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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).

Bibliography:

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

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