Macroeconomics, as a field of study, is not a set of principles that is set in stone. Rather, the field has developed and changed over time as new empirical and theoretical techniques have been invented and as historical events have raised new questions for which people have urgently desired answers. To give you an idea about how the various principles of macroeconomics fit into social and historical context, this article will provide a short overview of the major historical developments in macroeconomics.
The Classical Period
Centuries ago, most people in Europe were involved in agriculture or in home production, such as when a family would work together to card, spin and weave raw wool into cloth. Merchants were a minority, and industrial production and large-scale trade were unknown. All this changed with the coming of the Industrial Revolution, which began in England in the mid-18th century. In many countries technological progress led to new methods of production, and more productive economies both increased and diversified their output. Necessities like food and clothing used up a decreasing proportion of the average family income, while a growing fraction of the population was able to acquire more comforts and luxuries – better bedding, plumbing, housing, and transportation, to name just a few of the improvements to living standards. Academic thinkers started to try to understand and explain how these changes came about – and classical economics was born.
During this period macroeconomic study focused on economic growth and distribution. The most famous Classical economist was Scottish philosopher Adam Smith (1723–1790) whose 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations set the terms of discussion for centuries to come. Smith attributed the growing “wealth of nations” to various factors. One was changes in the organization of work, particularly the division of labor that assigned workers to specialized, narrowly defined tasks. Whereas in family-based production each individual had usually performed a variety of tasks, in industrial production a person would repeat one very specific task over and over, presumably becoming more proficient with increased practice. Another factor was technological progress, such as the invention of new machines powered by burning coal. The third was the accumulation of funds to invest in plants and machinery (“capital accumulation”). Classical economists were also particularly concerned with theorizing about how the funds generated by selling output would come to be distributed between the people who worked in factories and the capitalists who owned the factories.
Smith is particularly known for promulgating the idea that market systems could coordinate the self-interested actions of individuals so that they would ultimately serve the social good. While Smith himself supported a number of government interventions and discussed the moral basis for social and economic behavior at length in others of his works, the school of classical economics has been popularly identified with the idea that individual self-interest is a positive force and that governments should let markets function without interference—that economies should be laissez-faire.
The classical economists did not much address the problem of economic fluctuations. A smoothly functioning market system, a number of them thought, should be entirely self-regulating. At the macroeconomic level, full employment should generally prevail. This view was summarized in Say’s Law, named after French classical economist Jean-Baptiste Say (1767-1832), which was said to prove that “supply creates its own demand.” The example Say gave was of a tradesman, for example a shoemaker, who sold $100 worth of shoes. Say argued that the shoemaker would naturally want to spend the $100 on other goods, thereby creating a demand which was exactly equal in money value to the supply he had provided. If this example is extended to the whole economy, it suggests that the quantities demanded and quantities supplied of goods will exactly balance, meaning that employment – producing shoes or something else – will be available for anyone willing to work. Classical economists discussed issues related to a country’s monetary system, but tended to assume that monetary issues affected only the price levels, and not the level of production, in a country.
The Great Depression, Keynes, and Monetarism
Yet economies did not seem to be working so smoothly, in practice. Some periods, like 1904-1906 and the 1920’s in the United States, were boom years where everyone seemed eager to invest and spend. People with extra funds would buy stocks (ownership shares in companies) or deposit their funds in banks (to be leant to others) with great confidence and optimism. On the other hand, these booms seemed to frequently end in painful recessions. Suddenly the tide would turn and everyone would want to sell—not buy—and stock prices would plummet. A lack of confidence in banks would lead to “bank runs” or “banking panics,” such as occurred in 1907 and 1930-1933 in the United States, when everyone tried to pull out their deposits all at once. With financial markets in tatters, businesses and individuals would be unable or unwilling to maintain or expand their activities. With people cutting back on spending, produced goods would go unsold. Industries would cut back on production. People would become unemployed.
A great many people in the United States (and much of the rest of the industrialized world) suffered considerable hardship during the Great Depression, touched off by the 1929 stock market crash. Production dropped by about 30% between 1929 and 1933. At its worst, the unemployment rate during the Great Depression topped 25%—one in four workers could not find a job. High unemployment persisted throughout the 1930’s, and classical economic theory did not seem to be of much help in either explaining or correcting the situation.
