Chapter One State of Macroeconomics

Chapter One
The State of Macroeconomics – Introduction
The separate treatment of Economics has accounted more than 200 years right from the book “An
Inquiry into the Nature and Causes of Wealth of Nations” of Adam Smith, who regarded as the father
of economics. The nature and scope of economics is different as the issues covered understudy and
the disciplines used the term are different. The definition of economics has encountered so many
controversies. The reason behind is that the economy in general is dynamic and subject to frequent
changes, likewise is the subject matter of economics. Different scholars define economics differently
as follows.

Adam Smith defines economics as “a science of wealth”.Before the innovative book of Adam
Smith, “An inquiry into the nature and causes of wealth of nation”, published in 1776, there was not
a separate field of study of economics. Rather economic ideas were found in a fragmented manner
coupled with religion and ethics.The basic theme of the book focused on enquiries in to the factors
that determine wealth of the country and its growth. The then name of economics was ‘political
economy’ and smith has said the great object of political economy of every country is to increase the
riches and power of that country. Thus, he treated economics as a subject matter trying to prosper
individuals with material well-being. It is a creation of wealth from a given scarce resources and
treated wealth as a means and end by itself.
J.S.Mill defines economics as “the science of production and distribution of wealth”. It is the
production and distribution of goods and services for consumption and further production purpose.
Alfred Marshall defines economics as “a science of welfare”.Foremost, Marshall believed that the
material wealth is not an end by itself. Rather, it is the study of man in relation to the gaps to be filled
directly by material wealth. He definedit as “Political Economy or Economics is the study of mankind
in the ordinary business of life; it examines that part of individual and social action which is most
closely connected with the attainment and with the use of the material requisites of well-being”.
Robinson defines economics as “a science of scarcity”. For him, economics is the science which
studied human behavior as a relationship between ends and scarce means which have alternative uses.

We can also find more definitions but all of them have similar message about the subject matter of
economics, i.e., economics is a subject which deals with how human beings use the scarce (limited)
resources in order to fulfill their unlimited wants. Comprehensively, it is defined as “a social science
that deals with the use of scarce resources in consumption, production and distribution of goods and
services to satisfy the unlimited material wants of human beings”. Thus, scarcity and unlimited
human wants are the building blocks of the subject matter.

Traditionally, economics is divided into two branches based on the scope of the study. These are
microeconomics and macroeconomics. Microeconomics deals with an economic behavior of
individual economic units, such as households and firms, and individual markets. It examines
questions like, how does an individual decide on how much of various commodities and services to
consume? How does a business firm decide what and how much to produce? How prices of goods
and services determined in single market, etc. The subject matter of macroeconomics is extensively
discussed starting from the next topic.

1
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

1.1 What macroeconomics is about?

Macroeconomics is the study of the economy as a whole and sub-aggregates of the economy -
including growth in incomes, changes in prices and the rate of unemployment. It is concerned with
the behavior of the economy as a whole, i.e., with booms and recessions, the economy’s total output
of goods and services and the growth of output, the rate of inflation and unemployment, the balance
of payments and exchange rates.

Macroeconomics deals both with the long run economic growth and the short run fluctuations that
constitutes the business cycle. It precisely defined as the study of the structure and overall
performance of the economy and the way in which the various sectors of the economy are related to
one another. It focuses on the economic behavior and policies that governments use to try to affect
consumption and investment, trade balance, the determinants of changes in wages and prices,
monetary and fiscal policies, the money stock, government budget, interest rate, and national debt.

