Introducing Macroeconomics

Micro to Macro

International economics

National economy

Markets

Firms

Consumers

Economics, but on a different scale…

"To dig holes in the ground, paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.”

John Maynard Keynes

“If you put the federal government in charge of the Sahara Desert, in 5 years there'd be a shortage of sand. “Milton Friedman

Macro economics is dominated by two schools of thought; free-market economics and Keynesian economics.

Free-market economists believe the market mechanism is the best way to allocate resources.

At the extreme, people can by very passionate about this ‘belief’ and ignore the evidence of market failure.

Keynesian economists believe in government intervention to ‘correct’ the economy.

People are also passionate (for and against) Keynes. To some he is the antidote to greedy capitalism. To others he is the enemy of freedom.

Where did the debate start?Adam Smith (1723-1790) more or less invented the subject of economics. He developed the idea that the economy worked best when each individual pursued their own self interest. He also recognised the importance of the ‘invisible hand’ of market forces in allocating resources to where they were most needed.

Adam Smith’s ideas became the accepted economic orthodoxy for many years. Free-market (or classical) economic s grew out of Adam Smith’s work. The government, it was believed, had little role to play in managing the economy.

The Great Depression

• http://www.youtube.com/watch?v=VpKmfjf5tUk

The Great Depression of the 1930s changed everything. The extent of deprivation, unemployment and poverty was unprecedented in the modern world. The depression became worse rather than getting better, as classical economists argued it would. Economic theory failed to explain what was going on, or how the problems could be solved…

Keynes to the rescueIn the 1930s, Keynes spearheaded a revolution in economic thinking,

overturning the older ideas of neoclassical economics that held that free markets would, in the short to medium term, automatically provide full employment, as long as workers were flexible in their wage demands. Keynes instead argued that aggregate demand determined the overall level of economic activity, and that inadequate aggregate demand could lead to prolonged periods of high unemployment. He advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic recessions and depressions. Following the outbreak of the Second World War, Keynes's ideas concerning economic policy were adopted by leading Western economies. During the 1950s and 1960s, the success of Keynesian economics resulted in almost all capitalist governments adopting its policy recommendations.

http://en.wikipedia.org/wiki/John_Maynard_Keynes “When the facts change I change my mind – what do you do, sir?”Actual Keynes quote!

Review

1. What is the difference between micro and macro economics

2. What is a ‘school of thought’?3. Name and explain the two schools of thought discussed.4. Name three important ideas that Adam Smith came up

with.5. What was the Great Depression and how did it

‘disprove’ the idea that markets are self-correcting?6. What did Keynes believe was necessary to solve the

economic problems of the time?

The critical role of the labour market

Unemployment is the fault of government and trade unions. If the labour market was allowed to work freely then there would be no unemployment. Wages need to fall to make workers affordable!

Utter nonsense. People are unemployed because there is a lack of overall demand in the economy. And demand won’t rise until people are in work. The economy is stuck in a depression and government need to act to get people in jobs and stimulate demand…

Who was correct… the free-market economists or Keynes?Start your micro-debate now!

The TheoryClassical or Real-wage UnemploymentIf a situation occurs whereby the supply of labour exceeds the demand for labour by firms unemployment results. If the market is functioning freely then wage levels should fall to the market-clearing wage rate (W1). This increases the demand for labour (workers become more affordable) and reduces supply (some people withdraw their services from the market). Unemployment is solved!

Or Demand-deficient Unemployment?However, if the market fails to adjust then unemployment will persist. Wages may be prevented from falling by trade unions and job contracts which specify a wage rate. Wages are ‘sticky downwards’. Demand for labour is derived from Aggregate Demand for goods. Therefore Keynes advocated stimulating demand through government spending, thereby increasing demand for labour.

D2

The Keynesian EraIn 1936, Keynes published ‘The General Theory of Employment, Interest and Money’. His ideas gradually became the orthodox view, firstly in the UK and eventually even in the US.

In 1971, the US PresidentRichard Nixon said‘We are all Keynesians now’.

Keynesian policies…

In a recession, Keynes advocated:• Increase government spending and reduced

taxation to increase aggregate demand (fiscal policy)

• The use of monetary policy (e.g. interest rates) to reduce borrowing costs

In a Boom, Keynesians would do the opposite and reduce demand pressures to control inflation.

1970s

Crisis in Keynesian Economics

In the 1970s, a new economic crisis arose. Stagflation, simultaneous high levels of unemployment and inflation, took off, driven by oil prices and militant trade unions pushing up workers’ wages. A free-market counter revolution was inevitable. The monetarists, Friedman and Thatcher were waiting in the wings…

Monetarism, Friedman and ThatcherismThe high inflation of the 1970s was said by some to be the result of too much money in the economy. The solution, according to these monetarists, was to control the money supply. This meant governments trying to control spending and the use of controls over the money supply (credit controls and interest rates).

Milton Friedman, an American economist, was the most famous monetarist. He advised President Reagan’s policy in the 1980s. He was also a strongly pro-market economist and developed ideas on supply-side policies. The belief behind this approach was that markets should be competitive and efficient – sound familiar?

Margaret Thatcher became British Prime Minister in 1979. She was heavily influenced by Friedman, monetarism and free-market economics. Thatcher quickly set about reducing the power of trade unions to prevent wage inflation and introduced severe spending cuts. By the mid-80s, monetarism was abandoned as it was proving ineffective, but Friedman’s free-market ideas still dominated and this led to the economic boom of the late 80s.

A decade of stability…

Key events• Early 1990s recession• Labour came to power in

1997• Bank of England given

control over interest rates with the job to limit inflation

• Decade of growth and stability

…before the crash!In 2007 the financial markets crashed leading the UK in to the deepest and longest period of economic decline since the 1930s. Many blamed the crash on unregulated financial markets. Free-market ideology once again came under fire. Keynesian policies once again came into use as the Labour government built up huge debts to bail out the banks and prevent a complete economic collapse.

Review

1. According to free-market economists, what was causing unemployment in the 1930s?

2. What did Keynes argue would solve unemployment?3. What economic problem was experienced in the 1970s?4. Why couldn’t Keynesian policies solve this problem?5. What did monetarists say the cause of 1970s inflation was?6. Why did Margaret Thatcher set about reducing the power

of the trade unions?7. When was the ‘decade of stability’?8. Why did Keynesian policy come back in to use in 2007?

SummaryAdam Smith creates the subject of micro-economics and the free-market orthodoxy which dominates until the 20th century.

John Maynard Keynes creates macro-economics in response to the 1930s depression. He advocates government intervention to boost aggregate demand.

Milton Friedman leads the free-market counter-revolution as unemployment and inflation soar in the 1970s. He blames excess money supply, trade unions and government failure. A new era of pro-market economic management begins.

The financial crisis of 2007 sends the UK in to its deepest recession since the 1930s. Keynes’ policy comes to the rescue. But who is to blame for the crisis; government or the market?