Macroeconomics Sessions

Macroeconomics

The Evolution & Development Of

Thought I
Objective of study of Macro
⚫How to explain the massive catastrophic
depression
⚫How the aggregate economy functions
⚫How to foresee the variety of Demand and
Supply shocks causing instability
⚫How to moderate them
Cannot ignore Micro
⚫Economy-wide events rooted in micro behavior
⚫Consumption Aggregate Investment
⚫Micro foundations of macro
Economists, & Detectives
– has one common trait
They rely on observation
⚫Use models &
theories
Models & Theories
Models
The economic model is a
simplified framework designed to
illustrate complex processes
⚫Dispense with irrelevant
details
⚫Show the impact of
exogenous factors on
endogenous phenomena
Theories
⚫Generalize the observed behavior validated by
empirical tests
⚫Ideas, theories, and models
⚫Constantly evaluated against the facts,
⚫often modified or rejected
⚫Eg two laws of economists
Macroeconomic evolution
– A summary view
Macroeconomics: Intellectual witch-brew

“Comprised many
ingredients,
Some of them exotic,
Many insights,
But also a great deal of
confusion“
The story of modern macroeconomics
Undoubtedly begins with the Great Depression.
For more than 80 years economists not attempted a
coherent explanation of its occurrence.
The intellectual problem with Macro
How to capture, in specific models, the complicated
interactive behaviour of millions of individuals.
The evolution far from smooth.

Rich knowledge with

prolonged research.
Yet, intense controversies
and debates
Need to explore the rise and
fall of the old ideas and
theories
Diverse views

Economics is the only field in which two people can share a Nobel
Prize for saying opposing things.
Reasons for macro controversy
⚫Limited knowledge about how the economy works,
⚫The ever-widening range of issues that economists investigate,
⚫The need to take into account wider influences, such as political
factors,
⚫Differences in the ‘metaphysical cores, value judgments, social
empathies, methodologies’ of various economists.
Consensus on policy objectives
“ There is wide agreement about the major goals of
economic policy:
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 M (1968) ‘The Role of monetary policy’,
AER, March.
Two streams of thought
Classical and Keynesian
⚫Point of difference – government intervention
⚫Classical approach
⚫Optimization of ‘the efficiency of unfettered
markets’
⚫Keynesian
⚫ Room for a more extensive role for government
The Classical School
The ‘Invisible hand theorem’

Classical idea
Profit and utility-maximizing behaviour of rational economic agents
under competitive conditions
translate the activities of millions of individuals
into a social optimum.

Adam Smith (1776) An Inquiry into the

Nature and Causes of the Wealth of Nations
 Classical vision
‘Supply creates its own demand’
denies the possibility of general over- or under-production.
Dominant view before 1930
exception - Malthus, Marx, other heretics,
Political economy biased towards laissez-faire
But no coherent plausible answer to Great Depression

French businessman and economist

Jean-Baptiste Say
Self correcting Classical mechanism
A downward shift of aggregate (effective) demand
will bring into play corrective forces involving falling
prices
The final impact
a lower price level with real output and employment
returning to full employment levels.
Self-correcting market forces
operating via the price mechanism,
restore equilibrium without the help of government
intervention.
Did it work?
Well it might have, during the 1920s.
But it certainly did not in the decade after 1929.
In any case, the classical model could not explain the
Depression
Keynesianism
First ever aggregate approach

First ever coherent and systematic approach

to aggregate economic phenomena
Great Depression - symptomatic of a fundamental flaw
in the operation of the price mechanism as a
coordinating device.
Capitalism needs modification

⚫Capitalism ‘not terminally ill but unstable’.

