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 (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.

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 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. Experience has shown that expectations do in fact have a significant influence upon some aspects of economic behaviour. In particular, it has been found that the inflation rate at any given time is influenced by expectations of future inflation - a fact that has implications for the conduct of monetary policy.

The Natural Rate of Unemployment

The concept of expectations is conceptually relevant to the level of unemployment. A relationship between wage increases and unemployment was discovered in the late 1950s that was known as the Phillips Curve But subsequent experience suggested the possibility of an association between the unemployment rate and both the inflation rate and the expected inflation rate - referred to as the expectations augmented Phillips curve . As a point of reference, the unemployment rate at which the expected inflation rate is the same as the actual inflation rate was termed The Non-Accelerating Inflation Rate of unemployment (NAIRU) or simply the natural rate of unemployment. The idea was that if unemployment were to rise, the expected inflation rate and the actual inflation rate would both fall, and that in the long term unemployment would fall back to its natural rate as expected inflation came back into line with actual inflation.

The Output Gap

The difference between the actual and the natural rate of unemployment is related to the difference between actual and potential output according to Okun’s Law . And the difference between actual and potential output, known as the output gap, is a factor affecting inflation. That is the basis of the Taylor Rule referred to below, which can be regarded as a version of the Phillips curve in which it is the output gap rather than the unemployment rate that determines the inflation rate.

Disequilibrium

When the unrealistic assumptions of general equilibrium theory are replaced by a more realistic account of the working of the economy, other explanations of unemployment emerge. In practice many of the adjustments toward an equilibrium in which between supply matches demand are incomplete at any particular point in time; and even as some adjustments approach completion, others are just starting. Thus the real economy is always to some extent in a state of disequilibrium, with shortages and surpluses always to be found somewhere or another. Unemployment could arise from the slowness or absence of price responses in the market for goods, as well as in the labour market. Although not envisaged by the classical economists, that possibility has been termed classical unemployment to distinguish it from Keynesian demand-deficient unemployment. Economic analysis of that possibility is termed Disequilibrium Macroeconomics . The possibility of reducing the extent of disequilibrium in the economy is discussed below under the heading of The Supply Side.

Imports and exports

The circular flow of income construction used in the basic Keynesian theory takes no account of imports and exports. A simplified version of the conventional explanation of what happens when they are taken into account is that an increase in domestic demand leads to an increase in imports, and the resultant imbalance between imports and exports is eventually corrected by a fall in the exchange rate. (That mechanism is explained more fully in the article on International Trade). An alternative explanation is provided by the monetary approach to the balance of payments . which treats the exchange rate as the relative price of moneys in circulation in the two countries in question. Payments for exports increase the domestic money supply and payments for imports reduce it. That system is self–balancing because an increase in imports causes a fall in the money supply which causes a fall in domestic activity which causes imports to fall. According to that explanation, it is only if the domestic money supply is increased that the exchange rate will fall.

The Money Supply

Evidence that emerged some years after the initial formulation of monetarism established its validity, together with some serious limitations upon its usefulness. It revealed a significant long-term association between the money supply and inflation. But, in addition to the variable time-lags in the relation that had been recognised in the original theories, that association exhibited a great deal of short-term instability. Nevertheless, large increases in the money supply are now generally recognised to give a rough indication of the probability of forthcoming inflation. But, as noted below, the belief of early monetarists that inflation could be controlled in the short term by control of the money supply, turned out to be mistaken.