Evolution of Macroeconomics as a schience: Events and Ideas - Essay Example

Macroeconomic Events and Ideas This study examined how the Great Depression of 1930s exposed the weaknesses of classical macroeconomics and led to the emergence of other schools of macroeconomic thoughts. The researcher mainly relied on secondary information from books and other articles in the internet to gather information about the topic. The study established that classical macroeconomics could not explain could not forecast, explain or give solutions to the problems caused by the Great Depression. This failure marked the emergence of Keynesian Revolution, which offered to provide solution to the problems of the Great Depression. The paper concludes by asserting that macroeconomics is a field still undergoing constant revolution citing 2008 financial crisis that led the abandonment of the Great Moderation consensus. Further, it concludes that old theory and policies become obsolete because new macroeconomic events demand foe new approaches. Introduction Macroeconomics focuses on the performance of the economy in its entirety. For a very long time, economists belonging to different schools of thought have attacked each other in a bid to prove that their approach is the best for emerging economic problems. However, each macroeconomic thought seems to be redundant when the world continues to encounter new economic problems demanding new thoughts all together. During 1930s, the United States capitalist system practically stopped working. The U.S free-market economy could not function at the desired level for over a decade (1929-1940). The Great Depression not only caused mayhem to the country’s economy, but to the entire world. The failure of classical economics to explain and provide solutions to the effects of the Great Recession of 1930s led to the birth of numerous economic thoughts aimed at providing answers to economic questions emanating from the underlying problems. This paper explores the classical economics and its failures that led to the development of new macroeconomic thoughts following the Great Recession of 1930s. The Classical Macroeconomics and the Great Depression Prior to the Keynesian Revolution, the classical school of thought is the economic thought that dominated economic world. At that time, classical economist had not crafted any theory or model for macroeconomics. Macroeconomic thoughts were basically in the form of hypotheses. Based on classical school of thought, free interaction of the forces of demand and supply will result into the following conditions: First, full employment will be achieved in the long-run (LR) and the problem of unemployment will only be experienced in the short-run (SR), if any. Second, there will be no overproduction or underproduction in the economy at the aggregate level. Third, the economy will ever be in equilibrium in the long-run (Dwivedi 13). However, the Great Depression of 1930s disapproved the claims of all the proponents of classical economic thought (Canterbery 11). The Great Recession “exposed the inadequacies of the theoretical foundations of the classical laissez-faire doctrine” (Dwivedi 13). At the time of Great Depression, there was unbelievably massive and high level of unemployment in almost all free-market industrial economies (Dwivedi 13). The Gross National Product (GDP) of such nations declined catastrophically (Dwivedi 13). For example, in the United States, the level of unemployment increased from 1929 3 percent to 25 percent level in 1933. Production level (of goods and services) fell by 30 percent while price level declined by 23 percent with business level falling to almost zero level (Dwivedi 13). According to Dwivedi, “the classical economics could offer neither an explanation nor a solution to the economic problems created by the Great Depression” (Dwivedi 13). Needless to say the Great Depression of 1930s brought down the classical macroeconomics. The Keynesian Revolution Following the downfall of classical economics, there was need for a new look at the mechanisms through which economic system works and developing corrective policy initiatives to cover up the failures of the market economy (Canterbery 11). John Maynard Keynes steered this task in his ‘General Theory’, which formed the basis of macroeconomics (Dwivedi 13). Keynes abandoned classical macroeconomics upon realizing that it was incapable of forecasting, explaining and offering solutions to economic challenges emanating from economic devastations such as the Great Depression (Dwivedi 13). The attempt by Keynes to pursue a solution to economic challenges resulting from the Great Depression led to the birth of Keynesian macroeconomics. In broad sense, Keynesian macroeconomic theories focus on three fundamental aspects of the economy: employment, growth and stability. Keynesian macroeconomic theories are built on the following tenets: first, the aggregate demand determines the level of output as well as employment in an economy. Second, lack of aggregate demand is the cause of unemployment in any given country and