Macroeconomics

Macroeconomics (from the Greek prefix makro- meaning "large" + economics) is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies.[1][2] Macroeconomists study aggregated indicators such as GDP, unemployment rates, national income, price indices, and the interrelations among the different sectors of the economy to better understand how the whole economy functions. They also develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, saving, investment, energy, international trade, and international finance.

While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by governments to assist in the development and evaluation of economic policy.

Macroeconomics and microeconomics, a pair of terms coined by Ragnar Frisch, are the two most general fields in economics.[3] In contrast to macroeconomics, microeconomics is the branch of economics that studies the behavior of individuals and firms in making decisions and the interactions among these individuals and firms in narrowly-defined markets.

Basic macroeconomic concepts

Macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research.[4] Macroeconomic theories usually relate the phenomena of output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also important to all economic agents including workers, consumers, and producers.

Output and income

National output is the total amount of everything a country produces in a given period of time. Everything that is produced and sold generates an equal amount of income. The total output of the economy is measured GDP per person. The output and income are usually considered equivalent and the two terms are often used interchangeably,output changes into income. Output can be measured or it can be viewed from the production side and measured as the total value of final goods and services or the sum of all value added in the economy.[5]

Macroeconomic output is usually measured by gross domestic product (GDP) or one of the other national accounts. Economists interested in long-run increases in output study economic growth. Advances in technology, accumulation of machinery and other capital, and better education and human capital are all factors that lead to increase economic output over time. However, output does not always increase consistently over time. Business cycles can cause short-term drops in output called recessions. Economists look for macroeconomic policies that prevent economies from slipping into recessions and that lead to faster long-term growth.

Unemployment

Okuns law differences 1948 to mid 2011
A chart using US data showing the relationship between economic growth and unemployment expressed by Okun's law. The relationship demonstrates cyclical unemployment. Economic growth leads to a lower unemployment rate.

The amount of unemployment in an economy is measured by the unemployment rate, i.e. the percentage of workers without jobs in the labor force. The unemployment rate in the labor force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded.

Unemployment can be generally broken down into several types that are related to different causes.

  • Classical unemployment theory suggests that unemployment occurs when wages are too high for employers to be willing to hire more workers. Other more modern economic theories suggest that increased wages actually decrease unemployment by creating more consumer demand. According to these more recent theories, unemployment results from reduced demand for the goods and services produced through labor and suggest that only in markets where profit margins are very low, and in which the market will not bear a price increase of product or service, will higher wages result in unemployment.
  • Consistent with classical unemployment theory, frictional unemployment occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment.[6]
  • Structural unemployment covers a variety of possible causes of unemployment including a mismatch between workers' skills and the skills required for open jobs.[7] Large amounts of structural unemployment commonly occur when an economy shifts to focus on new industries and workers find their previous set of skills are no longer in demand. Structural unemployment is similar to frictional unemployment as both reflect the problem of matching workers with job vacancies, but structural unemployment also covers the time needed to acquire new skills in addition to the short-term search process.[8]
  • While some types of unemployment may occur regardless of the condition of the economy, cyclical unemployment occurs when growth stagnates. Okun's law represents the empirical relationship between unemployment and economic growth.[9] The original version of Okun's law states that a 3% increase in output would lead to a 1% decrease in unemployment.[10]

Inflation and deflation

M2andInflation
The ten-year moving averages of changes in price level and growth in money supply (using the measure of M2, the supply of hard currency and money held in most types of bank accounts) in the US from 1875 to 2011. Over the long run, the two series show a close relationship.

A general price increase across the entire economy is called inflation. When prices decrease, there is deflation. Economists measure these changes in prices with price indexes. Inflation can occur when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to deflation.

Central bankers, who manage a country's money supply, try to avoid changes in price level by using monetary policy. Raising interest rates or reducing the supply of money in an economy will reduce inflation. Inflation can lead to increased uncertainty and other negative consequences. Deflation can lower economic output. Central bankers try to stabilize prices to protect economies from the negative consequences of price changes.

Changes in price level may be the result of several factors. The quantity theory of money holds that changes in price level are directly related to changes in the money supply. Most economists believe that this relationship explains long-run changes in the price level.[11] Short-run fluctuations may also be related to monetary factors, but changes in aggregate demand and aggregate supply can also influence price level. For example, a decrease in demand due to a recession can lead to lower price levels and deflation. A negative supply shock, such as an oil crisis, lowers aggregate supply and can cause inflation.