The publication of the British economist John Maynard Keynes’ The General Theory of Employment, Interest, and Money in 1936 was a watershed event. In this book, Keynes (pronounced “canes”) argued that Say’s Law was wrong. It is possible for an economy to have a level of demand for goods that is insufficient to meet the supply from production, he said. In such a case, producers, unable to sell their goods, will cut back on production, laying off workers, and thus creating economic slumps. The key to getting out of such a slump, Keynes argued, is to increase aggregate demand—the total demand for goods and services in the national economy as a whole.
Keynes suggested a number of ways to achieve this. People could be encouraged to consume more, the government could buy more goods and services, or businesses could be encouraged to spend more. Some economists thought that the best way to encourage business spending was to keep interest rates low, so that businesses could borrow easily to invest in their enterprises. But, while Keynes believed that increasing investment spending would be the key to getting out of a depression, he thought that low interest rates alone would be insufficient to tempt discouraged and uncertain business leaders to start investing again. He wrote in The General Theory that the solution to business cycles lay in the government taking more direct control of the level of national investment. In his view capitalist economies were inherently unstable, and only a more socially-oriented direction of investment could cure this instability. This policy, however, was not generally adopted and the Great Depression continued for the remainder of the 1930’s.
In actuality, it was the high government spending associated with national mobilization for World War II that finally brought the Great Depression to an end. Perhaps this is one reason why the followers of what came to be known as Keynesian economics did not follow Keynes on all points. While they retained his emphasis on deficiencies in aggregate demand, they tended to emphasize the use of fiscal policy to keep employment rates up. Fiscal policy is the manipulation of levels of government spending and taxation to raise or lower the level of aggregate demand.
Other economists in these post-WWII years—most notably University of Chicago economist Milton Friedman—took a different tack. While the Keynesians argued that active government fiscal policies were the way to get out of a recession, the monetarists argued that bad government monetary policies were how economies tend to get into bad situations in the first place. It was primarily the United States government’s poor use of its monetary policy tools, such as banking regulations and the issuance of currency (most often understood as “printing money”), that led to the Great Depression, they said. They blamed government policies encouraging overly “loose” money (that is, easy credit, low interest rates, and high levels of money supply) for the overspending of the late 1920’s. Then, they claimed, “tight” money policies (tight credit, higher-than-optimal interest rates, and low money supply) during the early 1930’s turned what could have been a more minor slump into a major depression. They argued that governments should focus on keeping the money supply steady, and not try to take an active role in directing the economy, even when unemployment is high. Like the classical economists, they believed that the economy should best be left to adjust on its own.
As time went on, the Keynesian approach was expanded to also include a role for monetary policy. This approach had a strong influence on macroeconomic policy-making in the United States and many other countries up through the 1960s. The idea became popular that the government might even be able to “fine tune” the economy, counteracting any tendencies to slump with expansionary (high spending and/or loose money) policies, and any excessive expansion with contractionary (low spending and/or tight money) policies, thereby largely eliminating business cycles. A related idea was that the government could choose to “trade off” unemployment and inflation—letting the economy suffer a little more inflation to get the unemployment rate down, or vice versa.
Synthesizing Classical and Keynesian Economics
In the early 1970s this rosy picture was shattered, however, as many industrialized countries began to experience both rising unemployment and rising inflation. To explain this, many macroeconomists began combining elements of both classical and Keynesian economics, making a distinction between the long-run and the short-run as follows:
- Classical theories assert first, that economies should naturally settle at full employment levels of output and, second, that the primary outcome of changes in money supply are changes in the price level or rate of inflation. In an idealized smoothly functioning market system, any unemployment (that is, surplus of labor) should be corrected by a drop in the (equilibrium) wage. In the emerging synthesis, full employment and purely inflationary effects came to be thought of as long-run outcomes, which occur only after all markets have had sufficient time to adjust.
- Keynesian economists after World War II had come to accept the idea that their theories should be explainable in terms of market models, but explained unemployment as being due to the fact that markets for labor do not adjust quite as quickly as classical theory implies. Keynesian economists argued that wages are “sticky” in real-world markets and will not fall fast enough during a slump for full employment to be quickly restored. Fiscal and monetary policies were thought, in this emerging synthesis, to be effective mechanisms for coping with this short-run phenomenon.
Thus the dominant macroeconomic theory that emerged argued that in the short run—a period of some months or years—we are in a primarily Keynesian world where fiscal and monetary policies can be effective. In the long run, however—after such a period of time that even “sticky” markets are able to adjust—we are in a classical world, where market adjustments assure full employment and money only affects prices.
