Macroeconomics theories essay

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Macroeconomics is a branch of economics that deals with the performance, structure, behavior and decision-making of the entire economy, be that a national, regional or the global economy. Along with microeconomics, macroeconomics is one of the two most general fields in economics. Macroeconomists study aggregate indicators such as GDP, unemployment rates and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. In the contrary, microeconomics is primarily focused on the actions of individual agents, such as firms and consumers, and how their behavior determines prices and quantities in specific markets (Blanchard, 2000).

Macroeconomics theories

The reason for why aggregate economic activity fluctuates the way it does, even in relatively stable institutional environments, remains largely an unresolved puzzle. Most macroeconomists interpret the business cycle as the product of economic behavior in response to various ‘shocks’ that are thought to afflict economies at a high frequency. Unfortunately, these high-frequency shocks (if they exist at all) are difficult to measure directly, leading to much debate concerning the ultimate source of the business cycle. Furthermore, economists are often divided on how they view an economy reacting to any given shock. Thus there are many different schools of thought that are distinguished by which shocks they choose to emphasize and/or in their explanation of how the economy reacts to any given shock (Keynes, 1936).

There are two broad strands of thinking each with its own many variations in terms of understanding the business cycle. The first strand, which I refer to as the ‘conventional wisdom,’ owes its intellectual debt primarily to the work of (Keynes, 1936), whose views on the business cycle were likely shaped to a large extent by the experience of the Great Depression. Almost every principles course in macroeconomics is taught according to the Keynesian perspective, which goes a long way to explaining why this view has become the conventional one among market analysts, central bankers, and policymakers in general. In academic circles, certain elements of this view live on in the work of the New-Keynesian school of thought.

According to this theory, the long-run trend rate of growth in real per capita GDP is considered to be more or less constant (e.g., 2% per annum). The level of GDP consistent with this trend is sometimes referred to as potential GDP. Fluctuations in GDP around trend are thought to be induced by various aggregate demands’ shocks, for example, an unexplained sudden surge in desired spending on the part of the consumer, the business sector, the government sector, or the foreign sector. At a deeper level, the private sector spending shocks are commonly thought to be the result of ‘irrational’ swings in consumer and business sector ‘sentiment,’ or what Keynes  referred to as ‘animal spirits (Keynes, 1936). He argues that any given shock influences market outcomes (like the GDP and employment) adversely. For instance, the current economic recession that hit the whole world. During recession macroeconomic indicators vary in a similar way. Production as measured by Gross Domestic Product (GDP), employment, investment spending, capacity utilization, household incomes, business profits and inflation all fall during recessions. While bankruptcies and the unemployment rate rise, all these in turn lead to a slump in market with goods and services not being availed of by people since the purchasing power of people is down. The industrial production is badly affected as investors avoid investing in companies that might suffer losses during recession. Bigger companies are able to withstand the setbacks but smaller companies have a tough time and some may end up closing down (Shukla, 2009).

Similarly, there is also increase in national debts meaning less money can be spent by the government on development. Money gets diverted in bailing out companies. For example the recent recession in the U.S. indicates how banks have to depend upon federal aid for their survival. Taxpayers’ money is being spent in giving these banks a boost (Shukla, 2009). Generally, all these will have a drastic effect on the macroeconomics indicators hence the surge explained in this theory.

Traditionally, macroeconomics has been concerned more with the issue of ‘short run’ growth, or what is usually referred to as the business cycle. The business cycle refers to the cyclical fluctuations in GDP around its ‘trend where trend may define either in terms of levels or growth rates. From Figure 1, we see that while per capita GDP tends to rise over long periods of time, the rate of growth over short periods of time can fluctuate substantially. In fact, there appear to be (relatively brief) periods of time when the real GDP actually falls (i.e., the growth rate is negative). When the real GDP falls for two or more consecutive quarters (six months), the economy is said to be in recession as the one that was experienced in the United States.

The second theory is the neoclassical theory. This school of thought is closer in spirit to the views of (Schumpeter ,1939). In academic circles, the neoclassical perspective is embodied in the work of a school of thought called Real Business Cycle Theory. According to the neoclassical view, the distinction between growth and cycles is largely an artificial one. Almost everyone agrees that long-run growth is the product of technological advancement. But unlike the New-Keynesian school, which views trend growth as being relatively stable, the neoclassical view is that there is no God-given reason to believe that the process of technological advancement proceeds in such a smooth manner. Indeed, it seems more reasonable to suppose that new technologies appear in ‘clusters’ over time. These technology shocks may cause fluctuations in the trend rate of growth through what Schumpeter called a process of ‘creative destruction.’ That is, technological advancements that ultimately lead to higher productivity may, in the short run, induce cyclical adjustments as the economy ‘restructures’ (i.e. as resources flow from declining sectors to expanding sectors).As with the conventional wisdom, the neoclassical view admits that sudden changes in private sector expectations may lead to sudden changes in desired consumer and business sector spending. But unlike the conventional wisdom, these changes are interpreted as reflecting the rational behavior of private sector decision-makers in response to perceived real changes in underlying economic fundamentals (i.e., technology shocks). In other words, changes in market sentiment are the result and not the cause of the business cycle (Schumpeter, 1939).

A basic outline of the neoclassical model is as follows. First, it is assumed that individuals in the economy have preferences defined over consumer goods and services so that there is a demand for consumption. Second, individuals also have preferences defined over a number of no market goods and services that are produced in the home sector (e.g., leisure). Third, individuals are endowed with a fixed amount of time that they can allocate either to the labour market or the home sector. Time spent in the labour market is useful for the purpose of earning wage income, which can be spent on consumption. On the other hand, time spent in the labuor market necessarily means that less time can be spent in other valued activities (e.g., home production or leisure). Hence individuals face a trade-off, more hours spent working imply a higher material living standard, but less in the way of home production which is not counted as GDP. A key variable that in part determines the relative returns to these two activities is the real wage rate (the purchasing power of a unit of labour) (Schumpeter, 1939).


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