Macro Economics Report

8/3/2019 Macro Economics Report

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MACRO ECONOMICS

ECONOMIC SCHOOLS OF THOUGHT

PRESENTED TO:

ZIA ABBASS RIZVI

PRESENTED BY:

Nabeel Danish

Bilal Mustafa

Summaiya Aidrus

Moez Mahboob



THE CLASSICAL SCHOOL

OF THOUGHT



Adam Smith (1723 –1790) was a Scottish moral philosopher and a pioneer of politicaleconomy. Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations. The latter, usually abbreviated as The

Wealth of Nations, is considered his magnum opus and the first modern work of

economics. Adam Smith is widely cited as the father of modern economics.

The Wealth of Nations expounds that the free market, while appearing chaotic andunrestrained, is actually guided to produce the right amount and variety of goods by a so-called "invisible hand". The image of the invisible hand was previously employed bySmith in Theory of Moral Sentiments, but it has its original use in his essay, "The Historyof Astronomy". Smith believed that when an individual pursues his self-interest, he promotes the good of society more than so if he intends to benefit society: "by pursuinghis own interest, [the individual] frequently promotes that of the society more effectuallythan when he intends to promote it." Self-interested competition in the free market, heargued, would tend to benefit society as a whole by keeping prices low, while still

building in an incentive for a wide variety of goods and services. Nevertheless, he waswary of businessmen and argued against the formation of monopolies.

An often-quoted passage from The Wealth of Nations is:

It is not from the benevolence of the butcher, the brewer, or the baker thatwe expect our dinner, but from their regard to their own interest. Weaddress ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.

The first page of the Wealth of Nations, 1776 London editionValue theory was important in classical theory. Smith wrote that the "real price of everything ... is the toil and trouble of acquiring it" as influenced by its scarcity. Smithmaintained that, with rent and profit, other costs besides wages also enter the price of acommodity. Other classical economists presented variations on Smith, termed the 'labour theory of value'. Classical economics focused on the tendency of markets to move tolong-run equilibrium.Smith also believed that a division of labour would effect a great increase in production.One example he used was the making of pins. One worker could probably make onlytwenty pins per day. However, if ten people divided up the eighteen steps required tomake a pin, they could make a combined amount of 48,000 pins in one day.



Classical Economics Theory:

The term classical economics was applied to a school of economic thought that began

with Adam Smith's writing of the Wealth of Nations in 1776. Interestingly enough, thecreator of the term was Marx, and it was further perpetuated by John Maynard Keynes inhis General Theory. The classical school of economic thought was the dominant schoolof thought until the time of the great depression.

The father of the classical school is Adam Smith. Smith used the concept of the invisible

hand to describe the role of the market in the allocation of resources. In the market, theinteraction of demand and supply determines how much of a good will be produced andthe price that is charged for that good. Absent any explicit guidance mechanism, theinvisible hand guides participants in the market towards an outcome that efficientlyallocates resources to the production of goods that society desires.

Other important classical economists include David Ricardo who introduced anddeveloped the concepts of comparative advantage and the benefits of an open economythat participates in international trade. J.B. Says presented what is today known as Say's

Law: supply creates its own demand . Say's law captures the essence of the classicalschool of thought. The statement that supply creates its own demand implies that by producing goods and services, firms create the jobs and incomes capable of buying thosegoods and services.

With economic foundations based on the role of markets, a theory generally free of outside intervention, and emphasizing the role of production in determining income and

economic output, the classical school of thought has several important implications:

• The government should play a minimal role in determining the condition of theeconomy. The government does have an important place in areas such as providing a legal framework, preventing abuses of the market, and to sustainnational defense. However, extensive government intervention will hinder theefficient operation of the market in the determination of prices of goods andservices and the allocation of resources towards their production.

• The normal economic state of the economy is at full employment. This impliesthat all workers that desire jobs will have them, and those who are unemployed

voluntarily choose to be so.

