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Macroeconomic Theory
Competing schools of thought
Macroeconomic theory is a set a views about the way the
economy operates.
Models are developed to illustrate how
the economy works
Economists differ in what they believe is the “correct model” of the
economy
leads to disagreement about the role and conduct of policy
Two main schools of thought
1.
Classical
2.
Keynesian
Old Classical (1776 – 1930s)
 An Inquiry into the Nature and Causes of theWealth of Nations by
Adam Smith (1776)
 Invisible hand theorem
 laissez –faire economics
 Say’s law
Invisible hand theorem
 states that if each consumer is allowed to choose freely what to
buy and each producer is allowed to choose freely what to sell and
how to produce it, the market will settle on a product distribution
and prices that are beneficial to all the individual members of a
community, and hence to the community as a whole.
 The reason for this is that self-interest drives economic actors to
beneficial behaviour.
 Video
laissez –faire economics
 The Invisible hand theorem leads to the concept of laissez-
faire economics.
 An approach to economics that emphasizes an environment
in which transactions between economic agents are free from
government intervention, including regulations, taxes, tariffs
and enforced monopolies.
Say’s Law
 “Supply creates its own demand” John Baptiste Say
 No possibility of overproduction and underproduction.
 The classical view was the predominant view of the period
from the late 18th century until the Great Depression in the
1930s.
The Great Depression
 1929 – early 1940s
 Worldwide economic depression began on October 29th,
1929 with a stock market crash…panic struck!
 Unemployment rates spiked and persisted (33% in Canada;
25% in U.S.)
 The Classical view did not explain the persistent levels of
high unemployment.
John Maynard Keynes
There is no invisible hand channeling self interest towards a
social optimum.
Keynes proposed a new approach in his “General Theory of
Employment, Interest and Money”
The Keynesian Revolution!
 Took hold in 1930s
 The great depression was a result of a lack of demand, not a
lack of supply.
 The dawn of Keynesian economics is marked by the
acceptance of the idea than changes in AD drive the business
cycles.
Keynesian economics
 Advocates wide use of stabilization policy.
 Post WWII, all advanced democratic societies adopted
Keynesian policies
 Policies that manage the demand side of the economy
 Unemployment remained low until 1973.
Key concepts of Keynesian economics
 Market failure
 Involuntary unemployment
 Stabilization policy
1970s
 High inflation!
 Rising unemployment!
 Low economic growth!
 Led to questioning of Keynesian economics
The reign of Keynesianism came to a
halt
No one school of thought has dominated since that time.
Other important schools of thought
1.
Monetarist school (Milton Friedman)


2.
Quantity theory of money
Expectations augmented Phillips curve
New Classical School

Real business cycle theory
3.
New Keynesian Economics


4.
Austrian School

5.
Adapted micro to macro theory
Micro foundations
Free markets, invisible hand, emphasis on individuals
Post Keynesian

Importance of uncertainty