Macroeconomics Essay

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Macroeconomics is a part  of economic  analysis that focuses on the understanding of economic issues at the aggregated level. It is related to microeconomic analysis, which pursues the study of the individual economic behavior  of  economic   agents  such  as  households, firms, and governments and deals with the issue of the functioning  of markets  with an emphasis on welfare. Macroeconomics  in contrast aims at the understanding of the economy as a whole. The study is concerned with the economic  aggregates such as total demand for goods and services by households  and firms, the total investment in the economy, the value of exports and the spending by the state sector. At the same time it endeavors to understand the relationship  between national income and consumption as well as taxation, savings, and imports.  The key issues of the analysis are national output and economic growth, unemployment, and the development  of the price level in the form of inflation.

Macroeconomic  analysis can  take  the  form  of a partial analysis in which relevant aspects are identified as the object of analysis within the general economic process. This follows an isolation of particular behavioral cause-effect relationships  on the basis of assumptions, which leads to a construction of models. The ceteris paribus analysis examines how a change of a variable affects another  dependent variable within the model and assumes that all other variables remain unchanged. This form of partial analysis is applied in the interest  rate–investment relationship,  for example. Here we assume that  all other  variables remain constant  but that a change in the money supply will have an effect on the interest rate, which in turn will change investment in the economy.

Macroeconomics can also pursue  a general analysis that analyzes the interdependence of all economic variables. Here the effect of a change in demand for a particular  good X will be analyzed with regard to its effect on all other  goods, prices, and production factors as well as on the general goods and factor markets. In particular,  does the general analysis focus on the effect of a change of the price level in the goods market  on other  partial  markets  such as the money market  and the factor market, in particular  the labor market. The analysis can be ex-ante or ex-post. The exante analysis incorporates the plans and expectations of economic agents and aggregates (e.g., construction of an equilibrium on the basis of the consumption and investment  plans on the goods markets), whereby the ex-post analysis explains economic situations that have already taken place (e.g., national income accounting, circular flow of income, gross domestic product, etc.). Macroeconomics can take a static or a dynamic form, when it is assumed  that  no economic  agent has any need to readjust their economic plans.

The analysis, however, blurs individual results due to the aggregation; this leads to macroeconomic analysis being less definite depending  on the size and heterogeneity of the selected groups of aggregates. Keeping this in mind, the value of the macroeconomic insight is necessary for the identification  of economic  policy options and their respective efficacy. Macroeconomics plays an important role in growth theory, labor market theory, monetary theory, and international and development economics. The input-output analysis aims to disaggregate some of the macroeconomic variables to gain a more detailed insight into economic processes.

Some of the main issues in macroeconomic analysis are inflation, unemployment, and output  and growth. The inflation rate is the annual increase in the average price of goods and services. The price index measures the average level of prices; the common  price index is the Consumer Price Index (CPI). The CPI measures the cost of purchasing a standard basket of goods at different points in time: the prices are weighted according to the economic  importance  of each individual good or service included in the basket. The CPI is the most widely used measure of inflation and is also used as the basis for many governmental  inflation targets. Other important indices used are the Retail Price Index (RPI), the GDP deflator, and the Producer Price Index (PPI).

Unemployment  measures   the  number   of  people who are registered  as actively looking for work. The unemployment rate is based on the labor force, which accounts for the total number of people in paid employment  and  those  who are registered  as looking for work. The unemployment rate is calculated as the number  of people who are looking for work as a percentage share of the total labor force. Output  and growth are commonly measured  on the basis of the gross domestic  product  (GDP), which measures  the total value of goods and services produced  within an economy over a particular  period of time (data can be quarterly  or annual).  The gross national  income (GNI) measures  the  total  income  that  is generated within an economy. Economic growth indicates a positive change in those figures. Macroeconomic  theory assumes  cyclical changes  in the  form  of recessions and booms that have impact on the general price level in the economy (recessionary gap, inflationary gap) as well as the rate of employment.