Macroeconomic models

Aggregate demand–aggregate supply

AS + AD graph
A traditional AS–AD diagram showing a shift in AD and the AS curve becoming inelastic beyond potential output.

The AD-AS model has become the standard textbook model for explaining the macroeconomy.[12] This model shows the price level and level of real output given the equilibrium in aggregate demand and aggregate supply. The aggregate demand curve's downward slope means that more output is demanded at lower price levels.[13] The downward slope is the result of three effects: the Pigou or real balance effect, which states that as real prices fall, real wealth increases, resulting in higher consumer demand of goods; the Keynes or interest rate effect, which states that as prices fall, the demand for money decreases, causing interest rates to decline and borrowing for investment and consumption to increase; and the net export effect, which states that as prices rise, domestic goods become comparatively more expensive to foreign consumers, leading to a decline in exports.[13]

In the conventional Keynesian use of the AS-AD model, the aggregate supply curve is horizontal at low levels of output and becomes inelastic near the point of potential output, which corresponds with full employment.[12] Since the economy cannot produce beyond the potential output, any AD expansion will lead to higher price levels instead of higher output.

The AD–AS diagram can model a variety of macroeconomic phenomena, including inflation. Changes in the non-price level factors or determinants cause changes in aggregate demand and shifts of the entire aggregate demand (AD) curve. When demand for goods exceeds supply there is an inflationary gap where demand-pull inflation occurs and the AD curve shifts upward to a higher price level. When the economy faces higher costs, cost-push inflation occurs and the AS curve shifts upward to higher price levels.[14] The AS–AD diagram is also widely used as a pedagogical tool to model the effects of various macroeconomic policies.[15]

IS-LM

Islm
In this example of an IS/LM chart, the IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y).

The IS–LM model gives the underpinnings of aggregate demand (itself discussed above). It answers the question “At any given price level, what is the quantity of goods demanded?” This model shows represents what combination of interest rates and output will ensure equilibrium in both the goods and money markets.[16] The goods market is modeled as giving equality between investment and public and private saving (IS), and the money market is modeled as giving equilibrium between the money supply and liquidity preference.[17]

The IS curve consists of the points (combinations of income and interest rate) where investment, given the interest rate, is equal to public and private saving, given output[18] The IS curve is downward sloping because output and the interest rate have an inverse relationship in the goods market: as output increases, more income is saved, which means interest rates must be lower to spur enough investment to match saving.[18]

The LM curve is upward sloping because the interest rate and output have a positive relationship in the money market: as income (identically equal to output) increases, the demand for money increases, resulting in a rise in the interest rate in order to just offset the insipient rise in money demand.[19]

The IS-LM model is often used to demonstrate the effects of monetary and fiscal policy.[16] Textbooks frequently use the IS-LM model, but it does not feature the complexities of most modern macroeconomic models.[16] Nevertheless, these models still feature similar relationships to those in IS-LM.[16]

Growth models

The neoclassical growth model of Robert Solow has become a common textbook model for explaining economic growth in the long-run. The model begins with a production function where national output is the product of two inputs: capital and labor. The Solow model assumes that labor and capital are used at constant rates without the fluctuations in unemployment and capital utilization commonly seen in business cycles.[20]

An increase in output, or economic growth, can only occur because of an increase in the capital stock, a larger population, or technological advancements that lead to higher productivity (total factor productivity). An increase in the savings rate leads to a temporary increase as the economy creates more capital, which adds to output. However, eventually the depreciation rate will limit the expansion of capital: savings will be used up replacing depreciated capital, and no savings will remain to pay for an additional expansion in capital. Solow's model suggests that economic growth in terms of output per capita depends solely on technological advances that enhance productivity.[21]

In the 1980s and 1990s endogenous growth theory arose to challenge neoclassical growth theory. This group of models explains economic growth through other factors, such as increasing returns to scale for capital and learning-by-doing, that are endogenously determined instead of the exogenous technological improvement used to explain growth in Solow's model.[22]

Macroeconomic policy

Macroeconomic policy is usually implemented through two sets of tools: fiscal and monetary policy. Both forms of policy are used to stabilize the economy, which can mean boosting the economy to the level of GDP consistent with full employment.[23] Macroeconomic policy focuses on limiting the effects of the business cycle to achieve the economic goals of price stability, full employment, and growth. [24]

Monetary policy

Central banks implement monetary policy by controlling the money supply through several mechanisms. Typically, central banks take action by issuing money to buy bonds (or other assets), which boosts the supply of money and lowers interest rates, or, in the case of contractionary monetary policy, banks sell bonds and take money out of circulation. Usually policy is not implemented by directly targeting the supply of money.

