The Development of Macroeconomic Theory and Policy since the 1930s - Essay Example

Explain and discuss the development of Macroeconomic theory and policy since the 1930’s, clearly highlighting the major areas of controversy and consensus Macroeconomics deals in the lessons related to aggregate prices, income, products and services pertaining to a country’s economy or the global economy. Federal government uses macroeconomics to assess and analyze the alterations in rates of taxation and supply of money which in turn influence the economic parameters like inflation and unemployment. John Maynard Keynes developed Macroeconomics in order to build theory and policies in order to ensure Great Depression of the 30s does not happen again. Keynesian economists Before Keynes, the classical school of economic thought prevailed and this school did not develop any integrated macroeconomic theory, there existed mainly postulates which expressed economic ideas. Their key postulates suggested that full employment will prevail in the long run is market forces of demand and supply were permitted to perform freely. Even if unemployment occurs it will be a short run impact. They also suggested that demand will always be equal to output in such a case and equilibrium will continue to exist in the long run. These ideas were proven to be wrong with the advent of the Great Depression of the 30s. The classical laissez-faire doctrine failed to hold. Unemployment (3 percent to 25 percent from 1929 to 1933) began to spread largely in the economies ruled by the free market industrial mechanism leading to fall in Gross National Production (fell by 30 percent) and price level fell by 23 percent (Dwivedi, 2005, p. 13). In an attempt to solve the problem, Keynes developed the modern macroeconomic theory which is associated with employment, growth and stability. According to Keynes, output and employment levels are functions of total resources available in the economy, unemployment is the result of shortfall in aggregate demand as well as economic variations brought about by deficiency in demand. This can be got rid of through government spending. This last aspect was introduced by Keynes as a tool for demand management. Such spending would therefore crowd out private investments and via the multiplier effect it would have favourable impact on income and employment. The time span between the 30s and 90s is known as the period of ‘Keynesian Revolution’ (Dornbusch, 2005, p.443). Keynesian policies were adopted by most nations’ governments in developed economies. However in reality, economic world goes through evolutions from time to time and transits form one system to another. Monetarists In the 1970s Keynesian economic thoughts began to show its loopholes as the fiscal policies did no longer solve the economic problems of developed nations consisting of low growth, high unemployment and inflation levels. Then there was the problem of stagflation in the early 70s. Keynes had theorized that disflation would be brought about with unemployment but the economy witnessed bad performance in both areas. As per Keynes’ suggestion, taxes and interest could be reduced in order to ensure inflow of money into the economy. However that would bring about inflation. A new phase of economists, who were popularised as monetarists, emerged. Monetarism could be known as ‘Counter Revolution’ and this group was directed by Milton Friedman who showed that Keynesian policy failed to forecast gross national output, price, unemployment rate and interest rate. He showed money supply changes could influence inflation levels in future time periods in nonlinear manner. This led to the emergence of a new thought of revolution. Where the role of money was the key idea behind growth and national income’s stability in the short run and determines price level in long run. This shifted the idea of aggregate real output’s demand towards the demand and supply of money at aggregate level. This also brought about a long span of debate between the monetarists and Keynesians centring on “what determines the aggregate demand” (Dwivedi, 2005, p. 15) and this is till date uncertain. Mainstream economics in present era however proposes several factors like investment spending, exports etc apart from monetary and fiscal policies. The random measure taken in the 70s saved the situation and today’s banking is in fact an offspring of the 70s economic situation (Snowdon and Vane, 2002, p.308). Neo-classical economists or radicalists In the 1980s the Keynesian economists faced opposition from another group of economists known as the ‘radicalists’. During late eighties the stock market came down by 20 percent overnight soon after Alan Greenspan came into position of Fed Chairman. This created problem in both Keynesian and Monetarists viewpoint. No static theory could explain this problem. The panic was brought forth as the investors seemed to be putting Greenspan to test. Greenspan however acted fast and poured money into the market and provided low interest loans to financial institutions of poor health. The stock market health improved fast and later this havoc was referred as “false panic” as it was suggested that the economy would have recovered despite Greenspan’s actions (White, 2003, p. 76). The problem arose owing to underpricing of stock market. Another problem came up in 1994 when inflation and bond interest rates increased. Greenspan managed this by increasing interest rates and making it difficult for people to take loans and hence buy less and thus price would become moderate. The radicalists’ ideas were classified as the neo-classical macroeconomics. These propositions