CHAPTER ONE

Concepts and Views of

Macroeconomics
1.1 Definition Of Macroeconomics

Two Major Branches of Economics

 Microeconomics
 Macroeconomics
 Microeconomics is the study of how
households and firms make decisions and how
these decision makers interact in the broader
market place.
1.1 Definition Of Macroeconomics

 Macroeconomics is concerned with

aggregates and averages of the entire
economy, such as national income,
aggregate output, total employment, total
consumption, savings, and investments,
aggregate demand, aggregate supply,
general level of prices etc.
1.1 Definition Of Macroeconomics

 Macroeconomics is concerned with the

behavior of the economy as a whole…
with booms and recessions, with
economies total output of goods and
services, the growth of output, the rate of
inflation and unemployment, the balance
of payment, and exchange rate.
1.1 Definition Of Macroeconomics

 Macroeconomics focuses on the

economic behavior and policies that
affects consumption and investments,
trade balance, determinants of wages
and prices, monetary and fiscal policies,
the money stock, budget, interest rate
and national debt.
Important issues in macroeconomics
Macroeconomics, the study of the economy
as a whole, addresses many topical issues:
 Why are millions of people unemployed,
even when the economy is booming?
 Why does the cost of living keep rising?
 Why are so many countries poor?
What policies might help them grow out of poverty?
U.S. inflation rate
(% per year)
25

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-15
The
1900

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U.S. Real GDP per capita
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1900

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 U.S. unemployment rate
(% of labor force)

25

20

15

10

0
1900

1910

1920

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1960

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1980

1990

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The
CHAPTER 1

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 Why learn macroeconomics?
1. The macroeconomy affects society’s well-being.
U.S. Unemployment and
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CHAPTER 1 2000
Science
1970 of 1980 1990 2000
Macroeconomi
 Why learn macroeconomics?
2. The macroeconomy affects your well-
being.

percent change from 12 mos earlier

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Macroeconomi
 Why learn macroeconomics?
3. The macroeconomy affects politics.
Unemployment & inflation in election years
year U rate inflation rate elec. outcome
1976 7.7% 5.8% Carter (D)
1980 7.1% 13.5% Reagan (R)
1984 7.5% 4.3% Reagan (R)
1988 5.5% 4.1% Bush I (R)
1992 7.5% 3.0% Clinton (D)
1996 5.4% 3.3% Clinton (D)
2000 4.0% 3.4% Bush II (R)
The
CHAPTER 1

2004 of 5.5%
Science 3.3% Bush II (R)
Macroeconomi
Economic models

 Economic models are re simplified versions

of a more complex reality
•irrelevant details are stripped away
 They are used to
• show relationships between variables
• explain the economy’s behavior
• devise policies to improve economic
performance
Example of a model:
Supply & demand for new cars
• shows how various events affect price and quantity of
cars
• assumes the market is competitive: each buyer and
seller is too small to affect the market price
• Variables:
Q d = quantity of cars that buyers demand
Q s = quantity that producers supply
P = price of new cars
Y = aggregate income
Ps = price of steel (an input)
 The market for cars: Demand

demand equation: P
Price
d
Q  D (P ,Y ) of cars

The demand curve

shows the relationship
between quantity D
demanded and price, Q
other things equal. Quantit
y of
cars
 The market for cars: Supply

supply equation: P
Price
s
Q  S (P , Ps ) of cars S

The supply curve

shows the relationship
between quantity D
supplied and price, Q
other things equal. Quantit
y of
cars
The market for cars: Equilibrium
P
Price
of cars S

equilibriu
m price
D
Q
Quantit
y of
equilibrium cars
quantity
 The effects of an increase in income
demand equation: P
Q d  D (P ,Y ) Price
of cars S

An increase in income
increases the quantity P2
of cars consumers P1
demand at each price… D2
D1
Q
…which increases Q1 Q2
Quantit
the equilibrium y of
price and quantity. cars
 The effects of a steel price increase
supply equation: P S2
Q  S (P , Ps )
s
Price
of cars S1