Issues addressed by macroeconomics are:

o Long run economic growth - What determines a nation’s long-run economic growth? Why
have some countries experienced rapid growth in incomes over the past centuries while others
stay stuck in poverty? Why output per person rise more or less steadily in some countries, more
rapidly in others, while still it is so slow in some other least developing countries? What makes
rapid economic growth, and what measures should be in place in cases of low economic
growth? Three main sources of growth: Population growth, Capital Accumulation and
increases in average labor productivity, i.e., increases in output produced per unit of labor
input.
o Unemployment - the number of people who are available for work and actively seeking work
but cannot find jobs. What causes unemployment? How do we explain periods of persistent
and high unemployment? There is also policy question of what should be done about
unemployment. Some advocate a hands-off policy (the government should put in place
appropriate unemployment compensation schemes). Others argue that the government should
pursue an active fiscal policy, such as,cutting taxes and/or raising government spending when
unemployment is high so as to create demand and hence jobs.
o Inflation - is an increase in the overall price level. What causes prices to rise? Why do some
countries have high rates of inflation while others maintain stable price levels?How do we
explain inflation? What causes hyperinflations? The policy issues here include: How to keep
inflation low? If it is high, how to reduce it without causing a recession?
 Mostly, these three issues are central to the research agenda of macroeconomics.
o Business cycle - Short-run contractions and expansions in economic activity. What causes a
nation’s economic activity to fluctuate? Why all countries do experiences recession and
depression- recurrent periods of falling incomes and rising unemployment- and how can
government policy reduce the frequency and severity of these periods?
o The international economy - How does being a part of a global economic system affect
nations’ economies? Open vs. closed economy? Trade imbalances?Exchange rates?

2
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

o Macroeconomic Policy - Can government policies be used to improve economic performance?

Fiscal or monetary policy?
These and other related questions can be answered if we have the knowledge of
macroeconomics.Regarding all this questions, whether the government can and should do something
about each of these issues and what is the best to do have been at the centre of macroeconomics for a
long time.

In brief, macroeconomics deals with the major economic issues and problems of the day. To
understand these issues, we have to reduce the complicated details of the economy to manageable
essentials. Those essentials lay in the interactions among the goods, labor, and asset markets of the
economy, and in the interactions among national economies whose residents trade each other. In
dealing with the essentials, which can be grouped under the ultimate and central issues of economic
growth, inflation, unemployment and open economy market policies, we go beyond details of the
behavior of individual economic units, such as, households and firms, and the determinants of prices
in particular markets, which are the subject matter of microeconomics.In macroeconomics, we deal
with the market for goods as a whole, treating all the markets for different goods as a single market.
We do the same thing for the labor market and for the asset market. Thus, macroeconomics is dealing
with great abstractions which have both advantages and disadvantages. Abstraction helps look at the
interaction between goods, labor and asset markets at general level passing over details of thousands
of individual markets and focus on the key markets. However, there are costs of abstraction like
sometimes omitting details matter in an analysis.

Macroeconomics is a policy-oriented part of economics. It attempts not only to explain economic

events but also to devise policies to improve economic performance. The emphasis in
macroeconomics is on the manageability of the theory and on its application, rather than a primary
theoretical concern. However, because macroeconomic events arise for many microeconomic
interactions, macroeconomists use many tools of microeconomics.

In macroeconomics, we do two things. First, we seek to understand the economic functioning of the
world we live in; and, second, we ask if we can do anything to improve the performance of the
economy. That is, we are concerned with both explanation of economic events and policy
prescriptions (formulating economic policy).Explanation involves an attempt to understand the
behavior of economic variables, both at a moment in time and as time passes. Modern
macroeconomics recognizes that it is important to focus on more than just short period of time, and so
has an explicitly dynamic focus. We thus try to explain the behaviour of economic variables over
time. This means that we wish to explain the behaviour of the economy both in the long run and in
the short run.

In general, macroeconomics tries to obtain an overview and outline of the economy of the nation. It is
a young and imperfect science. The macroeconomist’s ability to predict the future course of economic
events is no better than the meteorologist’s ability to predict next month’s weather.

