Macroeconomics

I INTRODUCTION

Macroeconomics, that part of economics concerned with the behaviour of aggregate variables, such as total national output and income, unemployment, the balance of payments, and the rate of inflation. This is distinct from microeconomics, which is concerned with 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.

II GROSS NATIONAL PRODUCT

The starting point of macroeconomics is probably an understanding of what constitutes national output, or national income, or its related concept of gross national product (GNP). This is the unduplicated measure of what a country’s economic activity produces in the end, which is consequently known as “final output” or “final demand”. It is “unduplicated” because it is important not to double-count the output of “intermediate goods”, which comprise output produced by some branches of economic activity in the economy that is subsequently used up as an input into the production of other goods and services further down in the chain of production. There are, however, differences of view and of international conventions with respect to what constitutes being “used” up in the process of production, and how widely one defines the boundaries around what constitutes “productive activity”. But such differences of opinion raise highly specialized issues, far from the centre of policy making and remote from current discussions of the key issues of macroeconomic theory. This is largely concerned with what determines the size of GNP, for any given set of national accounts conventions, and definitions, and what determines its stability, and its relationship to other variables.

The size of a country’s potential GNP at any moment of time depends on its factors of production—labour and capital—and its technology. Over time the country’s labour force, capital stock, and technology will change, and the determination of long-term changes in a country’s productive potential is the subject matter of one branch of the macroeconomic theory known as “growth theory”. But at any given point in time, given the stock of capital and other physical assets, the quality, skill, and level of education of its labour force, and the existing technology, actual output will then depend on the extent to which the labour force and the capital assets are fully used. At any point in time output may fall below potential when either labour is unemployed or capital assets are not used to full capacity.

III MACROECONOMICS AND UNEMPLOYMENT

It is, of course, the unemployment of labour that causes the acutest social distress and concern, so that it is the causes and consequences of unemployment to which most attention in macroeconomic theory has been directed. Until the publication in 1936 of the famous The General Theory of Employment, Interest, and Money by John Maynard Keynes, the conventional explanation of large-scale unemployment was in terms of some rigidity in the labour market that prevented wages from falling to a level at which the market would be in “equilibrium”. The idea behind this sort of model of the labour market was that if there were large-scale unemployment, pressure from members of the labour force seeking work would bid down the wage to the point where, on the one hand, some of them would drop out of the labour market (that is, the supply of labour would fall) and, on the other hand, firms would be willing to take on more labour insofar as the lower wage increased the profitability of hiring more labour. If, however, some rigidity prevented wages from falling to the equilibrium level at which the supply and demand for labour were brought into equality, unemployment could persist. Such an obstacle to the emergence of a market-clearing wage could be, for example, trade union action to maintain minimum wages or minimum wage legislation.

Keynes’s major innovation, however, was to argue that persistent unemployment might be caused by a deficiency of demand for output rather than by a disequilibrium in the labour market. Such a deficiency of demand could be explained by a failure of “planned” (that is, intended) investment to match “planned” savings. For savings constitute a “leakage” in the circular flow of which the incomes earned in the course of producing goods or services become transferred back into the 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”) by which is meant the production of machines, factories, housing, and so on, has the opposite effect—namely an injection into the circular flow relating income to output—and hence tends to raise the level of demand.

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In the earlier “classical” models of unemployment, such as that 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. For 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, there would be a fall in the rate of interest. This would, on the one hand, reduce the supply of savings and, at the same time, increase the desire of companies to borrow money for purposes of investing 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.

The Keynesian model, by contrast, emphasizes changes in the level of output and income as the equilibrating movement that brings planned savings and investment into equality and hence leads to the equilibrium level of total national income and output. And this equilibrium level of income and output does not necessarily correspond to a level of output at which the demand for labour would equal the supply of labour. Furthermore, Keynes maintained, a cut in wages in such a situation would not help cure unemployment, for various reasons spelt out, notably, in Chapter 19 of the General Theory. Keynes was not, of course, the first economist to explain unemployment in terms of an aggregate deficiency of demand in the goods market. As he himself recognized, Thomas Robert Malthus and others had advanced similar explanations in the past. Also, at the same time as Keynes, and quite independently, the core of the theory was published by the great Polish economist, Michal Kalecki.