An increase in Ps
reduces the quantity P2
of cars producers P1
supply at each price…
D
…which increases Q
Q2 Q1
the market price and Quantit
y of
reduces the quantity.
cars
 Endogenous vs. exogenous variables
• The values of endogenous variables
are determined in the model.
• The values of exogenous variables
are determined outside the model:
the model takes their values & behavior
as given.
• In the model of supply & demand for cars,
exogenous: Y , Ps
endogenous: P , Qd , Qs
A multitude of models

• No one model can address all the issues we

care about.
• e.g., our supply-demand model of the car
market…
•can tell us how a fall in aggregate income
affects price & quantity of cars.
•cannot tell us why aggregate income falls.
A multitude of models
• So we will learn different models for studying
different issues (e.g., unemployment, inflation,
long-run growth).
• For each new model, you should keep track of
• its assumptions
• which variables are endogenous,
which are exogenous
• the questions it can help us understand,
and those it cannot
Macroeconomic Analysis
 Helps in understanding the complicated
economic system
 Formation and understanding of economic
policy
Tool for the solution of economic problems
related to output, employment, and national
income
 Individuals are ignored
individual differences are over looked
1.2 Goals of Macroeconomic Policy
 Full employment
 High standard of living
 Price stability
 Reduction of income inequality and removal of
poverty
 Rapid economic growth
 External Balance v/s overall balance in
economic relations with the rest of the world.
1.3 Schools of Macroeconomic
Thought
 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.
 1.3 Schools of Macroeconomic
Thought
 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).
 1.3 Schools of Macroeconomic
Thought
 In almost all countries of the world there are about
four main objectives at the macroeconomy level.
1. Steady and sustainable growth,
2. Stable price level (avoid unpredictability in price level),
3. Avoid involuntary unemployment or high employment
(create job opportunity to all those who are willing and
able to work at a reasonable pay), and
4. 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.
 1.3 Schools of Macroeconomic
Thought
 Almost all macroeconomists agree that the above
mentioned are the major objectives of the
macroeconomy 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:
 1.3 Schools of Macroeconomic
Thought
 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)
1.3 Schools of Macroeconomic Thought
 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’ model of the
economy.
1.3 Schools of Macroeconomic Thought
 Based on this difference we can categorize the
intellectual traditions in macroeconomics into two
broad groups:
1. The classical Approach
2. The Keynesian approach.
 All the other schools of macroeconomic thought are
the outgrowths of these two approaches in one way or
another.
1.3 Schools of Macroeconomic Thought
 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 Economic Theory
 The usage of the term classical theory is attributed to
John Maynard Keynes, who used it to refer to all
economists who wrote prior to 1930s.
 Yet another categorization distinguishes between two
periods: (i) classical period which refers to work of
Adam Smith, David Ricardo, John Stuart Mill, J. B. Say
and others (18th and 19th centuries), and (ii)
neoclassical period dominated by Alfred Marshall, A. C.
Pigou and others (20th century).
1.3.1 Classical Economic Theory
 Classical economics emerged as a critique of the ideas
of ‘mercantilism’.
 Mercantilists believed that
1. wealth of nations depended on the amount of
bullion (gold and silver) with it.
2. The government should actively intervene (through
export subsidies and import duties) to ensure that a
nation’s stock of precious metals was maximized.
1.3.1 Classical Economic Theory
 Classical economists emphasized that ‘wealth of
nations’ depended on real factors and money was
considered merely as a medium of exchange.
 The classical economists were famous for attacking
and successfully refuting the mercantilist doctrine.
Classical economists focused on real assets, rather
than financial assets, as being important because they
determined the productive capacity of an economy.
 They also argued that markets would act to co-
ordinate people’s plans (i.e. the “invisible hand” of
Adam Smith). This view is captured by Say’s law.
1.3.1 Classical Economic Theory
 According to J. B. Say, ‘supply creates its own
demand’. In this theory, level of aggregate output is
constant at the full employment level; money supply
determines only the price level.
 They assumed that aggregate production(supply)
would generate sufficient aggregate demand and
thereby Say’s Law is satisfied.
 The classical economists assumed that wages and
prices are fully flexible which results in full
employment level of output.
 Classical economists stressed upon the self-adjusting
tendencies of the economy.
1.3.1 Classical Economic Theory