• The government has a minimal role over the course of the business cycle, and leftalone the economy will gravitate toward full employment. In the long run,unemployment is not an important public policy concern as the unemployment present will be voluntary.



• Economic analysis should emphasize the study of markets and how theyeffectively operate.

One of the most important questions early classical economists attempted to answer washow the value or price of a good is determined. Smith described how the interaction of

supply and demand in the market determined a good's price. Smith needed to go further and explain why two goods with identical demands would have different prices.According to Smith, the prices of goods are determined by what it costs to produce them.Since the majority input used in production during the eighteenth century was labor,Smith developed a labor-based theory of prices. The price of a good reflects the amountof labor used in its creation. One good's price is higher than another's because of the extralabor used in its production.



The Classical School's Labor Market

Classical Theory: The Classicalist argued that the aggregate labor market determines totalemployment, and can be summarized by 2 postulates.

Postulate 1:

Wage = MPL (marginal product of labor)

Assumptions:

• we are talking about the real wage• everyone receives the MPL as their wage – this is a necessary assumption for

profit maximization• finally we assume diminishing returns to a fixed factor, in this case, capital is

fixed in the long run

We see that the second derivative is negative (the curve is downward sloping). There areseveral possible causes of this:

1. The first and most prominent reason is that diseconomies of scale set in2. The second could be a skill argument (you are forced to hire less and less

productive workers, as the pool of available workers shrinks.)3. Long run fixed capital argument – represents fixed plant equipment



We assume one productive sector making both an output and a consumption good. Thismeans that the real wage is same for both producers and consumers. An example would be people eating robots (basically eating that which they produce).

Here we can see that demand is downward sloping – this is a consequence of profitmaximization. This leads us to our second postulate:

Postulate 2:

Uwage = MDUwork (surrendered leisure time or marginal disutility of work)

If we have voluntary contracting in the economy (no forced labor), max employment isthe intersection, L*.

Max employment therefore yields max output. At wages below L*, we have a shortageand the level of labor and output is less, as determined by the supply curve. At wagesabove L*, we have a surplus and labor/output are determined by the demand curve.

Two types of classical unemployment:

1. Frictional – between jobs



Synoptic View:

a) All unemployment can be largely construed as voluntary and fits into three categories:

1) Frictional – time lag between jobs

2) Search – idea is that workers may quit existing job to try to find another

3) Money-wage stickiness –real-wage is too high because money-wages don’tadjust and this goes back to the notion that workers refuse to accept money-wagecuts.

b) The Economic System is self-adjusting to full employment. Classical view that forcesor mechanisms exist to restore a position of full employment. If you didn’t have any

interference or government intervention, you would have a tendency to move to fullemployment (they would still admit there could be lags or leaks in the system).

c) Money is neutral – if we increase the quantity of money, it only influences the generallevel of prices. It will have no effect on relative prices. It will have no effect on the realoutput and employment of the economy.

d) The interest rate functions to clear the loanable funds market. Interest rates should bring savings and investment in conjunction with one another, but it does not affect thereal output of the economy.

e) Savings drive economic growth. Income that is not spent for consumption purposes issavings (That which is left over from the expenditure screen of consumers). Savingswould then go to capital accumulation.



KEYNESIAN SCHOOL

OF THOUGHT



John Maynard Keynes:

Keynes was born in Cambridge and attended King’s College, Cambridge, where heearned his degree in mathematics in 1905. He remained there for another year to study

under ALFRED MARSHALL and ARTHUR PIGOU, whose scholarship on the quantity theory of money led to Keynes’s Tract on Monetary Reform many years later. After leavingCambridge, Keynes took a position with the civil service in Britain. While there, hecollected the material for his first book in economics, Indian Currency and Finance, inwhich he described the workings of India’s monetary system. He returned to Cambridgein 1908 as a lecturer, then took a leave of absence to work for the British Treasury. Heworked his way up quickly through the bureaucracy and by 1919 was the Treasury’s principal representative at the peace conference at Versailles. He resigned because hethought the Treaty of Versailles was overly burdensome for the Germans.