The “Keynesian revolution” implied that, in the terminology of macroeconomics, the “goods market” could be an “underemployment” equilibrium, in that it did not ensure equilibrium in the labour market. In the labour market, therefore, 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 labour” and so on were extensively developed in subsequent years.

IV RECENT REFINEMENTS

During the past few decades, there have been numerous other refinements of the theory. For example, although there is still much disagreement as to the importance of wage rigidity, there has been much progress in explaining it without recourse to trade union behaviour or government regulation. At first, it seemed difficult to reconcile the notion of wage rigidity with the usual economist’s assumption that people seek to maximize utility and hence would be willing to accept a lower wage in order to get a job. However, by widening the range of variables over which individuals optimize to include variables such as job search in the interests of maximizing welfare over time, or sociological and psychological variables such as loyalty and self-respect, it has become easier to reconcile labour market disequilibrium with the usual assumptions of optimizing behaviour.

Another important recent ingredient of modern macro theory has its roots in Keynes’s emphasis on the importance of uncertainty in economic behaviour. This is the analysis of information gaps in explaining aggregate unemployment, to which certain elements of the game theory are sometimes linked. For example, firms might find it worthwhile employing more labour if they could be sure that other firms were doing likewise since they could then expect that the resulting increase in total wage payments would raise total demand in the economy and hence the demand for their own products. The absence of any mechanism in the economy by which this sort of collective superior decision could be reached results in an inferior equilibrium that has some of the characteristics of a “Prisoners’ Dilemma” situation, where each individual company decides selfishly to secure private benefits, though pooling of information and decision-making would enable them to secure common benefits. Other labour market theories—such as “insider-outsider” theory, which emphasizes the conflict of interest between the unemployed and those who are in employment and who are the people who are actually engaged in wage negotiation—also add to our understanding of the way labour markets operate.

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V THE LEGACY OF KEYNESIANISM

The concentration in Keynesianism on-demand as the key determinant of the level of output in the short term stimulated developments in many other fields of macroeconomics. It was partly instrumental in initiating development of national income accounting, the main concepts of which—consumer expenditure, expenditure on capital formation (that is, machines, factories, and so on), public consumption, exports, and imports—constituted the main headings into which total “final demand” (as distinct from intermediate output) of the economy were divided. The Keynesian approach also led to considerable developments in the analysis of the determinants of these categories of final demand, for example, in the theory of aggregate consumer demand and its relationship to income levels and its sensitivity to prevailing rates of interest.

This consideration of interest is particularly important, for reference has already been made above to the role of the rate of interest in ensuring equilibrium in the “goods market”. Consequently, monetary theory is central to the macroeconomic theory and has given rise to some of the acutest controversies. In Keynes’s view, the rate of interest was largely a monetary phenomenon, and its chief function in a world of uncertainty was to equilibrate supply and demand for money, rather than planned savings and investment. This view of the function of money permitted considerable variations in the willingness to hold money at any given rate of interest, and hence in the velocity of circulation of money. This emphasis on the short-run determinants of the rate of interest contrasted with the conventional view that, in the longer run, the rate of interest was determined by “real” forces of productivity and thrift. The latter view closely matched the conventional model of the labour market, in which the level of employment was determined by the “real” forces of (1) people’s willingness to sacrifice leisure for income—which determined the supply of labour—and (2) the productivity of labour—which determined the demand for it. Keynes’s view that the rate of interest was primarily a monetary phenomenon reflected his concern with the short run, and most economists would agree that, in the longer run, the average real rate of interest—corrected for distortions such as rates of inflation or taxes—would tend to approximate to the longer-run real rate of return on capital assets.

