MACRO ECONOMICS

Module: 1 ORIGIN AND DEVELOPMENT OF MACROECONOMICS

Economic theory is divided into two main branches: Microeconomics and

Macroeconomics. The term ‘micro’ means small and microeconomics means ‘economics in
small’. It studies economic actions of individual units like households or individuals, firms,
industries etc. Problems of resource allocation and determination of equilibrium relative
prices constitute the major domain of microeconomics. On the other hand the term ‘macro’
means large and macroeconomics is ‘economics in large’. It is the study of relationships
between broad aggregates in the economy, like national income and output, aggregate
employment, aggregate demand, general price level, etc. It deals with overall dimensions of
economic life. In terms of a metaphor used by Gardner Ackley, “it studies the character of
forest independently of the trees which compose it”.
Macroeconomics is concerned with questions related to the functioning of the economy as a
whole. Main topics of analysis in macroeconomics are determination of aggregate employment,
output and income in economy, cyclical fluctuations in general economic activity, determination of
general price level, inflation or deflation in general price level, economic growth, balance of
payments, exchange rate, etc.

The term ‘macroeconomics’ was introduced by the Norwegian economist, Ragnar Frisch. in
1933. But as a main branch of the mainstream economic theory, macroeconomics became popular
after the publication of ‘The General Theory of Employment Interest and Money’ by J.M. Keynes in
1936. So J.M. Keynes is called the father of modern macroeconomics.

Difference between Macroeconomics and Microeconomics

Macroeconomics Microeconomics

1) Macroeconomics is the study of economy 1) Microeconomics deals with behaviour of

as a whole individual economic units.
2) It deals with economic aggregates like 2) It deals with economic activities of
national income, aggregate demand, households, firms, industries, etc.
general employment, general price level,
etc.
3) Macroeconomics is concerned with
determination and fluctuations in 3) Microeconomics is primarily concerned
 aggregate employment, output, and with resource allocation and equilibrium
income and general price level. level of relative prices of goods and
4) Aggregate demand and aggregate supply factors.
are the main tools of analysis in 4) In microeconomics main tools of analysis
macroeconomics. are demand and supply.
5) Macroeconomics takes relative prices as
given.
5) Microeconomics takes general price level
6) Macroeconomics uses general
as given.
equilibrium analysis to study the working
6) Microeconomics uses mainly partial
of an economy
equilibrium analysis.
In recent years the boundary line between macro economics and micro economics is
becoming less and less distinct. It is the difference in approach and method of analysis
macroeconomics distinguishable from microeconomics. Some economists believe that meaningful
macroeconomics is possible only if it has a strong micro foundation. According to them behaviour of
macro variables should be rationalized on the basis of behaviour of micro units which constitute the
aggregate. Thus macro economic analysis has micro dimensions and the two branches of economics
are mutually supporting.

Importance of macroeconomics

Macro economic theory is a very important tool of analysis. Importance of macro economics
can presented as follows.

1) Macroeconomics provides the theoretical framework to analyze the functioning and

performance of an economy.
2) Macroeconomics provides the tools for estimating national income and to analyze
associated problems.
3) Macroeconomics is facilitates the study of growth and development of economies.
4) Macroeconomics studies economic instability, problems of inflation and deflation and
suggest remedies.
5) Macroeconomic theories are helpful in the formulation of economic policies.
6) Macroeconomic theories provide the scope for the use of quantitative techniques for
forecasting, programming and empirical estimation.
Limitations of Macroeconomics

1) In macroeconomics, there is the danger of excessive aggregation and generalization.

2) Economic units are not always homogenous and therefore meaningful aggregation is
impossible.
 3) There are conceptual and practical difficulties in the formulation of economic aggregates.
4) Economic aggregation is subject to errors and ambiguities.

CONTRIBUTIONS OF VARIOUS SCHOOLS OF THOUGHT

CLASSICAL SCHOOL

J.M. Keynes used the term ‘Classical economists’ to refer to virtually all economists who had
written on macroeconomics prior to 1936. Prominent among them were Adam Smith, David Ricardo,
J.S. Mill, Alfred Marshall, A.C. Pigou, etc. All these economists dealt primarily with microeconomic
questions with significant differences in their approach. But their macroeconomic postulates were
characterized by a high degree of homogeneity and hence Keynes grouped them together and called
classical economists.

1. Productive capacity determines the real output. Real output that an economy can produce
depends on the productive capacity which in turn depends on the real stock of factors of production
and technology. The growth of an economy is the result of increase in the stock of factors and
advances in technology. Classical analysis was real analysis.

2. Full employment. Classical economists believed in the optimizing behaviour of markets.

Free operation of market forces will ensure full employment of all available resources. No resources
will remain idle for want of market.

