School of Distance Education MACROECONOMICS: THEORIES AND POLICIES II (ECO2C06) STUDY MATERIAL II SEMESTER CORE COURSE MA ECONOMICS (2019 Admission ONWARDS) UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION Calicut University P.O, Malappuram Kerala, India 673 635. 190306 Macro Economics : Theories and Policies II Page 1 School of Distance Education UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION STUDY MATERIAL SECOND SEMESTER MA ECONOMICS (2019 ADMISSION) CORE COURSE : ECO2C06 : MACROECONOMICS : THEORIES AND POLICIES II Prepared by : SUJIN K N, Assistant Professor, PG & Research Department of Economics, Government College, Kodanchery, Kozhikode - 673 580. Scrutinized by : Dr.K.X Joseph, Professor (Retd.), Dr.John Matthai Centre, Thrissur. Macro Economics : Theories and Policies II Page 2 School of Distance Education CONTENTS I Classical Vs Keynes 5 II Monetarism 79 New Classical Macro Economics, Real III Business cycle School and Supply side 93 Economics IV The New Keynes School 126 V New Political Macroeconomics 151 Macro Economics : Theories and Policies II Page 3 School of Distance Education Macro Economics : Theories and Policies II Page 4 School of Distance Education MODULE I CLASSICAL VS KEYNES “Economics is an easy subject in which few excel”-- John Maynard Keynes INTRODUCTION TO MACROECONOMICS Macro economics is the branch of economics studying the behaviour of the aggregate economy – at the regional, national or international level. In other words Macroeconomics is the study of the behavior of the whole economy or economy as a whole. It is concerned with the determination of the broad aggregates in the economy, in particular the national output, unemployment, inflation and the balance of payments position. The way in which we nowadays study macroeconomics largely owes its origins to John Maynard Keynes’s “The General Theory of Employment, Interest and Money”. Published in 1936, “The General Theory” was regarded by its author, and by many others since, as a revolutionary work. In it Keynes set out to challenge the mainstream neoclassical economic thought of his day, which he castigated as unable to explain or offer policy solutions for the high level of unemployment which, in Britain between 1921 and 1939, was just under 10 per cent at its lowest level and rose to 22 per cent at the depth of the depression in 1930. The term ‘macroeconomics’ was coined and used by a Norwegian economist, Ragnar Frisch in 1933 in his paper “Propagation Problems and Impulse Problems in Dynamic Economics” in ‘Economic Essays in the Honor of Gustav Cassel’(London, 1933). The prefix ‘macro’ meaning large has been derived from Greek language. What is macroeconomics? The aim of studying macroeconomics is to understand how an economy works, and identifying the levers that can be pulled to put the overall economy on the right path of growth. The system that is a result of different economic agents coming into contact is much more complex than the sum of its independent and often disjoint parts. Macro Economics : Theories and Policies II Page 5 School of Distance Education Moreover, it is strictly “non-experimental” as we do not have the luxury of conducting controlled experiments like in the field of science. We can just wait and observe the effects of broader policy measures with a certain level of accuracy and a tinge of hope. It usually deals with goals that are conflicting; ensuring growth, taming inflation, full employment and fair income distribution at the same time! Classical macroeconomics The term “classical economics” was firstly coined by KARL MARX to refer the economic theories of David Ricardo and his predecessors including Adam Smith. Classical economics covered almost a period of 150 years (1776-1929). The leaders of this school were David Ricardo, Malthus, J.S Mill, J.B Say and A.C Pigou. Classical economics is that body of thought which existed prior to the publication of Keynes’s (1936) General Theory. For Keynes the classical school not only included Adam Smith, David Ricardo and John Stuart Mill, but also ‘the followers of Ricardo, those, that is to say, who adopted and perfected the theory of Ricardian economics’ (Keynes, 1936, p. 3). Keynes was therefore at odds with the conventional history of economic thought classification, particularly with his inclusion of both Alfred Marshall and Arthur Cecil Pigou within the classical school. However, given that most of the theoretical advances which distinguish the neoclassical from the classical period had been in microeconomic analysis, Keynes perhaps felt justified in regarding the macroeconomic ideas of the 1776–1936 period, such as they existed, as being reasonably homogeneous in terms of their broad message. This placed great faith in the natural market adjustment mechanisms as a means of maintaining full employment equilibrium. Before moving on to examine the main strands of macroeconomic thought associated with the classical economists, the reader should be aware that, prior to the publication of the General Theory, there was no single unified