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1 Understanding modern macroeconomics

1.1 Macroeconomic issues and ideas
1.2 The role of economic theory and controversy
1.3 Objectives, instruments and the role of government
1.4 The Great Depression
1.5 Keynes and the birth of macroeconomics
1.6 The rise and fall of the Keynesian consensus
1.7 Theoretical schizophrenia and the neoclassical synthesis
1.8 Schools of thought in macroeconomics after Keynes
1.9 The new political macroeconomics
1.10 The renaissance of economic growth research

Macroeconomic thoughts
1. Macroeconomics Issues and Ideas

Macroeconomics is concerned with the structure, performance and behaviour of the economy as a whole

Attempt to understand the underlying determinants of the main aggregate trends, total output of goods and
services (GDP), unemployment, inflation and international transactions

Influence on the lives and welfare of all

Macroeconomic performance and policies are closely connected

Successful macroeconomic management: low unemployment and inflation, and steady and sustained eco-
nomic growth.

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Macroeconomic thoughts
Main topics in macroeconomics

BOP
Environmental Budget
Economics Deficit

Economic Fiscal
Growth Policy

Macroeconomic
Issue

International Globalization
trade

Exchange
Inequality Rate
Monetary
Policy

Macroeconomic thoughts

2. The Role of Economic Theory and Controversy

 To develop as comprehensive understanding as possible of the way the economy functions

 Macroeconomic theory, consisting of a set of views about the way the economy operates, organized within a
logical Framework

 How it is likely to react to specific policies and the wide variety of demand and supply shocks which can cause
instability

 Given the complexity of the real world, problem for economists is how to capture, in the form of specific models,
the complicated interactive behaviour of millions of individuals

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Macroeconomic thoughts

Macroeconomics is not an exact science but an applied one where ideas,

theories, and models are constantly evaluated against the facts, and often modified
or rejected ...
Macroeconomics is thus the result of a sustained process of construction,
of an interaction between ideas and events

-Blanchard (1997)

Macroeconomic thoughts

Mayer (1994) identifies seven sources controversy:

1. Limited knowledge about how the economy works

2. The ever-widening range of issues that economists investigate
3. Need to take into account wider influences of political factors
4. Differences in the natural resources (metaphysical core)
5. Value judgements
6. Social empathies
7. Methodologies of various economists

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Macroeconomic thoughts

3. Objectives, Instruments and the Role of Government

Friedman (1968)

There is wide agreement about the goals : high employment, stable prices, and rapid growth

There is less agreement: whether these goals are mutually compatible or, incompatible, can substituted for one
another

There is least agreement: role that various instruments of policy can in achieving the several goals

Disagreements between economists on matters of policy, what is the proper role of government in the economy?

Macroeconomic thoughts

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1.4 The Great Depression

The Great Depression gave birth to modern macroeconomics

Macroeconomic schools
Classical
Keynesian
Monetarist
New-Keynesian
Real Business Cycle
Austrian economics

Classical
1776, Adam Smith’s celebrated An Inquiry into the Nature and Causes of the Wealth of
Nations

Main idea here is that the profit and utility-maximizing behaviour of rational
economic agents operating under competitive conditions will, via the ‘invisible-hand’
mechanism

Free markets lead to an efficient outcome and are self-regulating

Favoured s laissez-faire: limiting government intervention and striving to keep

markets free of potential barriers to their efficient operation

Supply will create its own Demand: long run aggregate supply curve is inelastic;
therefore any deviation from full employment will only be temporary

Economic rationality, conceptions of rationality used in economic theory

wage theory: The marginal productivity theory of wages

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Adam Smith Henry George

Francis Hutcheson Thomas Malthus
Bernard de Mandeville James Mill
David Hume Francis Place

David Ricardo Jeremy Bentham

Henry Thornton Jean Charles
John Ramsay McCulloch Johann Heinrich
James Maitland, John Stuart Mill
Karl Marx

Nassau William Senior Thomas Tooke

Edward Gibbon Wakefield Robert Torrens
John Rae

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1.4 The Great Depression

 Prior to Great Depression

1870-1929: GDP growth was 3.5%

Increased life expectancy by (average) 10-12 % - During 1900-1929

Increase in employment – unemployment rate were 3.2%

Weekly working hours were reduce from 60 hrs per week during 1900 to 44 hrs per
week during 1929

1 Cr New investors in share market

Share market enjoyed boom period during 1921 to 1928 ( nearly 20 fold increase in
share value)

Economy was at cyclical pick (During August 1929)

Therefore, the expected inevitable contraction of GDP during 1929-30

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1.4 The Great Depression

Prior to Great Depression

Impact of First World War period – 1914-1918

Three rival ideologies of liberal democracy, fascism and communism

Great Depression began in the United States and then spread around the world

Wall Street Crash of 1929 heralded one of the most dramatic and catastrophic periods

In a single week from 23 to 29 October the Dow Jones Industrial Average fell 29.5 per
cent, with ‘vertical’ price drops on ‘Black Thursday’ (24 October) and ‘Black Tuesday’
(29 October). Controversy exists over the causes of the stock market crash and its
connection with the Great Depression in the economic activity which followed

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1.4 The Great Depression

‘How did the severe recession of 1929–30 turn into the

Great Depression of 1931–33?’