Contrarily, on the assumption that the demand for money is related in a stable manner to the level of wealth—being just a substitute for other ways of holding wealth—it has been argued that an increase in the supply of money will tend to reduce interest rates, which, in turn, would tend to stimulate investment and hence total demand. An alternative way of reducing unemployment, therefore, would be an expansion of the money supply. However, although, again, there is a wide variety of views as to the way money affects the economy, there would be a considerable area of agreement amongst proponents of monetarism to the effect that such methods of raising output would probably be only temporarily useful. The main reason for this, it would be argued, would be that an increase in the money supply, other things being equal, would eventually lead to inflation. Some schools of thought, particularly those associated with the hypothesis of “rational expectations”, would go so far as to argue that the public would eventually recognize the link between the money supply and the price level, with the result that attempts to reduce unemployment by an expansion of the money supply might not even have short-run effects.

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VI MACROECONOMICS AND INFLATION

Monetary theory is thus also closely linked to another major ingredient of macro-theory, namely inflation. It has been conventional for several decades after World War II to classify the main types of inflationary theory into “demand-pull” and “cost-push” theories. The latter basically emphasized the role of excessive increases in wages relative to productivity increases as a cause of continuous inflation, whereas the former tended to attribute inflation more to excessive demand in the goods market. In turn, this is often ascribed to excessive expansion of the money supply. A central concept in inflationary theory since the mid-1950s has been the “Phillips Curve”, which relates the level of unemployment to the rate of inflation. The basic idea behind this is that lower unemployment leads to higher wage settlements, other things being equal. Insofar as the existence of a stable relationship of this kind can be established, it might suggest that society can make a choice between various combinations of the inflation rate and unemployment level. Many economists, however, dispute whether such a choice really exists, on the grounds that if society chooses, say, lower unemployment with higher inflation, the Phillips curve will shift so that, eventually, the higher inflation will not be accompanied by lower unemployment, and that, in order to keep unemployment below some “natural rate”, it will be necessary to accept continuously increasing inflation. At the same time, many other economists dispute whether a stable relationship between unemployment and the level of real wage demands exists and hence whether there is any “natural rate of unemployment” to begin with. There are also many economists who believe that there is such a thing as a “natural rate of unemployment”, but that it keeps changing all the time.

Macroeconomics is also concerned, as indicated above, with the other main determinants of final demand, such as “real” investment as distinct from investment in financial assets which only indirectly affect the level of demand in the economy. Another major component of final demand is public expenditure, and the scope, if any, for fiscal policy as an instrument for stabilizing the economy in the region of full employment without inflation also figures prominently in any analysis of macroeconomic theory. To complete the main components of aggregate demand, macroeconomics also has to take account of the external balance—that is, between exports and imports—and its determinants, notably the exchange rate. For exports play much the same role as capital formation in stimulating demand. And imports constitute a leakage in the circular flow of incomes since they satisfy domestic demand without generating domestic incomes that will be “recycled” to create further domestic demand.

VII MACROECONOMIC MODELLING IN PRACTICE

Macroeconomic theories of the way that the determinants of total final demand operate form the basis of large macroeconomic models of the economy that are used in economic forecasting to make predictions of output and employment and related variables. During the past few years, the record of most such predictions has been very poor, and the scrutiny of the sources of the errors has led to continual revisions to the basic models and refinements in the theory. For example, much more attention has been paid lately to the role of consumer credit and wealth in determining consumers’ savings and expenditure behaviour, as well as the role of possibly volatile expectations. Some of the refinements of the theory may turn out, of course, to have been mistaken and to have led some members of the profession along false trails. Only time will tell. No doubt macroeconomic models will continue to be substantially revised as further prediction errors are made and analysed. Whether the theory will eventually converge to the point where reasonably accurate economic predictions can be made is, however, far from certain. It may well be that the macroeconomic questions put to economists will turn out to be unanswerable.

Contributed By:
Wilfred Beckerman