From New World Encyclopedia

Circulation in macroeconomics

Macroeconomics is a branch of economics that deals with the performance, structure, and behavior of a national economy as a whole. Macroeconomists seek to understand the determinants of aggregate trends in an economy with particular focus on national income, unemployment, inflation, investment, and international trade. In contrast, microeconomics is primarily focused on the determination of prices and the role of prices in allocating scarce resources. In particular, the Great Depression of the 1930s led economists to try to understand its causes, and thus to be able to avoid similar situations causing such suffering in the future.

While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by both governments and large corporations to assist in the development and evaluation of economic policy and business strategy. Accurate models support successful development of the economy, allowing a society or organization to maintain stability and to attain successful growth when appropriate, allowing not only the economy of the whole but also the individual members to prosper.


The first published use of the term macroeconomics was by the Norwegian economist Ragnar Frisch in 1933, and before this, there already was an effort to understand many of the broad elements of the field.

Until the 1930s, most economic analysis did not separate out individual behavior from aggregate behavior. With the Great Depression of the 1930s and the development of the concept of national income and product statistics, the field of macroeconomics began to expand. Before that time, comprehensive national accounts, as we know them today, did not exist. Theoretically, the ideas of the British economist John Maynard Keynes, who worked on explaining the Great Depression, were particularly influential.

One of the challenges of economics has been a struggle to reconcile macroeconomic and microeconomic models. Starting in the 1950s, macroeconomists developed micro-based models of macroeconomic behavior, such as the consumption function. Dutch economist Jan Tinbergen developed the first comprehensive national macroeconomic model, which he first built for the Netherlands and later applied to the United States and the United Kingdom after World War II. The first global macroeconomic model, Wharton Econometric Forecasting Associates LINK project, was initiated by Lawrence Klein and was mentioned in his citation for the Nobel Memorial Prize in Economics in 1980.

Theorists such as Robert Lucas Jr. suggested (in the 1970s) that at least some traditional Keynesian (after John Maynard Keynes) macroeconomic models were questionable as they were not derived from assumptions about individual behavior, but instead based on observed past correlations between macroeconomic variables. However, New Keynesian macroeconomics has generally presented microeconomic models to shore up their macroeconomic theorizing, and some Keynesians have contested the idea that microeconomic foundations are essential, if the model is analytically useful. An analogy might be that the fact that quantum physics is not fully consistent with relativity theory does not mean that relativity is false. Many important microeconomic assumptions have never been proved, and some have proved wrong.

There exists vigorous debates among adherents to each of the various schools. Despite this, the goal of economic research is not to be "right," but rather to be useful. An economic model should accurately reproduce observations beyond the data used to calibrate or fit the model. None of the current schools of economic thought perfectly capture the workings of the economy, however each approach contributes a unique perspective to the overall puzzle. As one learns more about each school of thought, it is possible to combine aspects of each in order to reach an informed synthesis, which is the ideal.

Analytical approaches

The traditional distinction is between two different approaches to economics: Keynesian economics, focusing on demand; and supply-side (or neo-classical) economics, focusing on supply. Neither view is typically endorsed to the complete exclusion of the other, but most schools do tend clearly to emphasize one or the other as a theoretical foundation.

  • Keynesian economics focuses on aggregate demand to explain levels of unemployment and the business cycle. That is, business cycle fluctuations should be reduced through fiscal policy (the government spends more or less depending on the situation) and monetary policy. Early Keynesian macroeconomics was "activist," calling for regular use of policy to stabilize the capitalist economy, while some Keynesians called for the use of incomes policies.
  • Supply-side economics delineates quite clearly the roles of monetary policy and fiscal policy. The focus for monetary policy should be purely on the price of money as determined by the supply of money and the demand for money. It advocates a monetary policy that directly targets the value of money and does not target interest rates at all. Typically the value of money is measured by reference to gold or some other reference. The focus of fiscal policy is to raise revenue for worthy government investments with a clear recognition of the impact that taxation has on domestic trade. It places heavy emphasis on Say's law, which states that recessions do not occur because of failure in demand or lack of money.


