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1 Understanding modern macroeconomics
1.1 Macroeconomic issues and ideas
1.2 The role of economic theory and controversy
1.3 Objectives, instruments and the role of government
1.4 The Great Depression
1.5 Keynes and the birth of macroeconomics
1.6 The rise and fall of the Keynesian consensus
1.7 Theoretical schizophrenia and the neoclassical synthesis
1.8 Schools of thought in macroeconomics after Keynes
1.9 The new political macroeconomics
1.10 The renaissance of economic growth research
Macroeconomic thoughts
1. Macroeconomics Issues and Ideas
Macroeconomics is concerned with the structure, performance and behaviour of the economy as a whole
Attempt to understand the underlying determinants of the main aggregate trends, total output of goods and
services (GDP), unemployment, inflation and international transactions
Influence on the lives and welfare of all
Macroeconomic performance and policies are closely connected
Successful macroeconomic management: low unemployment and inflation, and steady and sustained eco-
nomic growth.
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Macroeconomic thoughts
Main topics in macroeconomics
BOP
Environmental Budget
Economics Deficit
Economic Fiscal
Growth Policy
Macroeconomic
Issue
International Globalization
trade
Exchange
Inequality Rate
Monetary
Policy
Macroeconomic thoughts
2. The Role of Economic Theory and Controversy
To develop as comprehensive understanding as possible of the way the economy functions
Macroeconomic theory, consisting of a set of views about the way the economy operates, organized within a
logical Framework
How it is likely to react to specific policies and the wide variety of demand and supply shocks which can cause
instability
Given the complexity of the real world, problem for economists is how to capture, in the form of specific models,
the complicated interactive behaviour of millions of individuals
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Macroeconomic thoughts
Macroeconomics is not an exact science but an applied one where ideas,
theories, and models are constantly evaluated against the facts, and often modified
or rejected ...
Macroeconomics is thus the result of a sustained process of construction,
of an interaction between ideas and events
-Blanchard (1997)
Macroeconomic thoughts
Mayer (1994) identifies seven sources controversy:
1. Limited knowledge about how the economy works
2. The ever-widening range of issues that economists investigate
3. Need to take into account wider influences of political factors
4. Differences in the natural resources (metaphysical core)
5. Value judgements
6. Social empathies
7. Methodologies of various economists
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Macroeconomic thoughts
3. Objectives, Instruments and the Role of Government
Friedman (1968)
There is wide agreement about the goals : high employment, stable prices, and rapid growth
There is less agreement: whether these goals are mutually compatible or, incompatible, can substituted for one
another
There is least agreement: role that various instruments of policy can in achieving the several goals
Disagreements between economists on matters of policy, what is the proper role of government in the economy?
Macroeconomic thoughts
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1.4 The Great Depression
The Great Depression gave birth to modern macroeconomics
Macroeconomic schools
Classical
Keynesian
Monetarist
New-Keynesian
Real Business Cycle
Austrian economics
Classical
1776, Adam Smith’s celebrated An Inquiry into the Nature and Causes of the Wealth of
Nations
Main idea here is that the profit and utility-maximizing behaviour of rational
economic agents operating under competitive conditions will, via the ‘invisible-hand’
mechanism
Free markets lead to an efficient outcome and are self-regulating
Favoured s laissez-faire: limiting government intervention and striving to keep
markets free of potential barriers to their efficient operation
Supply will create its own Demand: long run aggregate supply curve is inelastic;
therefore any deviation from full employment will only be temporary
Economic rationality, conceptions of rationality used in economic theory
wage theory: The marginal productivity theory of wages
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Adam Smith Henry George
Francis Hutcheson Thomas Malthus
Bernard de Mandeville James Mill
David Hume Francis Place
David Ricardo Jeremy Bentham
Henry Thornton Jean Charles
John Ramsay McCulloch Johann Heinrich
James Maitland, John Stuart Mill
Karl Marx
Nassau William Senior Thomas Tooke
Edward Gibbon Wakefield Robert Torrens
John Rae
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1.4 The Great Depression
Prior to Great Depression
1870-1929: GDP growth was 3.5%
Increased life expectancy by (average) 10-12 % - During 1900-1929
Increase in employment – unemployment rate were 3.2%
Weekly working hours were reduce from 60 hrs per week during 1900 to 44 hrs per
week during 1929
1 Cr New investors in share market
Share market enjoyed boom period during 1921 to 1928 ( nearly 20 fold increase in
share value)
Economy was at cyclical pick (During August 1929)
Therefore, the expected inevitable contraction of GDP during 1929-30
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1.4 The Great Depression
Prior to Great Depression
Impact of First World War period – 1914-1918
Three rival ideologies of liberal democracy, fascism and communism
Great Depression began in the United States and then spread around the world
Wall Street Crash of 1929 heralded one of the most dramatic and catastrophic periods
In a single week from 23 to 29 October the Dow Jones Industrial Average fell 29.5 per
cent, with ‘vertical’ price drops on ‘Black Thursday’ (24 October) and ‘Black Tuesday’
(29 October). Controversy exists over the causes of the stock market crash and its
connection with the Great Depression in the economic activity which followed
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1.4 The Great Depression
‘How did the severe recession of 1929–30 turn into the
Great Depression of 1931–33?’