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Macroeconomic thoughts

The extent and magnitude of the depression

The most severe downturn was in the USA

USA experienced

46.8% decline in industrial production

28 % decline in GDP

Unemployment, which was 3.2 per cent in 1929,rose to a

peak of 25.2 per cent in 1933

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Macroeconomic thoughts

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Macroeconomic thoughts

https://mru.org/courses/principles-economics-macroeconomics/business-fluctuations-great-depression-
ad-as-model

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Macroeconomic thoughts

How can we explain such a massive and catastrophic decline in aggregate economic activity?

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Macroeconomic thoughts

The vast majority of economists now agree that the catastrophic collapse of
output and employment after 1930 was in large part due to a series of policy
errors made by the fiscal and monetary authorities in a number of industrial
economies, especially the USA, where the reduction in economic activity was
greater than elsewhere

(Bernanke, 2000)

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Macroeconomic thoughts

1.5 Keynes and the Birth of Macroeconomics

1936 of Keynes’s -The General Theory of Employment, Interest and Money

Keynes recognized that the drastic economic situation confronting the capitalist system in the 1930s
threatened its very survival and was symptomatic of a fundamental flaw in the operation
of the price mechanism as a coordinating device

Classical world believed self-correcting market forces, operating via the price mechanism, restore equilibrium without the help of
government intervention
Say’s Law, denies the possibility of general overproduction or underproduction

Denies the possibility of deficiency of Aggregate demand

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Macroeconomic thoughts

1.6 The Rise and Fall of the Keynesian Consensus

1. Keynesian ideas concerning the responsibility of government for maintaining full employment

In the USA, the Employment Act of 1946 dedicated the Federal Government to the pursuit of
‘maximum employment, production and purchasing power’

2. Principle of Effective Demand : The most plausible explanation of the Great Depression is one involving a
massive decline in aggregate demand

3. Role of Stabilization policy : Fiscal and Monetary policy to govern the output

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Imperfect labour markets

Paradox of thrift (in recession, individuals save more, but this worsens the economic downturn
Liquidity trap: When low-interest rates fail to boost demand
Importance of confidence to the economic cycle
Deficit spending- In a recession, Keynes advocated government borrowing to provide
an injection of demand into the economy.
Economy operates less than full employment
propensity to consume, inducement to invest, marginal efficiency of capital,
liquidity preference, and multiplier effect
 Government intervention is desirable to stabilized disequilibrium

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1.6 The Rise and Fall of the Keynesian Consensus

The elimination of mass unemployment during the Second World War had a profound
influence on the spread and influence of Keynesian ideas concerning the responsibility of
government for maintaining full employment

The post-war prosperity enjoyed in the advanced economies was assumed to be in large
part the direct result of Keynesian stabilization policies

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1.6 The Rise and Fall of the Keynesian Consensus

‘Golden Age’ (1950–73): During ‘Golden Age’ both unemployment and inflation were low
Period of exceptional economic performance:
1.Increased liberalization of international trade and transactions
2. Favourable circumstances and policies which contributed to producing low
inflation in conditions of very buoyant aggregate demand
3. Active government promotion of domestic demand
4. Growth possibilities following the end of the Second World War

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1.6 The Rise and Fall of the Keynesian Consensus

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1.6 The Rise and Fall of the Keynesian Consensus

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1.6. Fall of the Keynesian Consensus

The period 1973–83 do we see the simultaneous combination of high

unemployment and high inflation, i.e. stagflation

To the critics of Keynesianism stagflation was an inevitable legacy of the

‘Golden Age’ of demand management

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Macroeconomic thoughts

‘New Neoclassical Synthesis’

The central elements of this new synthesis involve both new classical and new Keynesian elements, namely:

1. The need for macroeconomic models to take into account intertemporal optimization;

2. The widespread use of the rational expectations hypothesis;

3. Recognition of the importance of imperfect competition in goods, labour and credit markets;

4. Incorporating costly price adjustment into macroeconomic models.

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1.8 Schools of Thought in Macroeconomics After Keynes

