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 application 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 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 summarises the main concepts and theories of macroeconomics without attempting to attribute them to those responsible; and some of its later paragraphs are confined to what is believed to be the consensus view among professional economists. Readers seeking an account of how, and by whom, those and other theories were developed should consult the article on the history of economic thought.

(for definitions of the terms shown in italics, see the glossary section of the related articles subpage)

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 by 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 reconcile supply and demand 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. The basic model was extended by John Hicks to create a model of the equilibrium level of demand in both product and monetary markets - known as the IS/LM model.

Monetarism

Monetarism is a theory that explains inflation as the inevitable consequence of an increase in the money supply. It is conventionally explained in terms of the "quantity theory of money" which derives from the identity MV=PT, in which M is money stock, V the velocity with which money circulates, P the average price level and T the number of transactions. An implication of that equation is that if V and T can be assumed constant, an increase in the money supply (normally taken to be cash plus bank deposits) will produce a corresponding increase in the general level of prices. Monetarism is founded upon the contention that for practical purposes, V and T can be assumed constant. Its validity thus depends upon the empirical confirmation of that assumption. An analysis of United States statistics , indicated that price increases had, in fact, followed money supply increases, but with time-lags that were long and variable. Critics argued that this was not conclusive proof, and further statistical tests were attempted to test it against the Keynesian theory that increases in the money supply would not affect the prices of goods because they would be spent on financial assets. The results did not give conclusive support to that alternative explanation, nor to the contention that it could safely be ignored.

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 monetarist alternative attributed to Friedman . 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 .

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 deficit in the balance of payments is eventually corrected by a fall in the exchange rate. The determination of domestic equilibrium in an open economy is the subject of the Mundell-Fleming model (see also the article on International Economics). 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 revealed a significant long-term association between the money supply and inflation with, however, a great deal of short-term instability. Attempts in the early 1980 to implement the monetarist prescription by the use of money supply targets ran into serious difficulties. In Britain, the Government adopted a four-year programme of progressively diminishing targets for money supply growth termed the Medium Term Financial Strategy but found itself so far unable to implement them that the growth in the money supply was no lower at the end of the period than at the beginning . Money supply targets had also been introduced in the United States and other western countries but had not appeared to have the intended effect. By 1985 they had generally been abandoned in favour of inflation-targeting procedures - in which, however, money supply growth is usually one of the factors that are taken into account.

Management of the Economy

Tackling unemployment

The classical economists believed that nothing could be done to reduce unemployment except by reducing market rigidities. Keynesians believed that any tendency for demand to fall below the level necessary for full employment could be corrected by increased public expenditure or reduced taxation. That would be partly effected without specific government action by the operation of the economy’s automatic stabilisers. Monetary economists recommended using a combination of automatic stabilisers and supply-side measures. . However, a fiscal stimulus can quickly boost spending power, whereas monetary policy acts with long and uncertain lags. Discretionary fiscal policy has often been used to regulate developed economies but, because of legislative delays it has sometimes had a destabilising effect because the stimulus arrived when activity was recovering. A study by economists at the International Monetary Fund has shown that a fiscal stimulus package equivalent to 1 percent of country's Gross Domestic Product (GDP) is associated on average with GDP increases of about 0.1 to 0.2 percent. In advanced economies, the longer-term effects are also positive and even possibly higher. But the longer-term effects are typically negative in emerging economies. .

Controlling inflation

In the 1970s Keynesian economists considered inflation to be mainly the consequence of existing wage bargaining systems, and recommended incomes policies as a means of control. Incomes policies were tried in the USA and in Britain, but never had more than a brief transitory effect on inflation. On the contrary, their ineffectiveness sometimes generated adverse inflationary expectations that caused people to behave in ways that gave impetus to the growth of inflation. As already noted, attempts to control inflation by setting money supply targets were also unsuccessful. Current practice, described below, uses published inflation rate targets and attempts to meet them using the Central Banks' power to control interest rates.

Current monetary policy

Under normal circumstances, monetary policy is nowadays targeted directly upon the inflation rate and aims to maintain it within predetermined limits. It operates by use of the central bank's power to control interest rates .). Briefly, an increase in interest rates discourages borrowing and encourages savings. Because borrowers spend more than savers it discourages consumer spending, and higher mortgage payments reinforce its effect by leaving householders with less to spend. Since it takes about a year for interest rate changes to affect output and two years to affect inflation, policy action depends upon judgements of forthcoming inflation. The authorities make use of economic forecasting models to assist those judgements, but they usually take account also of a range of factors including inflationary expectations (as indicated by the differences between the prices of fixed-interest and index-linked bonds) and the state of the housing market. Regulatory action depends mainly upon empirical data concerning the relation between the inflation rate and the output gap such as is embodied in the Taylor Rule.

Under exceptional circumstances such as a severe recession, a credit crunch or an impending deflation, monetary policy may be used to create an increase in the money supply by substantial reductions in interest rates, and - if that action reduces its effectiveness - by the creation of money by a technique known as quantitative easing .

