Download Macroeconomics (AGEC 512)

Advanced Macroeconomics
Lecture 2
Introduction
•
Two basic questions
macroeconomics:
in
classical
1. Is the market economy self-equilibrating,
esp. can a sustained situation of
unemployment exist?
2. If the economy is self-equilibriating, can the
government do anything to improve it, in
particular, can the government reduce
and/or prevent sustained states of
unemployment?
Classical macroeconomics
• Following Keynes’s definition, the Classical Macro refers
to all macroeconomics before Keynes’s General Theory
of Employment, Interest and Money (1936).
• Classical macro answers the two basic questions as
follows:
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 – where people wish to work at the
existing wage rate but cannot find a job – cannot occur.
• Essentially, macroeconomic relationships, and wages
and prices are assumed to be flexible at macro as well at
micro level.
For example,
– Say’s law (AD = AS, i.e. economic agents supply goods and
services only if, and b/c, they demand other goods and services)
:Supply(production) creates it own demand (income).
Classical macro...
• Classical macroeconomics was thus hardly a separate
branch of the subject.
• It had no theory of the demand for (or supply of) output
as a whole.
• It had a theory of the determination of the price
determination, the quantity theory of money, and a
theory of the determination of real wages in the labor
market.
• But, it had very little to say about aggregate demand, it
perceived no problem of unemployment and it envisaged
no role for any form of macro policy other than control of
money supply to prevent inflation.
• The essential reason for all this was that classical
economics concentrated, at least in its more formal and
rigorous analysis, on the long-term development of the
economy, and it produced no clear-cut agreed
explanation of short-run fluctuations in economic activity.
John Maynard Keynes
(1883-1946)
 He was the Cambridge (UK) economist, whose
work has produced a revolution in
macroeconomics.
 His work can be regarded as the sine quo non
of modern macroeconomics.
 Keynes’s answers to the two basic questions
of macroeconomics were:
1. The economy is not self-equilibrating, and sustained
states of involuntary unemployment may occur,
2. The government can do something to reduce and/or
prevent unemployment, by making appropriate use
of monetary and fiscal policy.
 He thus provided a justification for a policy of
macroeconomic intervention, in contrast to the
laissez-faire of the classical economists who
proceded him.
Keynes...
”Keynesian” thus refers to the work of those
economists who saw themselves as following
in Keynes’s footsteps.
In contrast to the classical economics, Keynes
was very concerned to develop a theory of the
demand for output as a whole and hence a
model of the (short-run) determination of
national income.
The simplest of such models is the Keynesian
cross model (Equilibrium occurs where
aggregate supply is equal to aggregate
demand for goods and services).
Keynesian Cross Model (KCM): an overview
 The key characteristics of the KCM is that
aggregate supply responds passively to aggregate
demand and national income is therefore
determined by aggregate demand.
On the other hand, aggregate demand is partly
autonomous and partly positively related to income,
with a marginal propensity to spend (on all forms of
demand) less than unity.
This means that aggregate demand depends on
income: at low levels of income aggregate demand
is greater than income, and at high levels of income
it is less.
Aggregate supply or output is simply equal to
national income, as a result of the way both
aggregates are defined and measured in terms of
the value added in production (which corresponds
to the factor incomes wages, profit, interest and
rent) generated.
Three defects of the Keynesian Cross model
1. It includes no money and no interest
rate, or more technically no ”monetary
sector”.
2. It implicitly assumes an exogenously
fixed price level, which does not vary
when output and income vary.
3. It incorporates no analysis of the labor
market and implicitly assumes an
exogenously fixed wage level.
Key results of the Keynesian Cross model
• Income can in principle be at any level,
depending on aggregate demand, and
there is nothing that makes it tend towards
the full employment level of income.
• In principle the government can do
something to bring this level of income
closer to full employment level, by varying
its own expenditure G or by varying tax
revenue T.
• G directly affects aggregate demand, and
T affects aggregate demand indirectly via
its influence on disposable income and
hence consumption.
New Classical Macroeconomics
• Developed in the 1970s and remained influential
in the 1980s, led by Robert Lucas, Thomas
Sargent, Robert Barro, Edward Prescott and Neil
Wallace.
• 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.
• This approach is a challenge to the traditional
macroeconomics which sees a useful role for
government action in an economy that is viewed
as adjusting sluggishly, with slowly responding
prices, poor information and social customs
impeding the rapid clearing of markets.
New Keynesian Macroeconomics
• The New Keynesians emerged in the
1980s through the works of George
Akerlof, Janet Yellen, David Romer, Oliver
Blancard, Greg Mankiw, Larry Summers
and Ben Bernanke (current US Fed
Reserve chairman)
• These figures do not believe that markets
clear all the time but seek to understand
and explain exactly why markets can fail.
• They 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.
Simple theory of income and employment
 The theory of income and employment is an aggregative
theory which groups all markets for goods and services
into a single product market, all financial markets into a
money market, and all markets for factor services into
labor market.
Let’s focus on the product market for the moment
 The sum total of the production of final goods and
services (defined as output that is not resold in any form
during the accounting period) when valued at market
prices is the Gross National Product (GNP).
 The deduction of a capital consumption allowance for the
replacement of capital equipment that was used up
during the course of producing current output reduces
this total to the Net National Product (NNP).
When NNP is deflated by an index of prices in
order to obtain constant dollar values, we get
real NNP (often referred to as just income)
The level of income may be broken down into
several components. Typically, we divide the
economy into sectors and examine the
determinants of spending and the income
receipts of each sector.
A complete analysis would include a household
sector (C), a business sector (I), a government
sector (G), and a foreign sector (X-M).
Hence, Y = C + I + G + X-M
Where Y = Income, C = consumption, I = Investment,
G = Government Expenditure, X = Export, M = Import.
Keynesians Vs Neoclassicals
Keynes’s General Theory led to a lively
debate in the 1940s and 1950s between
those economists who saw themselves as
his followers and Neoclassical economists
(or neoclassicals).
Neoclassicals felt closer to pre-Keynesian
classical economics but were prepared to
use Keynes’s analytical framework with its
emphasis on aggregate demand in
arguing against Keynes and his followers.
Responses of Neoclassicals to
the basic questions
1. A market economy is self-equilibrating
and it will automatically tend to full
employment, provided wages and prices
are flexible;
2. In theory, there is no need for the
government to intervene in the economy,
but
in
practice
the
automatic
mechanisms may take so long to work
that some limited intervention may be
justified.
 Much of the Keynesian-Neoclassical
debates were conducted in terms of ISLM model.