Central banks continuously shift the money supply to maintain a targeted fixed interest rate. Some of them allow the interest rate to fluctuate and focus on targeting inflation rates instead. Central banks generally try to achieve high output without letting loose monetary policy that create large amounts of inflation.

Conventional monetary policy can be ineffective in situations such as a liquidity trap. When interest rates and inflation are near zero, the central bank cannot loosen monetary policy through conventional means.

Economic Policy - Intervention Strategy Matrix
An example of intervention strategy under different conditions

Central banks can use unconventional monetary policy such as quantitative easing to help increase output. Instead of buying government bonds, central banks can implement quantitative easing by buying not only government bonds, but also other assets such as corporate bonds, stocks, and other securities. This allows lower interest rates for a broader class of assets beyond government bonds. In another example of unconventional monetary policy, the United States Federal Reserve recently made an attempt at such a policy with Operation Twist. Unable to lower current interest rates, the Federal Reserve lowered long-term interest rates by buying long-term bonds and selling short-term bonds to create a flat yield curve.

Fiscal policy

Fiscal policy is the use of government's revenue and expenditure as instruments to influence the economy. Examples of such tools are expenditure, taxes, debt.

For example, if the economy is producing less than potential output, government spending can be used to employ idle resources and boost output. Government spending does not have to make up for the entire output gap. There is a multiplier effect that boosts the impact of government spending. For instance, when the government pays for a bridge, the project not only adds the value of the bridge to output, but also allows the bridge workers to increase their consumption and investment, which helps to close the output gap.

The effects of fiscal policy can be limited by crowding out. When the government takes on spending projects, it limits the amount of resources available for the private sector to use. Crowding out occurs when government spending simply replaces private sector output instead of adding additional output to the economy. Crowding out also occurs when government spending raises interest rates, which limits investment. Defenders of fiscal stimulus argue that crowding out is not a concern when the economy is depressed, plenty of resources are left idle, and interest rates are low.[25][26]

Fiscal policy can be implemented through automatic stabilizers. Automatic stabilizers do not suffer from the policy lags of discretionary fiscal policy. Automatic stabilizers use conventional fiscal mechanisms but take effect as soon as the economy takes a downturn: spending on unemployment benefits automatically increases when unemployment rises and, in a progressive income tax system, the effective tax rate automatically falls when incomes decline.

Comparison

Economists usually favor monetary over fiscal policy because it has two major advantages. First, monetary policy is generally implemented by independent central banks instead of the political institutions that control fiscal policy. Independent central banks are less likely to make decisions based on political motives.[23] Second, monetary policy suffers shorter inside lags and outside lags than fiscal policy. Central banks can quickly make and implement decisions while discretionary fiscal policy may take time to pass and even longer to carry out.[23]

Development

Origins

Macroeconomics descended from the once divided fields of business cycle theory and monetary theory.[27] The quantity theory of money was particularly influential prior to World War II. It took many forms, including the version based on the work of Irving Fisher:

In the typical view of the quantity theory, money velocity (V) and the quantity of goods produced (Q) would be constant, so any increase in money supply (M) would lead to a direct increase in price level (P). The quantity theory of money was a central part of the classical theory of the economy that prevailed in the early twentieth century.

Austrian School

Ludwig Von Mises's work Theory of Money and Credit, published in 1912, was one of the first books from the Austrian School to deal with macroeconomic topics.

Keynes and his followers

Macroeconomics, at least in its modern form,[28] began with the publication of John Maynard Keynes's General Theory of Employment, Interest and Money.[27][29] When the Great Depression struck, classical economists had difficulty explaining how goods could go unsold and workers could be left unemployed. In classical theory, prices and wages would drop until the market cleared, and all goods and labor were sold. Keynes offered a new theory of economics that explained why markets might not clear, which would evolve (later in the 20th century) into a group of macroeconomic schools of thought known as Keynesian economics – also called Keynesianism or Keynesian theory.