After resigning, he returned to Cambridge to resume teaching. A prominent journalist and

speaker, Keynes was one of the famous Bloomsbury Group of literary greats, which alsoincluded Virginia Woolf and Bertrand Russell. At the 1944 Bretton Woods Conference,where the International Monetary Fund was established, Keynes was one of the architectsof the postwar system of fixed exchange rates (see FOREIGN EXCHANGE). In 1925 hemarried the Russian ballet dancer Lydia Lopokova. He was made a lord in 1942. Keynesdied on April 21, 1946, survived by his father, John Neville Keynes, also a renownedeconomist in his day.

Keynes became a celebrity before becoming one of the most respected economists of thecentury when his eloquent book The Economic Consequences of the Peace was publishedin 1919. Keynes wrote it to object to the punitive reparations payments imposed on

Germany by the Allied countries after World War I. The amounts demanded by the Allieswere so large, he wrote, that a Germany that tried to pay them would stay perpetually poor and, therefore, politically unstable. We now know that Keynes was right. Besides itsexcellent economic analysis of reparations, Keynes’s book contains an insightful analysisof the Council of Four (Georges Clemenceau of France, Prime Minister David LloydGeorge of Britain, President Woodrow Wilson of the United States, and Vittorio Orlandoof Italy).

Keynes wrote: “The Council of Four paid no attention to these issues [which includedmaking Germany and Austro-Hungary into good neighbors], being preoccupied withothers—Clemenceau to crush the economic life of his enemy, Lloyd George to do a deal

and bring home something which would pass muster for a week, the President to donothing that was not just and right”

In the 1920s Keynes was a believer in the quantity theory of money (today calledMONETARISM). His writings on the topic were essentially built on the principles he hadlearned from his mentors, Marshall and Pigou. In 1923 he wrote Tract on Monetary

Reform, and later he published Treatise on Money, both on MONETARY POLICY. His major policy view was that the way to stabilize the economy is to stabilize the price level, and



that to do that the government’s central bank must lower INTEREST RATES when prices tendto rise and raise them when prices tend to fall.

Keynes’s ideas took a dramatic change, however, as UNEMPLOYMENT in Britain dragged onduring the interwar period, reaching levels as high as 20 percent. Keynes investigated

other causes of Britain’s economic woes, and The General Theory of Employment, Interest and Money was the result.

Keynes’s General Theory revolutionized the way economists think about economics. Itwas pathbreaking in several ways, in particular because it introduced the notion of aggregate demand as the sum of consumption, INVESTMENT, and government spending; and because it showed (or purported to show) that full employment could be maintained onlywith the help of government spending. Economists still argue about what Keynes thoughtcaused high unemployment. Some think he attributed it to wages that take a long time tofall. But Keynes actually wanted wages not to fall, and in fact advocated in the General

Theory that wages be kept stable. A general cut in wages, he argued, would decrease

income, consumption, and aggregate demand. This would offset any benefits to outputthat the lower price of labor might have contributed.

Why shouldn’t government, thought Keynes, fill the shoes of business by investing in public works and hiring the unemployed? The General Theory advocated deficit spendingduring economic downturns to maintain full employment. Keynes’s conclusion initiallymet with opposition. At the time, balanced budgets were standard practice with thegovernment. But the idea soon took hold and the U.S. government put people back towork on public works projects. Of course, once policymakers had taken deficit spendingto heart, they did not let it go.

Contrary to some of his critics’ assertions, Keynes was a relatively strong advocate of free markets. It was Keynes, not ADAM SMITH, who said, “There is no objection to be raisedagainst the classical analysis of the manner in which private self-interest will determinewhat in particular is produced, in what proportions the factors of production will becombined to produce it, and how the value of the final product will be distributed between them.” Keynes believed that once full employment had been achieved by FISCAL POLICY measures, the market mechanism could then operate freely. “Thus,” continuedKeynes, “apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reasonto socialise economic life than there was before” (p. 379).