economic instability is as a result of demand deficiency. Third, the government can do away with demand deficiency via compensatory government spending (Dwivedi 14). In order to ensure a stable economic growth, Keynesian economics emphasizes the role of the government in managing demand. Indeed, one of the most conspicuous achievements of Keynesian revolution is the acknowledgement as well as transforming economists’ perception of the influence of the government activities on private economy. Unlike the classical economics that postulates that government spending results into “crowding out” of private investment, Keynesian economic takes a different course by emphasizing “the favorable macroeconomic effects of the government spending on national income and employment through its multiplier effect” (Dwivedi 14). The classical economic thought was at least overshadowed by Keynesian economic perspective for some time. Keynesian Revolution can be traced back to the period between late 1930s and mid 1960s. This period is basically referred to as the Keynesian era. Keynesian economist dominated the field of economics and most governments, especially in developed nations, had adopted Keynesian economic policies. Many developing nations were struggling to break through their “low-equilibrium trap” and implemented Keynesian strategies to steer their economic advancement. The Keynesian theory of growth and development ruled most economies until late 1960s. Despite its dominance, Keynesian economic thought had to give way to other new perceptions with changes in the world. “The real economic world has never conformed to any particular economic thought or principle, idea or ideology” (Dwivedi 14). As the world continues to evolve, going through different economic phases, the necessity to adopt new economic systems renders the previous ones redundant. This compels economists to review existing theories and work on modalities of developing new ideas to explain and provide solutions to emerging economic trends. As such, Keynesian revolution had been rendered redundant and had to give way for new economic thoughts. How Challenges Led To Revision of Keynesian Economics and Emergence of New Classical Macroeconomics During early period of 1970s, signs of failures in the Keynesian economics began to show. Keynesian economics, particularly its fiscal measures, were incapable of providing solutions to economic problems such as low growth, high inflation rate in developed nation like the United States, as well as the problem of low economic growth. “It could offer neither a reasonable explanation nor an effective solution to the problem of ‘stagflation’ face by the US in the early 1970s” (Dwivedi 14). As such, new camps of macroeconomic thoughts emerged to bridge the gaps in the Keynesian economics. The post-Keynesian economics saw the emergence of the following macroeconomic ideas and theories: monetarism, neo-classical macroeconomics and neo-Keynesianism. Monetarism “Monetarism is a reformulated quantity theory of money, its essential allegation being that the evolution of national nominal income is dominated by changes in the money supply” (Felderer and Homburg 171). The failure of Keynesian economics to provide explanation and answers to emerging economic problems of 1970s led to its downfall. Many economists began to question the relevance of Keynesian economics to economic growth and stability problems. Monetarist economists under the leadership of Milton Friedman argued that Keynesian theory was not capable of forecasting national output, price levels, interest rates as well as the rates of employment and unemployment (Felderer and Homburg 171; Dwivedi 15). Following these failures of Keynesian economics, the monetarists develop a new radical thought. According to the monetarists, money plays a significant role in economic growth and stability of national output, which is opposed to aggregate demand as postulated in Keynesian economics (Felderer and Homburg 171; Dwivedi 15). The monetarists argue that it is money supply that is the major determinant of output and employment in the short-run as well as price level in the long-run. With this, they added extra idea to theory and policy of macroeconomics. At theoretical level, monetarists shifted the attention “from aggregate demand for real output to the aggregate demand for and supply of money, and at the policy level, the emphasis shifted from demand management to monetary management” (Dwivedi 15). This revolutionary thought led to a heated debate between monetarists and Keynesians as to what causes aggregate demand. According to the monetarists, despite the fact that aggregated demand is determined by multifold factors, money supply remains the most important determinant compared to all the other forces that influence nominal GNP in the SR and prices in the LR. Neo-classical Macroeconomics Amidst the heated debate between Keynesians and monetarists, Keynesian economics was again attacked in 1980s by the ‘radicalists’, whose propositions are known as neo-classical macroeconomics (Sardoni 17). This school of