In Keynes's theory, the quantity theory broke down because people and businesses tend to hold on to their cash in tough economic times – a phenomenon he described in terms of liquidity preferences. Keynes also explained how the multiplier effect would magnify a small decrease in consumption or investment and cause declines throughout the economy. Keynes also noted the role uncertainty and animal spirits can play in the economy.[28]

The generation following Keynes combined the macroeconomics of the General Theory with neoclassical microeconomics to create the neoclassical synthesis. By the 1950s, most economists had accepted the synthesis view of the macroeconomy.[28] Economists like Paul Samuelson, Franco Modigliani, James Tobin, and Robert Solow developed formal Keynesian models and contributed formal theories of consumption, investment, and money demand that fleshed out the Keynesian framework.[30]

Monetarism

Milton Friedman updated the quantity theory of money to include a role for money demand. He argued that the role of money in the economy was sufficient to explain the Great Depression, and that aggregate demand oriented explanations were not necessary. Friedman also argued that monetary policy was more effective than fiscal policy; however, Friedman doubted the government's ability to "fine-tune" the economy with monetary policy. He generally favored a policy of steady growth in money supply instead of frequent intervention.[31]

Friedman also challenged the Phillips curve relationship between inflation and unemployment. Friedman and Edmund Phelps (who was not a monetarist) proposed an "augmented" version of the Phillips curve that excluded the possibility of a stable, long-run tradeoff between inflation and unemployment.[32] When the oil shocks of the 1970s created a high unemployment and high inflation, Friedman and Phelps were vindicated. Monetarism was particularly influential in the early 1980s. Monetarism fell out of favor when central banks found it difficult to target money supply instead of interest rates as monetarists recommended. Monetarism also became politically unpopular when the central banks created recessions in order to slow inflation.

New classical

New classical macroeconomics further challenged the Keynesian school. A central development in new classical thought came when Robert Lucas introduced rational expectations to macroeconomics. Prior to Lucas, economists had generally used adaptive expectations where agents were assumed to look at the recent past to make expectations about the future. Under rational expectations, agents are assumed to be more sophisticated. A consumer will not simply assume a 2% inflation rate just because that has been the average the past few years; she will look at current monetary policy and economic conditions to make an informed forecast. When new classical economists introduced rational expectations into their models, they showed that monetary policy could only have a limited impact.

Lucas also made an influential critique of Keynesian empirical models. He argued that forecasting models based on empirical relationships would keep producing the same predictions even as the underlying model generating the data changed. He advocated models based on fundamental economic theory that would, in principle, be structurally accurate as economies changed. Following Lucas's critique, new classical economists, led by Edward C. Prescott and Finn E. Kydland, created real business cycle (RBC) models of the macroeconomy.[33]

RBC models were created by combining fundamental equations from neo-classical microeconomics. In order to generate macroeconomic fluctuations, RBC models explained recessions and unemployment with changes in technology instead of changes in the markets for goods or money. Critics of RBC models argue that money clearly plays an important role in the economy, and the idea that technological regress can explain recent recessions is implausible.[33] However, technological shocks are only the more prominent of a myriad of possible shocks to the system that can be modeled. Despite questions about the theory behind RBC models, they have clearly been influential in economic methodology.

New Keynesian response

New Keynesian economists responded to the new classical school by adopting rational expectations and focusing on developing micro-founded models that are immune to the Lucas critique. Stanley Fischer and John B. Taylor produced early work in this area by showing that monetary policy could be effective even in models with rational expectations when contracts locked in wages for workers. Other new Keynesian economists, including Olivier Blanchard, Julio Rotemberg, Greg Mankiw, David Romer, and Michael Woodford, expanded on this work and demonstrated other cases where inflexible prices and wages led to monetary and fiscal policy having real effects.

Like classical models, new classical models had assumed that prices would be able to adjust perfectly and monetary policy would only lead to price changes. New Keynesian models investigated sources of sticky prices and wages due to imperfect competition,[34] which would not adjust, allowing monetary policy to impact quantities instead of prices.

By the late 1990s economists had reached a rough consensus. The nominal rigidity of new Keynesian theory was combined with rational expectations and the RBC methodology to produce dynamic stochastic general equilibrium (DSGE) models. The fusion of elements from different schools of thought has been dubbed the new neoclassical synthesis. These models are now used by many central banks and are a core part of contemporary macroeconomics.[35]

New Keynesian economics, which developed partly in response to new classical economics, strives to provide microeconomic foundations to Keynesian economics by showing how imperfect markets can justify demand management.