Little of Keynes’s original work survives in modern economic theory. His ideas have been endlessly revised, expanded, and critiqued. Keynesian economics today, whilehaving its roots in The General Theory, is chiefly the product of work by subsequenteconomists including JOHN HICKS, JAMES TOBIN, PAUL SAMUELSON, Alan Blinder, ROBERT SOLOW,William Nordhaus, Charles Schultze, WALTER HELLER , and ARTHUR OKUN. The study of econometrics was created, in large part, to empirically explain Keynes’s macroeconomicmodels. Yet the fact that Keynes is the wellspring for so many outstanding economists istestament to the magnitude and influence of his ideas.



So influential was John Maynard Keynes in the middle third of the twentieth century thatan entire school of modern thought bears his name. Many of his ideas were revolutionary;almost all were controversial. K EYNESIAN ECONOMICS serves as a sort of yardstick that candefine virtually all economists who came after him.



Keynes and the Classics

Keynes sought to distinguish his theories from "classical economics," by which he meantthe economic theories of David Ricardo and his followers, including John Stuart Mill,

Alfred Marshall, F.Y. Edgeworth, and A. Cecil Pigou. A central tenet of the classicalview, known as Say's law, states that “supply creates its own demand.” Say's Law can beinterpreted in two ways. First, the claim that the total value of output is equal to the sumof income earned in production is a result of a national income accounting identity, and istherefore indisputable. A second and stronger claim, however, that the "costs of outputare always covered in the aggregate by the sale-proceeds resulting from demand"depends on how consumption and saving are linked to production and investment. In particular, Keynes argued that the second, strong form of Say's Law only holds if increases in individual savings exactly match an increase in aggregate investment.Keynes sought to develop a theory that would explain determinants of saving,consumption, investment and production. In that theory, the interaction of aggregate

demand and aggregate supply determines the level of output and employment in theeconomy.Because of what he considered the failure of the “Classical Theory” in the 1930s, Keynesfirmly objects to its main theory--adjustments in prices would automatically makedemand tend to the full employment level. Neo-classical theory supports that the two main costs that shift demand and supply arelabor and money. Through the distribution of the monetary policy, demand and supplycan be adjusted. If there were more labor than demand for it, wages would fall untilhiring began again. If there was too much saving, and not enough consumption, theninterest rates would fall until people either cut their savings rate or started borrowing.

Wages and spending

During the Great Depression, the classical theory defined economic collapse as simply alost incentive to produce. Mass unemployment was caused only by high and rigid realwages.To Keynes, the determination of wages is more complicated. First, he argued that it is notreal but nominal wages that are set in negotiations between employers and workers, asopposed to a barter relationship. First, nominal wage cuts would be difficult to put intoeffect because of laws and wage contracts. Even classical economists admitted that theseexist; unlike Keynes, they advocated abolishing minimum wages, unions, and long-termcontracts, increasing labor-market flexibility. However, to Keynes, people will resist

nominal wage reductions, even without unions, until they see other wages falling and ageneral fall of prices.

He also argued that to boost employment, real wages had to go down: nominal wageswould have to fall more than prices. However, doing so would reduce consumer demand,so that the aggregate demand for goods would drop. This would in turn reduce businesssales revenues and expected profits. Investment in new plants and equipment—perhaps



already discouraged by previous excesses—would then become more risky, less likely.Instead of raising business expectations, wage cuts could make matters much worse.

Further, if wages and prices were falling, people would start to expect them to fall. Thiscould make the economy spiral downward as those who had money would simply wait as

falling prices made it more valuable—rather than spending. As Irving Fisher argued in1933, in his Debt-Deflation Theory of Great Depressions, deflation (falling prices) canmake a depression deeper as falling prices and wages made pre-existing nominal debtsmore valuable in real terms.

Excessive saving

Classics on Saving and Investment.