3
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

1.2 Basic Concepts and Methods of Macroeconomics Analysis

I. Basic Concepts of Macroeconomic Analysis
There are some basic aggregates or concepts that are frequently used in macroeconomic analysis.
1. Gross Domestic Product (GDP): is the value of all final goods and services (total output)
produced in an economy during a certain period, mostly in a year. It is the basic measure of
economic activities (performance) of countries. GDP = P * total output (Q)
There are some other basic concepts related to GDP.
a) Nominal Versus Real GDP
 Nominal GDP: - measures the value of output of an economy at the prices
prevailing in the period during which the output is produced. It is affected by the
price fluctuations, and thus, not a good measure of economic activities of a nation
because variations in NGDP may not be reflections of change in output.
 Real GDP: - measures the value of output of an economy produced in different
periods at a base year price (same price). It is not affected by the price fluctuations,
and thus, a good measure of the economic performance of nations because changes
in real GDP are estimates of real or physical change in production or output.
b) GDP per Capita: is a measure of GDP adjusted for the size of population of an economy.
It is a measure of economic activities of a nation per head. It is found by dividing
NGDP/RGDP by the total size of the population.
c) GDP Growth: the growth rate of the economy is the rate at which real GDP is increasing.
The growth rate of real GDP is a determinant of the growth rate of the economy since it
measures the growth rate of output in an economy. What are the basic causes for the
growth rate of real GDP over time? They are:
 The changes (increases) in the availability of the amount of resources in an
economy. The labour force and capital stock grow over time and give source of
increased production/output. Thus, increases in the availability of factors of
production account for part of the increase in real GDP.
 The efficiency with which factors of production work may change, i.e., due to the
improvement in efficiency of resources, so called productivity increases. Overtime,
the same (available) factors of production can produce higher level of output. These
increase in the efficiency of production result from changes in knowledge,
including learning by doing, as people learn through experience to perform familiar
tasks better.
2. Unemployment Rate: factors of production may not be fully employed (used) all the time.
Unemployment rate is the measure of the fraction of the labour force that cannot find jobs. It
is a measure of the percentage of the labour force which is not employed.

4
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

3. Inflation rate: is the measure of the percentage rate of increase in the general price of an
economy. It is a basic cause attributed the difference between the growth rates of nominal and
real GDP. This difference is due to the fluctuations in price level.

Measuring the macroeconomic performance

Macroeconomic performance is judged by the three broad measures we have introduced: the inflation
rate, the growth rate of output (GDP), and the rate of unemployment. These three variables dominate
the research agenda in macroeconomics.
 During periods of inflation –
 The prices of goods people buy are rising
 The living standard of citizens deteriorates
 Thus, it is a major political issue of every nation.
 When the growth rate of output is high –
 Good performance of the economy
 Increase employment of resources
 More production of goods and services
 Improvements in living standard
 Thus, it is a target goal and hope of every nation.
 During high unemployment rate –
 Jobs are difficult to find
 Unemployment of more resources
 Decline in production of goods and services
 Suffering of unemployed in their standard of living, personal distress, etc.
 Thus, it is the number one social, economic and political issue.
The growth rate of real GDP per capita is the most important of all the macroeconomic indicators
by which to judge/measure the economy’s long run performance.Economic expansion is
associated with falling unemployment rate. This inverse relationship between real growth and
changes in the unemployment rate is known as Okun’s law. It states that the deviation of output
from its natural rate is inversely related to the deviation of unemployment from its natural rate.

4. Business Cycle: Inflation, growth and unemployment are related through the business cycle.
The business cycle is the more or less regular pattern of expansion (recovery) and contraction
(recession) in economic activity around the path of trend growth. Trend path of GDP is the
path GDP would take if factors of production were fully employed.Output is not always at its
trend level; rather it fluctuates around the trend. We will discuss in details later in chapter two.

5
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

5. Aggregate Demand and Aggregate Supply-(read your notebook, and Dornbusch&Fischer)

II. Methods of Macroeconomic Analysis – (read your notebook and other related materials)
1.3 Macroeconomic Goals and Policy Instruments
Goals are objectives that an individual person, firm, society or government wants to achieve in the
future. There are also ways, tools or means by which these goals are achieved, called
instruments.Macroeconomic Goals: are the objectives of the government in relation to the well
functioning and good performance of the economy. The major macroeconomic objectives of every
economyinclude:

1. Achieving High and Sustainable Economic Growth – produce more and better goods and
services. The ultimate objective of an economic activity is to provide the goods and services that the
population desires. One of the important benchmarks to measure the performance of an economy is
the rate of increase in output over a period of time. A country seeks to achieve higher economic
growth over a long period so that the standards of living or the quality of life of people, on an
average, improve. It may be noted here that while talking about higher economic growth, we take into
account general, social and environmental factors so that the needs of people of both present
generations and future generations can be met.i.e., to improve the well being of the people without
compromising the resource availability of the future generation.There are three major’ sources of
economic growth, viz. (i) the growth of the labour force, (ii) capital formation, and (iii) technological
progress.

