Introduction to Economics –ECO401 VU

Lesson 25

INTRODUCTION TO MACROECONOMICS
MACROECONOMICS
As a subject, macroeconomics only began to be taught in colleges and universities in the 1940s
after the influence of a very influential British economist, John Maynard Keynes who believed the
macro economy (with its associated variables) deserved to be understood and analyzed in its
own right, and not just as an aggregation of the various micro-markets, as was believed earlier.
Macroeconomics is a branch of economics that deals with the performance, structure, and
behavior of a national economy as a whole. The variables of interest change from the price,
demand or supply of a particular product to the economy-wide price level, aggregate demand
and aggregate supply.

AGGREGATE DEMAND (AD)

Aggregate demand (AD) is the total planned or desired spending (expenditure) in the economy
during a given period. AD is the sum of consumption, investment, government spending and net
exports (i.e. exports minus imports), and is inversely related to the aggregate price level through
the wealth, interest rate and international purchasing power effects.

AGGREGATE SUPPLY (AS)

Aggregate supply (AS) is the total value of goods and services that all the firms in the economy
would and can willingly produce in a given time period. Aggregate supply is a function of
available inputs, technology and the price level. It slopes upward in P-Output space but the
exact slope depends whether the economy is operating at below full employment (flat) or full
employment (steep).

CLASSICAL ECONOMICS
Classical economics is widely regarded as the first modern school of economic thought. Its
major developers include Adam Smith, David Ricardo, Thomas Malthus and John Stuart Mill.
Sometimes the definition of classical economics is expanded to include William Petty, Johann
Heinrich von Thünen, and Karl Marx. Classical economists were the earliest brand of
economists the world knew. They were essentially micro-economists who believed the macro
economy was an uninteresting aggregation of individual (or micro) markets, and any problem at
the macro level was necessarily a symptom of some micro level problem.

OPTIMAL ROLE OF GOVERNMENT UNDER CLASSICAL ECONOMICS

The optimal role for the government under classical economics was one of laissez-faire. They
believed that if the prices of goods, services and factors were allowed to be determined by the
free operation of the forces of demand and supply (i.e. the price mechanism) the best possible
outcome for resource allocation would obtain. In other words the economy would be at the full
employment level, and it would not be possible to improve that situation through government
intervention.
Before 1930, there was no concept of macroeconomics. There were number of events
happened during 1920-30s that necessitated the need of macroeconomics. Until the 1930s,
most economic analysis did not separate out individual behavior from aggregate behavior.
With the Great Depression of the 1930s and the development of the concept of national
income and product statistics, the field of macroeconomics began to expand.

THE CONCEPT OF INVISIBLE HAND

Invisible hand was a concept introduced by Adam Smith in 1776 to describe the paradox of
laissez-faire market economy. The invisible hand doctrine holds that, with each participant
pursuing his or her own private interest, a market system nevertheless works to the benefits of
all as though a benevolent invisible hand were directing the whole process. According to Adam
smith, invisible hand of the market operates therefore the market mechanism is the best model

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Introduction to Economics –ECO401 VU

if the economy wants to operate at a high level of efficiency. Since the classical economists
believed on perfectly competitive markets, so according to them shortages & surpluses are
temporary phenomena when markets decide about the price, market would automatically clear
these shortages & surpluses through price mechanism. According to say’s law, “supply
creates its own demand”. When there is surplus labor in the economy that situation could not
persist so long because the excess supply of labor push the prices of labor go down, wage
rate goes down, firms will demand more labor due to lower wage rates, so in this way, supply
of labor creates its own demand of labor.
Invisible hand is the term used by Adam Smith to describe the natural force that guides free
market capitalism through competition for scarce resources. According to Adam Smith, in a
free market each participant will try to maximize self-interest, and the interaction of market
participants, leading to exchange of goods and services, enables each participant to be better
of than when simply producing for him/her. He further said that in a free market, no regulation
of any type would be needed to ensure that the mutually beneficial exchange of goods and
services took place, since this "invisible hand" would guide market participants to trade in the
most mutually beneficial manner.