3. Says law of markets. The classical doctrine of full employment was based on the Say’s law
markets developed by J.B. Say. The law states that ‘supply will create its own demand’. It means
every act of production or supply will generate income and demand equivalent to the value of output.
The law implied that demand will not be a constraint in the attainment of full employment.

4. Price mechanism. In the real market, forces of demand and supply will determine relative
prices in such a way that demand for each commodity is equal to its supply. Free operation of price
mechanism will ensure general equilibrium at full employment.

5. Money is neutral. Classical economists considered money as a medium of exchange only,

without any role to play in the determination of real variables. Quantity of money will influence only
the absolute price level. They considered money as ‘neutral’ in its impact on real variables.

6. Classical dichotomy. In classical theory real and money markets are separated, without any
interconnection between them. In real market relative prices are determined and absolute price level is
determined in the money market. This approach was called Classical dichotomy between real and
monetary sectors of the economy.
7. Role of economic policies. According to classical economists, free enterprise economies are
self adjusting and self regulating. There is no role for government policies in stabilizing an economy
at full employment level. They considered economic policies as unnecessary and harmful
interventions in the free working of economies.

However, the great depression of 1930’s shattered the foundations of classical

macroeconomics. It was historically proved that demand is not automatic and a glut in aggregate
demand can lead to large scale unemployment. Market mechanism failed to restore full employment
equilibrium. Classical economists failed miserably in explaining the economic depression. J.M.
Keynes criticized the classical macro economics as a special theory, which can explain only the rare
case of full employment.

KEYNESIAN ECONOMICS

J. M. Keynes is the founder of the Keynesian School of economics. The foundation of the
Keynesian system rests on ‘The General Theory of Employment Interest and Money”, published
by J.M. Keynes in 1936. The publication of the General Theory introduced revolutionary changes in
the theoretical analysis of functioning of an economy and policy prescriptions for economic
stabilization. The fundamental change in macroeconomic thinking brought about by ‘the General
Theory’ is called Keynesian Revolution. In the post-Keynesian period the disciples of Keynes
developed and refined the theoretical approach of J. M. Keynes with simplified techniques of analysis.
The theoretical edifice founded on the basic principles and ideas of J.M. Keynes is known as
Keynesian economics.

Keynesian economics was developed against the backdrop of the great depression of 1930’s.
During the periods of great depression, in all major free enterprise economies of the world
employment and output declined sharply. The prevailing economic orthodoxy, classical economics,
was unable to explain large scale unemployment and to suggest remedies. The faith in classical
economics was shattered and it was relegated to the background. It was in this context that Keynes’s
economics and policy prescriptions swept the field of economic thinking, replacing the classical
macroeconomics.

Macroeconomic Postulates of J.M. Keynes

1. Principle of effective demand. The corner stone of Keynes’s theory is the principle of
effective demand. Employment and output in an economy depends on the level of effective
demand.
2. Underemployment equilibrium. Keynes has pointed out that the demand in an economy
need not always be sufficient enough to support full employment output. If aggregate demand
 falls short of aggregate supply at full employment, the result will be underemployment
equilibrium, with significant amount of unemployment of labour and capital. According to
Keynes, full employment is a rare situation and the more ‘general’ case is that of
underemployment equilibrium.
3. Consumption function. One major contribution of J.M. Keynes to macroeconomic theory is
the consumption function, which make aggregate consumption a stable function of aggregate
real income. Keynes argued that consumption will increase, whenever income increases, but it
may not increase as much as income increases. It is through consumption function Keynes
pointed out the possibility of a glut in aggregate demand
4. Importance of investment Demand As aggregate income is divided between consumption
and saving, it is necessary that investment demand should fill the gap between aggregate
income and aggregate consumption demand. According to Keynes investment demand is
highly unstable because of its dependence on expectations about future. Therefore at any time
investment may fall short of the quantity required to fill the gap between aggregate income
and aggregate consumption. It follows that aggregate demand may not always be equal to
aggregate supply at full employment. The result will be underemployment equilibrium.
5. Theory of Multiplier. A very important contribution of J.M. Keynes is his theory of
multiplier, in which he explained the impact change in investment demand on aggregate
income.
6. Liquidity preference theory. Another important contribution of J.M. Keynes is the liquidity
preference theory, which stated demand for money as a function of interest rate.
7. Integration of real and money markets. Keynes criticized the classical dichotomy and has
succeeded in integrating the real and monetary sectors of the economy through interest rate
effect. According to him change in money supply is not neutral; it can influence real income
through its effect on interest rate and investment demand.
8. Role of economic policies An important outcome of Keynes’s theory of income
determination was the enhanced role of economic policies in stabilizing an economy close to
full employment equilibrium. According to Keynes, free enterprise economies are not self
regulating and market mechanism may fail to bring about full employment equilibrium if
aggregate demand is insufficient. In such cases government can stabilize the economy using
fiscal and monetary policies.