2. Full employment – suitable jobs for all citizens who are willing and able to work. Performance of
any government is judged in terms of goal of achieving full employment. Thismay be called the key
indicator of health of an economy. In other words, modern governments aim at reducing
unemployment. Unemployment refers to involuntary idleness of mainly labour force and other
productive resources. Unemployment (of labour) is closely related to the economy’s aggregate
output. Higher the unemployment rate, greater the divergence between actual aggregate output (or
GNP/GDP) and potential output. So, one of the objectives of macroeconomic policy is to ensure full
employment.The objective of full employment became uppermost amongst the policymakers in the
era of Great Depression when unemployment rate in all the countries except the then socialist
country, the USSR, rose to a great height. It may be noted here that a free enterprise capitalist
economy always exhibits full employment.But, Keynes said that the goal of full employment may be

6
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

a desirable one but impossible to achieve. Full employment, thus, does not mean that nobody is
unemployed. Full employment, though theoretically conceivable, is difficult to attain in a market-
driven economy. In view of this, full employment objective is often translated into ‘high
employment’ objective. People want to be able to get high-paying jobs without searching or waiting
too long, and they want to have job security and good benefits. In macroeconomic terms these are the
objectives of high employment. This goal is desirable indeed, but ‘how high’ should it be? One
author has given an answer in the following way; “The goal for high employment should therefore be
not to seek an unemployment level of zero, but rather a level of above zero consistent with full
employment at which the demand for labour equals the supply of labour. This level is called the
natural rate of unemployment.”

3. Price-level stability – avoid large fluctuations in the price level (inflation + deflation).The third
macroeconomic goal is to maintain stable prices within free markets.A market economy uses prices
as a yardstick to measure economic values.By price stability we must not mean an unchanging price
level over time. Not necessarily, price increase is unwelcome, particularly if it is restricted within a
reasonable limit. In other words, price fluctuations of a larger degree are always unwelcome. Rapid
price changes lead to economic inefficiency.However, it is difficult again to define the permissible or
reasonable rate of inflation. But, sustained increase in price level as well as a falling price level
produces destabilizing effects on the economy. Therefore, one of the objectives of macroeconomic
policy is to ensure (relative) price level stability. This goal prevents not only economic fluctuations
but also helps in the attainment of a steady growth of an economy.
 The above three measures of macroeconomic performance are the majorgoals of any
government in a give economy.
In addition to these, economic efficiency (achieving the maximum production using available
resources), economic freedom (businesses, workers, consumers have a high degree of freedom in
economic activities), economic security (provide for those who are not able to earn sufficient
income), equitable distribution of income (try to minimize gap between rich and poor), international
trade (try to seek a trade balance with the rest of the world) and exchange rate stability because
changes in exchange rates can also affect output, employment, and inflation are also goals of the
macro economy.

Macroeconomic Policy Instruments - are economic variables under the control of government that
can affect one or more of the macroeconomic goals. Governments have certain instruments that they
can use to affect macroeconomic activities (i.e., to achieve the above mentioned goals). Among others
fiscal policy, monetary policy and income policy are the most widely used instruments in every
economy.
Fiscal Policy: is deliberate manipulation of government expenditure and tax rates soas to achieve
high economic growth, high employment and reasonable price level. There are two types of fiscal
policies:
a) Expansionary fiscal policy: it is a tax-cut and/or rise in government expenditure aimed at
increasing aggregate demand thereby increasing total output and employment. It is usually
taken during recession.