were led by the views of Robert E. Lucas who was the Nobel Laureate of 1995. He laid stress on the redundancy of Keynesian orthodox thoughts with respect to economic policymaking as well as theoretical and methodological perspectives. Here came into play the role of rational expectations of an individual regarding future economic occurrences especially on the supply side and the government polices. In fact Greenspan had quoted the term ‘irrational exuberance’ while switching to increased interest rates policy in order to adjust price levels. The neo classical economists or radicalists believed “people’s rational expectations about government monetary and fiscal policies determine the behaviour of aggregate supply an aggregate demand curves in such a way that real output remains unaffected, though prices and wages go up” (Dwivedi, 2005, p.15). However this thought of the neo-classical economists is also debatable. Supply-side economists On the supply side, there came out another school of economic thought led by ‘supply-side economists’ presided by Arthur Laffer who stressed upon the importance of the role of supply side of an economy. This tended to put forward an alternative to the Keynesian theory related to employment and output. These economists pointed out that unlike the demand side, the supply side was the key determinant of changes in employment and output levels and this revealed the importance of supply curve shifts. Laffer explained that a cut in rate of taxation brings about a shift in supply curve to be in right direction and hence output and employment would increase. This gave birth to the renowned Laffer curve (Tucker, 2010, p.341). In fact both Keynesian and supply side economists stressed upon the importance of fiscal policies in economic management (Mankiw, 2011, p.471). Neo-Keynesians Despite all controversies Keynesian economics has remained as a pivot point of macroeconomic theory and policy whether taken as a ground to attack or rebuilding. With respect to this another stream of macroeconomics emerged, known as “Neo-Keynesian” economics. This group proposes that the market does not always clear despite the fact households, firms and labour work for their interests. These economists propose that the problem of information and the cost of altering price levels bring about price rigidities. This in turn causes variations in output and employment. In fact macroeconomics is still in the procedure of development and perfection. In fact as Samuelson puts it “The political, social, and military fate of the nations depends greatly upon their economic success” (Dwivedi, 2005, p. 16). Developed and underdeveloped nations keep facing challenges related to macroeconomic issues leading to recessions, continuous inflation, deficits and debt trap. In topical times, the economic mechanism itself has become complex owing to increasing human desire to enjoy goods and services, rising interplay between countries and globalization of different economic mechanisms, increase in movement of capital, manpower and technology at global level, increasing interdependence of economies and upsurge of economic unions and their impact on different countries. In market economies governments follow two kinds of policymaking-monetary and fiscal. In a command economy however the degree of the policies vary and in a planned economy taxes play an important role as they help in financing the economy’s different aspects and even ensure law and military expenditure (Griffiths & Wall, 2004, p. 615). Conclusion One might infer that the need for a dynamic component is felt. System dynamics can help in facing the problems in macroeconomic theories and help in avoid resistance to policies, thus bringing about sustained improvement. Static elements must be replaced with dynamic ones. After the recent financial crisis of 2008, the macroeconomic policies were again brought under review. The key to this upheaval could be explained by the lack in considering financial intermediation as a key macroeconomic element. In fact macroeconomic policies mainly undertook the stability of individual institutions and markets and financial regulation also did the same. This was more a problem in developed economies where, unlike the less developed economies there was hardly any rule pertaining to limits of currency exposures, use of regulatory ratios like loan-to-value, capital ratios, etc in order to ensure macro stability (White, 2009, p.11). In fact core inflation was stable in developed economies before the crisis began. Some economists argue that instead of core inflation housing and oil prices should have been considered. In fact despite keeping both inflation and output stable before the crisis, the nature and movements of asset prices and aggregate credit levels or the composition of output could lead to several adjustments in other macro variables (White, 2009, p. 6). Examples could be drawn from high levels of housing investment or abnormal expenditure on consumption. References 1. Dornbusch (2005), Macroeconomics, 6th Edition, Tata McGrawHill 2. Dwivedi, (2005), Macroeconomics, 3rd Edition, Tata MacGrawHill 3. Griffiths, A.& Wall, S. (2012) Applied Economics, 10th edition, Prentice Hall,, chapters 30, (some sections only) 4. Mankiw, G. (2011), Principles of Macroeconomics, 6th edition, Cengage Learning. 5. Snowdon, B.E. and H.R. Vane (2002), An Encyclopedia of Macroeconomics, Edward Elgar Publication. 6. Tucker, I.B. (2010) Survey of Economics, Cengage Learning 7. White, W. (2009) Modern Macroeconomics is on the Wrong Track, Finance and Development, (IMF publication) December, 46:4 8. White, J. (2003) False Alarm, JHU Press Read More