Macroeconomic Policy

Macroeconomic   policy  is  divided  into  two  main policy options that aim to stabilize the economy and smooth  out any cyclical fluctuations.  These policies are fiscal policy and  monetary  policy. Fiscal policy uses a variation of taxation  and government  expenditure to affect the injections into and the withdrawals from the economy. Monetary policy focuses on a variation of the money supply and the setting of the interest  rate as a cost of borrowing from the central bank by commercial banks and thereby affecting the overall lending rate within the economy. The government can also use the exchange rate to influence its trade volume and trade direction  with other  economies (open economy macroeconomics).

Keynesian Economics

The  history  of  macroeconomic  thought   is  determined  by the  development  from  classical economics where a natural  adjustment  toward  full employment is assumed to Keynesian beliefs. John Maynard Keynes revolutionized  economics  by suggesting  in his General Theory of Employment, Interest, and Money that this automatic  adjustment  does not take place and that supply does not create its own demand. He emphasized  a refocus  on  an adjustment  of the demand side within the economy to achieve an equilibrium. The General Theory reiterates  many behavioral assumptions of the classical theory, in particular, the objectives of profit and utility maximization, marginal values, perfect competition  on goods markets, the static form of analysis that assumes technology as given; furthermore, the analysis ignores the dynamic impact on economic growth of any of such factors as population  and production factors. Keynes accepted the capitalist form of the economic structure,  which enabled an incorporation of his theory into a neoclassical synthesis.

The Keynesian emphasis lies in the construction of the equilibrium level of national income from a short-term perspective, while allowing the capital stock to remain unchanged. This can result in an equilibrium situation  below the level of full employment,  which would then necessitate governmental  intervention in the form of fiscal or monetary  policy. The impact of any changes in consumption demand is highlighted by the multiplication-accelerator process, which describes the size of the effect that a change in any of the autonomous  demand  aggregates  (i.e., not  dependent on national   income,   here   nonconsumption  demand) have on national income. This analysis assumes both a constant  marginal  propensity  to  consume  and  a constant marginal propensity to withdraw.

In the case of a national  income  level below full employment, any change in the autonomous demand aggregates will lead to an increase in national income over a number  of periods in the form of the multiplier process, whereas any change in the autonomous demand aggregates (investment,  government  expenditure, exports) in a situation of full employment will lead to inflationary  tendencies  as demand  will outweigh the potential  of supply due to the scarcity of resources. One such autonomous demand  aggregate is investment  demand,  and this aggregate is dependent  on  the  interest  rate  and  the  marginal  rate  of capital productivity.  As long as the  marginal  factor productivity  is greater than the market rate of interest, investment will be positive, with the constraint  of the constant  marginal productivity investment  being negatively related to the interest rate.

On  the  monetary  side  of the  economy,  Keynes assumes  three  motives  for  holding  money,  which have macroeconomic implications. These motives are transaction,  precaution,  and speculation.  He derives the liquidity preference curve as the money demand curve, which shows a negative relationship  between money demand and the interest rate. In the case of a strong fall of the market rate of interest, the speculation demand of money becomes infinite, which might lead to a liquidity trap. The Keynesian theory had a major influence in the formation  of the relationship between  inflation  and  unemployment. The Phillips Curve  represents  a growing rate  of unemployment going alongside a fall in the inflation rate, thus suggesting a trade-off between inflation and unemployment.  The trade-off  was later  refuted  by Friedman and  Phelps and  their  suggestion  of the  nonaccelerating inflation rate of unemployment (NAIRU). This NAIRU is the natural rate of unemployment at which the   inflation   rate   remains   constant.   Monetarists believe that governmental policies can only achieve a reduction  of this rate in the short term, as in the long term any of such policies will be purely inflationary.