⚫Needs modification of the rules of the game to preserve and
strengthen it.
⚫Its potential weakness - failure to provide full employment
⚫Failures of capitalism led to totalitarianism
Keynes Talk 1934

Economy self-adjusting?
“On the one side are those that believe that the existing economic
system is, in the long run, a self-adjusting system,
though with creaks and groans and jerks and interrupted by
time lags, outside interference and mistakes …
Keynes Talk 1934 …
On the other side of the gulf are those that reject the idea that the
existing economic system is, in any significant sense, self-adjusting.
Keynes Talk 1934 …
The strength of the self-adjusting school depends on it having behind
it almost the whole body of organised economic thinking of the last
hundred years …
Keynes Talk 1934 …
Thus, if the heretics on the other side of the gulf are
to demolish the forces of nineteenth-century orthodoxy
… they must attack them in their citadel …
Now I range myself with the heretics”.
⚫Moggridge, D (1973) The Collected Writings of
John Maynard Keynes, XIII, Macmillan, London.
Keynesianism

⚫Keynes’s major discovery the ‘Principle of Effective Demand’

⚫The most plausible explanation of the Great Depression is
massive decline in aggregate demand.
⚫Government intervention, in the form of activist monetary and
fiscal policies, could correct the aggregate instability.
Keynesianism

For a long time Keynesianism dominated the economic scene.

“ Virtually all advanced democratic capitalist societies adopted, in
varying degrees, Keynesian strategies of demand management after
World War Two.
Keynesian ‘Golden Age’

“ The period, certainly between 1950 and 1973, was one of

unparalleled prosperity, growth, expansion of world trade, and
stability.
During this ‘Golden Age’ inflation and unemployment were low, the
business cycle was tamed.”
Tobin, J (1987), Policies For Prosperity: Essays in a Keynesian
Mode.
Popular with policy makers

Council of Advisers dominated

by Keynesians
Golden Age 1950-73
Practical use of Keynesian model

⚫Foundation for large-scale macro-econometric models by Klein

and the Cowles Commission.
⚫Useful for forecasting purposes and to assess the likely impact of
alternative economic policies.