  • Austrian economics is a laissez-faire school of macroeconomics. It focuses on the business cycle that arises from government or central-bank interference that leads to deviations from the rate of interest, and emphasizes the importance of credit and investment misallocation in business cycle fluctuations.
  • Monetarism, led by Milton Friedman, holds that Inflation is always and everywhere a monetary phenomenon. It rejects fiscal policy because it leads to "crowding out" of the private sector. Further, it does not wish to combat inflation or deflation by means of active demand management as in Keynesian economics, but by means of monetary policy rules, such as keeping the rate of growth of the money supply constant over time.
  • New classical economics. The original theoretical impetus was the charge that Keynesian economics lacks microeconomic foundations—its assertions are not founded in basic economic theory. This school emerged during the 1970s. This school asserts that it does not make sense to claim that the economy at any time might be "out-of-equilibrium." Fluctuations in aggregate variables follow from the individuals in the society continuously re-optimizing as new information on the state of the world is revealed. A neo-classical economist would define macroeconomics as dynamic stochastic general equilibrium theory, which means that choices are made optimally considering time, uncertainty and all markets clearing.
  • New Keynesian economics, which developed partly in response to new classical economics, strives to provide microeconomic foundations to Keynesian economics by showing how imperfect markets can justify demand management.
  • Post-Keynesian economics represents a dissent from mainstream Keynesian economics, emphasizing the role of uncertainty, liquidity preference and the historical process in macroeconomics.

Business Cycles

The idea of business cycles is that of economic volatility and the concept that this volatility usually occurs in a cyclical manner with highs of economic health and lows of recession or depression. A great deal of study has gone into trying to understand what causes the upturns and downturns of business cycles and whether or not they can actually be influenced by conscious efforts. Some theories as to the causes of the business cycle include:

  • Psychological/Lead-lag theory: In this theory, investors irrationally extend lines of credit when they believe the economy to be healthier than it actually is, leading to failed businesses and an eventual downturn.
  • Monetary theory: This theory puts forth the idea that misperceptions regarding allocations of capital and its worth over a period of time cause shifts in economic fortunes
  • Underconsumption theory: Similar to the lead-lag theory, this idea says that at some points consumers feel less confident in the economy, or do not feel as wealthy as they actually are and therefore do not spend in line with what they should in order to drive the economy
  • Shock-based theory: This theory says that the economy is shaped by large events rather than the mundane activities of everyday business. These shocks can be events such as wars, famines, or bankruptcies which affect huge numbers of people and therefore can actually affect the economy at large.

Economic Growth

Economic growth is an increase in the amount of goods and services produced within an economy (also known as the amount of value added within an economy). Economic growth is measured using the term "gross domestic product." Ideas about what can cause economic growth have evolved over human history. It has variously been suggested that growth is driven by exports, imports, manufacturing, diversification, specialization, isolationism, protectionism, free trade, and others. There is some element of truth to each of these as there is no exact formula that has consistently succeeded in growing economies.

Macroeconomic Policies

In order to try to avoid major economic shocks, such as great depression, governments make adjustments through policy changes which they hope will succeed in stabilizing the economy. Governments believe that the success of these adjustments is necessary to maintain stability and continue growth. This economic management is achieved through two types of strategies.

  • Fiscal Policy - This is the government's use of a budget to affect the level of economic activity in a country. The budget can affect activity in two ways: taxes and spending. Increased taxation will slow down the economy of a country while increased spending will speed up a country's economy.
  • Monetary Policy - This is the government's regulation of its country's money supply with the goal of speeding up or slowing down economic activity. Modern monetary policy is accomplished by the setting of interest rates at which banks borrow money. Monetary policy is usually executed by central banks through the buying (selling) of bonds, which increases (decreases) the amount of money in supply, which creates more (less) money chasing after the same amount of capital thereby increasing (decreasing) interest rates.

ISBN links support NWE through referral fees

  • Baumol, William and Alan Blinder. Macroeconomics: Principles and Policy. Southwestern College Publishers, 2005. ISBN 0324221142
  • Blaug, Mark. Economic Theory in Retrospect. Cambridge University Press, 1985. ISBN 0521316448
  • Frisch, Ragnar. "Propagation Problems and Impulse Problems in Dynamic Economics" in Economic Essays in Honour of Gustav Cassel. London: Allen and Unwin, 1933.
  • Mankiw, N. Gregory. Macroeconomics. Worth Publishers, 2006. ISBN 0716762137
  • Moss, David. Concise Guide to Macroeconomics: What Managers, Executives, and Students Need to Know. Harvard Business School Press, 2007. ISBN 1422101797
  • Snowdon, Brian and Howard R. Vane. Modern Macroeconomics: Its Origins, Development And Current State. Edward Elgar Publishing, 2005. ISBN 184376394X


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