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Macroeconomic thoughts
The extent and magnitude of the depression
The most severe downturn was in the USA
USA experienced
46.8% decline in industrial production
28 % decline in GDP
Unemployment, which was 3.2 per cent in 1929,rose to a
peak of 25.2 per cent in 1933
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Macroeconomic thoughts
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Macroeconomic thoughts
https://mru.org/courses/principles-economics-macroeconomics/business-fluctuations-great-depression-
ad-as-model
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Macroeconomic thoughts
How can we explain such a massive and catastrophic decline in aggregate economic activity?
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Macroeconomic thoughts
The vast majority of economists now agree that the catastrophic collapse of
output and employment after 1930 was in large part due to a series of policy
errors made by the fiscal and monetary authorities in a number of industrial
economies, especially the USA, where the reduction in economic activity was
greater than elsewhere
(Bernanke, 2000)
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Macroeconomic thoughts
1.5 Keynes and the Birth of Macroeconomics
1936 of Keynes’s -The General Theory of Employment, Interest and Money
Keynes recognized that the drastic economic situation confronting the capitalist system in the 1930s
threatened its very survival and was symptomatic of a fundamental flaw in the operation
of the price mechanism as a coordinating device
Classical world believed self-correcting market forces, operating via the price mechanism, restore equilibrium without the help of
government intervention
Say’s Law, denies the possibility of general overproduction or underproduction
Denies the possibility of deficiency of Aggregate demand
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Macroeconomic thoughts
1.6 The Rise and Fall of the Keynesian Consensus
1. Keynesian ideas concerning the responsibility of government for maintaining full employment
In the USA, the Employment Act of 1946 dedicated the Federal Government to the pursuit of
‘maximum employment, production and purchasing power’
2. Principle of Effective Demand : The most plausible explanation of the Great Depression is one involving a
massive decline in aggregate demand
3. Role of Stabilization policy : Fiscal and Monetary policy to govern the output
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Imperfect labour markets
Paradox of thrift (in recession, individuals save more, but this worsens the economic downturn
Liquidity trap: When low-interest rates fail to boost demand
Importance of confidence to the economic cycle
Deficit spending- In a recession, Keynes advocated government borrowing to provide
an injection of demand into the economy.
Economy operates less than full employment
propensity to consume, inducement to invest, marginal efficiency of capital,
liquidity preference, and multiplier effect
Government intervention is desirable to stabilized disequilibrium
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1.6 The Rise and Fall of the Keynesian Consensus
The elimination of mass unemployment during the Second World War had a profound
influence on the spread and influence of Keynesian ideas concerning the responsibility of
government for maintaining full employment
The post-war prosperity enjoyed in the advanced economies was assumed to be in large
part the direct result of Keynesian stabilization policies
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1.6 The Rise and Fall of the Keynesian Consensus
‘Golden Age’ (1950–73): During ‘Golden Age’ both unemployment and inflation were low
Period of exceptional economic performance:
1.Increased liberalization of international trade and transactions
2. Favourable circumstances and policies which contributed to producing low
inflation in conditions of very buoyant aggregate demand
3. Active government promotion of domestic demand
4. Growth possibilities following the end of the Second World War
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1.6 The Rise and Fall of the Keynesian Consensus
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1.6 The Rise and Fall of the Keynesian Consensus
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1.6. Fall of the Keynesian Consensus
The period 1973–83 do we see the simultaneous combination of high
unemployment and high inflation, i.e. stagflation
To the critics of Keynesianism stagflation was an inevitable legacy of the
‘Golden Age’ of demand management
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Macroeconomic thoughts
‘New Neoclassical Synthesis’
The central elements of this new synthesis involve both new classical and new Keynesian elements, namely:
1. The need for macroeconomic models to take into account intertemporal optimization;
2. The widespread use of the rational expectations hypothesis;
3. Recognition of the importance of imperfect competition in goods, labour and credit markets;
4. Incorporating costly price adjustment into macroeconomic models.
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1.8 Schools of Thought in Macroeconomics After Keynes
1970s this Keynesian approach increasingly came under attack
Two ‘counter-revolutionary’ approaches, monetarism and new classical macroeconomics
these approaches belief that there is no need for activist stabilization policy
the authorities cannot, and therefore should not, attempt to stabilize fluctuations in output and
employment through the use of activist demand management policies
https://mru.org/courses/principles-economics-macroeconomics/business-cycles-
monetarists
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The real business cycle approach
each stage of the business cycle, boom and slump, is an equilibrium
the business cycle is a Pareto efficient equilibrium
https://mru.org/courses/principles-economics-macroeconomics/business-cycles-real-business-cycle
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Monetarist on Macroeconomics
The Money Supply rises faster than the rate of growth of national income, then there will be inflation
Inflation is always and everywhere a monetary phenomenon
Friedman placed great emphasis on the role of price expectations
https://www.youtube.com/watch?v=YWrWQ4TUVW0
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Austrian economics
Austrian economics is a school of thought which places great emphasis on free markets,
Austrian school of Economics believe in free markets and avoiding government intervention in markets
Recessions caused by credit cycles. They argue Central Banks encourage excessive growth of credit by keeping
interest rates too low for too long. Some argue the credit bust of 2008 is a good example of Austrian economics
theory in action
Austrians criticise Keynesian fiscal policy. They argue government intervention to stimulate demand just leads to
wasted resources, greater inefficiency and stores up more problems
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Macroeconomic thoughts
New Keynesian economics
Menu costs and imperfect competition
The Calvo staggered contracts model
Coordination failure
Labor market failures: Efficiency wages
The new neoclassical synthesis
Taylor Rule
The New Keynesian Phillips curve
The science of monetary policy
The introduction of imperfectly competitive labor markets
The development of complex DSGE models
Sticky information
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Real business cycle theory
Growth and fluctuations are not distinct
(supply-side) shocks rather than unanticipated monetary (demand-side) shocks
Real shocks involves large random fluctuations in the rate of technological progress
Fluctuations in output and employment are Pareto-efficient
Government should not attempt to reduce these fluctuations through stabilization policy
Each stage of the business cycle, boom and slump, is an equilibrium
Every stage of the business cycle is a Pareto efficient equilibrium
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New Keynesian
Economist : Janet Yellen, Olivier Blanchard, Gregory Mankiw, Edmund
Phelps, David Romer, Joseph Stiglitz and Ben Bernanke
Adapt micro to macro theory
Incorporated the rational expectations hypothesis: wage and price
stickiness
Stabilization policy as capitalist economies are subjected to both
demand- and supply-side shocks
New Keynesians prefer to refer to as NAIRU – non-accelerating inflation
rate of unemployment)
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Austrian approach
https://mru.org/courses/principles-economics-macroeconomics/business-cycles-
austrian-economic-theory
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The New Political Macroeconomics
Macroeconomists is the influence by political factors
issues as business cycles, inflation, unemployment, growth, budget deficits and the
conduct and implementation of stabilization policies
two general political forces
1. policy maker’s desire to retain power, which acts as an incentive to ‘opportunistic’ behavior
2. society is polarized and this inevitably gives rise to some degree of social conflict
Rational forward looking Economic Agent: use adaptive expectations
The rational expectations hypothesis
‘rational opportunistic’ models, and ‘rational partisan’ theory
These models show that while the scope for opportunistic or
ideological behavior is more limited in a rational expectations setting
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Political macroeconomics involved research into the origin and persistence
of rising fiscal deficits and debt ratios, the political economy of growth, the
optimal size of nations, the economic and political risk
successful fiscal adjustment is highly correlated with the composition of
spending cuts
Unsuccessful adjustments are associated with cuts in public investment
expenditure
link between trade liberalization and political separatism
world dominated by trade restrictions, large political units make sense because
the size of a market is determined by political boundaries
Politicization of growth theory
Impact on economic growth of politics, policy, and institutional arrangements
Economists recognize that economic growth is a necessary condition for
the elimination of poverty and sustainable increases in living standards
why do political élites deliberately block the adoption of institutions and
policies that would help to eliminate economic backwardness?
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Politicization of growth theory
Impact on economic growth of politics, policy, and institutional arrangements
Economists recognize that economic growth is a necessary condition for
the elimination of poverty and sustainable increases in living standards
why do political élites deliberately block the adoption of institutions and
policies that would help to eliminate economic backwardness?
Acemoglu and Robinson (2000a, 2003) argue that superior institutions and
technologies are resisted because they may reduce the political power of the
élite
absence of strong institutions allows autocratic rulers to adopt political
strategies that are highly effective at defusing any opposition
As a result economic growth and development stagnate
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