1970s this Keynesian approach increasingly came under attack

Two ‘counter-revolutionary’ approaches, monetarism and new classical macroeconomics

these approaches belief that there is no need for activist stabilization policy

the authorities cannot, and therefore should not, attempt to stabilize fluctuations in output and
employment through the use of activist demand management policies

https://mru.org/courses/principles-economics-macroeconomics/business-cycles-
monetarists

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The real business cycle approach

each stage of the business cycle, boom and slump, is an equilibrium

the business cycle is a Pareto efficient equilibrium

https://mru.org/courses/principles-economics-macroeconomics/business-cycles-real-business-cycle

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Monetarist on Macroeconomics

The Money Supply rises faster than the rate of growth of national income, then there will be inflation
Inflation is always and everywhere a monetary phenomenon
Friedman placed great emphasis on the role of price expectations

https://www.youtube.com/watch?v=YWrWQ4TUVW0

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Austrian economics

Austrian economics is a school of thought which places great emphasis on free markets,

Austrian school of Economics believe in free markets and avoiding government intervention in markets

Recessions caused by credit cycles. They argue Central Banks encourage excessive growth of credit by keeping
interest rates too low for too long. Some argue the credit bust of 2008 is a good example of Austrian economics
theory in action

Austrians criticise Keynesian fiscal policy. They argue government intervention to stimulate demand just leads to
wasted resources, greater inefficiency and stores up more problems

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Macroeconomic thoughts

New Keynesian economics

 Menu costs and imperfect competition
 The Calvo staggered contracts model
 Coordination failure
 Labor market failures: Efficiency wages
 The new neoclassical synthesis
 Taylor Rule
 The New Keynesian Phillips curve
 The science of monetary policy
 The introduction of imperfectly competitive labor markets
 The development of complex DSGE models
 Sticky information

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Real business cycle theory

Growth and fluctuations are not distinct

(supply-side) shocks rather than unanticipated monetary (demand-side) shocks

Real shocks involves large random fluctuations in the rate of technological progress

Fluctuations in output and employment are Pareto-efficient

Government should not attempt to reduce these fluctuations through stabilization policy

Each stage of the business cycle, boom and slump, is an equilibrium

Every stage of the business cycle is a Pareto efficient equilibrium

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New Keynesian

Economist : Janet Yellen, Olivier Blanchard, Gregory Mankiw, Edmund

Phelps, David Romer, Joseph Stiglitz and Ben Bernanke

Adapt micro to macro theory

Incorporated the rational expectations hypothesis: wage and price

stickiness

Stabilization policy as capitalist economies are subjected to both

demand- and supply-side shocks

New Keynesians prefer to refer to as NAIRU – non-accelerating inflation

rate of unemployment)

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Austrian approach

https://mru.org/courses/principles-economics-macroeconomics/business-cycles-
austrian-economic-theory

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The New Political Macroeconomics

Macroeconomists is the influence by political factors

issues as business cycles, inflation, unemployment, growth, budget deficits and the
conduct and implementation of stabilization policies

two general political forces

1. policy maker’s desire to retain power, which acts as an incentive to ‘opportunistic’ behavior
2. society is polarized and this inevitably gives rise to some degree of social conflict

Rational forward looking Economic Agent: use adaptive expectations

The rational expectations hypothesis

‘rational opportunistic’ models, and ‘rational partisan’ theory

These models show that while the scope for opportunistic or

ideological behavior is more limited in a rational expectations setting

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 Political macroeconomics involved research into the origin and persistence

of rising fiscal deficits and debt ratios, the political economy of growth, the
optimal size of nations, the economic and political risk

successful fiscal adjustment is highly correlated with the composition of

spending cuts

Unsuccessful adjustments are associated with cuts in public investment

expenditure

 link between trade liberalization and political separatism

world dominated by trade restrictions, large political units make sense because
the size of a market is determined by political boundaries

 Politicization of growth theory

Impact on economic growth of politics, policy, and institutional arrangements

Economists recognize that economic growth is a necessary condition for

the elimination of poverty and sustainable increases in living standards

why do political élites deliberately block the adoption of institutions and

policies that would help to eliminate economic backwardness?
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 Politicization of growth theory

Impact on economic growth of politics, policy, and institutional arrangements

Economists recognize that economic growth is a necessary condition for

the elimination of poverty and sustainable increases in living standards

why do political élites deliberately block the adoption of institutions and

policies that would help to eliminate economic backwardness?

Acemoglu and Robinson (2000a, 2003) argue that superior institutions and
technologies are resisted because they may reduce the political power of the
élite

absence of strong institutions allows autocratic rulers to adopt political

strategies that are highly effective at defusing any opposition

As a result economic growth and development stagnate

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