Macroeconomics
Macroeconomics is the study of the economy viewed as a single interactive system. It is concerned, not with individual transactions, but with economy-wide aggregates including national income, the rate of inflation and the unemployment rate. At the theoretical level it seeks to explain how national income grows, how it fluctuates and what then happens to prices and unemployment. At the positive level it tests competing theories against the evidence provided by economic statistics, and it estimates the numerical relationships required to construct forecasting models. At the normative level it considers what policies would serve to promote economic stability and growth and full employment.
Since a national economy is too complex to analyse for those purposes, macroeconomics uses simplified versions, or “economic models” which ignore those components that are thought to have relatively little influence upon the question under consideration. The initial procedure postulates the way that the components of the system interact and deduces from those postulated relationships, how the system as a whole may be expected to behave. That deductive process is normally followed by the use of evidence and inductive reasoning to test, either the relationships themselves, or the deduced behaviour of the system.
This article is concerned with the concepts and theories of economics. An account of the way in which those theories developed, and of the contributions of those responsible, is available in the article on the History of Economic Thought.
The Main Macroeconomic Theories
The circular flow of income
The simplest theoretical model of a national economy is a system consisting of all of the country’s firms on the one hand, and all of its households on the other. National income in such a system is the total value of the firms’ output, which must be the same as the amount of money reaching the households in the form of wages interest and dividends (it has nowhere else to go). That money is then either saved, or spent on the firms’ products. The money reaching the firms consists of that spent by consumers and that invested (ie spent on the purchase of capital equipment from some of the firms). National income is thus both household spending plus savings and household spending plus investment. It follows, as a matter of arithmetic, that in such a system, savings must match investment. But in the economy as we know it, savings plans and investment plans are mostly made independently by different people. If the model is to represent what happens in such an economy, it must contain a mechanism by which planned investment is brought into line with planned savings
The classical model
Classical theory applies the market mechanism (which is described in the article on microeconomics) both to the problem of reconciling savings and investment plans, and to the operation of the labour market. It envisages the economy as a set of inter-linked markets with supply in one market determining demand in others in a manner which could be represented as a vast set of simultaneous equations. It embodies the concept of general equilibrium in which an imaginary auctioneer organises trading at prices which keep demand constantly in supply in all markets. It assumes in particular that in the market for savings, an excess of planned saving over planned investment would result in a reduction in the interest rate sufficient to bring the plans into line – and vice versa. In the market for labour, it assumes that if the planned demand for labour fell below the level required for full employment, wages would fall to a level at which full employment would be restored. The economy is thus taken to have a self-righting capacity as regards both output and employment.
The Keynesian model
In the Keynesian model, planned savings are determined mainly by the level of income of the households. The adjustment mechanism by which a rise in planned saving would be brought into line with planned investment would be a fall in firms’ output - resulting in a sufficient fall in household income to reduce planned savings to equality with planned investment. And if the fall in output brought about a reduction in planned investment, there would be a further output reduction. The economy could settle into a stable condition in which output was below productive capacity. In the Keynesian model, moreover, the labour market does not have a self-righting capacity either, because wages are assumed to be “sticky downwards”, so the output fall would be accompanied by a rise in unemployment.
Monetarism
In its simplest form, monetarism seems to offer an easily understood explanation of inflation and a straightforward prescription for its cure. It seems obvious that if pound notes were dropped from a helicopter to the extent necessary to double the amount in circulation, then prices would double. It is a small step to the conclusion that inflation is caused by increases in the money supply , and an obvious further step to prescribe control of the money supply as the cause for inflation. Those conclusions are not in fact obvious because they depend upon the assumption that people would spend the additional money on goods. That need not be the case. The assumption of the Keynesian model is that they would spend it all on interest-bearing financial assets, and on that assumption there would be no tendency to bid up prices in the goods market. All depends upon which assumption is nearer the truth. Monetary economics is mainly about the answer to that question. An examination of the statistics revealed a strong association between money supply and the monetary value of national income in the United States and in Britain [1] (with income roughly constant in real terms, that implied that the main change had been in prices). For various reasons that conclusion turned out not to be decisive, however. [2]
Qualifications and Extensions
Expectations
None of the above theories makes allowance for the fact that people learn from experience. The fact that they do has a bearing upon economic activity, however. The price that an investor pays for a security is determined by expectations of future returns, based upon the experience of past performance. But it is hard to say how widely such behaviour applies. The assumption that people generally fail to learn from experience and make persistent forecasting errors is clearly unsatisfactory, but the opposite assumption is also difficult to believe. The Rational Expectations Hypothesis [3] postulates that, in forming their expectations, people make use of all of the relevant information; and that, although they may make random errors, their forecasts are not systematically biased. While not claiming it to be literally true, economists of the New Classical school claim that it offers a better hypothesis concerning the working of the economy than the available alternatives.