See also

Notes

  1. ^ O'Sullivan, Arthur; Sheffrin, Steven M. (2003), Economics: Principles in Action, Upper Saddle River, New Jersey 07458: Pearson Prentice Hall, p. 57, ISBN 978-0-13-063085-8
  2. ^ Steve Williamson, Notes on Macroeconomic Theory, 1999
  3. ^ Blaug, Mark (1985), Economic theory in retrospect, Cambridge: Cambridge University Press, ISBN 978-0-521-31644-6
  4. ^ Blanchard (2011), 32.
  5. ^ Blanchard (2011), 22.
  6. ^ Dwivedi, 443.
  7. ^ Freeman (2008). http://www.dictionaryofeconomics.com/article?id=pde2008_S000311.
  8. ^ Dwivedi, 444–45.
  9. ^ Dwivedi, 445–46.
  10. ^ Neely, Christopher J. "Okun's Law: Output and Unemployment. Economic Synopses. Number 4. 2010. http://research.stlouisfed.org/publications/es/10/ES1004.pdf.
  11. ^ Mankiw 2014, p. 634.
  12. ^ a b Healey 2002, p. 12.
  13. ^ a b Healey 2002, p. 13.
  14. ^ Healey 2002, p. 14.
  15. ^ Colander 1995, p. 173.
  16. ^ a b c d Durlauf & Hester 2008.
  17. ^ Peston 2002, pp. 386–87.
  18. ^ a b Peston 2002, p. 387.
  19. ^ Peston 2002, pp. 387–88.
  20. ^ Solow 2002, pp. 518–19.
  21. ^ Solow 2002, p. 519.
  22. ^ Blaug 2002, pp. 202–03.
  23. ^ a b c Mayer, 495.
  24. ^ "AP Macroeconomics Review".
  25. ^ Ye, Fred Y. (2017). Scientific Metrics: Towards Analytical and Quantitative Sciences. Springer. ISBN 978-981-10-5936-0.
  26. ^ Arestis, Philip; Sawyer, Malcolm (2003). "Reinventing fiscal policy" (PDF). Levy Economics Institute of Bard College (Working Paper, No. 381). Retrieved 7 December 2018.
  27. ^ a b Dimand (2008).
  28. ^ a b c Blanchard (2011), 580.
  29. ^ Snowdon, Brian; Vane, Howard R. (2005). Modern Macroeconomics – Its origins, development and current state. Edward Elgar. ISBN 1-84542-208-2.
  30. ^ Blanchard (2011), 581.
  31. ^ Blanchard (2011), 582–83.
  32. ^ "Phillips Curve: The Concise Encyclopedia of Economics | Library of Economics and Liberty". www.econlib.org. Retrieved 2018-01-23.
  33. ^ a b Blanchard (2011), 587.
  34. ^ The role of imperfect competition in new Keynesian economics, Chapter 4 of Surfing Economics by Huw Dixon
  35. ^ Blanchard (2011), 590.

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AP Macroeconomics

Advanced Placement Macroeconomics (also known as AP Macroeconomics, AP Macro, APMa, or simply Macro) is an Advanced Placement macroeconomics course for high school students culminating in an exam offered by the College Board.

Study begins with fundamental economic concepts such as scarcity, opportunity costs, production possibilities, specialization, comparative advantage, demand, supply, and price determination.

Major topics include measurement of economic performance, national income and price determination, fiscal and monetary policy, and international economics and growth. AP Macroeconomics is frequently taught in conjunction with (and, in some cases, in the same year as) AP Microeconomics, although more students take the former.

Consumption (economics)

Consumption, defined as spending for acquisition of utility, is a major concept in economics and is also studied in many other social sciences. It is seen in contrast to investing, which is spending for acquisition of future income.Different schools of economists define consumption differently. According to mainstream economists, only the final purchase of newly produced goods and services by individuals for immediate use constitutes consumption, while other types of expenditure — in particular, fixed investment, intermediate consumption, and government spending — are placed in separate categories (see Consumer choice). Other economists define consumption much more broadly, as the aggregate of all economic activity that does not entail the design, production and marketing of goods and services (e.g. the selection, adoption, use, disposal and recycling of goods and services).Economists are particularly interested in the relationship between consumption and income, as modeled with the consumption function.

Democratic capitalism

Democratic capitalism, also known as capitalist democracy, is a political ideology that combines liberal democracy with capitalism to support individual freedom and pluralism. It stands in contrast to corporatism by limiting the influence of special interest groups, including corporate lobbyists, on politics.

