For instance, any unemployed person who really wants a
job will offer to cut this or her wage until the wage is low enough to attract an offer from some
employer. Similarly, anyone with an excess supply of goods on the shelf will cut prices so as to
sell. The essence of the new classical approach is the assumption that markets are continuously in
equilibrium.
One dramatic implication of these assumptions, which seem so reasonable individually, is
that there is no possibility for involuntary unemployment. The essence of the new classical
approach is the assumption that markets are continuously in equilibrium. In particular, new
classical macroeconomics regard as incomplete or unsatisfactory any theory that leaves open
the possibility that private individuals could make themselves better off by trading among
themselves.
Economy Is Self-Correcting
While the initial affect of an economic shock is to alter employment and output, this will not last
as people learn about what has happened. Once people have learnt what has happened then
expectations will adjust to the new situation and employment and output will return to their
original values. We saw this above as once people learnt about the fall in I they adjusted their
expectations and the economy went back to its original levels of employment and output.

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