To Keynes, excessive saving, i.e. saving beyond planned investment, was a serious problem, encouraging recession or even depression. Excessive saving results if investment falls, perhaps due to falling consumer demand, over-investment in earlier years, or pessimistic business expectations, and if saving does not immediately fall instep, the economy would decline.The classical economists argued that interest rates would fall due to the excess supply of "loanable funds". The first diagram, adapted from the only graph in The General Theory,shows this process. (For simplicity, other sources of the demand for or supply of fundsare ignored here.) Assume that fixed investment in capital goods falls from "old I" to"new I". Second, the resulting excess of saving causes interest-rate cuts, abolishing theexcess supply: so again we have saving (S) equal to investment. The interest-rate (i) fall

prevents that of production and employment.

http://en.wikipedia.org/wiki/File:CLASSIX.png



Keynes had a complex argument against this laissez-faire response. The graph belowsummarizes his argument, assuming again that fixed investment falls. First, saving doesnot fall much as interest rates fall, since the income and substitution effects of fallingrates go in conflicting directions. Second, since planned fixed investment in plant and

equipment is mostly based on long-term expectations of future profitability, that spendingdoes not rise much as interest rates fall. So S and I are drawn as steep (inelastic) in thegraph. Given the inelasticity of both demand and supply, a large interest-rate fall isneeded to close the saving/investment gap. As drawn, this requires a negative interest rateat equilibrium (where the new I line would intersect the old S line). However, thisnegative interest rate is not necessary to Keynes's argument.

Keynes on Saving and Investment.

Third, Keynes argued that saving and investment are not the main determinants of interest rates, especially in the short run. Instead, the supply of and the demand for thestock of money determine interest rates in the short run. (This is not drawn in the graph.) Neither changes quickly in response to excessive saving to allow fast interest-rateadjustment.

Finally, because of fear of capital losses on assets besides money, Keynes suggested thatthere may be a "liquidity trap" setting a floor under which interest rates cannot fall. (Inthis trap, bond-holders, fearing rises in interest rates (because rates are so low), fear capital losses on their bonds and thus try to sell them to attain money (liquidity).) Eveneconomists who reject this liquidity trap now realize that nominal interest rates cannotfall below zero (or slightly higher). In the diagram, the equilibrium suggested by the newI line and the old S line cannot be reached, so that excess saving persists. Some see thislatter kind of liquidity trap as prevailing in Japan in the 1990s.

http://en.wikipedia.org/wiki/File:KEYNES.png



Even if this "trap" does not exist, there is a fourth element to Keynes's critique. Savinginvolves not spending all of one's income. It thus means insufficient demand for businessoutput, unless it is balanced by other sources of demand, such as fixed investment. Thus,excessive saving corresponds to an unwanted accumulation of inventories, or whatclassical economists called a general glut. This pile-up of unsold goods and materials

encourages businesses to decrease both production and employment. This in turn lowers people's incomes and saving, causing a leftward shift in the S line in the diagram. For Keynes, the fall in income did most of the job by ending excessive saving and allowingthe loanable funds market to attain equilibrium. Instead of interest-rate adjustmentsolving the problem, a recession does so. Thus in the diagram, the interest-rate change issmall.Whereas the classical economists assumed that the level of output and income wasconstant and given at any one time (except for short-lived deviations), Keynes saw this asthe key variable that adjusted to equate saving and investment.Finally, a recession undermines the business incentive to engage in fixed investment.With falling incomes and demand for products, the desired demand for factories and

equipment (not to mention housing) will fall. This accelerator effect would shift the I lineto the left again, a change not shown in the diagram above. This recreates the problem of excessive saving and encourages the recession to continue.In sum, to Keynes there is interaction between excess supplies in different markets, asunemployment in labor markets encourages excessive saving—and vice-versa. Rather than prices adjusting to attain equilibrium, the main story is one of quantity adjustmentallowing recessions and possible attainment of underemployment equilibrium.