or formalized theory of aggregate employment, and substantial differences existed between economists on the nature and origin of the business cycle (see Haberler, 1963). The structure of classical macroeconomics mainly emerged after 1936 and did so largely in response to Keynes’s own theory in order that comparisons could be made. Here we take the conventional approach of presenting a somewhat artificial summary of classical macroeconomics, a body of thought that in reality was extremely complex and diverse. Although no single classical economist ever held all the ideas presented below, there are certain strands of thought running through the pre-Keynes literature which permit us to characterize classical theory as a coherent story with clearly identifiable building-blocks. To do so will be analytically useful, even if ‘historically somewhat inaccurate’ (see Ackley, 1966, p. 109). Even an ‘Aunt Sally’ version of the classical theory can, by comparison, help us better Macro Economics : Theories and Policies II Page 6 School of Distance Education understand post-1936 developments in macroeconomic theory. We accept that, whilst the major presentations of the ‘Keynes v. Classics’ debate consist of ahistorical fictions – especially those of Hicks (1937) and Leijonhufvud (1968) – and serve as straw men, they aid our understanding by overtly simplifying both the Keynes and the classics positions. Classical economists were well aware that a capitalist market economy could deviate from its equilibrium level of output and employment. However, they believed that such disturbances would be temporary and very short-lived. Their collective view was that the market mechanism would operate relatively quickly and efficiently to restore full employment equilibrium. If the classical economic analysis was correct, then government intervention, in the form of activist stabilization policies, would be neither necessary nor desirable. Indeed, such policies were more than likely to create greater instability. As we shall see later, modern champions of the old classical view (that is, new classical equilibrium business cycle theorists) share this faith in the optimizing power of market forces and the potential for active government intervention to create havoc rather than harmony. It follows that the classical writers gave little attention to either the factors which determine aggregate demand or the policies which could be used to stabilize aggregate demand in order to promote full employment. For the classical economists full employment was the normal state of affairs. That Keynes should attack such ideas in the 1930s should come as no surprise given the mass unemployment experienced in all the major capitalist economies of that era. But how did the classical economists reach such an optimistic conclusion? In what follows we will present a ‘stylized’ version of the classical model which seeks to explain the determinants of an economy’s level of real output (Y), real (W/P) and nominal (W) wages, the price level (P) and the real rate of interest (r) (see Ackley, 1966). In this stylized model it is assumed that: 1. All economic agents (firms and households) are rational and aim to maximize their profits or utility; furthermore, they do not suffer from money illusion; 2. All markets are perfectly competitive, so that agents decide how much to buy and sell on the basis of a given set of prices which are perfectly flexible; 3. All agents have perfect knowledge of market conditions and prices before engaging in trade; 4. Trade only takes place when market-clearing prices have been established in all markets, this being ensured by a fictional Walrasian auctioneer whose presence prevents false trading; 5. Agents have stable expectations. These assumptions ensure that in the classical model, markets, including the labour market, always clear. To see how the classical model explains the determination of the crucial macro variables, we will follow their approach and divide the economy into two sectors: a real sector Macro Economics : Theories and Policies II Page 7 School of Distance Education and a monetary sector. To simplify the analysis we will also assume a closed economy, that is, no foreign trade sector. In examining the behaviour of the real and monetary sectors we need to consider the following three components of the model: (i) the classical theory of employment and output determination, (ii) Say’s Law of markets, and (iii) the quantity theory of money. The first two components show how the equilibrium values of the real variables in the model are determined exclusively in the labour and commodity markets. The third component explains how the nominal variables in the system are determined. Thus in the classical model there is a dichotomy. The real and monetary sectors are separated. As a result, changes in the quantity of money will not affect the equilibrium values of the real variables in the model. With the real variables invariant to changes in the quantity of money, the classical economists argued that the quantity of money was neutral.