Macro Economics

Keynesian Economics

Macroeconomics, branch of economics concerned with the aggregate, or overall, economy. Macroeconomics deals with economic factors such as total national output and income, unemployment, balance of payments, and the rate of inflation. It is distinct from microeconomics, which is the study of the composition of output such as the supply and demand for individual goods and services, the way they are traded in markets, and the pattern of their relative prices. At the basis of macroeconomics is an understanding of what constitutes national output, or national income, and the related concept of gross national product (GNP). The GNP is the total value of goods and services produced in an economy during a given period of time, usually a year. The measure of what a country's economic activity produces in the end is called final demand. The main determinants of final demand are consumption (personal expenditure on items such as food, clothing, appliances, and cars), investment (spending by businesses on items such as new facilities and equipment), government spending, and net exports (exports minus imports). Macroeconomic theory is largely concerned with what determines the size of GNP, its stability, and its relationship to variables such as unemployment and inflation. The size of a country's potential GNP at any moment in time depends on its factors of production-labor and capital-and its technology. Over time the country's labor force, capital stock, and technology will change, and the determination of long-run changes in a country's productive potential is the subject matter of one branch of macroeconomic theory known as growth theory. The study of macroeconomics is relatively new, generally beginning with the ideas of British economist John Maynard Keynes in the 1930s. Keynes's ideas revolutionized thinking in several areas of macroeconomics, including unemployment, money supply, and inflation. Keynesian Theory and Unemployment Unemployment causes a great deal of social distress and concern; as a result, the causes and consequences of unemployment have received the most attention in macroeconomic theory. Until the publication in 1936 of The General Theory of Employment, Interest and Money by Keynes, large-scale unemployment was generally explained in terms of rigidity in the labor market that prevented wages from falling to a level at which the labor market would be in equilibrium. Equilibrium would be reached when pressure from members of the labor force seeking work had bid down the wage to the point where either some dropped out of the labor market (the supply of labor fell) or firms became willing to take on more labor given that the lower wage increased the profitability of hiring more workers (demand increased). If, however, some rigidity prevented wages from falling to the point where supply and demand for labor were at equilibrium, then unemployment could persist. Such an obstacle could be, for example, trade union action to maintain minimum wages or minimum-wage legislation. Keynes's major innovation was to argue that persistent unemployment might be caused by a deficiency in demand for production or services, rather than by a disequilibrium in the labor market. Such a deficiency of demand could be explained by a failure of planned (intended) investment to match planned (intended) savings. Savings constitute a leakage in the circular flow by which the incomes earned in the course of producing goods or services are transferred back into demand for other goods and services. A leakage in the circular flow of incomes would tend to reduce the level of total demand. Real investment, known as capital formation (the production of machines, factories, housing, and so on), has the opposite effect-it is an injection into the circular flow relating income to output-and tends to raise the level of demand. In the earlier classical models of unemployment, such as the one described above, deficiency of demand in the aggregate market for goods and services (known by the short-hand term as the goods market) was ruled out. It was believed that any discrepancy between planned savings and planned investment would be eliminated by changes in the rate of interest. Thus, for example, if planned savings exceeded planned investment, the rate of interest would fall, which would reduce the supply of savings and, at the same time, increase the desire of companies to borrow money to invest in machines, buildings, and so on. In other words, changes in the rate of interest would provide the equilibrating force bringing the overall (aggregate) goods market into equilibrium in the same way that changes in, say, the price of apples would be the equilibrating force bringing the supply and demand for apples into equilibrium. In the Keynesian model, changes in the level of output and income bring planned savings and investment into equilibrium, and thereby lead to equilibrium in total national income and output. However, this equilibrium level of income and output is not necessarily the level of output at which the demand for labor equals the supply of labor. Furthermore, Keynes maintained, a cut in wages in such a situation would not help eliminate unemployment. Keynes was not the first economist to explain unemployment in terms of an aggregate deficiency of demand in the goods market. The 19th-century British economist Thomas Robert Malthus and others had advanced similar explanations. The Keynesian revolution implied that, in the terminology of macroeconomics, the goods market could be at an underemployment equilibrium, in that it did not ensure equilibrium in the labor market. In such a labor market, employers would not employ workers up to the point where it would have been profitable for them to do so had there been adequate demand for their output. Concepts of underemployment equilibrium, and related concepts of constrained demand for labor were extensively developed in subsequent years. Keynes's emphasis on demand as the key determinant of output in the short run stimulated developments in many other fields of macroeconomics. It was partly instrumental in the development of national income accounting, which measures the components of GNP-consumption, investment, government spending and net exports. The Keynesian approach also stimulated analysis of the factors influencing these components of GNP. For example,