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Macroeconomics

Circulation in macroeconomics
Circulation in macroeconomics
Macroeconomics (from Greek prefix "makros-" meaning "large" + "economics") is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes national, regional, and global economies.[1][2] With microeconomics, macroeconomics is one of the two most general fields in economics.

Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. In contrast, microeconomics is primarily focused on the actions of individual agents, such as firms and consumers, and how their behavior determines prices and quantities in specific markets. While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by both governments and large corporations to assist in the development and evaluation of economic policy and business strategy.

Contents


Basic macroeconomic concepts

Macroeconomics encompasses a variety of concepts and variables, but three are central topics for macroeconomic research.[3] Macroeconomic theories usually relate the phenomena of output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also extremely important to all economic agents including workers, consumers, and producers.

Output and income

National output is the total value of everything a country produces in a given time period. Everything that is produced and sold generates income. Therefore, output and income are usually considered equivalent and the two terms are often used interchangeably. Output can be measured as total income, or, it can be viewed from the production side and measured as the total value of final goods and services or the sum of all value added in the economy.[4] Macroeconomic output is usually measured by Gross Domestic Product (GDP) or one of the other national accounts. Economists interested in long-run increases in output study economic growth. Advances in technology, accumulation of machinery and other capital, and better education and human capital all lead to increased economic output overtime. However, output does not always increase consistently. Business cycles can cause short-term drops in output called recessions. Economists look for macroeconomic policies that prevent economies from slipping into recessions and that lead to faster long-term growth.

Unemployment

The amount of unemployment in an economy is measured by the unemployment rate, the percentage of workers without jobs in the labor force. The labor force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded from the labor force.

Chart using US data showing the relationship between economic growth and unemployment expressed by Okun's law. The relationship demonstrates cyclical unemployment. Economic growth leads to a lower unemployment rate. Unemployment can be generally broken down into several types that are related to different causes. Classical unemployment occurs when wages are too high for employers to be willing to hire more workers. Wages may be too high because of minimum wage laws or union activity. Consistent with classical unemployment, frictional unemployment occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment.[5] Structural unemployment covers a variety of possible causes of unemployment including a mismatch between workers' skills and the skills required for open jobs.[6] Large amounts of structural unemployment can occur when an economy is transitioning industries and workers find their previous set of skills are no longer in demand. Structural unemployment is similar to frictional unemployment since both reflect the problem of matching workers with job vacancies, but structural unemployment covers the time needed to acquire new skills not just the short term search process.[7] While some types of unemployment may occur regardless of the condition of the economy, cyclical unemployment occurs when growth stagnates. Okun's law represents the empirical relationship between unemployment and economic growth.[8] The original version of Okun's law states that a 3% increase in output would lead to a 1% decrease in unemployment.[9]

Inflation and deflation

A general price increase across the entire economy is called inflation. When prices decrease, there is deflation. Economists measure these changes in prices with price indexes. Inflation can occur when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to deflation. Central bankers, who control a country's money supply, try to avoid changes in price level by using monetary policy. Raising interest rates or reducing the supply of money in an economy will reduce inflation. Inflation can lead to increased uncertainty and other negative consequences. Deflation can lower economic output. Central bankers try to stabilize prices to protect economies from the negative consequences of price changes.

Chart showing the ten year moving averages of changes in price level and growth in money supply (using the measure of M2, the supply of hard currency and money held in most types of bank accounts) in the United States from 1875 to 2011. Over the long run, the two series show a close relationship. Changes in price level may be result of several factors. The quantity theory of money holds that changes in price level are directly related to changes in the money supply. Most economists believe that this relationship explains long-run changes in the price level. Short-run fluctuations may also be related to monetary factors, but changes in aggregate demand and aggregate supply can also influence price level. For example, a decrease in demand because of a recession can lead to lower price levels and deflation. A negative supply shock, like an oil crisis, lowers aggregate supply and can cause inflation.

Macroeconomic models

Aggregate Demand-Aggregate Supply

Traditional AS-AD diagram showing an shift in AD and the AS curve becoming inelastic beyond potential output. The AD-AS model has become the standard textbook model for explaining the macroeconomy. This model shows the price level and level of real output given the equilibrium in aggregate demand and aggregate supply. The aggregate demand curve's downward slope means that more output is demanded at lower price levels. The downward slope is the result of two effects:[10] the Pigou or real balance effect, which states that as real price fall real wealth increases, so consumers demand more goods, and the Keynes or interest rate effect, which states that as prices fall the demand for money declines causing interest rates to decline and borrowing for investment and consumption to increase. In the conventional Keynesian use of the AS-AD model, the aggregate supply curve is horizontal at low levels of output and becomes inelastic near the point of potential output, which corresponds with full-employment. Since the economy cannot produce beyond more than potential output, any AD expansion will lead to higher price levels instead of higher output.

The AD-AS diagram can model a variety of macroeconomic phenomena including inflation. When demand for goods exceeds supply there is an inflationary gap where demand-pull inflation occurs and the AD curve shifts upward to a higher price level. When the economy faces higher costs, cost-push inflation occurs and the AS curve shifts upward to higher price levels. The AS-AD diagram is also widely used as pedagogical tool to model the effects of various macroeconomic policies.

IS/LM

In this example of an IS/LM chart, the IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y). The IS/LM model represents the equilibrium in interest rates and output given by the equilibrium in the goods and money markets. The goods market is respoed by the equilibrum in investes and saving (IS), and the money market is represented by the equilibrium between the money supply and liquidity preference. The IS curve consists of the points where investment, given the interest rate, is equal to savings, given output. The IS curve is downward sloping because output and the interest rate have an inverse relationship in the goods market: As output increases more money is saved, which means interest rates must be lower to spur enough investment to match savings. The LM curve is upward sloping because interest rates and output have a positive relationship in the money market. As output increases, the demand for money increases, and interest rates increase.

