Introduction to Macroeconomics - Essay Example

In a closed economy, goods can be at market equilibrium yet large degree of unemployment In a closed economy, goods or the outputs can be at market equilibrium, in which case the quantity of the goods produced equal the quantity of the goods demanded. While the output of the economy can be at market equilibrium, the high level of unemployment can be traced back, not from the demand-supply equilibrium in the wage market as classical economists argue, but because of lower aggregate demands which, as Keynes argues, leads to lower demands in labor in turn. In a closed economy where there is no foreign trade, the level of outputs that are produced will be at market equilibrium as the demand levels will further be met by the supply levels. However, during recessions, when unemployment rate rises, the demand will still be met by the supply, although the demand level will be lower. This is why in the goods market prices and quantity will settle at the equilibrium but high unemployment can still be present in the economy. This has been termed as the “Keynesian unemployment”. As what has been described earlier, in determining output to meet the demands, there are two views—the Keynesian and the classical view. The classical view argues that prices and wages are flexible, in such a way that excesses in either demand or supply will quickly be absorbed by the economy and resume full employment of resources after economic shocks—or abrupt changes in the aggregate demand and supply curves. The Keynesian view on the other hand argues, as apparent in its sticky theory of prices and wages which says that these two factors are sticky in the short run because of contractual rigidities such as agreements made with different interest groups such as the labor unions. In the latter situation, the one proposed by Keynes, higher levels of aggregate demands are needed for output to respond positively because aggregate supply curve is relatively flat especially when output levels are low. In this situation, the economy can have long periods of unemployment because prices and wages are slow to adjust to shocks, and reaching full employment of resources is slow to reach. When classical economists argue that unemployment results from the interaction of the labor demand and supply curves, and lowering the wages will spread the labor supply which can curb unemployment in the process, Keynes argue that such is not applicable when unemployment is due to business cycle downturns, when because of lower demands of products in the economy, demand for labor is also low. The lower demand for goods results into lower demands for labor. Labor is a necessary input and resource in order to produce goods. But with employers facing a lower demand for their products, they would not be motivated to further employ some labor which costs would not be covered by sufficient demands and turn into sales. Cutting down on labor would result into layoffs, which further results into the rise in unemployment. The sticky theory of wages as earlier discussed argues that due to inflexibility of wages, labor markets are slow to adjust to labor shortages and surpluses, which does not address unemployment in what the classical view suggests. Keynes’ proposed solution: monetary and fiscal policy for cyclical unemployment Economists sometimes distinguish types of unemployment into voluntary and involuntary. Voluntary unemployment is seen to be efficient outcome of competitive markets, that is when qualified people not to work because of the going wage rate. On the other hand, involuntary unemployment is the result of business cycle downturns, when given the going rate in the market is insignificant, and unemployment arises because of lower demand for labor due to lower demand in goods in the market. When Keynes traced the cause of this kind of unemployment and found out that this is not just a result of the labor market forces that interact, but due to business cycle downturns, or recessions, he proposed that government can actively curb down this unemployment rates by employing some policy: the monetary and fiscal policy. In order to counter the impacts of business downturns, through fiscal policy, governments can boost its spending in order to boost aggregate demand, which in turn increases output. As aggregate demand in a closed economy is a function consist of consumption, investment and government spending, by increasing government spending by the creation of more collective goods, or other forms of government spending will help increase in aggregate demand. Keynes argues that government can affect the allocation of resources through policies that concerns its spending and taxation. This is the fiscal policy that Keynes prescribes. When the government collects money from people in the form of taxes, resources thus flows into the government coffers. This increase in aggregate demand will determine a matching increase in output to meet it is supposed to maintain the demand levels for labor, which can curb down unemployment or sustain it in its current rate in order not to make it rise any higher. The government can in turn decide to channel these resources into certain projects that will require spending and funding. It can channel the resources to those industries that have high unemployment levels. This spending will further increase demands for businesses in such industry, and this increase demand in the goods of the industry will in turn increase demand for labor. Equally as powerful as the fiscal policy in determining the allocation of resources, thus actively affects important variables in the economy such as unemployment is monetary policy. Monetary policy affects sectors in the