 Since the economy returns to its full employment
output level automatically, the classical economists
disliked government intervention in economic policies.
 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.
 The basic tenets of classical theory can be understood
with the help of production function, labour market
and capital market. The ‘quantity theory of money’
explains the determination of price level.
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.
Basic tenets of the classical school
1. The economy is inherently stable and this is
achieved since prices and wages are fully flexible.
Implication:
• 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.
Basic tenets of the classical school
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.
Basic tenets of the classical school
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.
Implication:
Basic tenets of the classical school
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.
Implication:
Basic tenets of the classical school
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
 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.
Classical aggregate supply
 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:
• The capital stock
• Technology
• The skills of the workers
• etc…
Classical aggregate supply
 The classical economists assume that firms and
workers (i) are optimisers, (ii) have perfect knowledge,
and (iii) operate under perfectly competitive
conditions.
Wages and prices are completely flexible. For profit
maximising firms, demand for labour is given by
equating the product price to the ratio of Wages to
Marginal Product of Labour. Price (P) is equal to its
marginal revenue (MR) received from sale of one unit
of output and W/MPN is the marginal cost of
producing an additional unit of output. The labour
demand curve in terms of real wage (W/P) is nothing
but the Marginal Product of Labour (MPN). This gives a
negatively sloping demand curve for labour.
Classical aggregate supply
Nd = f (W / P)
 Supply of labour is based on the assumption of utility
maximising individual labourers and depends
positively on real wage (W/P).
Ns = g(W / P)
Classical aggregate supply
• The full employment of labour translates into full employment level
of output given some production function such as Y = (K,N) . This
gives a perfectly inelastic Aggregate Supply (AS) curve at full
employment level of output.
Classical Aggregate Demand
 The classical theory of aggregate demand centers on
the quantity theory of money.
MV ≡ PT
– M = the quantity of money in circulation.
– V = the transaction velocity of money.
– P = the price level.
– T = the volume of transactions.
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:
Classical Aggregate Demand
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.(V= constant in the SR)
Classical Aggregate Demand
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 labor 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.
Classical Aggregate Demand
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.
𝑃= 𝑉 𝑀
𝑌
Equilibrium output and the price level
• Putting the Classical AD and AS curve representations
together we get the following picture:
Equilibrium output and the price level
• 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 money stock in the economy
will affect only the price level (nominal variable) and
not real variables like output.
Equilibrium interest rate
• The Classical theory predicts that the price level and
output level are determined independently of the
interest rate.
• That said, the interest rate is still important in the
Classical system.
• The role of the interest rate is to stabilize aggregate
demand.
• The interest rate was considered by the Classical
economists to be determined in the market for loan
able funds, the market in which bonds are sold and
bought.
Equilibrium interest rate
• Net Suppliers of Bonds (Net Borrowers) are assumed
to be:
Firms
• Firms routinely undertake investment projects. The
firms look at the expected profitability of the projects
which depend (positively) on future expected demand,
and (negatively) on interest costs.
• Investment is thus expected to depend negatively on
the interest rate.
Government
• Governments need to fund their deficits through
borrowing.
Equilibrium interest rate
• Net Purchasers of Bonds (Net Lenders) are assumed to
be:
Households
• People save for the future.
• Since saving is forgoing consumption today some
payment is required to induce people to do this with
positive interest rates reward people for saving.
• It is assumed that a higher interest rate will induce
people to save more today (and thus consume less
today).
• The equilibrium interest rate ensures that the amount
of bonds supplied by borrowers equaled the amount
of bonds demanded by the lenders.
Equilibrium interest rate
• Say that firms believe that future demand would be
higher and thus believe that more investment projects
are profitable than currently is the case. The demand
for loanable funds would shift to the right.
