Advanced Macroeconomics

Lecture 2

Introduction

• Two basic questions in classical macroeconomics:

1. Is the market economy self-equilibrating, esp. can a sustained situation of unemployment exist?

2. If the economy is self-equilibriating, can the government do anything to improve it, in particular, can the government reduce and/or prevent sustained states of unemployment?

Classical macroeconomics

• Following Keynes’s definition, the Classical Macro refers to all macroeconomics before Keynes’s General Theory of Employment, Interest and Money (1936).

• Classical macro answers the two basic questions as follows:A market economy is self-equilibrating, it adjusts so that the supply

of and demand for labor are equated, and sustained states of involuntary unemployment – where people wish to work at the existing wage rate but cannot find a job – cannot occur.

• Essentially, macroeconomic relationships, and wages and prices are assumed to be flexible at macro as well at micro level. For example,– Say’s law (AD = AS, i.e. economic agents supply goods and

services only if, and b/c, they demand other goods and services) :Supply(production) creates it own demand (income).

Classical macro...

• Classical macroeconomics was thus hardly a separate branch of the subject.

• It had no theory of the demand for (or supply of) output as a whole.

• It had a theory of the determination of the price determination, the quantity theory of money, and a theory of the determination of real wages in the labor market.

• But, it had very little to say about aggregate demand, it perceived no problem of unemployment and it envisaged no role for any form of macro policy other than control of money supply to prevent inflation.

• The essential reason for all this was that classical economics concentrated, at least in its more formal and rigorous analysis, on the long-term development of the economy, and it produced no clear-cut agreed explanation of short-run fluctuations in economic activity.

John Maynard Keynes (1883-1946)

He was the Cambridge (UK) economist, whose work has produced a revolution in macroeconomics.

His work can be regarded as the sine quo non of modern macroeconomics.

Keynes’s answers to the two basic questions of macroeconomics were:

1. The economy is not self-equilibrating, and sustained states of involuntary unemployment may occur,

2. The government can do something to reduce and/or prevent unemployment, by making appropriate use of monetary and fiscal policy.

He thus provided a justification for a policy of macroeconomic intervention, in contrast to the laissez-faire of the classical economists who proceded him.

Keynes...

”Keynesian” thus refers to the work of those economists who saw themselves as following in Keynes’s footsteps.

In contrast to the classical economics, Keynes was very concerned to develop a theory of the demand for output as a whole and hence a model of the (short-run) determination of national income.

The simplest of such models is the Keynesian cross model (Equilibrium occurs where aggregate supply is equal to aggregate demand for goods and services).

Keynesian Cross Model (KCM): an overview

The key characteristics of the KCM is that aggregate supply responds passively to aggregate demand and national income is therefore determined by aggregate demand.

On the other hand, aggregate demand is partly autonomous and partly positively related to income, with a marginal propensity to spend (on all forms of demand) less than unity.

This means that aggregate demand depends on income: at low levels of income aggregate demand is greater than income, and at high levels of income it is less.

Aggregate supply or output is simply equal to national income, as a result of the way both aggregates are defined and measured in terms of the value added in production (which corresponds to the factor incomes wages, profit, interest and rent) generated.

Three defects of the Keynesian Cross model

1. It includes no money and no interest rate, or more technically no ”monetary sector”.

2. It implicitly assumes an exogenously fixed price level, which does not vary when output and income vary.

3. It incorporates no analysis of the labor market and implicitly assumes an exogenously fixed wage level.

Key results of the Keynesian Cross model

• Income can in principle be at any level, depending on aggregate demand, and there is nothing that makes it tend towards the full employment level of income.

• In principle the government can do something to bring this level of income closer to full employment level, by varying its own expenditure G or by varying tax revenue T.

• G directly affects aggregate demand, and T affects aggregate demand indirectly via its influence on disposable income and hence consumption.

New Classical Macroeconomics• Developed in the 1970s and remained influential

in the 1980s, led by Robert Lucas, Thomas Sargent, Robert Barro, Edward Prescott and Neil Wallace.

• It sees the world as one in which individuals act rationally in their self-interest in markets that adjust rapidly to changing conditions.

• It argues that the government is only likely to make things worse by intervening.

• This approach is a challenge to the traditional macroeconomics which sees a useful role for government action in an economy that is viewed as adjusting sluggishly, with slowly responding prices, poor information and social customs impeding the rapid clearing of markets.

New Keynesian Macroeconomics

• The New Keynesians emerged in the 1980s through the works of George Akerlof, Janet Yellen, David Romer, Oliver Blancard, Greg Mankiw, Larry Summers and Ben Bernanke (current US Fed Reserve chairman)

• These figures do not believe that markets clear all the time but seek to understand and explain exactly why markets can fail.

• They argue that markets sometimes do not clear even when individuals are looking out for their own interests. – Both information problems and costs of

changing prices lead to some price rigidities, which help cause macroeconomic fluctuations in output and employment.

Simple theory of income and employment

The theory of income and employment is an aggregative theory which groups all markets for goods and services into a single product market, all financial markets into a money market, and all markets for factor services into labor market.

Let’s focus on the product market for the moment The sum total of the production of final goods and

services (defined as output that is not resold in any form during the accounting period) when valued at market prices is the Gross National Product (GNP).

The deduction of a capital consumption allowance for the replacement of capital equipment that was used up during the course of producing current output reduces this total to the Net National Product (NNP).

When NNP is deflated by an index of prices in order to obtain constant dollar values, we get real NNP (often referred to as just income)

The level of income may be broken down into several components. Typically, we divide the economy into sectors and examine the determinants of spending and the income receipts of each sector.

A complete analysis would include a household sector (C), a business sector (I), a government sector (G), and a foreign sector (X-M).

Hence, Y = C + I + G + X-M Where Y = Income, C = consumption, I = Investment,

G = Government Expenditure, X = Export, M = Import.

Keynesians Vs Neoclassicals

Keynes’s General Theory led to a lively debate in the 1940s and 1950s between those economists who saw themselves as his followers and Neoclassical economists (or neoclassicals).

Neoclassicals felt closer to pre-Keynesian classical economics but were prepared to use Keynes’s analytical framework with its emphasis on aggregate demand in arguing against Keynes and his followers.

Responses of Neoclassicals to the basic questions

1. A market economy is self-equilibrating and it will automatically tend to full employment, provided wages and prices are flexible;

2. In theory, there is no need for the government to intervene in the economy, but in practice the automatic mechanisms may take so long to work that some limited intervention may be justified.

Much of the Keynesian-Neoclassical debates were conducted in terms of IS-LM model.