Keynes’ General Theory and Macroeconomics
Macroeconomics refers to a study of the economy in terms of the total income earned, and the total amount of services and goods produced; the behavior as well as changes in prices, and the degree of utilization of productive resources (White 2009). As a result, it can be utilized in analyzing the effect of policy goals, such as price stability, economic growth, and an achievement of a viable balance of payments. It is believed that different schools of thought of macroeconomics have originated from various interpretations of a general theory. It has been found by John Maynard Keynes. According to early theorists, monetary factors could not affect the real ones, including a real output. Keynes directly attacked some of the classical theories of early theorists. He composed a general theory (Taylor & Taylor 2009). Keynes' general theory has defined the entire economy in terms of combinations instead of respective microeconomic components. While trying to explain recessions and unemployment, Keynes recognized the tendency of businesses and people to avoid investment as well as hoard cash during the recession.
Origin of Macroeconomics
It is important to first discuss an origin of macroeconomics since it provides the basic interpretations used in the creation of various schools of thought of macroeconomics. A macroeconomic theory originates from two research areas that include a monetary theory and a business cycle (Snowdon & Vane 2005).
The monetary theory can be dated back to the sixteenth century. The association between an output and a price level had been initially interpreted in terms of the quantity of money. The theories of quantity or money viewed the entire economy through Say's law. It stated that everything supplied to the market was sold (Snowdon & Vane 2002). This has implied that markets clear everything. From this view, money seems to be neutral. It cannot have an effect on the real factors in the economy, such as output levels. According to Burda and Wyplosz (2012), this agrees with the classical dichotomy interpretation, which holds that the nominal factors, including the money supply and price levels. The real aspects of the economy can be viewed to be independent from each other. For instance, injecting more money into the economy would be anticipated to increase prices, and not to create more goods.
The theories of the money quantity were popular before the 1930s. Two versions of this theory were specifically influential (Burda & Wyplosz 2012). One of them was the purchasing power of money, developed by Irving Fisher in 1911. Cambridge economists have created the other one in the early 20th century (Screpanti & Zamagni 2005). The theory of purchasing power of money is expressed by holding the money velocity (V) and a real income (Q) constant while allowing the price level (P) and money supply (M) to be variables in the exchange equation. This can be written as M × V = P × Q (Snowdon & Vane 2005).
Keynes, the father of general theory, began attacking the assumptions of this theory. Keynes and others have developed a Cambridge cash-balance theory that studies money demand and how it affected the economy. This theory did not presume that the supply and demand of money were always at equilibrium (Krugman 2009). Keynes and other Cambridge economists took steps toward a theory of liquidity preference. These economists argued that individuals hold money for two major reasons: to maintain liquidity and to facilitate transactions. Keynes later added the third motive for holding money, which is speculation. Keynes used the liquidity preference theory and this third motive to create the general theory that would be interpreted differently to form various schools of thought of macroeconomics.
On the other hand, a business cycle theory can be dated back to the mid-nineteenth century, when economics tried explaining the cycles of frequent and violent changes in economic activities (Snowdon & Vane 2002). These interpretations marked the commencement of a boom in the statistical economic fluctuation models. They have resulted in the discovery of the clearly regular economic patterns, such as Kuznets wave. Other economists focusing more on the theory interpreted a business cycle as a single factor, such as an effect of weather on agricultural economics or monetary policies. Despite being established by the 1920s, it had a little effect on the public policy. The partial equilibrium theories were unable to capture the general equilibrium, where markets were interacting with each other. In fact, early theorists of the business cycle interpreted the financial markets and goods markets separately (Snowdon & Vane 2005).
Keynes' General Theory
As mentioned above, Keynes extrapolated a concept of liquidity preference in order to develop a general theory concerning how the economy works. The general theory brought together both real economic and monetary factors (Burda & Wyplosz 2012). Except for explaining unemployment, the general theory also has suggested policies that can be used in achieving economic stability.
Keynes has found out that economic and money velocity has a positive correlation (Snowdon & Vane 2005). According to Keynes, people tend to increase their money holdings in times of the economic crisis by decreasing their spending. This further slows the economy. This implies that the individuals attempt to survive through a downturn only worsens the economic crisis. Money velocity slows, especially when the demand for the money goes up. A decrease in economic activities implies that markets might not have the ability to clear the goods supplied. This results in an excess supply. Keynes has suggested that changes in the market shift quantities instead of prices. This has replaced the presumption of stable velocity with one of a fixed price-level (Snowdon & Vane 2005).
According to Krugman (2009), classical economic theories had a problem interpreting the involuntary unemployment recessions. This is because classical economists have used Say's Law in the labor market and anticipated that everyone would be willing to work at the prevailing wage rate. In the general theory, output and employment are driven by a combination of demand. It comprises of the investment and the sum of consumption. Because consumption is always stable, the majority of fluctuations in the aggregates demand brood from the investment that is driven by several factors, such as interest rates and expectations (Screpanti & Zamagni 2005). According to Keynes, a fiscal policy can pay off for this volatility. In times of economic downturns, the government can increase its spending in order to buy the excess goods and employ idle labor. In addition, an effect of multiplier raises the impact of this direct spending because the newly hired employees would spend their wages that is likely to infiltrate through the economy. On the other hand, firms are likely to react to a demand increase.
