Adigrat University Dep.

t of AcFn Macroeconomics 2019

1. State of Macroeconomics

1.1. Introduction

Economics is the study of the economy and the behavior of people in the economy. Traditionally,
economics is divided into two: microeconomics and macroeconomics. Microeconomics studies the
behavior of individuals and firms in economic decision making. Macroeconomics is a branch of
economics that deals with aggregate behavior of individuals in the economy. It is concerned with the
study of the behavior of the economy as a whole. It is concerned with the study of macroeconomic
variables such as booms and recessions, national output, growth of output, inflation, unemployment,
the balance of payments, and Exchange rates. Moreover, Macroeconomics focuses on economic
policies [monetary or fiscal policies] that affect consumption and investment, trade balance, the
money stock, government budget, interest rate, and national debt.

The macroeconomics policy of any country focuses in achieving the following two most important
objectives. These are economic growth and stability of the economy. Economic growth refers to the
growth of output (GDP) in an economy whereas economic stability refers to achieving low or stable
inflation, stable nominal interest rate, stable exchange rate, and low level of unemployment.

1.2. Evolution of Macroeconomics Schools of Thoughts and Recent Development

Available documents suggest that formal study on economic issues was started around 2 century
AD in ancient Greek philosophy/wisdom. Plato and Aristotle were the two prominent (famous)
ancient Greek philosophers who produced enormous economic articles on economics that served
as foundation/basis for further studies and advancement of economics. However, the studies of
scholars conducted on economic issues and theories developed up to the industrial revolution of
the 18th century focus only on microeconomic issues.

Macroeconomics as a branch of economics was emerged 238 years back with the writing of
Adam Smith ―The wealth of Nation‖ in 1776. The study of macroeconomics from 1776 to date
is divided in to two broad categories: the orthodox school and the recent/contemporary
macroeconomics schools.

Chapter I State of Macroeconomics Page 1 of 5

Adigrat University Dep.t of AcFn Macroeconomics 2019

1. The Orthodox Macroeconomics

This school of thought includes macroeconomics thinking of schools of thoughts evolved

between 1776 and 1975. The three schools of thought categorized under the orthodox
macroeconomics school are the classical school of thought, the neo-classical school of thought,
and the Keynesian macroeconomics.

A. Classical School of Thought (1776 - 1870)

This is the era of the marginalist approach (thought). During this period, the distinction between
micro and macroeconomics was not clear. The ruling principle (the dominant idea) of this school
of thought was the invisible hand or laissez-faire (which means leave the market free or free
market) coined by Alfred Marshall and advocated by Adam Smith. The reason for their argument
was that supply will create its own demand or price set by the private sector alone will
automatically correct/equilibrate any imbalance or disequilibria created in the economy both in
the short run and the long run without government intervention.

Adam Smith also described the government as the necessary evil and hence advocated that the
government should refrain from intervening in the market. For Adam Smith and his followers
any government policy is ineffective to correct economic disorder or disequilibrium. In other
words, government intervention will distort the market rather than stabilizing.

B. The Neo Classical School of Thought (1870 - 1936)

The idea of the neoclassical school of thought was not different from the classical school. The
only difference between the two schools of thought is the contribution that is made by Marshall
on ‘absolute and comparative advantage of nations in international trade.

C. Keynesian Macroeconomics (1936-1975)

An American economist called Keynes challenged/criticized the classical wisdoms of

macroeconomics based on the events or episodes during the great economic depression of the
early 1930s (1929 to 1935). The great depression was caused by excessive or overproduction of
wheat and coffee. Due to excess production than demanded the price of wheat and coffee goes
down, implying supply fails to create its demand as argued by the classical. So, the main thesis

Chapter I State of Macroeconomics Page 2 of 5

Adigrat University Dep.t of AcFn Macroeconomics 2019
of the Keynesian stream is that the economy is subjected to failure so that it may not achieve full
employment level. Thus, government intervention is inevitable (unavoidable).

2. Recent Developments in Macroeconomics (1970s – Present)

There is no dominant school of thought of macroeconomics from 1970s onward. There have
been two main intellectual traditions in macroeconomics. One school of thought believes that
government intervention can significantly improve the operation of the economy; the other
believes that markets work best if left to themselves. In the 1960s, the debate on these questions
involved Keynesians including Franco Modigliani and James Tobin on one side and monetarists
led by Milton Friedman on the other. In the 1970s, the debate on the same issues brought to the
new group- the new classical macroeconomists, who by and large replaced the monetarists in
keeping up the argument against using active government policies to try to improve economic
performance. On the other side are the new Keynesians; they may not share many of the detailed
belief of Keynesians except the belief that government policy can help the economy to perform
better.

A. New Classical School

The new classical macroeconomics remained influential in the 1980s. This school of
macroeconomics shares many policy views with Friedman. It sees the world as one in which
individuals act rationally in their self-interest in the markets that adjust rapidly to changing
conditions. According to it, the government worsens things if it intervenes in the market. The
central working assumptions of the new classical school are three:

Economic agents maximize: Households and firms make optimal decisions if all available
information is given and those decisions are the best possible in the circumstances in which they
find themselves.

Expectations are rational: Rational expectations are statistically the best predictions of the
future as they can be made using the available information.

Markets clear: The essence of the new classical approach is the assumption that markets are
continuously in equilibrium. That means prices and wages adjust in order to equate supply and
demand. In other words they are market clearing. For instance, any unemployed person who

Chapter I State of Macroeconomics Page 3 of 5

Adigrat University Dep.t of AcFn Macroeconomics 2019
really wants a job will offer to cut his or her wage until the wage is low enough to attract an
employer. Similarly, anyone with an excess supply of goods on the shelf will cut prices so as to
sell.

B. New Keynesians

The New Keynesian macroeconomics is the school of thought in modern macroeconomics that
evolved from the ideas of John Maynard Keynes. Keynes wrote The General Theory of
Employment, Interest, and Money in the thirties, and his influence among academics and
policymakers increased through the sixties. In the seventies, however, new classical economists
such as Robert Lucas, Thomas J. Sargent, and Robert Barro called into question many of the
precepts (principles) of the Keynesian revolution. The label "new Keynesian" describes those
economists who, in the eighties, responded to the new classical critique with adjustments to the
original Keynesian tenets (doctrine).

The new classical group remains highly influential in today‘s macroeconomics. But a new
generation of scholars, the new Keynesians, mostly trained in the Keynesian tradition but
moving beyond it, emerged in the 1980s. They do not believe that markets clear all the time but
seek to understand and explain exactly why markets fail.

The new Keynesians argue that markets sometimes do not clear even when individuals are
looking out for their own interests because of information problem and cost of changing prices.
Both information problems and costs of changing prices lead to some price rigidities which cause
macroeconomic fluctuations in output and employment. For example, in the labor market, firms
that cut wage not only reduce the cost of labor but are likely to wind up with a poorer quality
labor. Thus they will be reluctant to cut wages.

The primary disagreement between new classical and new Keynesian economists is over how
quickly wages and prices adjust. New classical economists build their macroeconomic theories
on the assumption that wages and prices are flexible. They believe that prices "clear" markets (or
balance supply and demand) by adjusting quickly. New Keynesian economists, however, believe
that market-clearing models cannot explain short-run economic fluctuations, and so they
advocate models with "sticky" wages and prices. New Keynesian theories rely on this stickiness

Chapter I State of Macroeconomics Page 4 of 5

Adigrat University Dep.t of AcFn Macroeconomics 2019
of wages and prices to explain why involuntary unemployment exists and why monetary policy
has such a strong influence on economic activity.

Chapter I State of Macroeconomics Page 5 of 5