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 MONETARISM
The term ‘Monetarism’ refers to the resurgence of Classical ideas in the field of quantity
theory of money in the post Keynesian period. Milton Friedman of Chicago University was the
founder father of Monetarism. Leading Monetarists include Karl Brunner, Allan Meltzer, Anna
Schwartz etc. Monetarists assign a very crucial role to money in determining the aggregate level of
economic activity.
Important macroeconomic propositions of monetarism are given below:
1 Money supply is the dominant influence on nominal income : It means that
nominal income in an economy is determined by money supply. Changes in money supply will lead to
changes in nominal income.
2 In the long run money supply influences only the price level and other nominal
magnitudes: Changes in money supply will not affect real variables in the long run, it will affect only
nominal values.
3 In the short run money supply does influence real variables : In the short run
employment and output are strongly influenced by changes in money supply. Monetarists argued that
money is the dominant factor that causes cyclical movements in output and employment.
4 Role of economic policies: Free operation of price mechanism will stabilize an
economy at full employment. Economic instability in the short run is the result of variations in the
growth money supply.
On the basis of these macroeconomic propositions, monetarists made two important policy
conclusions:
1 Monetary Policy: As variations money supply can destabilize an economy, it is
necessary to maintain a stable money supply. According to monetarists, stability is best achieved by
adopting a rule for the growth in money supply.
2 Fiscal policy: Fiscal policy has no systematic effect on economic activity. It is
ineffective as a tool of economic stabilization.

Ref: 1 R T Froyen – Macroeconomics

2 M.C Vaish – Macroeconomic Theory
NEW CLASSICAL MACROECONOMICS
New Classical macroeconomics refers to the strong revival of classical macroeconomics,
during 1970s, as a strong reaction against Keynesian economics. Historically new classical economics
emerged against the background of the phenomenon called ‘stagflation’ (co-existence of inflation and
high unemployment) and the failure of Keynesian policy prescriptions to solve the problem. The
origin of new classical macroeconomics owes primarily to the works of economists like Robert E.
Lucas, T.J. Sargent, and Edward Prescott etc.
Main propositions of the New Classical School are the following:
 1 Economic agents are rational and they optimize.
2 Prices are perfectly flexible and markets clear.
3 Expectations are formed rationally. Expectations are rational, when they are based on
all available information.
4 Aggregate supply of output depends on relative price level. Relative price level
means the current price level in relation to expected price level. An increase in relative price will
induce additional supply of output and vice-versa.
5 An anticipated inflation can have no impact on the supply of output. As inflation is
fully expected, expected price level will also change along with current price level. There will be no
change in relative price and supply of output.
6 If inflation is unanticipated, it can have some temporary impact on output. Because of
incomplete information about the rise in price level, expected price will lag behind actual price level.
Inflationary rise in current price will be mistaken as an increase in relative price level and supply of
output will increase. But as people get more information about the inflation, expected price will also
rise t the level of current prices. Increase in relative price will disappear and the additional output will
be withdrawn. In the long run inflation cannot influence output.
7 Systematic economic policies are ineffective in influencing the level of output,
because they can be predicted. Rule based monetary policies are totally ineffective.
8 Discretionary policies are unexpected and as such, can have some temporary impact
on output. But once people get more information, people will revise their expectations in tune with
policy changes. In the long run discretionary policies are also ineffective.
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NEW KEYNESIAN SCHOOL
J.M Keynes and his followers were highly skeptical of the classical idea that free market
economies are self-adjusting and maintain full employment equilibrium. They believed that markets
fail to clear because prices and wages are sticky. While early versions of Keynesian models
emphasized money wage rigidity, in later models focus on price and real wage rigidities. The New
Keynesian approach that emerged during 1980s attempted to provide strong micro-foundation for the
Keynesian macro economic system. New Keynesian economists like N. Gregory Mankiw, David
Romer, and George Akerlof etc have attempted to show that rigidities in wages and prices arise from
the optimizing behaviour of economic agents. Thus the main theme of the New Keynesian Economics
is the rationalization of rigidities in prices and wages.
New Keynesian economists have developed different rationale for price and wage rigidities.
They believed that a number of features of wage and price setting contribute to the rigidities in them.
In spite of the differences in the rationale, a common feature of all Keynesian models is the
assumption of imperfect competition in product and labour markets.
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