Evolution of macroeconomic thought I

Evolution of Macroeconomic Thought:

1. Classical Era (19th - early 20th century):

o Belief in a self-correcting economy without major fluctuations.

o Minimal government intervention was advocated.

o Prices, wages, and interest rates should be determined by market forces (supply and demand).

o Assumed flexibility of prices and wages.

2. Great Depression (1929-1933):

o Led to a massive decline in income, output, employment, and prices.

o Shook the confidence in classical economics.

3. Keynesian Revolution (by John Maynard Keynes):

o Criticized classical assumptions of flexible prices and wages; argued they are sticky.

o Advocated for active government intervention to counter economic recessions.

o Marked a radical shift from classical ideas and became known as the Keynesian Revolution.

4. Counter-Revolution (1970s):

o Economic problems (e.g., stagflation) revealed the limitations of Keynesian theory.

o Robert E. Lucas and others revived classical ideas.

o Argued that government intervention is ineffective.

o This movement is sometimes termed a counter-revolution to Keynesianism.

5. Differences between Classical and Keynesian Schools:

o Role of Supply and Demand: Classical focuses more on supply; Keynesian emphasizes demand,
especially in recessions.

o Price and Wage Flexibility: Classical assumes flexibility; Keynesian assumes stickiness.

o Real vs. Monetary Sector: Classical view supports dichotomy (they are separate); Keynesian
challenges this view.

o Say’s Law (Classical): "Supply creates its own demand".

 Keynesians reject Say’s Law, especially during recessions.

Various Schools of Macroeconomic Thought:

1. Historical Background and Evolution:

 Macroeconomics did not exist as a separate branch before Keynes.

 Classical economists used microeconomic tools to explain macro phenomena.

 Keynesian economics emerged in response to the Great Depression (1930s).

 Subsequent global developments led to new schools of thought.

2. Role of Economic Theory:

 Theory: A well-tested explanation of an observable phenomenon.

 Hypothesis: A tentative statement that becomes a theory after repeated confirmation.

 Theories reflect social, political, and historical contexts.

 Example: Oil crisis affects both oil-exporting and oil-importing countries differently — theory helps predict
and guide policy.

3. Classical and Neoclassical Schools:

 Classical theory (18th–19th centuries) arose with capitalism.

 Assumed flexible prices and self-correcting markets that maintain full employment.

 Evolved into neoclassical theory, focusing on utility, marginalism, and mathematical models.

 Advocated minimal government intervention.

4. Keynesian Revolution (1930s):

 Great Depression showed classical models failed to explain mass unemployment.

 Keynes argued that unemployment results from deficient aggregate demand, due to low investment.

 Advocated government intervention to stimulate demand and employment.

5. Later Developments:

 Neoclassical synthesis tried to merge classical and Keynesian ideas.

 Post-1970s: Rise of:

o Monetarism (Milton Friedman),

o New Classical Economics (rational expectations, micro-foundations),

o New Keynesian Economics (improved Keynesian models with micro-foundations).

6. Alternative Schools:

 Institutionalist Economics and Marxist Economics developed outside mainstream theory.

 Emerged strongly after World War II.

7. Post-Keynesian Economics:

 Economists like Harrod, Domar, and Kaldor extended Keynesian thought to long-run growth.

 Focused on investment-driven increases in productive capacity.

 Post-Keynesians emphasized economic growth as the central concern.

8. Neoclassical Growth Theory:

 Solow’s Growth Model was a response to Post-Keynesian models.

 It provided a neoclassical explanation of long-term economic growth.

Keynesian theory
1. Definition and Historical Context:

 The term "classical theory" was popularized by John Maynard Keynes.

 It refers to economists before the 1930s, like Adam Smith, David Ricardo, J. S. Mill, and J. B. Say.

 Two periods:

o Classical Period (18th–19th centuries): Adam Smith, Ricardo, etc.

o Neoclassical Period (20th century): Alfred Marshall, A. C. Pigou, etc.

2. Classical vs. Mercantilism:

 Classical theory critiqued mercantilism, which linked national wealth to gold/silver (bullion).

 Classical economists believed real factors (like production and labor) determine wealth.

 Money is only a medium of exchange, not a source of wealth.

3. Key Assumptions of Classical Theory:

 Wages and prices are fully flexible, ensuring:

o Full employment output.

o No involuntary unemployment.

 Say’s Law: "Supply creates its own demand."

 Money affects only price level, not output (Quantity Theory of Money).

 Economy has self-adjusting mechanisms, needing no government intervention.

4. Labour Market Mechanics:

 Firms and workers are:

o Optimisers.

o Fully informed.

o Operating under perfect competition.

 Labour Demand = Marginal Product of Labour (MPN) — downward sloping in real wage.

 Labour Supply increases with real wage — upward sloping.

 Labour market equilibrium determines:

o Full employment level of labour.

o No involuntary unemployment.

5. Output Determination:

 Output (Y) is determined by a production function:

Y=F(K,N)

where:

o K = Capital

o N = Labour
  At full employment of labour (N₀), full employment output (Y₀) is achieved.

 Aggregate Supply (AS) is perfectly inelastic at full employment output.

6. Wage and Price Adjustments:

 If price level increases, nominal wages adjust to keep real wages constant, maintaining full employment.

 If nominal wages do not rise with price level, real wage falls, leading to reduced labour supply.