The coexistence of modern capitalism and democracy was supported by the creation of the modern welfare state in the post-war period, which enabled a relatively stable political atmosphere and widespread support for capitalism. This period of history is often referred to as the "Golden Age of Capitalism".

Disequilibrium macroeconomics

Disequilibrium macroeconomics is a tradition of research centered on the role of disequilibrium in economics. This approach is also known as non-Walrasian theory, equilibrium with rationing, the non-market clearing approach, and non-tâtonnement theory. Early work in the area was done by Don Patinkin, Robert W. Clower, and Axel Leijonhufvud. Their work was formalized into general disequilibrium models, which were very influential in the 1970s. American economists had mostly abandoned these models by the late 1970s, but French economists continued work in the tradition and developed fixprice models.

Dynamic stochastic general equilibrium

Dynamic stochastic general equilibrium modeling (abbreviated as DSGE, or DGE, or sometimes SDGE) is a method in macroeconomics that attempts to explain economic phenomena, such as economic growth and business cycles, and the effects of economic policy, through econometric models based on applied general equilibrium theory and microeconomic principles.

External debt

External loan (or foreign debt) is the total debt a country owes to foreign creditors; its complement is internal debt which is owed to domestic lenders. The debtors can be the government, corporations or citizens of that country. The debt includes money owed to private commercial banks, other governments, or international financial institutions such as the International Monetary Fund (IMF) and World Bank. Note that the use of gross liability figures greatly distorts the ratio for countries which contain major money centers such as the United Kingdom due to London's role as a financial capital. Contrast with net international investment position.

History of macroeconomic thought

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.The generation of economists that followed Keynes synthesized his theory with neoclassical microeconomics to form the neoclassical synthesis. Although Keynesian theory originally omitted an explanation of price levels and inflation, later Keynesians adopted the Phillips curve to model price-level changes. Some Keynesians opposed the synthesis method of combining Keynes's theory with an equilibrium system and advocated disequilibrium models instead. Monetarists, led by Milton Friedman, adopted some Keynesian ideas, such as the importance of the demand for money, but argued that Keynesians ignored the role of money supply in inflation. Robert Lucas and other new classical macroeconomists criticized Keynesian models that did not work under rational expectations. Lucas also argued that Keynesian empirical models would not be as stable as models based on microeconomic foundations.

The new classical school culminated in real business cycle theory (RBC). Like early classical economic models, RBC models assumed that markets clear and that business cycles are driven by changes in technology and supply, not demand. New Keynesians tried to address many of the criticisms leveled by Lucas and other new classical economists against Neo-Keynesians. New Keynesians adopted rational expectations and built models with microfoundations of sticky prices that suggested recessions could still be explained by demand factors because rigidities stop prices from falling to a market-clearing level, leaving a surplus of goods and labor. The new neoclassical synthesis combined elements of both new classical and new Keynesian macroeconomics into a consensus. Other economists avoided the new classical and new Keynesian debate on short-term dynamics and developed the new growth theories of long-run economic growth. The Great Recession led to a retrospective on the state of the field and some popular attention turned toward heterodox economics.

IS–LM model

The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates (ordinate) and assets market (also known as real output in goods and services market plus money market, as abscissa). The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift.

Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.The model was developed by John Hicks in 1937, and later extended by Alvin Hansen, as a mathematical representation of Keynesian macroeconomic theory. Between the 1940s and mid-1970s, it was the leading framework of macroeconomic analysis. While it has been largely absent from macroeconomic research ever since, it is still a backbone conceptual introductory tool in many macroeconomics textbooks. By itself, the IS–LM model is used to study the short run when prices are fixed or sticky and no inflation is taken into consideration. But in practice the main role of the model is as a path to explain the AD–AS model.

International finance

International finance (also referred to as international monetary economics or international macroeconomics) is the branch of financial economics broadly concerned with monetary and macroeconomic interrelations between two or more countries. International finance examines the dynamics of the global financial system, international monetary systems, balance of payments, exchange rates, foreign direct investment, and how these topics relate to international trade.Sometimes referred to as multinational finance, international finance is additionally concerned with matters of international financial management. Investors and multinational corporations must assess and manage international risks such as political risk and foreign exchange risk, including transaction exposure, economic exposure, and translation exposure.Some examples of key concepts within international finance are the Mundell–Fleming model, the optimum currency area theory, purchasing power parity, interest rate parity, and the international Fisher effect. Whereas the study of international trade makes use of mostly microeconomic concepts, international finance research investigates predominantly macroeconomic concepts.