Active fiscal policy

Keynes's ideas influenced Franklin D. Roosevelt's view that insufficient buying-power caused the Depression. During his presidency, Roosevelt adopted some aspects of Keynesian economics, especially after 1937, when, in the depths of the Depression, theUnited States suffered from recession yet again following fiscal contraction. But to manythe true success of Keynesian policy can be seen at the onset of World War II, which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official in social-democratic Europeafter the war and in the U.S. in the 1960s.Keynes's theory suggested that active government policy could be effective in managingthe economy. Rather than seeing unbalanced government budgets as wrong, Keynes

advocated what has been called countercyclical fiscal policies, that is policies whichacted against the tide of the business cycle: deficit spending when a nation's economysuffers from recession or when recovery is long-delayed and unemployment is persistently high and the suppression of inflation in boom times by either increasing taxesor cutting back on government outlays. He argued that governments should solve problems in the short run rather than waiting for market forces to do it in the long run, because "in the long run, we are all dead."



This contrasted with the classical and neoclassical economic analysis of fiscal policy.Fiscal stimulus (deficit spending) could actuate production. But to these schools, therewas no reason to believe that this stimulation would outrun the side-effects that "crowdout" private investment: first, it would increase the demand for labor and raise wages,hurting profitability; Second, a government deficit increases the stock of government

bonds, reducing their market price and encouraging high interest rates, making it moreexpensive for business to finance fixed investment. Thus, efforts to stimulate theeconomy would be self-defeating.The Keynesian response is that such fiscal policy is only appropriate whenunemployment is persistently high, above what is now termed the Non-AcceleratingInflation Rate of Unemployment, or "NAIRU". In that case, crowding out is minimal.Further, private investment can be "crowded in": fiscal stimulus raises the market for business output, raising cash flow and profitability, spurring business optimism. ToKeynes, this accelerator effect meant that government and business could becomplements rather than substitutes in this situation. Second, as the stimulus occurs,gross domestic product rises, raising the amount of saving, helping to finance the increase

in fixed investment. Finally, government outlays need not always be wasteful:government investment in public goods that will not be provided by profit-seekers willencourage the private sector's growth. That is, government spending on such things as basic research, public health, education, and infrastructure could help the long-termgrowth of potential output.A Keynesian economist might point out that classical and neoclassical theory does notexplain why firms acting as "special interests" to influence government policy areassumed to produce a negative outcome, while those same firms acting with the samemotivations outside of the government are supposed to produce positive outcomes.Libertarians counter that because both parties consent, free trade increases net happiness, but government imposes its will by force, decreasing happiness. Therefore firms thatmanipulate the government do net harm, while firms that respond to the free market donet good.In Keynes' theory, there must be significant slack in the labor market before fiscalexpansion is justified. Both conservative and some neoliberal economists question thisassumption, unless labor unions or the government "meddle" in the free market, creating persistent supply-side or classical unemployment. Their solution is to increase labor-market flexibility, e.g., by cutting wages, busting unions, and deregulating business.Deficit spending is not Keynesianism. Keynesianism recommends counter-cyclical policies to smooth out fluctuations in the business cycle.] An example of a counter-cyclical policy is raising taxes to cool the economy and to prevent inflation when there isabundant demand-side growth, and engaging in deficit spending on labor-intensiveinfrastructure projects to stimulate employment and stabilize wages during economicdownturns. Classical economics, on the other hand, argues that one should cut taxes whenthere are budget surpluses, and cut spending or, less likely, increase taxes duringeconomic downturns.[citation needed] Keynesian economists believe that adding to profits and incomes during boom cycles through tax cuts, and removing income and profits from the economy through cuts in spending and/or increased taxes duringdownturns, tends to exacerbate the negative effects of the business cycle. This effect is



especially pronounced when the government controls a large fraction of the economy,and is therefore one reason fiscal conservatives advocate a much smaller government.