Economists thus explained the inflation that occurred in the first few years of the 1970’s (in spite of the simultaneous presence of unemployment) as the long-run outcome of expansionary monetary policies of the previous years. It appeared that short-run, active (Keynesian) government policies could have unintended negative long-term (classical) consequences.
While many economists have come to agree on this general theoretical picture, debates have continued, now centered around the question of whether the short-run benefits of active government policies are worth their long-run, presumably mostly negative, consequences.
Macroeconomists at the more classical end of the spectrum tend to emphasize market efficiency and a small role for government. They are suspicious about the use of monetary policy because of the possible negative effects we just discussed. They are suspicious about the use of fiscal policy, as well, arguing (in line with the classical emphasis on economic growth) that excessive government spending or taxation can decrease future growth by “crowding out” private activities.
Economists on the more Keynesian end of the spectrum, meanwhile, tend to emphasize the way in which unemployment can cause severe human suffering and be very persistent. Waiting for markets to adjust on their own, they believe, may mean waiting too long. And, as Keynes himself put in, “In the long run, we are all dead.”
While it might seem that many economists have finally come to at least a general agreement about how the macroeconomy works, real-world developments have brought still new issues to public attention.
In 1973-74 the macroeconomic environment of the United States and most other industrialized economies took a sharp hit when countries belonging to the Organization of Petroleum Exporting Countries (OPEC) cut production, drastically increased the price at which they would sell crude oil, and even for several months completely stopped shipping oil to certain nations. The price of oil, a key input to many production and consumption activities, suddenly quadrupled. Stock markets fell, inflation rose, and unemployment shot up as people struggled to adjust. People waited in long lines at gas stations, or were even limited to buying gas only on certain days. The price of crude oil in the United States continued to rise until at its peak in 1979 a barrel of crude oil cost over ten times as much as it had in 1973.
This crisis brought increased attention to two areas. First, the oil price shock made it clear how closely national economies are tied to each other. While many previous theories had neglected to take into account international linkages, these now became more prominent in macroeconomic thinking. Second, while Keynes had led the field into paying attention to aggregate demand, this “supply shock” encouraged economists to think more about the supply side of the economy—the resources and technology that allow production to occur.
Macroeconomics for the 21st Century
While issues of economic growth and the business cycle preoccupied macroeconomic thinking for generations, once again, in the 21st century, new developments are demanding new ways of looking at the economic world.
First, the environmental impact of long-term, fossil-fuel-based economic growth is becoming increasingly a topic of economic, social, and political concern. Most previous theories assumed that resources and the capacity of the environment to absorb the by-products of economic growth were essentially unlimited—or at least that continued developments in technology would keep problems of depletion and pollution at bay. This is increasingly questioned as the scale of human economic activity grows larger.
The growth in global gross domestic product (GDP) shown in Figure 1 illustrates an impressive human ability to increase production. The growth in global atmospheric carbon dioxide (CO2) illustrated in Figure 2 is equally impressive, but more sobering, as it shows the human ability to affect our environment significantly – sometimes in dangerous ways. Carbon dioxide is released in fossil-fuel-burning industrial production, transportation, and heating, and more is released the more such production takes place. Deforestation also contributes to increases in atmospheric CO2. Carbon dioxide is the main gas involved in global climate change, a problem that scientists say is already starting to cause floods and droughts and irreversible disturbances to ecosystems.
Unless slowed or reversed, within the next 20 years we can expect to see increasingly dramatic disturbances to agriculture, disruptions in water supply, and an expansion of the reach of tropical diseases. How national and international economic environments can be made ecologically sustainable, while keeping employment and standards of living high, is rising in prominence as a macroeconomic issue. New thinking about the relation between production and living standards, and about the quality of our working lives, will likely be central to these discussions.
Second, the persistence of substantial global poverty has called into question the appropriateness of traditional ideas about economic development. Questions of what, how and for whom—rather than just “how much”—are becoming increasingly important in evaluating the effect of economic activity on human well-being. The lopsided global distribution of resources, disparities in power, war and peace, and global institutions of trade and finance will become increasingly important issues as economists continue to participate in the humanitarian attempt to increase human well-being on a global scale.
- Global Development And Environment Institute, Tufts University
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