7
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

b) Contractionary fiscal policy: this is a policy aimed at decreasing aggregate demand by

increasing tax and/or reducing government expenditure to reduce inflationary pressures.
Monetary Policy:is deliberate manipulation of money supply and interest rate by the central bankin
order to achieve the desired economic objectives. The instruments of monetary policy include open
market operation (OMO), changes in discount rate and changes in required reserve ratio.Like fiscal
policy, monetary policy can be tight (contractionary) or expansionary.
a) Expansionary monetary policy: it is policy to increase money supply and /or to reduce the
interest rate to raise aggregate demand. It is taken when the government wants to raise total
output and employment.
b) Contractionary monetary policy: this involves a reduction in the growth of money supply
and/or increase in interest rate to reduce an aggregate demand and thereby reduce inflation.It
is taken during inflationary pressures in an economy.

Income Policy: is the government’s effort puts on prices and wages.It refers to the set of rules and
regulations to control wage and price rise. Incomes policies are government attempts to moderate
inflation by direct steps (legislated wage, price controls).They are the most controversial of all
macroeconomic policies because price and wage control disrupts the free functioning of the market.

In addition to these policies, there is international economic policy,which consists of two sets of
policies: Trade policies (consists of tariffs, quotas, and other devices that restrict or encourage
imports and exports) and exchange-rate settings (which represent the price of one currency in terms
of the currencies of the other nations).

1.4 The State of Macroeconomics:Evolution and Recent Developments

Schools of Thought in Macroeconomics
There have long been two main intellectual traditions in macroeconomics towards the working of the
economy. One school of thought believes that markets work best if left to themselves. The other
believes that government intervention can significantly improve the operation of the economy. In the
1960s, the debate on these issues involved Keynesians, including Franco Modigliani and James
Tobin, on one side, and monetarists, led by Milton Friedman, on the other. In the 1970s, the debate
on much the same issues brought to the fore a new group- the new classical macroeconomists, who
by and large replaced the monetarists in keeping up the argument against using active government
policies to try to improve economic performance. On the other side are the new Keynesians; they may
not share many of the detailed belief of Keynesians three or four decades ago, except the belief that
government policy can help the economy perform better.

Now, let us see in detail the different schools of thought in macroeconomics.

1. Classical Macroeconomics (1776 – 1870)

The birth of the classical school go back to more than two centuries, which was leaded and developed
by the famous Scottish economist Adam Smith, with his publication of “The Wealth of Nation” in
1776. In this period, the distinction between micro and macro economics was not clear. The ruling
principle was the invisible hand coined by Alfered Marshall.The idea of the invisible hand is that if

8
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

all markets (goods, labor and financial makets) are free and individuals conduct their economic self
interset freely, there will be a well work in the overall economy.Market force will determine real
variable such as output, employment and prices and this will be made possible by flexibility of price
and wage levels, can be rapidly and reasonably adjusted to equilibrate demand and supply in all
markets.

The classicalists advise no government intervention (using fiscal and monetary policies) in an
economic system for the economy has a self-correction mechanism. For example, when aggregate
demand fluctuates so that equilibrium real GDP is less than potential real GDP and unemployment
exceeds that natural rate of unemployment, there is a downward pressure on wages and prices. As
nominal wages fall, the aggregate supply curve shifts out until macroeconomic equilibrium is re-
attained at full employment. Thus, government is described as the necessary evil and hence advocated
that the government should stay away or refrain from intervening in the market. Any government
policy is ineffective to correct economic disorder or disequilibrium. In other words, government
intervention will distort the market rather than stabilizing.
They believe that aggregate supply curve is vertical so that no change in equilibrium level of output
and employment (because price and nominal wage are flexible). The question is: how does the supply
of aggregate output respond when the price level increases? As price rises, there tends to be excess
demand in the labor market if the nominal wage remains unchanged (a lower real wage). For any
price level, the nominal wage is fully flexible and adjusts to keep the supply of labor and the demand
for labor equilibrated. So, the nominal wage will rise by the same amount as the price level in order to
re-establish the market clearing real wage. Thus, the real wage remains unchanged as do the
equilibrium level of employment and the supply of output.