FULL EMPLOYMENT
The Classical economists assumed that if the economy was left to itself, then it would tend to
full employment equilibrium. This would happen if the labour market worked properly.
Full employment is a state of the economy in which the productive resources of the economy are
fully employed. Output may be expanded from this full employment level by asking laborers to
work overtime or renting capital from outside. An alternative (historical) definition of full
employment was: that level of employment at which no (or minimal) involuntary unemployment
exists.
An important law the Classical subscribed to, which assumed particular importance in the
context of the Great Depression, was Say’s law: “supply creates its own demand.” The
implication of this was that involuntary unemployment (people being unemployed against their
wishes) was a temporary phenomenon as the excess supply of labour would cause wages to
fall thereby prompting firms to demand more labour. If there was persistent unemployment, it
was voluntary, i.e. workers themselves preferred to remain unemployed.

THE CLASSICAL VIEWS ABOUT GREAT DEPRESSION

The Classical’ reading of the three problems of the Great Depression, i.e. low investment, high
unemployment and low output, was as follows:
a. Investment was low because the interest rate was too high in the loanable funds
market. Policy recommendation: savings be increased to lower the interest rate and
boost investment
b. Unemployment was high because of obstructions to the free market mechanism in the
labour market which were preventing wages from falling to the market clearing level.
Policy recommendation: these obstructions: benefit payments to unemployed, taxes on
income and trade unions be eliminated.

FAILURE OF THE CLASSICAL MODEL

After 1930, the classical model failed. Solution of classical economist was not found reasonable
to solve the world crises prevailed at that time. The Great Depression was the longest and
severest recession the world has ever seen. It struck North America and Europe in the late
1920s after the Wall Street crash of 1929 (and following the earlier hyperinflation in Germany,
and the formation of the Soviet Union) and lasted till the mid 1930s. It was characterized by
persistent high unemployment, low investment by firms and falling prices of goods, services
and factors. Hyperinflation is inflation at extremely high rates (say 1000, 1 million, or even 1
billion percent a year).
At that time, unemployment rate went upto 25% in 1933 in USA and Western Europe. The
classical model failed because they did not give satisfactory solution to all these problem.

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Introduction to Economics –ECO401 VU

They kept on insisting on old doctrine. They focused on the removal of impediments of free
market economy.

KEYNES AND THE ORIGINS OF MODERN MACRO ECONOMICS

Keynesian economics also called Keynesianism or Keynesian Theory is an economic theory
based on the ideas of the 20th-century British economist John Maynard Keynes. Keynesian
economics promotes a mixed economy, in which both the state and the private sector are
considered to play an important role. He argued that government policies could be used to
promote demand at a macro level, to fight high unemployment and deflation of the sort seen
during the 1930s. Keynes gave the reasons of great depression and also suggested the policy
advice on how Govt can rectify the situation.
THE KEYNESIANS’ VIEWS ABOUT GREAT DEPRESSION
Keynes’ view on the causes of the Great Depression and what needed to be done was very
different. He believed that there were overarching problems of low demand and static
pessimistic expectations that needed to be addressed rather than disequilibria in the loanable
funds, labour and goods markets. In particular, he maintained that:
a. Low investment was because of firms’ bearish expectations about their ability to sell
the products they produced. Firms needed to see that the potential buyers of their
goods had the money and the willingness to buy goods before they could be convinced
to undertake more production thereof. Therefore, higher savings, which would lead to
low consumption expenditure on goods and services would not increase but decrease
investment by reinforcing firms’ bearish expectations about their ability to sell their
products. Policy recommendation: households should be convinced to increase
consumption and reduce saving.
b. Unemployment was high and rising because the labour market equilibrium was moving
further and further away from the full employment level. This was not because wages
were being prevented from falling to the market clearing level, but because the market
clearing level fell further with each wage decrease. This happened because a reduction
in wages also lowered consumers’ earning and spending power reinforcing firms’
pessimistic view of their ability to sell their products. Policy recommendation: higher
money payments to consumers should be given out (possibly by the state) in order to
increase their ability to buy the goods being produced by firms.

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