The IS/LM model is often used to demonstrate the effects of monetary and fiscal policy. Textbooks frequently use the IS/LM model, but it does not feature the complexities of most modern macroeconomic models. Nevertheless, these models still feature similar relationships to those in IS/LM.

Macroeconomic policies

To try to avoid major economic shocks, such as The Great Depression, governments make adjustments through policy changes they hope will stabilize the economy. Governments believe the success of these adjustments is necessary to maintain stability and continue growth. This economic management is achieved through two types of governmental strategies:

Development

Origins

Macroeconomics descended from the once divided fields of business cycle theory and monetary theory.[11] The quantity theory of money was particularly influential prior to World War II. It took many forms including the version based on the work of Irving Fisher:

M\cdot V = P\cdot Q

In the typical view of the quantity theory, money velocity (V) and the quantity of goods produced (Q) would be constant, so any increase in money supply (M) would lead to a direct increase in price level (P). The quantity theory of money was a central part of the classical theory of the economy that prevailed in the early twentieth century.

Keynes and his followers

Macroeconomics, at least in its modern form,[12] began with the publication of John Maynard Keynes's General Theory of Employment, Interest and Money.[13] When the Great Depression struck, classical economists had difficulty explaining how goods could go unsold and workers could be left unemployed. In classical theory, prices and wages would drop until the market cleared, and all goods and labor were sold. Keynes offered a new theory of economics that explained why markets might not clear, which would evolve (later in the 20th century) into a group of macroeconomic schools of thought known as Keynesian economics - also called Keynesianism or Keynesian theory.

In Keynes's theory, the quantity theory broke down because people and businesses tend to hold on to their cash in tough economic times, a phenomenon he described in terms of liquidity preferences. Keynes also explained how the multiplier effect would magnify a small decrease in consumption or investment and cause declines throughout the economy. Keynes also noted the role uncertainty and animal spirits can play in the economy.[14]

The generation following Keynes combined the macroeconomics of the General Theory with neoclassical microeconomics to create the neoclassical synthesis. By the 1950s, most economists had accepted the synthesis view of the macro economy.[15] Economists like Paul Samuelson, Franco Modigliani, James Tobin, and Robert Solow developed formal Keynesian models, and contributed formal theories of consumption, investment, and money demand that fleshed out the Keynesian framework.[16]

Monetarism

Milton Friedman updated the quantity theory of money to include a role for money demand. He argued that the role of money in the economy was sufficient to explain the Great Depression and aggregate demand oriented explanations were not necessary. Friedman argued that monetary policy was more effective than fiscal policy; however, Friedman doubted the government has ability to "fine-tune" the economy with monetary policy. He generally favored a policy of steady growth in money supply instead of frequent intervention.[17] Friedman also challenged the Phillips Curve relationship between inflation and unemployment. Friedman and Edmund Phelps (who was not a monetarist) proposed an "augmented" version of the Phillips Curve that excluded the possibility of a stable, long-run tradeoff between inflation and unemployment. When the oil shocks of the 1970s created a high unemployment and high inflation, Friedman and Phelps were vindicated. Monetarism was particularly influential in the early 1980s. Monetarism fell out of favor when central banks found it difficult to target money supply instead of interest rates as monetarists recommended. Monetarism also became politically unpopular when the central banks created recessions in order to slow inflation.

New classicals

New classical macroeconomics further challenged the Keynesian school. A central development in new classical thought came when Robert Lucas introduced rational expectations to macroeconomics. Prior to Lucas, economists had generally used adaptive expectations where agents were assumed to look at the recent past to make expectations about the future. Under rational expectations, agents are assumed to be more sophisticated. A consumer will not simply assume a 2% inflation rate because that has been the average the past few years; he will look at current monetary policy and economic conditions to make an informed forecast. When new classical economists introduced rational expectations into their models, they showed that monetary policy could only have a limited impact.

Lucas also made an influential critique of Keynesian empirical models. He argued that forecasting models based on empirical relationships would be unstable. He advocated models based on fundamental economic theory that would, in principle, be more stable as economies changed. Following Lucas's critique, new classical economists, led by Edward C. Prescott and Finn E. Kydland created real business cycle (RBC) models of the macroeconomy. RBC models were created by combining fundamental equations from neo-classical microeconomics. RBC models explained recessions and unemployment with changes in technology instead changes in the markets for goods or money. Critics of RBC models argue that money clearly plays an important role in the economy, and the idea that technological regress can explain recent recessions is also implausible.[18] Despite questions about the theory behind RBC models, they have clearly been influential in economic methodology.

New Keynesian response

New Keynesian economists responded to the new classical school by adopting rational expectations and focusing on developing micro-founded models that are immune to the Lucas critique. Stanley Fischer and John B. Taylor produced early work in this area by showing that monetary policy could be effective even in models with rational expectations when contracts locked-in wages for workers. Other new Keynesian economists expanded on this work and demonstrated other cases where inflexible prices and wages led to monetary and fiscal policy having real effects. Like classical models, new classical models had assumed that prices would be able to adjust perfectly and monetary policy would only lead to price changes. New Keynesian models investigated sources of sticky prices and wages, which would not adjust, allowing monetary policy to impact quantities instead of prices.

By the late 1990s economists had reached a rough consensus. The rigidities of new Keynesian theory were combined with rational expectations and the RBC methodology to produce dynamic stochastic general equilibrium (DSGE) models. The fusion of elements from different schools of thought has been dubbed the new neoclassical synthesis. These models are now used by many central banks and are a core part of contemporary macroeconomics.[19]

See also

Notes

References

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