The prescriptions of the general theory had ties to Keynes' interest in uncertainty. According to the general theory, a strong fiscal policy and public investment would counter the negative effects of the uncertainty of the economic fluctuations might have on the economy. Whereas the various interpretations of the general theory have paid a little attention to the probabilistic aspect of Keynes' work, uncertainty might have played a key role in liquidity preference (Taylor & Taylor 2009).
Interpretations of the General Theory by Other Economists
An accurate meaning of the general theory has been debated leading to different interpretations and schools of thought among economists. Even the prescription for unemployment by the general theory has been a subject of debates (Burda & Wyplosz 2012). Scholars and economists have debated whether Keynes' general theory intended to be a significant shift in the policy to address serious problems, or relatively a conservative solution for addressing minor economic issues. Various schools of thoughts debated the accurate mechanisms, formulations, and effects of a Keynesian model. Economic theorists such as Robert Lucas Jr. argued that at least certain Keynesian macroeconomic models were dubious (Screpanti & Zamagni 2005). This is because they were not consequential of the assumptions concerning individual behavior. The interpretation of the general theory has resulted in the alternative schools of thought in macroeconomics. They include monetarism, the new classical, new Keynesian, neoclassical and Austrian schools. There are other economic schools of thoughts, such as classical and Keynesian. However, they were not the outcome of the interpretation of the general theory. The classical school of macroeconomics is the one that claims those markets. This school had been established before Keynes' general theory. In fact, Keynes attacked and modified the classical school of economics to create the general theory (Screpanti & Zamagni 2005).
The monetarist school of macroeconomics is often credited to the works of Milton Friedman. Milton developed an alternative to Keynesian macroeconomics and eventually labeled it as the monetarist. This school of macroeconomics strongly believes that the responsibility of the government is to regulate inflation by regulating the supply of money (Krugman 2009). After their own interpretation of the general theory, monetary economists believed that markets were essentially clear, and participants have rational expectations. They strongly dejected Keynesian's claim that governments can control demand. Those attempts to do so are destabilizing (Screpanti & Zamagni 2005). This implies that fine-tuning via monetary and fiscal policy is counterproductive, according to monetarist economists.
The school of monetarism gained prominence during the late 1970s and 1980s. By the 1970s, major central banks had largely adopted the monetarist policy of targeting the supply of money rather than interest rates when setting a policy (Burda & Wyplosz 2012). Nevertheless, monetarist economics makes the targeting of monetary aggregates difficult of central banks due to measurement difficulties (Sachs 2009).
This school of macroeconomics tried adding other macroeconomic foundations to the traditional general economic theories (Screpanti & Zamagni 2005). Whereas this school of thought does not acknowledge that firms and households operate based on rational expectations, it still maintains that there are various failures in the markets, such as sticky wages and prices. Due to this, the government can enhance macroeconomic conditions via the monetary and fiscal policy (Sachs 2009). Economists of the school frequently have developed models with rational expectations.
This school macroeconomics presumes that people have rational anticipations and struggle to maximize their satisfaction. According to Sachs (2009), the neoclassical school of macroeconomics assumes that people act self-sufficiently based on all the information they have concerning a product or service. The neoclassical interpretation of the general theory has created an idea of marginalism and maximization of marginal utility as well as the concept that economic agents act based on rational expectations. Because these economists strongly believe that the market is often in equilibrium, macroeconomics focuses on the influence of the supply of money on price levels and the growth of supply factors (Krugman 2009).
This macroeconomic school is built on a neoclassical school. It emphasizes the significance of models and microeconomics based on that behavior. Screpanti and Zamagni (2005) have cited that the new classical school presumes that all economic agents attempt to maximize their satisfaction and have rational expectations. In addition, similar to the classical school, they also believe that the market clears. With regard to unemployment, this school of macroeconomics believes that unemployment is majorly voluntary and with the discretionary fiscal policy. Though the monetary policy, inflation can be regulated.
This school is relatively old in the field of economics that is looking at some renaissance in popularity. According to Snowdon and Vane (2002), this school of macroeconomics believes that the behavior of human beings is too characteristic to be modeled precisely with mathematics. The minimal intervention by the government in the private sector is the best one. As a result, this school has provided very useful explanations and theories on the business cycle, the significance of opportunity and time costs in determination of consumption and value as well as some implications of capital intensity.
Macroeconomics can be utilized in analyzing the effect of policy goals, such as price stability, economic growth, and the achievement of a viable balance of payments. A macroeconomic theory originates from two research areas that include a monetary theory and a business cycle. With regard to the monetary theory, the association between an output and a price level has been initially interpreted in terms of the quantity of money. Keynes has used the liquidity preference theory, and this third motive to create the general theory that would be interpreted differently to form various schools of thought of macroeconomics. The interpretation of the general theory has resulted in the alternative schools of thought in macroeconomics, which include monetarism, the new classical, new Keynesian, neoclassical, and Austrian schools. Monetarism school of macroeconomics strongly believes that the responsibility of the government is to regulate inflation by regulating the supply of money. New Keynesian school of macroeconomics has tried adding other macroeconomic foundations to the traditional general economic theories. The new classical school emphasizes the significance of models and microeconomics based on that behavior.