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 cannot occur – at full employment level.
The economy’s output would always equal the full employment output (natural level of output). Any
involuntary unemployment of resources would quickly lower resource prices and establish full-
employment. Under these circumstances, argued the classical economists, deliberate governmental
intervention to raise or lower aggregate demand makes no sense. Full employment is assured through
flexible input prices and the sale of full employment output is assured through flexible output prices.
A government that raised aggregate demand would only raise the price level, thus creating inflation.
A government that lowered aggregate demand would only lower the price level, thus bringing about
deflation. Its policy, however, would have no effect on output, employment, and unemployment. For
example, an excessive growth in the money market causes only inflation. The best policy, therefore,
was one of “laissez-faire,” of leaving things alone. A greater labor supply, for example, would lower
wages, so would a lower demand for labor that might accompany a labor saving technical advance.
And, wages would fall to whatever level was needed to encourage the full use of labor resources.
Given the higher aggregate supply of goods and an unchanged level of aggregate demand, the extra
physical output would quickly be sold at lower prices. Thus, “supply would create its own demand”
as stated in Say’s law.
In general, the basic assumptions of these economists are:
1. Flexible wages and prices,

9
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

2. Supply creates its own demand – Say’s Law,

3. Households are forward looking
4. The price level is proportional to the money stock in the long run.

2. The Neoclassical Macroeconomics (1870 – 1936)

This school of thought suggests that economic fluctuations can be explained while maintaining
classical assumptions of free market with little government intervention and endorsement of classical
‘price and wage flexibility’i.e., basically this school is not different from the classical school. The
main distinctions are the tool of analysis, such as the marginal analysis and the concepts of “absolute
and comparative advantages” of nations in international trade.

3. The Keynesian Macroeconomics (1936-1970)

The birth of modern macroeconomics is linked to the Great Depression of 1930s (a period of high
unemployment & stagnant production) and John Maynard Keynes. During this period, the market
adjustment concept of the classical and neoclassical schools didn’t work at the period; the mass
unemployment disproved their conclusion. In 1936, in the midst of the Great Depression, the British
economist John Maynard Keynes challenged the views of his classical predecessors in a now famous
work, “The General Theory of Employment, Interest and Money”. As Keynes saw it, despite massive
involuntary unemployment of resources, no rapid downward adjustment of resource prices was
occurring to return the economy to full employment. Among the reasons were minimum wage laws
and widespread bargaining agreements between firms and labor unions. In addition, there was little
evidence that Say’s law was working well. In such a situation of downward price inflexibility, argued
Keynes, the classical prescription of laissez-faire had become irrelevant.
The main thesis of the Keynesian stream is that the market economy is subjected to failure so that it
may not achieve full employment level. Thus, government intervention is inevitable and the
government demand management now made sense. Keynes emphasized “effective demand” or AD,
and proposed expansionary policies. The expansionary policies consist of two elements: expansionary
monetary policy (increasing money supply) and expansionary fiscal policy (increasing government
spending). Increasing money supply decreases the interest rate. This encourages agents (investors) to
invest their money rather than putting it in banks (saving). The increase in investment results in
increased output (as Y= C+I+G+X-M)… – the multiplier effect. However, interest rate (and thus
investors) may not respond to the change in money supply or all the increase in money supply may be
absorbed at the existing interest rate. This is particularly the case when recession is deep. In such
situations, households and firms became pessimistic, and be unwilling to spend more. Contrast to
spend more, they hold their additional money. If this is the case, the economy is said to be in a
liquidity trap. If there is liquidity trap, Keynes argued that, the classical model will be incapable of
producing equilibrium, and that monetary policy is ineffective. In such a case, the second element
(increasing government expenditure) is proposed by Keynes, for the solution of Great Depression, so
as to increase aggregate demand, which will in turn encourage production. Increased output/income

