New Macroeconomics

Apek Mulay

• Publisher: Business Expert Press
• Year: 2018
• ISBN:
  9781947441132
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

According to the National Bureau of Economic Research (NBER), a deep recession started in the United States in December 2007 and ended in June 2009. However, most people recognize that even though the recession was said to be over, its after-effects lingered well into the next decade, and even in 2017, some ten years later, governments in America and around the world were struggling with problems of low growth, wage stagnation and high poverty. Most economists were caught off guard, and they began to look for new ideas that may be appropriately called NEW MACROECONOMICS. This book examines conventional economics in the context of recent developments. It shows that a new theory, known as the wage-productivity model, explains almost every macro-economic experience of the global economy since 1980. You have to read this theory to believe it. This theory will turn out to be more important than the Keynesian revolution.

CHAPTER 1

Introduction

When John Maynard Keynes wrote his masterpiece, The General Theory of Employment, Interest and Money, in 1936, macroeconomics was dominated by a belief in laissez-faire, that is, the government should keep its hands off the economy. The subject of macroeconomics is quite old and we can find a discussion of what creates prosperity and a higher living standard in ideas offered as long ago as the third century BC. According to Navin Doshi, an engineer-cum-economist, economics, especially macroeconomics,

has an ancient history. In the West, especially Greece, it was first propounded by the likes of Plato and Aristotle. In India, it was offered by Kautilya.

(Economics and Nature: Essays in Balance, Complementarity and Harmony, p. 10)

Many economists regard Keynes as the most influential economist who founded modern macroeconomics. Yet, Kautilya, the author of Arthshastra, meaning the science of wealth, anticipated Keynes in many ways. Kautilya, the prime minister of a vast Mauryan empire, was a contemporary of Alexander the Great. He argued that the king should actively manage the economy and offer tax relief during bad economic times. In this way he anticipated what Keynes argued much later in his General Theory. I don’t intend to downgrade Keynes’ influence and contribution to economic thought. I just want to say that Keynes, who spent a few years as an officer of Her Majesty’s Government in India, was not the first to offer ideas about fiscal policy.

In 1936, Keynes looked around and found a world in the middle of the worst depression in history. He wanted to do something about it, but conventional ideas stood in the way, because they were in favor of laissez-faire, which calls for no government intervention at all. However, Keynes persisted, met with several world leaders, and after World War II his theories were largely accepted by economists.

1.1 The Concept of Equilibrium

Keynes began with the concept of equilibrium in macroeconomics. Although equilibrium was a well-known concept in microeconomics, it had a special meaning in macroeconomics, which Keynes emphasized. In microeconomics, equilibrium generally refers to a balance between supply and demand for a certain product. For instance, the automobile market is said to be in equilibrium when demand for autos meets the supply, or the market for wheat is in equilibrium, when quantity of wheat demanded equals the quantity of wheat supplied.

Thus, in a single market, the concept of equilibrium is simple, but this is not the case in macroeconomics where we need to look at the economy as a whole, or all the markets in which consumers and producers are interested. The consumers generate demand and the producers generate supply. But how do we measure macro demand for consumption goods, because they are offered in different units. For example, the autos are described in terms of numbers, whereas wheat is described in terms of the bushels of production and consumption. The difficulty arises because how do we add apples to bananas and come up with an aggregate measure.

There is, however, a simple way to describe macro demand and supply. Macro demand, sometimes called aggregate demand, is in terms of money spent on various consumption and investment goods during a year; similarly, macro supply, also called aggregate supply, can be described as revenue or the money value of the production of these goods in 1 year. In theory, we look at the purchasing power of spending and business revenue, but in terms of practical economic policy, it is the money spent by consumers and investors and the money earned by producers that describe aggregate demand and supply.

Consumption goods are those that are in demand by consumers, and investment goods are those in demand by investors engaged in the process of production. Food, clothing, shelter, education, healthcare, and so on, are considered consumption goods and services, whereas office buildings, machines, and new homes are considered investment goods. So, the money spent on these goods is the major part of macro demand. But there are others who also spend money on such goods. For instance, the government at the federal and state levels buys such products too. So, government purchases are also included in aggregate demand. Foreigners also buy a nation’s products. So, the value of exports is part of macro demand, but Americans spend money on foreign goods, so we need to subtract the value of imports from the total. Thus, aggregate demand (AD) may be written as:

AD = Consumer spending + Investment spending + Government spending + Exports – Imports.

Aggregate supply (AS), on the other hand, is the value of a nation’s production of consumption and investment goods during a year, that is,

AS = Revenue of firms producing such goods.

AS is sometimes called gross domestic product (GDP), but it is measured by estimating aggregate spending on domestically produced goods.

When Keynes wrote his book, the government spending and tax revenues were relatively small; so, he initially ignored these items and began his analysis by noting that

AD = Consumption (C) + Investment (I)

Since all production becomes somebody’s income, he wrote AS as,

AS = Aggregate income = Consumption (C) + Saving (S)

In order to understand this idea, let us see how we spend our income. It goes either into consumption or paying taxes, while the rest goes into savings. But since he started his analysis by assuming that tax revenue was unimportant, he wrote

AS = Consumption + Saving

In equilibrium, macro demand equals aggregate supply, or

Consumption + Saving = Consumption + Investment

And from this

Saving = Investment

in equilibrium. It should be clear by now that macro-equilibrium concept is different from the micro concept. When

AD = AS, Saving = Investment

This is how Keynes started his analysis.

