Applications of Macroeconomics
In this lesson, you’re expected to learn:
– the difference between Classical and Keynesian economics
– the relevance of the Phillips Curve
Free market economies allow individuals to pursue their own self-interests and rely on the market to focus the use of resources.
Importance of Macroeconomics
1) It helps to understand the functioning of a complicated modern economic system.
2) It helps to achieve the goal of economic growth, higher level of GDP and higher level of employment.
3) It helps to bring about stability in price levels and analyzes fluctuations in business activities. It also suggests policy measures to control Inflation.
4) Last but not least, macroeconomic theory has saved us from the dangers of the application of microeconomic theory to problems that require a look at the economy as a whole.
Government in the Marketplace
Government interaction in markets can include taxes, regulations, and restrictions on using certain resources or engaging in specific activities.
The applications of macroeconomics here may be to determine which government policies help a free market and which do not. Studies on international economies can also help domestic economists discover which portions of a free market may or may not need regulation.
Most economies in the world are mixed, with some government interaction in alleged free markets, making this an important macroeconomic application.
Employment, Interest Rates & Investment Theories
Essentially, there are two theories of employment: Classical and Keynesian.
Classical economists suggest that full employment is the norm of a market economy and that a laissez-faire policy is best.
Keynesian economics holds that unemployment is characteristic of laissez-faire capitalism, and activist government policies are required if one is to avoid the waste of idle resources. These economists believe that full employment is accidental.
Classical economists view aggregate supply as determining the full-employment level of real national output while aggregate demand establishes the price level.
Aggregate demand is stable as long as there are no significant changes in the money supply. When aggregate demand declines, the price will fall to eliminate the temporary excess supply and to restore full employment.
One of the assumptions at the heart of classical economic thought is Say’s Law.
French economist Jean-Baptiste Say believed that supply creates its own demand, and as a result, surpluses could not be sustained in a market economy.
Keynes is a polarizing figure in economics. His ideas challenged the status quo, and he is considered by many as the enemy of free-market economics.
Volatility of aggregate demand and downward inflexibility of prices mean that unemployment can persist for extended periods of time. An increase in savings will decrease Gross National Product (GNP).
Economist A. W. Phillips’s study of wage inflation and unemployment in the United Kingdom from 1861 to 1957 is a milestone in the development of macroeconomics.
He found a consistent inverse relationship between the two – when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly.
• However, as the economy gets closer to full capacity, we see an increase in inflationary pressures.
• With lower unemployment, workers are able to demand higher wages, which causes wage inflation. Also firms can increase prices due to rising demand.
Therefore, in this situation, we see falling unemployment, but higher inflation.
For example, from 2009-13, the Bank of England was willing to tolerate inflation above the government’s target of 2% because they felt to reduce inflation would have caused serious problems for unemployment and economic growth.
This willingness to consider a higher inflation rate, suggests that policy makers feel that the trade off of higher inflation is worth the benefit of lower unemployment. However, not all economists agree with this belief.