Lawrence Klein
Romer’s Critique

the period after 1945 more

unstable than the pre-Great
Depression period
To continue…
 Macroeconomics
The Evolution & Development Of Thought II
Keynesian ‘Golden Age’
“ The period, certainly between 1950 and 1973, was
one of unparalleled prosperity, growth, expansion of
world trade, and stability.
During this ‘Golden Age’ inflation and unemployment
were low, the business cycle was tamed.”
Tobin, J (1987), Policies For Prosperity: Essays in a
Keynesian Mode.
Phillips curve
Phillips Curve
⚫Enabled prediction of the rate of inflation resulting from
different target levels of unemployment.
⚫The simultaneous increase in both unemployment and inflation in
the early 1970s
⚫proved fatal to the more simplistic versions of ‘hydraulic’
Keynesianism
A widely held empirical finding
Real output more stable in the US
‘under conscious policies of built-in and discretionary stabilisation
adopted since 1946 and particularly since 1961’
- Tobin, 1980.
Romer’s Critique
Discovered methodological biases.
Reality - The period after 1945 more unstable than the pre-Great
Depression period
- Romer, 1986
Golden Age – due to other factors
⚫Increased liberalization of international trade
⚫Favorable circumstances for low inflation conditions and buoyant
aggregate demand
⚫A backlog of growth possibilities following the end of the WWII.
Decline of Keynesianism since 70s
⚫Resulted from the empirical failings
⚫And increasing success of critiques (‘counter-revolutions’)
⚫mounted by monetarist and new classical economists
Keynesian Schizophrenia (Delusions)
⚫The way economics was taught
⚫Micro, macro focusing on separate issues.
⚫Keynesian ideas conflicting with Walrasian
⚫Incompatibility ignored till 1973
⚫Need for reconciliation
⚫Led to Neo-classical Synthesis
The Neo-classical / Neo-Keynesian Synthesis 50-73
Neo-Keynesian interpretations
John Hicks, Franco Modigliani, and Paul Samuelson
Interpret and formalize Keynes' writings,
Synthesize it with the neo-classical models of economics
Hicksian interpretation
⚫The synthesis dominated mainstream economics until the early
1970s.
⚫Hicks DA (1937) ‘Mr Keynes and the Classics: A Suggested
interpretation’ (Econometrica April) became standard textbook
approach until the early 1970s
⚫Contributions by Modigliani, Patinkin and Tobin
Neoclassical Synthesis
⚫The ‘Neoclassical synthesis’ (coined and popularized by
Samuelson) dominated mainstream economics
⚫the classical–neoclassical view extols the efficiency of the price
mechanism
⚫in solving the fundamental allocation and production problems
which arise from the scarcity of resources.
Neoclassical Synthesis
⚫The Keynes’s iconoclastic vision
⚫highlights the shortcomings of the invisible hand, with respect
to the general level of output and employment.
⚫This later problem could be solved with limited government
intervention
⚫Post-70s the synthesis is not effective and kept separate ways.
Monetarism
Orthodox Monetarism
⚫Maintains that there is no need for Stabilization policy and
government intervention, as economy adjusts to equilibrium path.
⚫Stabilization could go wrong
Orthodox Monetarism
⚫problems include
⚫the length of the inside lag associated with fiscal policy,
⚫the long and variable outside time lags
⚫uncertainty over precise value of the natural rate of
unemployment.
⚫monetarists argue that the authorities shouldn’t be given
discretion.
Post-Keynesian developments
⚫The ‘Stagflation’ leading to slowdown in economic growth
⚫Attributed to the misguided and repeated expansionary policies
carried out in the name of Keynes
⚫Predicted by Friedman (1968) ‘Role of Monetary Policy’
New Classical approach
New Classical approach
⚫1970s the second counter-revolution
⚫Lucas (1972) – unanticipated inflation leads to short-run
Phillips curve
⚫Contributors
⚫Thomas Sargent, Neil Wallace, Robert Barro, Edward Prescott
and Patrick Minford
New Classical approach
⚫By combining
⚫Muth’s Rational Expectations hypothesis
⚫the assumption that markets continuously clear,
⚫and Friedman’s natural rate of unemployment, NAIRU,
hypothesis,
Real Business Cycle Theory
Real Business Cycle Theory
⚫Kydland & Prescott seminal contribution
⚫Economic fluctuations predominantly caused by persistent real
(supply-side) shocks, rather than unanticipated monetary (demand-
side) shocks.
Real Business Cycle Theory
⚫The shocks
⚫Involve fluctuations in the technological progress
⚫result in fluctuations in relative prices
⚫to which rational economic agents respond.
⚫observed output fluctuations are not random deviations from
trend.
⚫No role for government intervention.
New Keynesianism
New Keynesianism
⚫Incorporate the rational expectations hypothesis
⚫Assume that markets may fail to clear due to wage, price
stickiness and Friedman’s natural rate hypothesis
⚫Support the need for stabilization policy
Post Keynesian schools
⚫descended from Keynes’s radical contemporaries and disciples
⚫Inspiration from Joan Robinson, Nicholas Kaldor, Michal Kalecki,
George Shackle and Piero Sraffa.
⚫Modern advocates of this approach
⚫ include Jan Kregel, Victoria Chick, Hyman Minsky and Paul
Davidson
The Austrian School
The Austrian School
⚫Intellectual roots - Ludwig von Mises and Friedrich von Hayek,
Israel Kirzner, Karen Vaughn and Roger Garrison.
⚫Indeed those economists belonging to the Mises–Hayek–Robbins–
Schumpeter Austrian school of thought believed
⚫that the depression was the inevitable result of overinvestment
during the artificially created boom.
The Austrian School
⚫Government intervention in the form of a stimulus to aggregate
demand would only make things worse.
⚫The choice was between depression now or, if governments
intervened inappropriately, even worse depression in the future.
⚫Great Depression should be tolerated
⚫Government intervention may either ineffective or merely postpone
the problem
Different schools of thought
⚫Orthodox Classical
⚫Orthodox Keynesian,
⚫Neo-Classical
⚫Orthodox monetarist,
⚫New classical,
⚫Real business cycle,
⚫New Keynesian,
⚫Post Keynesian,
⚫Austrian,
⚫New Neo-Classical,
⚫New Political.
More new Developments
New Neoclassical Synthesis
⚫Need for to incorporate inter-temporal optimization;
⚫Widespread use of the rational expectations hypothesis;
⚫Recognition of the imperfect competition in goods, labour and
credit markets;
⚫Incorporating cost price adjustment into macroeconomic models.
⚫Goodfriend & King, 1997
New Political Macroeconomics
⚫Studies the influence of political factors on
⚫business cycles, inflation, unemployment, growth,
⚫Alesina, 2000, Drazen, 2000, Snowdon & Vane
⚫Modern politico-economic models, views the government as an
endogenous component of the political and economic system
⚫concerned with how policy makers should act rather than how
they do act
Political economy and fiscal planning
⚫political forces likely to play a crucial distorting role in the
economy
⚫society is polarized leading to social conflict.
⚫ideological considerations manifest in the form of ‘partisan’
behaviour and actions
Political business cycle
⚫predicts self-interested opportunistic behaviour, irrespective of
party allegiance, before an election.
⚫When political motivations mixed with
⚫myopic non-rational behaviour of voters
⚫non-rational expectations of economic agents,
⚫a political business cycle is generated which ultimately leads to a
higher rate of inflation in a democracy than is optimal.
Microeconomics Foundations of Macroeconomics
Microeconomics Foundations of Macroeconomics
Circular flow models
the circular flow model is the
circulation or flow of income
between producers and consumers.