The three major components setting international finance apart from its purely domestic counterpart are as follows:

Foreign exchange and political risks.

Market imperfections.

Expanded opportunity sets.These major dimensions of international finance largely stem from the fact that sovereign nations have the right and power to issue currencies, formulate their own economic policies, impose taxes, and regulate movement of people, goods, and capital across their borders.The term "international finance" is sometimes also used as an anti-Semitic code word.

Investment (macroeconomics)

In macroeconomics, investment is the amount of goods purchased or accumulated per unit time which are not consumed at the present time. The types of investment are residential investment in housing that will provide a flow of housing services over an extended time, non-residential fixed investment in things such as new machinery or factories, human capital investment in workforce education, and inventory investment (the accumulation, intentional or unintentional, of goods inventories).

In measures of national income and output, "gross investment" (represented by the variable I ) is a component of gross domestic product (GDP), given in the formula GDP = C + I + G + NX, where C is consumption, G is government spending, and NX is net exports, given by the difference between the exports and imports, X − M. Thus investment is everything that remains of total expenditure after consumption, government spending, and net exports are subtracted (i.e. I = GDP − C − G − NX ).

"Net investment" deducts depreciation from gross investment. Net fixed investment is the value of the net increase in the capital stock per year.

Fixed investment, as expenditure over a period of time (e.g., "per year"), is not capital but rather leads to changes in the amount of capital. The time dimension of investment makes it a flow. By contrast, capital is a stock—that is, accumulated net investment up to a point in time.

Keynesian economics

Keynesian economics ( KAYN-zee-ən; sometimes called Keynesianism) are a group of various macroeconomic theories about how in the short run – and especially during recessions – economic output is strongly influenced by aggregate demand (total demand in the economy). In the Keynesian view, named for British economist John Maynard Keynes, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.Keynesian economics served as the standard economic model in the developed nations during the later part of the Great Depression, World War II, and the post-war economic expansion (1945–1973), though it lost some influence following the oil shock and resulting stagflation of the 1970s. The advent of the financial crisis of 2007–08 caused a resurgence in Keynesian thought, which continues as new Keynesian economics. Keynesian economics developed during and after the Great Depression from the ideas presented by Keynes in his 1936 book, The General Theory of Employment, Interest and Money. Keynes contrasted his approach to the aggregate supply-focused classical economics that preceded his book. The interpretations of Keynes that followed are contentious and several schools of economic thought claim his legacy.

Keynesian economists generally argue that as aggregate demand is volatile and unstable, a market economy often experiences inefficient macroeconomic outcomes in the form of economic recessions (when demand is low) and inflation (when demand is high), and that these can be mitigated by economic policy responses, in particular, monetary policy actions by the central bank and fiscal policy actions by the government, which can help stabilize output over the business cycle. Keynesian economists generally advocate a managed market economy – predominantly private sector, but with an active role for government intervention during recessions and depressions.

Microfoundations

In economics, the microfoundations are the microeconomic behavior of individual agents, such as households or firms, that underpins a macroeconomic theory.Most early macroeconomic models, including early Keynesian models, were based on hypotheses about relationships between aggregate quantities, such as aggregate output, employment, consumption, and investment. Critics and proponents of these models disagreed as to whether these aggregate relationships were consistent with the principles of microeconomics. Therefore, in recent decades macroeconomists have attempted to combine microeconomic models of household and firm behavior to derive the relationships between macroeconomic variables. Today, many macroeconomic models, representing different theoretical points of view, are derived by aggregating microeconomic models allowing economists to test them both with macroeconomic and microeconomic data.

Neoclassical economics

Neoclassical economics is an approach to economics focusing on the determination of goods, outputs, and income distributions in markets through supply and demand. This determination is often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by firms facing production costs and employing available information and factors of production, in accordance with rational choice theory, a theory that has come under considerable question in recent years.

Neoclassical economics dominates microeconomics and, together with Keynesian economics, forms the neoclassical synthesis which dominates mainstream economics today. Although neoclassical economics has gained widespread acceptance by contemporary economists, there have been many critiques of neoclassical economics, often incorporated into newer versions of neoclassical theory, but some remaining distinct fields.