"Multiplier effect" and interest rates

Two aspects of Keynes' model had implications for policy:First, there is the "Keynesian multiplier", first developed by Richard F. Kahn in 1931.Exogenous increases in spending, such as an increase in government outlays, increasestotal spending by a multiple of that increase. A government could stimulate a great dealof new production with a modest outlay if:

1. The people who receive this money then spend most on consumption goods and savethe rest.

2. This extra spending allows businesses to hire more people and pay them, which inturn allows a further increase consumer spending.This process continues. At each step, the increase in spending is smaller than in the

previous step, so that the multiplier process tapers off and allows the attainment of anequilibrium. This story is modified and moderated if we move beyond a "closedeconomy" and bring in the role of taxation: the rise in imports and tax payments at eachstep reduces the amount of induced consumer spending and the size of the multiplier effect.

Second, Keynes re-analyzed the effect of the interest rate on investment. In the classicalmodel, the supply of funds (saving) determined the amount of fixed business investment.That is, since all savings was placed in banks, and all business investors in need of borrowed funds went to banks, the amount of savings determined the amount that wasavailable to invest. To Keynes, the amount of investment was determined independently

by long-term profit expectations and, to a lesser extent, the interest rate. The latter opensthe possibility of regulating the economy through money supply changes, via monetary policy. Under conditions such as the Great Depression, Keynes argued that this approachwould be relatively ineffective compared to fiscal policy. But during more "normal"times, monetary expansion can stimulate the economy, mostly by encouragingconstruction of new housing.

Postwar Keynesianism

After Keynes, Keynesian analysis was combined with neoclassical economics to produce

what is generally termed the "neoclassical synthesis" which dominates mainstreammacroeconomic thought. Though it was widely held that there was no strong automatictendency to full employment, many believed that if government policy were used toensure it, the economy would behave as classical or neoclassical theory predicted.In the post-WWII years, Keynes's policy ideas were widely accepted. For the first time,governments prepared good quality economic statistics on an ongoing basis and had atheory that told them what to do. In this era of new liberalism and social democracy, mostwestern capitalist countries enjoyed low, stable unemployment and modest inflation.



It was with John Hicks that Keynesian economics produced a clear model which policy-makers could use to attempt to understand and control economic activity. This model, theIS-LM model is nearly as influential as Keynes' original analysis in determining actual policy and economics education. It relates aggregate demand and employment to threeexogenous quantities, i.e., the amount of money in circulation, the government budget,

and the state of business expectations. This model was very popular with economists after World War II because it could be understood in terms of general equilibrium theory. Thisencouraged a much more static vision of macroeconomics than that described above.The second main part of a Keynesian policy-maker's theoretical apparatus was thePhillips curve. This curve, which was more of an empirical observation than a theory,indicated that increased employment, and decreased unemployment, implied increasedinflation. Keynes had only predicted that falling unemployment would cause a higher price, not a higher inflation rate. Thus, the economist could use the IS-LM model to predict, for example, that an increase in the money supply would raise output andemployment—and then use the Phillips curve to predict an increase in inflation.Through the 1950s, moderate degrees of government demand leading industrial

development, and use of fiscal and monetary counter-cyclical policies continued, andreached a peak in the "go go" 1960s, where it seemed to many Keynesians that prosperitywas now permanent. However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberal economics began to fall out of favor. During this time, manyeconomies experienced high and rising unemployment, coupled with high and risinginflation, contradicting the Phillips curve's prediction. This stagflation meant that thesimultaneous application of expansionary (anti-recession) and contractionary (anti-inflation) policies appeared to be necessary, a clear impossibility. This dilemma led to theend of the Keynesian near-consensus of the 1960s, and the rise throughout the 1970s of ideas based upon more classical analysis, including monetarism, supply-sideeconomics[citation needed] and new classical economics. At the same time Keynesians began during the period to reorganize their thinking (some becoming associated with New Keynesian economics); one strategy, utilized also as a critique of the notably highunemployment and potentially disappointing GNP growth rates associated with the latter two theories by the mid-1980s, was to emphasize low unemployment and maximaleconomic growth at the cost of somewhat higher inflation (its consequences kept in check by indexing and other methods, and its overall rate kept lower and steadier by such potential policies as Martin Weitzman's share economy).