economy that are interest-sensitive, such that interest rates and credit conditions have significant effect in encouraging aggregate demand overall. By either raising or curbing the interest rates, the government can affect the aggregate demand—which in its composition comprises consumption and investments, which are greatly affected by these interest rates. By curbing down interest rates, government is in a way encouraging more investments to be created in the economy. By encouraging people to unleash their money and put into businesses, demand for labor will once again increase with the increase of businesses. This demand for labor will in turn provide employment for people; increase their purchasing power which will result in increase in consumption. And this increase in consumption will in turn contribute to the increase the aggregate demand, which will further increase the demand for labor which causes unemployment rates to fall. Problems and limitation of Keynes’ proposed solution The classical view of macroeconomics states that any excess in supply or demand in the economy is offset by flexible wages and prices, thus reestablishing full employment and full utilization of capacity. While macroeconomic policy can determine the path of prices, it does not have a role in stabilizing an economy. On the other hand, Keynes argued that the inflexibility of prices and wages result in the output and unemployment determination through the interaction of demand and the supply forces in the economy. Due to this inflexibility, the economy is slow to absorb shocks in the short run that unemployment rises with an abrupt decrease in aggregate demand due to business cycle downturns. Monetary and fiscal policy can therefore affect both prices and real output. Quoting from Robert E. Lucas, Jr. and Thomas J. Sargent from their work “After Keynesian Macroeconomics,” they state “existing Keynesian macroeconomic models cannot provide reliable guidance in the formulation of monetary, fiscal, or other types of policy… [T]here is no hope that minor or even major modifications of these models will lead to significant improvements in their reliability.” However plausible Keynes’ macroeconomics is, critiques have been formed as regards its limitations in affecting and stabilizing the economy. As argued by the new classical macroeconomics through their policy ineffectiveness theorem and rational-expectation theorem, predictable government policies cannot affect real output and unemployment. It states that while a downward sloping short-run Phillips can be observed, it cannot be thus exploited for the purposes of lowering unemployment. Philips curve shows the relationship between unemployment and inflation; in which relationship, if unemployment is lowered in the short-run will raise inflationary effects, and vice versa. But as expected inflation and other factors change, this short-run Philips curve shifts such that attempts to lower unemployment, inflation is really sure to go upward. Such relationship asserts that if there is a systematic attempt to increase output and lower unemployment, people will anticipate it, see through the policy and will not be motivated to cooperate, because the stimulation of the economy is a policy that will require them to work more—more labor supply to meet labor demands, which is related to the rational expectation theory. As earlier discussed, this attempt to lower unemployment will result into higher inflation in the long run. Another limitation of Keynes’ model is raised by critiques of monetarists. When monetarism is associated with laissez-faire and anti-big-government political philosophy, the model proposed by Keynes has been viewed to create distortions in the market and drive out the more efficient private firms. As raised by monetarists that inflation, and therefore unemployment is not a consequence of aggregate demand, but is a result of variations in money supply. Therefore, if inflation is due to variation of money supply, government spending seems to be insignificant; further, to cut down unemployment by lowering inflation, as in the Philips curve seems to be irrelevant as a policy. Apart from the critique raised by monetarists as regards free market mechanisms, is a more relevant critique by Friedrich Hayek of London Business School. According to him, Keynesian economic policies are fundamentally collectivist in approach, and no matter how the intentions of such theories are for the good of the many, they require centralized planning, which Hayek argued leads to totalitarian abuses. Furthermore, according to him, Keynes’ proposed policies are more adaptable in totalitarian states rather than in free or laissez-faire markets. All in all, the limitations that the model Keynes proposes arise due to the distinction of the degree of government interference in the free market. Because governments can curb the problems of business cycle downturns with fiscal and monetary policies, this power can lead to abuse by government which can lead to totalitarian approach, which can distort efficient markets. Works Cited Barro, R. J., Macroeconomics. 5th ed. Cambridge, Massachusetts: MIT Press, 1997. Friedman, M. & Schwartz, A. J., Monetary History of the United States 1867-1960. Princeton, New Jersey: Princeton University Press, 1963. Hayek, F., The Road to Serfdom. UK: Routledge Press, 1944. Lucas, R. & Sargent, T.J. "After Keynesian Macroeconomics" Federal Reserve Bank of Minneapolis. Quarterly Review. Minneapolis. Spring, 1979. . Phelps, E., Structural Slumps: The Modern Equilibrium Theory of Unemployment, Interests, and Assets. Cambridge, Massachusetts: Harvard University Press, 1994. Pigou, A., The Theory of Unemployment. London: Macmillan, 1933. Read More