Discuss about the Macroeconomics for Deak with Various Theories.
Various theories in macroeconomics have been created to deal the great depression analysis. One of the central theory that analyses such results is the classical theory of Keynes. Keynesianism was named after John Maynard Keynes . He is also known as the “father of modern economics”. When the great depression had struck, it had become very important for all the economists to analyse the situation and reason the happening in the world. Keynes, however came up with a classic explanation that was agreed by many. The theory was too easy to be understood and was named as the simple Keynesian model (Asensio and Atesoglu 2014). Keynes issued various issues and remedies for the government and the people of the economy to deal in such situations. Yet, Keynes explanations was not enough. Some loopholes were found by various economists it eh later period. Some of the famous economist are Milton Friedman and Robert Lucas (Duarte 2016).
As stated by Sumner (2015), Milton Friedman showed that there is no stable relationship between unemployment and inflations. According to his theory, policymakers face short term tradeoffs due to private sector’s failure to adapt the change in environment. There are long term costs that are exploited in order to settle the short term tradeoffs. The theory of Milton Friedman, adaptive expectations, was further formulated and modernised by Robert Lucas in his theory of rational expectations.
In this report, we analyse the three different theories of Keynes, Friedman and Lucas and in the fourth and fifth section, the difference between Friedman and Keynes and Lucas and Keynes is analysed.
According to Pressman (2013), in the general theory formulated by Keynes, he suggested that “the national income depends on the volume of employment”. Keynes also showed in his model that involuntary unemployment is consistent in equilibrium.
The principle theory of effective demand states that in a closed economy and spare capacity, the level of employment is determined by aggregate planned expenditure, that consists of consumption expenditure and investment expenditure from firms.
Hence the equilibrium condition can be stated as E= C+I.
According to Rozmainsky (2013), in Keynes model consumption expenditure is endogenous in nature which depends on the income and the interest rate, whereas, the investment expenditure depends on the expected probability of investment and interest rate. Therefore, in this model, employment becomes dependent on investment expenditure which is an unstable factor. In calculating the equilibrium, expectations of future levels of demand and costs are involved that allows hopes and fears, to influence the decision. Expectations of future investment is considered as far more important than the interest rate in linking the present and future as the level of output and employment depends on the level of investment. The “extreme precariousness” concerned with the prospective yield of the investment decision is based on the Keynes’ explanation of the business cycle.
The consumption function is written as C = a+Cy , hence the equilibrium condition stated in equation 1 can be written as
Y = a + Cy + I.
Y =( a+I) /(1-c )
Y= (a+I) K
In this final equation, k is the investment multiplier, which shows that when there is an increase in investment, the income will increase by k times. The larger the investment multiplier would be, the smaller would be the marginal propensity to save. Hence, the multiplier would now depend on marginal propensity to consume, c. This shows that with a shift in demand, income will rise by an equivalent amount initially, but that would raise the consumption level too. And this process would keep on repeating that would further raise the income. Hence it can be concluded that an increase it eh autonomous spending raises the output and employment level. From the level lesser than full employment, with the increase in autonomous spending, there would be an increase in investment, that would lead to an increase in employment . The newly employed people would consume some of their income an save the rest. The increase in the demand for goods would also increase employment and would further raise the expenditure. This shows how an initial rise in investment, raises the level of proportionate income. There are various factors that could limit the size of the multiplier effect, like increasing the rate of interest adverse effect on confidence and leakage of expenditure into taxation and imports in an open economy (Palley, Rochon and Vernengo 2016).
Keynes rejected the idea that the interest rate was determined by the real forces of thrift and the marginal productivity of capital. Interest rate is purely addressed as monetary phenomenon determined by the liquidity preference. In order to hold money, Keynes added precautionary and speculative motives. In Keynes model, the proposition that quantity of money is neutral is rejected. According to the model, an increase in the money supply as a result of reduction in rate of interest can be affect aggregate spending.
As stated by Sneessens (2012), according to Keynes model, in order to save to increase the investment, was to reduce the aggregate instability was to find the stabilizing investment expenditure at the sufficient level. Keynes model was “moderately conservative and at the same time implies a large extension of traditional functions of the government”.
As stated by Galí (2015) , Milton Friedman introduced monetarism which had a better and precise analysis of the way the effects of changes in the rate of monetary expansion were divided between real and nominal magnitudes. Keynesian ideas were contradicted by Friedman , where Friedman stated the initial Phillips curves was a misconception. He said that Phillips curve must not be set in terms of “rate of change of real wages”.
Phillips curve can be expressed as W = f(U) +PE
This shows how the rate of money wage increases depending on excess demand and expected rate of inflation.