Economic Policy

Policy aims

Applied macroeconomics is concerned with the policy aim of achieving stability of economic activity and of the price level, and with the policy aim of achieving growth of the country's economic well-being. According to the current (neoclassical economics) consensus, both aims are well served by the effective working of competition in markets for goods and services. That is because competitive markets have the flexibility to respond to external shocks to the economy and because they promote economic efficiency and facilitate growth by directing economic resources into activities that improve economic welfare. Consequently, many of the policy actions considered are concerned either with the removal of obstacles to market competition, or with the promotion of economic efficiency in activities that cannot normally be traded (such as defence and public health). The policy instruments by which those aims can be pursued fall into the three categories of public expenditure, taxation and regulation.

Public expenditure

Spending by local and central government is made up of transfer payments (such as social security payments), the provision of goods and services, and subsidies to private sector providers of goods and services. Of particular economic significance are public goods such as the infrastructure, which the market cannot supply because they cannot be bought and sold by individuals. Equally significant are goods that have public benefits which would otherwise be under-provided by the market. An example in the latter category is industrial research which, without government subsidies, would be underprovided because some of its benefits are often copied and thus lost to its providers. Another example is training by employers, which would be under-provided because of the prospect that some employees will leave, taking with them the skills that they have learned. According to endogenous growth theory those factors may be expected to have a determining effect on economic growth rates. Then there are activities such as education and medical care that are directed at the welfare of their clients but which have spin-off effects upon the community in terms of the benefits of living among healthy, well-educated people. Those externalities are held to justify some degree of subsidy, particularly as they may be expected to contribute to growth prospects. In principle, the criterion for each item of public investment is the satisfaction of a cost/benefit analysis criterion, with the amount of investment determined by the requirement that its marginal benefit should be equal to its marginal cost; and public investment that fails that test may be expected to reduce economic efficiency, as may failure to make investments that pass it. In practice, however, the necessary information may be uncertain or unavailable. In practice, also, the total amount of government expenditure may be limited by a budgetary constraint. If public expenditure exceeds the revenue from taxation, the resulting budget deficit has to be financed by borrowing. As noted in the above paragraph on current stabilisation policies, the tendency for deficits to increase during a recession in demand provides a contribution to the maintenance of stability. The resulting cyclical deficit may be expected to be balanced by a budgetary surplus during the cycle's recovery phase, leaving the total of the national debt unchanged. However, it is generally feared that a non-cyclical or structural deficit will have adverse long-term consequences, "crowding-out" private sector investment , increasing taxation, and possibly raising the inflation rate. Although the evidence for those fears is somewhat uncertain, there is a widespread consensus that structural budget deficits should be limited and preferably avoided.

Taxation

There is evidence to suggest that taxation can reduce economic output and growth in a number of different ways. Redistributive taxes can reduce private savings and investment because the rich save more than the poor. Income tax and social security contributions can reduce employment and output because the difference that they create between what employers pay and what employees receive, reduces work incentives. Other taxes can distort supply and demand relationships in other markets to the detriment of economic efficiency. According to an OECD working paper , however, a review of published evidence indicates that “the effects of taxes on economic performance are ambiguous in some areas and unsettled and controversial in others” The only unequivocal policy conclusion that emerges from the evidence is that economic performance is best served by taxes that do not distort incentives such as a poll tax or a tax on land values. (Exceptions may arise, however, when the incentives promoted are used as an alternative to the economically positive regulations referred to in the next paragraph.)

Regulation

In most countries, regulatory policy has significant positive and negative effects upon economic efficiency, output and growth. On the positive side is the basic framework of laws, regulations and codes of practice without which economic activity on the modern scale would not be possible. Without an effective system of law-enforcement and an accepted way of settling disputes,for example, much activity would be diverted from production and exchange into defence against violence. Also on the positive side – or potentially so – are measures to promote competition, either by removing barriers, as in the case of antitrust or competition policy, or by providing consumers with information that they would otherwise lack, as in the case of product standards. In the case of natural monopolies, and otherwise in absence of effective competition, regulations can be used to limit the extent of anti-competitive behaviour. Growth may also be facilitated by systems of patent law that provide incentives to innovation that might otherwise be lacking. Offsetting the benefits in every case are the costs to companies and individuals of complying with the regulations. On the negative side as far as macroeconomic considerations are concerned, are the many regulations that yield no economic benefit, and those whose costs exceed their benefits. Among them are regulations that prohibit innovation on the grounds of the mere possibility of harm – as advocated in the more extreme interpretations of the precautionary principle – and safety regulations that are based upon mistaken estimates of the expected (probability-weighted) negative value of the events against which they guard .

Dissenting views

Among dissenting views are those of:

• economists of the Austrian School who consider the economy to be too complex to justify the use of macroeconomic aggregates, and who use logical deductions from axioms rather than induction from economic statistics;
• sustainability advocates who favour restricting or halting economic growth in order to preserve resources for the use of future generations;
• proponents of public choice theory who consider people in government to be motivated by their own interests rather than those that they purport to represent.