The recent revival of Keynes

In the wake of the financial crisis of 2007-2008 the free-market consensus began to

attract negative comment even by mainstream opinion formers from the economic right.In March 2008, free-market guru Martin Wolf, chief economics commentator at the Financial Times, announced the death of the dream of global free-market capitalism, andquoted Josef Ackermann, chief executive of Deutsche Bank, as saying "I no longer believe in the market's self-healing power." Shortly afterward economist Robert Shiller began advocating robust government intervention to tackle the financial crisis,specifically citing Keynes. Macro economist James K. Galbraith used the 25th AnnualMilton Friedman Distinguished Lecture to launch a sweeping attack against theconsensus for monetarist economics and argued that Keynesian economics were far morerelevant for tackling the emerging crises. A series of major bailouts followed, starting onSeptember 7 with the announcement that the U.S. government was to nationalize the two

firms which oversaw most of the U.S. sub prime mortgage market—Fannie Mae andFreddie Mac. In October, the British Chancellor of the Exchequer referred to Keynes ashe announced plans for substantial fiscal stimuli to head off the worst effects of recession, in accordance with Keynesian economic thought. Similar policies have beenannounced in other European countries, by the U.S., and by China. This is in stark contrast to the scope given to Indonesia during its financial crisis of 1997, when the IMFforced it to close 16 banks simultaneously, prompting a bank run.

Prominent Keynesian economists included Paul Krugman, Robert Reich and JosephStiglitz. Greg Mankiw argued that Keynes was the economist who provided the greatestsingle insight into the crisis, but later encouraged skepticism about a fiscal stimulus.

The works on Keynes of Hyman Minsky, Robert Skidelsky, and Donald Markwellwerewidely cited. Much discussion reflected Keynes's advocacy of international coordinationof fiscal or monetary stimulus, and of international economic institutions such as theInternational Monetary Fund and World Bank, which he had helped to create at BrettonWoods in 1944, and which many argued should be reformed at a "new BrettonWoods".This was evident at the G20 and APEC meetings in Washington, D.C., andLima, Peru, in November 2008, and in coordinated reductions of interest rates by manycountries in November and December 2008. IMF and United Nations economists and political leaders such as British Prime Minister Gordon Brown advocated a coordinatedinternational approach to fiscal stimulus. The President of the World Bank, Robert

Zoellick, advocated that all developed country pledge 0.7 percent of its stimulus packageto a vulnerability fund for assisting developing countries.

Keynesian thinking was reflected in U.S. President Barack Obama's appointing LawrenceSummers, Timothy F. Geithner and Christina Romer to principal economic positions inhis administration. In a speech on January 8 2009, President Obama unveiled a plan for extensive domestic spending to combat recession, further reflecting Keynesian thinking.The plan was signed by the President on 17 February 2009. There had been extensive



debate in Congress concerning the necessity, adequacy, and likely effects of the package,which saw it being cut from $819 to $787 billion during its passage through the Senate.

A renewed interest in Keynesian ideas was not limited to western countries. In a speechdelivered in March 2009 entitled Reform the International Monetary System, Zhou

Xiaochuan, the governor of the People's Bank of China revived Keynes's idea of acentrally managed global reserve currency. Dr Zhou argued that it was unfortunate thatKeynes's Bancor proposal was not accepted at Bretton Woods in the 1940s. He arguedthat national currencies were unsuitable for use as global reserve currencies as a result of the Triffin dilemma - the difficulty faced by reserve currency issuers in trying tosimultaneously achieve their domestic monetary policy goals and meet other countries'demand for reserve currency. Dr Zhou proposed a gradual move towards adopting IMFSpecial Drawing Rights (SDRs) as a centrally managed global reserve currency

Macro Economics Report

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