Figure 1 : The Expectations Augmented Phillips Curve
According to figure 1, suppose the economy is initially at short run Phillips curve 1 (Srpc1) at point a, and the corresponding unemployment level is un with rate of interest as 0, expected rate of inflation would be 0, hence w is the expected rate of inflation that is 0 percent. Suppose that unemployment decrease from UN to U1 by increasing aggregate demand as a result of monetary expansion. With the result of excess demand, an upward pressure on the price and money wages would be generated. Workers would be misled by the increase in real wage, they would supply more labour. They would suffer from temporary money illusion. In reality, real wage would rather fall and with the demand of more labour, unemployment would fall. The real situation of inflation sets in and the curve shifts from SRPC1 to SRPC2. Hence, it can be seen that the actual rate of inflation is completely anticipated and there would be no long run trade off between unemployment and wage inflation. The points a and c together, a long-run vertical Phillips curve is obtained at the natural rate of unemployment (UN). At un, the increase in money wages is equivalent to the increase in prices, so the real wage rate is constant. Natural rate of labour market is in equilibrium and inflation is fully estimated (Hommes 2013).
As per Nelson (2013), Friedman allowed to reconcile the classical theory with respect to the long run neutrality of money, still money to have real effects in the short run. According to Friedman, inflation rates become increasingly volatile at higher rates of inflation. This increase volatility results in uncertainty. This also results in the rise of unemployment as the productivity decreases and price system becomes less efficient. Uncertainty also leads to fall in investment and decrease in employment. With the increase in inflation rates, government tend to intervene more by imposing wage and price controls which further reduces the efficiency and increases unemployment. There is a positive relation between inflation and unemployment in the economy. Once the economy is successful in adjusting the high and volatile inflation, it can return to it natural rate of unemployment efficiently.
In 1970, a new approach has been initiated by Lucas to study the fluctuations. He advocated the equilibrium approach to business cycle modelling. In Keynesian model, market fail to clear and gross domestic product can vary from its initial level to extended period of time. According to Lucas “monetary changes have real consequences, but only because agents cannot discriminate perfectly between monetary and real demand shifts, so there is no usable trade off between inflation and real output”. According to Lucas, business cycles are serially correlated movements that depends on trends of real output. Lucas is considered as a new classical monetarist based on his explanation of business cycle (Shaikh 2013).
According to Lucas model, monetary shocks are the main cause of aggregate instability and there is a confusion based on the relative and general price movements. The supply of output Y has both permanent component Yn and cyclical component Yc.
So, YT = YN + YC.
In cyclical component, there is a lagged out term that recognizes the deviations in output. The combination of rational expectation hypothesis and surprise supply function denotes that the output and employment would fluctuate randomly around their self levels (Gabisch and Lorenz 2013 ).
According to Palley (2013), One of the famous critiques of Keynesian model was Milton Friedman,. He accepted the definitions of recessions but rejected the method of treating them. According to Friedman, government should keep the money supply steady, thereby expanding it slightly only to allow the yearly growth of the economy. Inflation, employment and output would adjust themselves accordingly. He names such a theory as monetarism.
Monetarism was tried in great Britain during the 80s, but it lost its worth. According to the theory, British economy would have enjoyed low inflation and high stability, but it reality, it went the other way. At first the economy as in deep recession, but then when inflation came down, unemployment level rose. Eventually bank of England had to abandon monetarism. Contradicting to the experience in England, monetarism was also followed in United States. This was just a cover story, ultimately the government was following the Keynesian model only. Whereas, unlike the case in great Britain, America experienced the direct contrast to England. As a result, many economists abandoned monetarist theory (Schwarzer 2016).
Another famous theory of Friedman is the theory of natural rate of unemployment. When the price increases in accordance with the increase in money wage, people do not mind paying extra. This is called neutrality of money. Inflation of these kinds are considered harmless to the society. But, this is not the scenario of the society. According to Friedman, this is o because the public are unaware of the expansion. When they receive extra money as their wages, it was transformed into more economic activity an not higher prices (Snowdon and Vane 2005).
According to Friedman, it is not possible to wipe out unemployment with the help of monetary policy, as Keynes theory suggested. Instead, it shows that monetary policy would keep the unemployment at 6%, which is the natural rate of unemployment when inflation prevails in the country.
According to Gaffeo, Gallegati and Gostoli (2015), an even greater attack on Keynesian theory was done by Robert Lucas, with the help of its theory of rational expectations. There are two main segments to rational expectations. The first one is that recessions are self adjustable. Once people start holding money, it gets quite difficult for them to notice that recession is coming. It is so because, individual businessmen know that they are making less money, but they may take time to sink the fact that everyone is experiencing the same thing. When prices fall, purchasing power of money raises, hence at that point f time, government should simply wait for recession to correct itself.
The second segment relation to rational expectations is that, government intervention might lead to ineffectiveness to harmful in nature. Any government who plans to expand the money supply cannot stand in front of business man’s decision to cut prices away. Keynesians are robbed of this argument since, Lucas predicted how the government is not much faster than discovering the problem than anyone else (Lucas et al. 2013).