10
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

again increases consumption, consumption further boosting aggregate demand which would raise
employment further… – the multiplier effect. Keynes focused primarily on the short-term. He wanted
to cure an immediate problem almost regardless of the long-term consequences of the cure. However,
increased government spending might:
 Trigger inflation (if supply doesn’t rise immediately with the increased aggregate demand), and
 Lower the long-term growth rate of production (by lowering saving and investment where
people/firms decide not to accumulate wealth in fear of future increase in taxes).
 With a lower long-term growth rate, the economy would create fewer jobs and thus
unemployment rate would rise.
In subsequent decades, Keynes gained many followers throughout the world who, naturally enough
are called Keynesians. A list of well-known Keynesians includes Paul Samuelson, Franco Modigliani
and James Tobin (all Nobel Prize Winners), as well as Arthur Okun, Walter Heller, and Gardner
Ackley. These economists were optimistic that the government, by managing the level of aggregate
demand, could assure full employment without inflation year after year.
For the Keynesians, inflation can be kept under control with either a contractionary fiscal or a
contractionary monetary policy.
Their basic assumptions are:
1. Inflexible nominal wages and prices in the downward direction,
2. The economy is unstable subject to shifts in aggregate demand,
3. There is a large multiplier effect for changes in government spending and tax rates.

Generally, unlike the classical schools of thought, for Keynes, prices and wages are not flexible, are
not adjusted quickly meant that markets could be out of equilibrium-with quantities demanded not
equal to quantities supplied-for long periods of time. Keynes believed that markets are not efficient;
so we need the intervention of the government to improve the performance of the economy. The
Keynesians macroeconomic theory was the best solution of the Great Depression. However, like
classical schools, it faced challenges and attacks when their injection became ineffective to solve the
macroeconomic theory of stagflation, higher rate of unemployment and inflation.

4. The Monetarists
The debate on whether government intervention can significantly improve the operation of the
economy or not went on and groups of intellectuals continued to emerge. Monetarists, as advocates of
free market, started challenging Keynes’s theory in the 1970s. The monetarists strongly debated against the
Keynesians on the ability of government to improve the operation of the economy, the relative
importance of fiscal and monetary policy, and the tradeoff between inflation and unemployment
(suggested by the Phillips Curve).
The problem of stagflation (stagnation + inflation) was what the monetarists considered to be the
weakness of the Keynesians. As aggregate demand increases when government spending increases,
the price level and nominal interest rate will increase. Thus, expansionary government policies are
more likely to cause stagnation and inflation. Hence, economists such as Milton Friedman (the
founder of the school, Nobel Prize Winner), Karl Brunner, and Allen Meltzer have argued that
Keynesian interventionist policies designed to eliminate unemployment are likely to do more harm
than good. As they see it, the government is unlikely to succeed in establishing long-run macro

11
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

equilibrium. For instance, the government may rise its own spending and stimulate private spending
so much as to shift the aggregate demand to the right and then to increase output. The resultant
inflation may then induce the government to cut aggregate demand and the reduce output. Such stop-
go policies that continually turn the aggregate demand off and on merely aggravate the business
cycle. For them, expansionary fiscal policy can lead to inflation when accompanied by monetary
authorities with increased money growth.
As monetarists see, a better policy would be to increase the money supply by fixed annual percentage
in order to accommodate the gradual growth of the potential output over time. Even if it is the case
that an economy can be unstable in the short-run, it has a good self-correction mechanism in the long
run. According to the monetarists inflation is primarily a monetary phenomenon – that the only way
to keep inflation from getting out of hand is to control the growth of the money stock. Because of
their advocacy of the fixed money growth rule, these economists are also known as monetarists and
the doctrine that became known as monetarism. Many economists began to appear that stabilization
policies were actually a major source of converted instability. The monetarists argued first that
market economies were self-regulating; that is, if left alone, economies would tend to return to full
employment on their own. Second, they argued that activist macroeconomic policies were part of a
problem, not part of the solution.
Milton Friedman and his followers suggest that a stable money supply is the true key to a stable
macro economy. Friedman began with a factual claim: most recessions, including the huge slump that
initiated the Great Depression, did not follow Keynes’s script. That is, they did not arise because the private
sector was trying to increase its holdings of a fixed amount of money. Rather, they occurred because
of a fall in the quantity of money in circulation.
Keynesian Theory Monetarist Theory
 Unstable economy Stable economy
 Not self-correcting Self - correcting
 Monetary target interest rate Monetary target money supply
 Money indirect impact on AD Money direct impact on AD
 Monetary policy may not work Monetary Policy works but time lags
 Fiscal policy is best in recessions Fiscal Policy is not effective - crowding out effect
5. New Classical Macroeconomics
The monetarist counter-attack on Keynesian ideas was pushed even farther during the 1970s and
1980s by the so-called school of new classical macroeconomics led by Robert Lucas, Thomas
Sargent, Robert Barro, Edward Prescott and Neil Wallace.The new classical macroeconomics
remained influential in the 1980s. New classical are the new versions and the natural followers of
classical school. This school of macroeconomics shares many policy views with Friedman.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.New classicals attached great importance to the role of expectation in influencing macro-
economic equilibrium. They introduced macroeconomic analysis from micro foundations.
Expansionary fiscal policy tends to increase inflationary expectations, shifting AS, causing real GDP
to fall & the price level to rise. Many of them supported supply-side policies meant to raise growth
rate of potential GDP.