Producer is referred to firm and

consumer is referred to
households.

The major exchanges are

represented as flow of money,
goods and services etc.

Households: 1. Supply of
different factors of production
2. Members of households work
as a consumer.
Firms: 1. Produce goods and
services and sell to the market.
2. Purchase raw-materials.
Circular flow models

Government
1. . Earn revenue from tax
resources both from households
and firms.
2. Provides essential services -
maintenance of law and order,
defence services, judiciary etc.

Financial Institution: consists of

bank and non-bank
intermediaries who engage in the
borrowing and lending of money.

Foreign Sector: 1. Export and

Import Goods and Services
2. Inflows and Outflows of
capital.
Circular flow models

Leakages: Withdrawal from the

flows.
Injections: Introduction of income
into the flow
Measuring economic activities
⚫GDP
⚫Real GDP vs Nominal GDP
⚫GDP Deflator = Nominal GDP/ Real GDP
⚫The concept of expenditure: C + I + G + (X-M)
⚫Others measure
(i) The consumer price index
(ii) The unemployment rate :
Labour force = No. of Employed + No. of Unemployed
Unemployment rate = No. of Unemployed/Labour force * 100
Labour force participation rate = Labour force/Adult population * 100
Readings

⚫Tobin, J (1987), Policies For Prosperity: Essays in a Keynesian

Mode.
⚫Hicks DA (1937) ‘Mr Keynes and the Classics: A Suggested
interpretation’ (Econometrica April) became standard textbook
approach until the early 1970s
⚫Modigliani (1944) ‘Liquidity preference, theory of interest and
money’ Econometrica, January
⚫Patinkin D (1956) ‘Money interest and prices: An integration of
monetary and value theory.
⚫Wicksell, K. (1958), ‘Ends and Means in Economics’, in his
Selected Papers on Economic Theory (ed. E. Lindahl), London: Allen
and Unwin.
Readings

⚫Tobin, J (1958) Liquidity preference as behavior towards risk,

Review of Economic Studies, February
⚫Friedman M (1968) ‘The Role of monetary policy’, AER, March.
⚫Samuelson, P A (1955) Economics, (3rd ed)
⚫Phillips, A.W. (1958), ‘The Relation Between Unemployment and
the Rate of Change of Money Wage Rates in the United Kingdom,
1861–1957’, Economica, November.
⚫Lucas (1972) Expectations and the neutrality of money, Journal
of Economic Theory, April
Thank you!