Here are the main points from the section on Quantity Theory of Money, Say’s Law, and Classical Policy
Prescriptions:

1. Quantity Theory of Money:

 Classical view: Money is demanded only as a medium of exchange.

 Equation:

MV=PY

where:

o M = Money supply

o V = Velocity of money (assumed constant)

o P = Price level

o Y = Output (assumed constant at full employment level)

 Implication:

 → Price level is directly proportional to money supply.

 Output (Y) is fixed; Money supply (M) determines Price level (P).

2. Aggregate Demand:

 Derived from the Quantity Theory of Money.

 As price level changes inversely with output (given constant MV), the Aggregate Demand (AD) curve slopes
downward.

3. Say’s Law:

 “Supply creates its own demand.”

 Savings (S) depend positively on interest rate.

 Investment (I) depends negatively on interest rate.

 Flexible interest rates ensure:

 Capital market clears automatically, keeping aggregate demand = aggregate supply.

4. Classical Policy Prescriptions:

 Full flexibility of wages and interest rates ensures self-adjusting economy.

 Real output and employment are determined by real factors (e.g., technology, capital, labor).

 Money only affects nominal variables (like price level), not real ones.

5. Classical Dichotomy:

 Real and nominal sides of the economy are separate.

  Neutrality of money: Money has no effect on real variables (output, employment).

6. Role of Government:

 Minimal or no government intervention.

 Economy is believed to naturally operate at full employment.

Keynesian Theory and the IS-LM Framework

1. Failure of Classical Theory:

 Classical theory couldn’t explain the Great Depression (1930s).

 Unemployment, bank failures, investment collapse showed that markets were not self-adjusting.

 Prompted Keynes to write The General Theory of Employment, Interest and Money.

2. Key Contributions of Keynesian Theory:

a. Unemployment due to Low Aggregate Demand

 High unemployment arises from insufficient aggregate demand, especially due to low investment.

b. Wage Rigidity

 Nominal wages are not fully flexible, unlike in classical theory.

 Leads to underemployment equilibrium (less than full employment output).

c. Aggregate Supply and Demand

 Equilibrium output is determined where Aggregate Supply (AS) meets Aggregate Demand (AD).

 This equilibrium may occur below full employment.

3. Aggregate Demand in Keynesian Theory:

a. Consumption Function:

 Consumption depends on current disposable income, not interest rates.

b. Investment Function:

 Investment is negatively related to interest rate and influenced by expectations ("animal spirits").

 Highly volatile component of AD.

c. Goods Market Equilibrium:

4. Money Market and Interest Rate Determination:

 Money demand arises from:

1. Transaction motive

2. Precautionary motive

3. Speculative motive (Keynes’ addition)

 Money demand function:

 Interest rate is determined by money market equilibrium, not saving–investment balance.

  Liquidity Trap: At very low interest rates, money demand becomes infinitely elastic, rendering monetary
policy ineffective.

5. IS-LM Model:

 Shows simultaneous equilibrium in goods (IS) and money (LM) markets.

a. IS Curve (Goods Market Equilibrium):

 Downward sloping (inverse relation between i and Y).

b. LM Curve (Money Market Equilibrium):

 Upward sloping (positive relation between i and Y).

 Flat LM in liquidity trap → interest-insensitive monetary policy.

6. Keynesian Aggregate Demand Curve:

 Derived from IS-LM model.

 Shows relationship between price level and output through money and goods market equilibrium.

7. Contrast with Classical Theory:

 No guarantee of full employment.

 Equilibrium can occur with unemployment.

 Active government intervention may be necessary to manage demand and stabilize output.

Aggregate Supply and Keynesian Policy Prescriptions

1. Keynesian View of Labour Market & Wage Rigidity

 Wages are set by contracts between workers and employers.

 Wages do not adjust quickly, unlike the classical belief of full flexibility.

 This rigidity in wages is key to understanding unemployment in the short run.

 New-Classical economists assume perfect competition and flexibility.

 New-Keynesians assume imperfect competition and rigid wages/prices.

2. Keynesian Aggregate Supply (AS) Curve

 AS curve slopes upward due to rising costs (especially wages) as output increases.

 In short run (recession phase), high unemployment keeps wages constant even if demand increases → flat
(horizontal) AS curve.

 This flat AS curve is called the Keynesian AS Curve or Short-Run Aggregate Supply (SRAS).

 In medium run, AS becomes upward sloping.

3. Phillips Curve

 Phillips Curve shows inverse relationship between inflation and unemployment.

 Short-Run Phillips Curve (SRPC): due to wage rigidity, policy makers can trade off between inflation and
unemployment.

 Keynesians emphasized reducing unemployment, even at the cost of some inflation.

  Classical economists believed in the neutrality of money (i.e., no real effect from money supply).

 Keynes believed money affects real variables like output and employment through investment and multiplier
effects.

4. Keynesian Policy Prescriptions

 Equilibrium output is where AD intersects AS, not necessarily at full employment.

 If private demand is insufficient, the government must intervene.

 Two main tools:

o Fiscal policy (preferred by Keynes): increase government spending to raise demand and reduce
unemployment.

o Monetary policy: lower interest rates to stimulate investment.

 But may be ineffective in a liquidity trap (interest rates can't go lower).

 Counter-cyclical fiscal policy:

o During inflation: cut government spending (surplus budget).

o During recession: increase government spending (deficit budget).

 Keynesian theory supports an activist government role in economic stabilization.

5. Historical Impact

 Keynesian economics dominated economic policy-making during the 1950s and 1960s.