• The increase in the demand for loanable funds leads
to the following series of changes in behavior.
• First, it results into an increase in the interest rate.
• Then the higher interest rate leads to a smaller
number of extra projects going ahead compared to the
increase in demand at the initial interest rate
(although some new projects do still get undertaken).
Equilibrium interest rate
• The higher interest rate also leads to an increase in
the supply of loanable funds because the higher
interest rate increases savings by the lenders.
• The increased saving by households is achieved by
reducing the amount of consumption undertaken.
• Overall, the increase in the demand for investment
goods exactly matches the decrease in the demand for
consumption goods and so AD is unaffected.
• This shows how the interest rate acts as a stabilizing
mechanism in the Classical model.
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. Changes in government expenditure have no effect
on current output and only affect the interest rate,
and the amount of investment and consumption
undertaken.
• To see this consider what happens if government
expenditure(G) increases:
• The increase in G increases the demand for loanable
funds given the initial level of taxation.
• The interest rate increases in response.
Implications of the classical model
• This causes investment demand to decrease (this is
“crowding out” with implications for future output). It
also causes saving to increase and consumption
demand to decrease.
• The increase in G is exactly offset by the fall in I and
the fall in C.
Implications of the classical model
• The end result from this analysis is that:
1. Traditional government policy tools will not affect
output or employment.
2. Traditional government policy tools will in fact add
instability or decrease future output.
3. Markets quickly adapt to economic changes.
4. There is a basic stability about the economic system
when left to itself.
5. 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 Keynesian Macroeconomics
• The Classical school of thought was dominant until the
1930s.
• In the 1930s a major world event occurred that gave
rise to a new way of thinking about the operation of
the macro-economy, 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.
• John Maynard Keynes (1883-1946) — lecturer of
economics at Cambridge University, position at the UK
Treasury, studied mathematics, philosophy and
economics, chief architect of the IMF.
1.3.2 Keynesian Macroeconomics
• The major work of Keynes’s was his “The General
Theory of Employment, Interest and Money”
published in 1936. This was a response to the
Depression era, and ushered in Keynesian economics.
1.3.2 Keynesian Macroeconomics
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 Theory, with its belief in the self-adjusting
markets could not explain the Great Depression which
hit most of the developed economies in the 1930s.
1.3.2 Keynesian Macroeconomics
The Great Depression
• Stock markets crashed, thousands of banks failed,
businessmen cut back investment and production, and
millions of workers became unemployed.
• The entire world was witnessing one of the worst
economic calamities.
• 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.
1.3.2 Keynesian Macroeconomics
The Great Depression
• 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.
1.3.2 Keynesian Macroeconomics
• It is in this context that John Maynard Keynes wrote
The General Theory of Employment, Interest and
Money which became the basis for Keynesian
economics.
• According to Keynes, high unemployment was a result
of low aggregate demand which in turn was a
consequence of low investment.
• Further, Keynes believed that nominal wages would
not be completely flexible (i.e., it would be rigid).
• As a result, full employment would not be ensured in
the economy.
• It implies that aggregate supply will not be at the full
employment level always.
Basic tenets of the Keynesian model
and their policy implications
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.
Basic tenets of the Keynesian model
and their policy implications
1. The Economy is inherently Unstable and Is Subject
to Erratic Shocks
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 behavior was taken
to be the Great Depression where investment
dropped, and international trade collapsed due to
increased worldwide protection.
Basic tenets of the Keynesian model
and their policy implications
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
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.
Basic tenets of the Keynesian model
and their policy implications
3. Need for Government Intervention
• 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.
Basic tenets of the Keynesian model
and their policy implications
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.
Basic tenets of the Keynesian model
and their policy implications
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.
Basic tenets of the Keynesian model
and their policy implications
