Macroeconomic Theory

Competing schools of thought

Macroeconomic Theory

Macroeconomic theory is a set a views about the way the economy operates.Models are developed to illustrate how the economy worksEconomists 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 thoughtClassical

Keynesian

Old Classical (1776 1930s)An Inquiry into the Nature and Causes of the Wealth of Nations by Adam Smith (1776)

Invisible hand theoremlaissez faire economics Says 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.

Says LawSupply 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 Depression1929 early 1940s

Worldwide economic depression began on October 29th, 1929 with a stock market crashpanic 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 MoneyThe 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 economicsAdvocates wide use of stabilization policy.

Post WWII, all advanced democratic societies adopted Keynesian policiesPolicies that manage the demand side of the economy

Unemployment remained low until 1973.

Key concepts of Keynesian economics

Market failure

Involuntary unemployment

Stabilization policy

1970sHigh inflation!

Rising unemployment!

Low economic growth!

Led to questioning of Keynesian economics15The reign of Keynesianism came to a halt No one school of thought has dominated since that time.Other important schools of thoughtMonetarist school (Milton Friedman)Quantity theory of moneyExpectations augmented Phillips curve

New Classical SchoolReal business cycle theory New Keynesian EconomicsAdapted micro to macro theoryMicro foundations

Austrian SchoolFree markets, invisible hand, emphasis on individuals

Post KeynesianImportance of uncertainty