thought can be traced back to the work of Robert E. Lucas in 1995 (Sherman and Meeropol 36). According to Lucas, Keynesian macroeconomics has been rendered redundant in all aspects including policy and theoretical dimensions. This school of thought stresses on “the role of individual’s rational expectations about future economic events, especially those taking place on the supply side of the economy and the expectations about future government policies” (Dwivedi 15). Rational expectations of consumers determine the behavior of aggregate supply and demand with real GNP remaining unaffected. However, prices and wage level increase. Supply-side Economics The supply-side economists under the leadership of Arthur Laffer placed much emphasis on supply-side factors of the market in determining aggregate demand (Dwivedi 15). Their focus was to provide an alternative to Keynesian employment and output theory. Unlike Keynesians who emphasizes on shifts of aggregate demand as the core determinant of employment and output, supply-side economists argue that tax rate reduction shifts aggregated supply curve to the right leading to increased output and employment. Neo-Keynesianism Keynesian macroeconomics remains the focal point for attack or development of new macroeconomic ideas. According to neo-Keynesians, the market does not always clear despite the fact that individuals work for their personal interests. Imperfect information and cost of fluctuating prices cause price rigidities, which in turn lead to fluctuation in output and employment (Dwivedi 15). From the above documentation of evolution of macroeconomic thoughts, macroeconomics seems to be developing progressively with changing economic conditions. Nonetheless, the already developed theories and principles have gained wide acknowledgment and application, giving credibility to macroeconomics. Why the Great Moderation Consensus Was Challenged By the 2008 Financial Crisis The U.S economy had been performance during the Great Moderation of 1984 to 2006 had appeared to restore faith in economists’ and policymakers’ regarding effective management of asset bubbles. However, the 2008 financial crisis had adverse impacts on the economy of the U.S as well as global economies triggering a new debate about asset bubbles and what role public policy play in managing the bubbles (Evanoff, Kaufman and Malliaris Para 3). Before the recent global financial crisis, the Federal Reserve, under chairmanship of both Alan Greenspan and Ben Bernanke, applied asymmetric approach to managing asset price bubble. In the dearth of inflation, the Fed method supported no, or minimal restrictive monetary policy action during the development and growth of asset bubble. It focused of swift action in the event that the bubble burst to cushion against potential decline in output and employment. The Fed strategy seemed flawless until 2008, when the financial system almost came crushing. It is these experience the rekindled the debate surrounding the management of asset price bubble. Federal Reserve officials and economists have since then called for reconsideration of the role of public policy in managing asset price bubbles effectively. Conclusion Macroeconomics focuses on the overall performance of the economy. The flaws in classical macroeconomic ideas and theories can be traced to the times of the Great Depression of 1930s. Classical economists could not offer explanation or solution to the problems posed by the Great Depression. As such, new economic thoughts sprung to provide explanation and solutions to the inadequacies of classical macroeconomics. The failure of classical macroeconomic postulates led to the emergence of Keynesian Revolution, which dominated global economic systems until mid 1960s. Thereafter, Keynesian economics also began to exhibit flaws and this led to the development of other school of thoughts as mentioned in the paper. Therefore, macroeconomics appears to be a field undergoing constant revolution as the world continues to encounter new economic challenges that demand new sets of thoughts. This is evident when the Great Moderation Consensus was challenged by the 2008 Financial Crisis. As new economic problems emerge, the existing policies and theories are rendered redundant and new ones are developed from them. Works Cited Canterbery, E. Ray. The Global Great Recession. Singapore: World Scientific, 2011. Print. Dwivedi, D.N. Macroeconomics: theory and policy (3rd Ed). New Delhi: Tata McGraw Hill Education Pte Ltd., 2010.Print. Evanoff, Douglas, George Kaufman and Anastasios G. Malliaris. Asset Price Bubbles: Lessons From The Recent Financial Crisis, 2013. Viewed on November 9, 2013 from Felderer, B. and Stefan Homburg. Macroeconomics and new macroeconomics. New York: Springer-Verlag, 1992.Print. Sardoni, Claudio. Unemployment, Recession and Effective Demand: the Contributions of Marx, Keynes and Kalecki. Cheltenham: Edward Elgar Pub., 2007.Print. Sherman, Howard J. and Michael A. Meeropol. Principles of Macroeconomics: Activist vs. Austerity Policies. New York: M.E. Sharpe, 2013. Print. Read More