Net capital outflow

Net capital outflow (NCO) is the net flow of funds being invested abroad by a country during a certain period of time (usually a year). A positive NCO means that the country invests outside more than the world invests in it. NCO is one of two major ways of characterizing the nature of a country's financial and economic interaction with the other parts of the world (the other being the balance of trade).

New Keynesian economics

New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.

Two main assumptions define the New Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have rational expectations. However, the two schools differ in that New Keynesian analysis usually assumes a variety of market failures. In particular, New Keynesians assume that there is imperfect competition in price and wage setting to help explain why prices and wages can become "sticky", which means they do not adjust instantaneously to changes in economic conditions.

Wage and price stickiness, and the other market failures present in New Keynesian models, imply that the economy may fail to attain full employment. Therefore, New Keynesians argue that macroeconomic stabilization by the government (using fiscal policy) and the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez faire policy would.

New classical macroeconomics

New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.

New classical macroeconomics strives to provide neoclassical microeconomic foundations for macroeconomic analysis. This is in contrast with its rival new Keynesian school that uses microfoundations such as price stickiness and imperfect competition to generate macroeconomic models similar to earlier, Keynesian ones.

Rational expectations

In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" and on average take the model's predictions as valid. Rational expectations ensure internal consistency in models involving uncertainty. To obtain consistency within a model, the predictions of future values of economically relevant variables from the model are assumed to be the same as that of the decision-makers in the model, given their information set, the nature of the random processes involved, and model structure. The rational expectations assumption is used especially in many contemporary macroeconomic models.

Since most macroeconomic models today study decisions under uncertainty and over many periods, the expectations of individuals, firms, and government institutions about future economic conditions are an essential part of the model. To assume rational expectations is to assume that agents' expectations may be wrong, but are correct on average over time. In other words, although the future is not fully predictable, agents' expectations are assumed not to be systematically biased and collectively use all relevant information in forming expectations of economic variables. This way of modeling expectations was originally proposed by John F. Muth (1961) and later became influential when it was used by Robert Lucas, Jr. in macroeconomics.

Deirdre McCloskey emphasizes that "rational expectations" is an expression of intellectual modesty:Muth's notion was that the professors [of economics], even if correct in their model of man, could do no better in predicting than could the hog farmer or steelmaker or insurance company. The notion is one of intellectual modesty. The common sense is "rationality": therefore Muth called the argument "rational expectations".

Hence, it is important to distinguish the rational-expectations assumption from assumptions of individual rationality and to note that the first does not imply the latter. Rational expectations is an assumption of aggregate consistency in dynamic models. In contrast, rational choice theory studies individual decision making and is used extensively in, among others, game theory and contract theory.

Real business-cycle theory

Real business-cycle theory (RBC theory) is a class of new classical macroeconomics models in which business-cycle fluctuations to a large extent can be accounted for by real (in contrast to nominal) shocks. Unlike other leading theories of the business cycle, RBC theory sees business cycle fluctuations as the efficient response to exogenous changes in the real economic environment. That is, the level of national output necessarily maximizes expected utility, and governments should therefore concentrate on long-run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to actively smooth out economic short-term fluctuations.

According to RBC theory, business cycles are therefore "real" in that they do not represent a failure of markets to clear but rather reflect the most efficient possible operation of the economy, given the structure of the economy.

Real business cycle theory categorically rejects Keynesian economics and the real effectiveness of monetary policy as promoted by monetarism and New Keynesian economics, which are the pillars of mainstream macroeconomic policy.

RBC theory is associated with freshwater economics (the Chicago School of Economics in the neoclassical tradition).

Saltwater and freshwater economics

In economics, the freshwater school (or sometimes sweetwater school) comprises US-based macroeconomists who, in the early 1970s, challenged the prevailing consensus in macroeconomics research. A key element of their approach was the argument that macroeconomics had to be dynamic and based on how individuals and institutions interact in markets and on how they make decisions under uncertainty.This new approach to macroeconomics was centered in the faculties of the University of Chicago, Carnegie Mellon University, Northwestern University, Cornell University, the University of Minnesota, and the University of Rochester. They were called the "freshwater school" because Chicago, Pittsburgh, Rochester, Minneapolis, etc. are located closer to the North American Great Lakes.The established methodological approach to macroeconomic research was primarily defended by economists at the universities and other institutions located near the east and west coast of the United States. These universities included University of California, Berkeley, Brown University, Dartmouth College, Harvard University, University of Pennsylvania, Princeton University, Columbia University, and Yale University. They were therefore often referred to as the saltwater schools.

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