As stated by Sargent (2013), though the works of Lucas had been valued in 70s, yet there have been noticed two flaws in the theory. Firstly, it is not feasible to believe that business man determine the rices of the goods by following the macroeconomic trends and secondly, recessions last for many years. Lucas failed to help the business man acknowledge the leading economic indicators and yet they were ignorant of the fact of being in recession.
Conclusion
Simple Keynesian model postulated by Keynes is the easiest model of macroeconomics that had dealt in the times of great depression and had provided with some injections, issues and solutions to the problems. Later on, some economists found loopholes in the simple model of growth , and they introduced monetarism in the society. Such economist re like Milton Friedman. Milton Friedman found out how unemployment and inflation are two different aspects and are never able to achieve stability. Friedman model had been further reconsidered and modernised in Lucas rational expectation model and business theory model. Hence, it has been seen how various economist with the change in time have noticed the change in the macroeconomics issues of the economy. This has led them formulate better versions of models from the past.
As stated by Leith, Moldovan and Rossi (2012), by the middle of 1980s, it was proved that neither monetarism nor rational expectations were ideal theories. Hence, the Neo Keynesian model started making a comeback. Today neo Keynesian has reached its prominence. People are nowadays not very rational but, rational in nature. They do not weigh unemployment rate, inflation rate or monetary rate, yet they do keep a small information and act accordingly (De Vroey 2016).
With the help of this report, we see how each economist had their own expectations regarding the output and employment level. Each had a better perspective than the other. Each formulated their own theories and helped the society to educate themselves by advocating the new theories and contradict ting the old ones. Macroeconomics trends have been considered as the base of any economic fluctuations and function of the economy. It helps in analysing the effects of change with the help of different theories that holds different perspectives and expectations.
References
Asensio, A. and Atesoglu, H.S., 2014. Accounting for uncertainty in a simple Keynesian model. International Journal of Pluralism and Economics Education, 5(1), pp.24-39.
De Vroey, M., 2016. A history of macroeconomics from Keynes to Lucas and beyond. Cambridge University Press.
Duarte, P.G., 2016. Macroeconomists as Revolutionary Schoolmates. Comments on Michel De Vroey’s A History of Macroeconomics from Keynes to Lucas and Beyond. Œconomia. History, Methodology, Philosophy, (6-1), pp.129-137.
Gabisch, G. and Lorenz, H.W., 2013. Business cycle theory: a survey of methods and concepts. Springer Science & Business Media.
Gaffeo, E., Gallegati, M. and Gostoli, U., 2015. An agent-based “proof of principle” for Walrasian macroeconomic theory. Computational and Mathematical Organization Theory, 21(2), pp.150-183.
Galí, J., 2015. Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.
Hommes, C., 2013. Behavioral rationality and heterogeneous expectations in complex economic systems. Cambridge University Press.
Leith, C., Moldovan, I. and Rossi, R., 2012. Optimal monetary policy in a New Keynesian model with habits in consumption. Review of Economic Dynamics, 15(3), pp.416-435.
Lucas, R., Mortensen, D., Shiller, R. and Wallace, N., 2013. Rational Expectations: Retrospect and Prospect. Macroeconomic Dynamics, 17, pp.1169-1192.
Nelson, E., 2013. Friedman’s monetary economics in practice. Journal of International Money and Finance, 38, pp.59-83.
Palley, T., Rochon, L.P. and Vernengo, M., 2016. The relevance of Keynes’s General Theory after 80 years. Review of Keynesian Economics, (1), pp.1-3.
Palley, T.I., 2013. Monetary policy and central banking after the crisis: the implications of rethinking macroeconomic theory. In Financialization (pp. 182-200). Palgrave Macmillan UK.
Pressman, S., 2013. Fifty major economists. Routledge.
Rozmainsky, I.V., 2013. A simple Post Keynesian model of investor myopia and economic growth. Montenegrin Journal of Economics, 9(3), p.45.
Sargent, T.J., 2013. Rational expectations and inflation. Princeton University Press.
Schwarzer, J.A., 2016. Keynes and Friedman on Laissez-Faire and Planning: Where to Draw the Line?.
Shaikh, A., 2013. On the role of reflexivity in economic analysis. Journal of Economic Methodology, 20(4), pp.439-445.
Sneessens, H.R., 2012. Theory and estimation of macroeconomic rationing models (Vol. 191). Springer Science & Business Media.
Snowdon, B. and Vane, H.R., 2005. Modern macroeconomics: its origins, development and current state. Edward Elgar Publishing.
Sumner, S., 2015. What Would Milton Friedman Have Thought of the Great Recession?. American Journal of Economics and Sociology, 74(2), pp.209-235.
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