6. Information is The Key
• Keynesian theories put the spotlight on the key facet
of the working of markets, that the price system acts
to efficiently transmit all the necessary information to
market participants so as to co-ordinate all of their
plans.
• If prices are not allowed to change to carry new
information, or if people are not capable of seeing all
of the relevant new information, then the market
system may not work well.
Phillips Curve
• The classical economists believed money is neutral in
the sense that changes in money supply do not
influence real variables such as output and
employment (classical dichotomy discussed earlier).
• According to them, an increase in money supply
results in an increase in prices only.
• Keynes believed that monetary variables have real
implications.
Phillips Curve
• An increase in money supply results in a decrease in
interest rate, which leads to an increase in the level of
investment.
• An increase in the level of investment leads to
manifold increase in output through the investment
multiplier.
• Keynes however could not provide a theoretical
relationship between monetary and real variables in
an economy.
Phillips Curve
• Much after the publication of the General Theory, an
inverse relationship between inflation and
unemployment was established. It is known as the
Phillips Curve, as the empirical relation was first shown
by A W Phillips in 1958.
• Later development in macroeconomic theory
distinguished between the short-run Phillips Curve
(SRPC) and the long-run Phillips Curve (LRPC).
Phillips Curve
• The SRPC is the basis for policy trade-off between
inflation and unemployment.
• Keynesian economists argued that it was more
important to reduce unemployment, even at the cost
of some inflation.
Policy Prescriptions
• Equilibrium output and price level are determined by
the intersection of AD and AS curves.
• As stated earlier, there is no reason for the output to
be at the full employment level.
• According to Keynes, if private spending does not
suffice to create enough demand so as to result in full
employment, the government needs to intervene and
create demand through higher government spending.
• The demand can also be increased by using
expansionary monetary policy to lower the interest
rate and stimulate investment spending.
Policy Prescriptions
• However, monetary policy may not be able to lower
the interest rate sufficiently in case the preference for
liquidity is very high (monetary policy is ineffective
under conditions of liquidity trap).
• Keynes laid particular emphasis on the use of fiscal
policy to alleviate unemployment and increase output.
• According to Keynesian economists, government
spending should be counter-cyclical.
• When there is inflationary pressure in the economy
the government should cut down on public
expenditure and it should go for a surplus budget.
Policy Prescriptions
• On the other hand, when there is recession,
government should increase public spending.
• Thus Keynesian economics prescribes an activist role
for the government.
• It found widespread acceptance among policy makers.
• Its popularity can be gauged from the fact that during
the 1950s and 1960s most economists were
Keynesian.
Explaining the great depression
• Keynesians believed that the cause of the Great
Depression was due to a combination of events that
led to great uncertainty, huge decreases in investment,
and economies being stuck in an unemployment trap.
We will now see why they thought this.
• During the 1920s a great boom occurred in many
countries, with much investment undertaken. At the
same time a great deal of uncertainty also arose over
the future because of the following changes:
1. Changing trading patterns due to the relative decline
of the UK as an economic powerhouse, and the rise
of countries such as Japan
Explaining the great depression
2. Increasing international currency fluctuations
3. Increasing use of restrictive trading practices
regarding international trade, essentially to prevent
adjustment to the changes that were occurring
4. . Doubts about the stability of the international
financial system related to the huge reparations
required of Germany following World War I.
• By 1929 a mild recession had started. This and the
high level of uncertainty, and the fact that people had
been borrowing large amounts to buy assets on the
expectation that the assets would increase in price (a
speculative bubble) saw the US stock-market crash.
Explaining the great depression
• This was believed to have led to extremely pessimistic
business expectations and thus a collapse in
investment. The multiplier effects then fed through,
which were exacerbated by governments cutting back
spending to balance their budgets and by countries
imposing large import tariffs to protect their domestic
markets from imports.
• It sounds like a very plausible explanation!
Other Schools of Thought

Reading Ass.
• Monetary Macroeconomics
• New Classical Macroeconomics
• Real Business Cycle(RBC) Macroeconomics
• New Keynesian Macroeconomics