A widely used form of analysis is the IS-LM model that describes a simultaneous  derivation of an equilibrium on the goods market and the money market. Here the IS curve is derived from the goods market, which represents  different equilibrium  situations  for various  combinations  of interest  rate  and  national income. Within  a closed economy with no state, the goods market is assumed in a state of equilibrium when Y = C(Y) + I (r) or when Y = C(Y) + S(Y), whereby Y denotes national income, C(Y) consumption demand dependent on national income, I(r) investment dependent on the market  rate of interest,  and S(Y), savings dependent on national  income  and it holds that C = Y – S. The LM curve represents  the money market  equilibrium,  where  the  demand  for money (L) has to equal the exogenously determined (by the central bank) supply of money (M). The demand for money depends on the market rate of interest as well as on the national income level (motives for holding money), for the equilibrium  M = L (r,Y) must  hold. Within this analysis the variables Y, C, I, S, and L are considered  ex-ante  variables—they are  planned.  In the IS-LM diagram we can identify the interest rate– national  income  combination  at which  both  goods and money market are in equilibrium.

A  situation   of  disequilibrium   leads  in  Keynesian analysis to output  adjustments  rather  than  price changes in the short  run. This has repercussions  on the labor market, hence also affecting national income, which in turn  affects the consumption demand  and hence  impacts  back onto  the  goods market.  Such a cumulative effect of contraction of output  and reduction in demand can result in a situation of depression with excess supply of products and labor. In this sense macroeconomic outcomes  can be led back to microeconomic behavioral forms of economic agents in situations of disequilibrium  that are also dependent  on their expectations  of future economic  situations  and outcomes. According to Leijonhufvud and Clover, Keynes highlighted the notion that prices do not always effectively signal shortages and excesses and hence do not  always act to coordinate  the plans of economic agents. Furthermore, it is doubtable whether the market rate of interest responds coherently to disequilibria between  savings and investment  demand  within the economy, in particular  when assuming international capital markets and recent developments  in financial markets in the form of securitization.

Keynesian economics found its main impact until the 1970s, when a sustained  phase of stagnation  in many developed nations led to a monetarist counterargument. This movement led to a refocus of governmental  policies onto  monetary  policies rather  than fiscal ones. Keynesian theory had a strong impact on functional finance whereby a contractionary economic policy was meant  to tackle an inflationary situation whereby the expansionary economic policy aimed at a deflationary gap in the form of economic fine tuning under the belief of cyclical changes. These cyclical fluctuations could vary from Kontradieff-cycles (50– 60 years), Juglar-cycles (9.5 years), to Kitchin-cycles (3.5 years).


  1. Daron Acemoglu,  Introduction  to  Modern Economic Growth (Princeton  University Press, 2009);
  2. Paul R. Bergin, “How Well Can the New Open Economy Macroeconomics  Explain the Exchange Rate and Current Account?”  Journal  of International  Money  and  Finance (v.25/5, 2006);
  3. Alper Cenesiz and Christian Pierdzioch, “Financial Market Integration,  Labor Markets,  and Macroeconomic  Policies,” International  Review of Economics and Finance (v.17/3, 2008);
  4. José María Fanelli, Macroeconomic Volatility, Institutions and Financial Architectures: The Developing  World  Experience (Palgrave  Macmillan, 2008);
  5. Robert H. Frank, Ben Bernanke, and Louis Johnston, Principles of Macroeconomics (McGraw-Hill Irwin, 2009);
  6. Milton Friedman, “The Role of Monetary Policy,” American Economic Review (v.58, 1968);
  7. H. Hahn and F. P. R. Brechling, eds., The Theory of Interest Rates (Macmillan, 1965);
  8. John Maynard Keynes, The General Theory of Employment, Interest and Money (Macmillan, 1936);
  9. Leijonhufvud, On Keynesian  Economics and  the  Economics of Keynes (Oxford University Press, 1968);
  10. Phelps, “Money-Wage Dynamics and Labour Market Equilibrium,” Journal of Political Economy (v.76, 1968);
  11. A. Samuelson, “Interaction Between the Multiplier Analysis and the Principle of Acceleration,” Review of Economics and  Statistics  (v.21, 1939);
  12. John N. Smithin, Money, Enterprise and Income Distribution: Towards a Macroeconomic Theory of Capitalism (Routledge, 2009).

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