12
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

Their central working assumptions are:

 Economic agents maximize– Households and firms make optimal decisions using all the
available information in reaching decisions and that those decisions are the best possible in the
circumstances in which they find themselves. That is, they are always doing their bests
towards their economic needs.
 Expectations are rational– which means they are statistically the best predictions of the future
that can be made using the available information. Indeed, the new classical school is
sometimes described as the rational expectations school, even though rational expectations is
only one part of the theoretical approach of the new classical economists. Rational expectations
imply that people will eventually come to understand whatever government policy is being
used, and thus that it is not possible to fool most of the people all the time or even most of the
time.
 Markets Clear– There is no reason why firms or workers would not adjust wages or prices if
that would make them better off. Accordingly, prices and wages adjust in order to equate
supply and demand; in other words, markets clear.

One dramatic implication of these assumptions, which seem so reasonable individually, is that there is
no possibility for involuntary unemployment. Any unemployed person who really wants a job will
offer to cut his or her wage until the wage is low enough to attract an offer from some employers so
that the labor market could be at equilibrium-demand and supply are equal as firms demand for labor
increases due to a reduction in wage rates. Similarly, anyone with an excess supply of goods on the
shelf will cut prices so as to sell. Flexible adjustment of wages and prices leaves all individuals all the
time in a situation in which they work as much as they want and firms produce as much as they want.
Thus, the essence of the new classical approach is the assumption that markets are continuously in
equilibrium.

6. The New Keynesians

The new classical group remains highly influential in today’s macroeconomics. But, a new generation
of scholars, the new Keynesians, mostly trained in the Keynesian tradition but moving beyond it,
emerged in the 1980s. The group includes among others George Akerlof and Janet Yellen and David
Romer of the University of California, Berkely, Oliver Blanchard of MIT, Greg Mankiw and Lary
Summers of Harvard and Ben Bernanke of Princeton University. This group does not believe that
markets clear all the time but seek to understand and explain exactly why markets fail.

The New Keynesians 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. For example, in
the labor market, firms that cut wages not only reduce the cost of labor but are also likely to wind up
with poorer quality labor force. Thus, they will be reluctant to cut wages. If it is costly for firms to
change the prices they charge and the wages they pay, the economy wide level of wages and prices
may not be flexible enough to avoid occasional periods of even high unemployment.

13
Macroeconomics I: Lecture note DMU By: H.B 2021
 Chapter One State of Macroeconomics

The New Keynesian model of unemployment is built on the notion that nominal wages and prices do
not adjust quickly to maintain labor market equilibrium. It differs from the classical model in its focus
on nominal rigidities rather than real rigidities. Sluggishly adjusting, with slowly responding prices,
poor information, and costs of changing price hinder the rapid clearing of markets, which cause
macroeconomic fluctuations in output and employment. They emphasize imperfections in various
markets. They gave micro foundation for Keynesian thoughts.

14
Macroeconomics I: Lecture note DMU By: H.B 2021