In a global economy setting, where both foreign trade and the government sectors are prominent in almost all nations and should not be excluded from analysis, the concept of macro demand includes government spending and the trade deficit or surplus. In terms of symbols,

AD = C + I + G + X − M

where C is spending by consumers, I equals spending by investors, G is government spending, X stands for the value of exports, and M for the value of imports. Aggregate income now includes payment for taxes, so that

AS = GDP = Aggregate Income = C + S + T

where S stands for a nation’s level of saving and T for its tax revenue. With AD = AS in equilibrium,

C + I + G + X – M = C + S + T,

which means that

I + G + X = S + T + M.

The left-hand side of this equation is usually described as injections, because each of its components is an addition to national spending, whereas the right-hand side is known as leakages, because its components are subtractions from the nation’s spending. Thus, in macro equilibrium, when demand equals supply, leakages equal injections. It should be clear that macro equilibrium is more complex than micro equilibrium, where equilibrium simply means a balance between demand and supply and where the producer sells all its production. The micro concept is also valid in the macro area, but the macro economy also refers to some ideas not relevant in the micro setting.

1.2 A Balanced Economy

In a balanced economy, the equilibrium of a global economy becomes the same as the one Keynes first used. The concept of a balanced economy has been introduced by economist Professor Ravi Batra, who describes it as one where foreign trade and the budget deficit are in balance. Thus, when

X = M and G = T,

so that the nation has no trade deficit and no budget deficit, then its economy is in balance. It should be clear from the leakage–injection equation that in a balanced economy X cancels out with M and G cancels out with T, so that

S = I.

Of course, there is hardly any nation today with a balanced economy. Most nations have massive ongoing budget deficits, while some have huge trade surpluses or deficits. Thus, the global economy faces vast imbalances that contribute to economic stagnation.

It should be noted that all these equilibrium concepts apply to almost all macro theories, including old as well as the new. Classical theories and Keynesian theories have at least this notion in common. They all use the same equilibrium conditions.

1.3 Classical Economics

Classical economics began when Adam Smith wrote his masterpiece, An Enquiry into the Nature and Causes of the Wealth of Nations. He did this in 1776, the same year when some colonies of America joined hands and declared independence from England. It turns out that the United States became a prosperous nation with the help of an economic system that Smith had described as ideal. So, it is more than a coincidence that Smith’s book and American independence occurred in the same year.

Although Smith’s book dealt mostly with micro concepts, he also touched upon some macro ideas that apply to the economy. He invented the idea of an invisible hand, which may be described as keen competition among firms in any industry. He assumed that people are generally self-interested and greedy, but this nature helps generate an efficient economy that raises economic growth and the general standard of living. For instance, facing keen competition from other firms, each producer has to offer high-quality products and sell them at reasonable prices to induce people to buy them. Otherwise a business loses customers and is stuck with unsold goods that generate losses. Thus, it is self-interest that makes a firm efficient.

Consumers too have a self-interest in buying high-quality goods at lowest prices, and this makes the companies efficient. Workers too have a self-interest in finding good jobs. They have to obtain the best training and work harder to earn a higher wage. Thus, self-interest or greed is good at all levels of the economy. We should not denounce greed, but we should denounce economic policies that reduce competition among businessmen, because without keen competition, firms will offer shoddy products and charge higher prices. People will generally suffer and the low level of competition will cause inflation that reduces real wages and hence the living standard. Thus, Smith criticized government policies that limited the number of firms in various industries.

Two quotes from Smith summarize his views. In the Theory Of Moral Sentiments, Smith wrote:

Every individual . . . neither intends to promote the public interest, nor knows how much he is promoting it . . . he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. (p. 184–85)

In his most famous book The Wealth Of Nations, Smith wrote:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages. (p. 456)

During the 18th century, when Adam Smith wrote his book, religion had a strong influence on people’s thinking. Self-interest and greed were not openly espoused because of the fear that they would create crime and anarchy. Smith’s thought was revolutionary as he challenged conventional views that had prevailed since the sixth century, when the Catholic Church came to dominate people’s thinking and lifestyle. But Smith argued that everyone’s self-interest ensures that high-quality goods and services are produced at the lowest possible price, provided there is a strong competition among firms as well as workers. In this way, Smith denounced state monopolies and laborers’ guilds that in those days restrained competition among businesses and employees.

According to Smith, the government should restrict its activity to national defense, law and order, and the provision of adequate infrastructure. In other words, the state should not engage in the management of the economy.

1.4 Development of Classical Economics

Smith laid the foundation of an economic framework that today is known as “classical economics,” and after its popularity, some other writers developed it further in other areas. The most well-known among them was a French economist named Jean-Baptiste Say. He offered what we now know as Say’s law of markets that asserts that supply creates its own demand. This is a simple statement but with far-reaching consequences. Normally, supply and demand are equal only in equilibrium, but according to Say’s law they are always equal because when supply creates its own demand, a company is able to sell all its production, so that it remains profitable. Furthermore, the law argues that there are never layoffs, because layoffs occur only when a business has unsold goods, which are ruled out by the law.

In order to prove such a strong statement, Say assumed the existence of a barter economy where there is no money, and goods exchange for goods. Let us suppose that a family starts a furniture-producing business and builds chairs. Since there is no money in the economy, it can offer only chairs to buy goods from other families. It will then build enough chairs to meet its own needs of chairs and other goods. For instance, suppose it builds 100 chairs of which 10 chairs are for its own needs and the other 90 are exchanged for goods produced by other families. Thus, the family’s total production of 100 chairs represents its total demand for all goods it needs. Thus, the family’s supply equals its own demand. If the argument is extended to all the families, their supplies equal their demands. Thus, aggregate supply equals aggregate demand.

Say’s law also argues that there is no need for the government intervention in the economy, because when supply equals demand, there are no layoffs or unemployment that might require the state’s attention and intervention. Say thus made...