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Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of
economics Economics () is the social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics analy ...
dealing with performance, structure, behavior, and decision-making of an
economy An economy is an area of the production, distribution and trade, as well as consumption of goods and services. In general, it is defined as a social domain that emphasize the practices, discourses, and material expressions associated with t ...
as a whole. For example, using interest rates, taxes, and government spending to regulate an economy's growth and stability. This includes regional, national, and global economies. According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism." Macroeconomists study topics such as GDP (Gross Domestic Product),
unemployment Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work during the refer ...
(including unemployment rates),
national income A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), gross national product (GNP), net national income (NNI), and adjusted nat ...
, price indices,
output Output may refer to: * The information produced by a computer, see Input/output * An output state of a system, see state (computer science) * Output (economics), the amount of goods and services produced ** Gross output in economics, the value ...
, consumption,
inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
,
saving Saving is income not spent, or deferred consumption. Methods of saving include putting money aside in, for example, a deposit account, a pension account, an investment fund, or as cash. Saving also involves reducing expenditures, such as recur ...
, investment,
energy In physics, energy (from Ancient Greek: ἐνέργεια, ''enérgeia'', “activity”) is the quantitative property that is transferred to a body or to a physical system, recognizable in the performance of work and in the form of hea ...
,
international trade International trade is the exchange of capital, goods, and services across international borders or territories because there is a need or want of goods or services. (see: World economy) In most countries, such trade represents a significan ...
, and
international finance International finance (also referred to as international monetary economics or international macroeconomics) is the branch of financial economics broadly concerned with monetary and macroeconomic interrelations between two or more countries. In ...
. Macroeconomics and microeconomics are the two most general fields in economics. The United Nations
Sustainable Development Goal 17 Sustainable Development Goal 17 (SDG 17 or Global Goal 17) is about "partnerships for the goals." One of the 17 Sustainable Development Goals established by the United Nations in 2015, the official wording is: "Strengthen the means of implement ...
has a target to enhance global macroeconomic stability through policy coordination and coherence as part of the 2030 Agenda.


Development


Origins

Macroeconomics descended from the once divided fields of business cycle theory and
monetary theory Monetary economics is the branch of economics that studies the different competing theories of money: it provides a framework for analyzing money and considers its functions (such as medium of exchange, store of value and unit of account), and ...
.Dimand (2008). The
quantity theory of money In monetary economics, the quantity theory of money (often abbreviated QTM) is one of the directions of Western economic thought that emerged in the 16th-17th centuries. The QTM states that the general price level of goods and services is directl ...
was particularly influential prior to World War II. It took many forms, including the version based on the work of Irving Fisher: :M\cdot V = P\cdot Q In the typical view of the quantity theory,
money velocity image:M3 Velocity in the US.png, 300px, Similar chart showing the logged velocity (green) of a broader measure of money M3 that covers M2 plus large institutional deposits. The US no longer publishes official M3 measures, so the chart only runs thr ...
(V) and the quantity of goods produced (Q) would be constant, so any increase in
money supply In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include Circulation (curren ...
(M) would lead to a direct increase in
price level The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set. ...
(P). The quantity theory of money was a central part of the classical theory of the economy that prevailed in the early twentieth century.


Austrian School

Ludwig Von Mises Ludwig Heinrich Edler von Mises (; 29 September 1881 – 10 October 1973) was an Austrian School economist, historian, logician, and sociologist. Mises wrote and lectured extensively on the societal contributions of classical liberalism. He is ...
's work ''
Theory of Money and Credit ''The Theory of Money and Credit'' is a 1912 economics book written by Ludwig von Mises, originally published in German as ''Theorie des Geldes und der Umlaufsmittel''. In it Mises expounds on his theory of the origins of money through his regre ...
'', published in 1912, was one of the first books from the
Austrian School The Austrian School is a heterodox school of economic thought that advocates strict adherence to methodological individualism, the concept that social phenomena result exclusively from the motivations and actions of individuals. Austrian scho ...
to deal with macroeconomic topics.


Keynes and his followers

Macroeconomics, at least in its modern form,Blanchard (2011), 580. began with the publication of ''
General Theory of Employment, Interest and Money ''The General Theory of Employment, Interest and Money'' is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory an ...
'' written by
John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...
. When the Great Depression struck, classical economists had difficulty explaining how goods could go unsold and workers could be left unemployed. In classical theory, prices and wages would drop until the market cleared, and all goods and labor were sold. Keynes offered a new theory of economics that explained why markets might not clear, which would evolve (later in the 20th century) into a group of macroeconomic schools of thought known as
Keynesian economics Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output ...
– also called Keynesianism or Keynesian theory. In Keynes' theory, the quantity theory broke down because people and businesses tend to hold on to their cash in tough economic times – a phenomenon he described in terms of liquidity preferences. Keynes also explained how the multiplier effect would magnify a small decrease in consumption or investment and cause declines throughout the economy. Keynes also noted the role uncertainty and animal spirits can play in the economy. The generation following Keynes combined the macroeconomics of the ''General Theory'' with neoclassical microeconomics to create the
neoclassical synthesis The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a neoclassical economics academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Ke ...
. By the 1950s, most economists had accepted the synthesis view of the macroeconomy. Economists like
Paul Samuelson Paul Anthony Samuelson (May 15, 1915 – December 13, 2009) was an American economist who was the first American to win the Nobel Memorial Prize in Economic Sciences. When awarding the prize in 1970, the Swedish Royal Academies stated that he "h ...
,
Franco Modigliani Franco Modigliani (18 June 1918 – 25 September 2003) was an Italian-American economist and the recipient of the 1985 Nobel Memorial Prize in Economics. He was a professor at University of Illinois at Urbana–Champaign, Carnegie Mellon Univ ...
,
James Tobin James Tobin (March 5, 1918 – March 11, 2002) was an American economist who served on the Council of Economic Advisers and consulted with the Board of Governors of the Federal Reserve System, and taught at Harvard and Yale Universities. He d ...
, and
Robert Solow Robert Merton Solow, GCIH (; born August 23, 1924) is an American economist whose work on the theory of economic growth culminated in the exogenous growth model named after him. He is currently Emeritus Institute Professor of Economics at th ...
developed formal Keynesian models and contributed formal theories of consumption, investment, and money demand that fleshed out the Keynesian framework.


Monetarism

Milton Friedman Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
updated the quantity theory of money to include a role for money demand. He argued that the role of money in the economy was sufficient to explain the Great Depression, and that aggregate demand oriented explanations were not necessary. Friedman also argued that monetary policy was more effective than fiscal policy; however, Friedman doubted the government's ability to "fine-tune" the economy with monetary policy. He generally favored a policy of steady growth in money supply instead of frequent intervention. Friedman also challenged the
Phillips curve The Phillips curve is an economic model, named after William Phillips (economist), William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did no ...
relationship between inflation and unemployment. Friedman and Edmund Phelps (who was not a monetarist) proposed an "augmented" version of the Phillips curve that excluded the possibility of a stable, long-run tradeoff between inflation and unemployment. When the oil shocks of the 1970s created a high unemployment and high inflation, Friedman and Phelps were vindicated. Monetarism was particularly influential in the early 1980s. Monetarism fell out of favor when central banks found it difficult to target money supply instead of interest rates as monetarists recommended. Monetarism also became politically unpopular when the central banks created recessions in order to slow inflation.


New classical

New classical macroeconomics New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundat ...
further challenged the Keynesian school. A central development in new classical thought came when Robert Lucas introduced
rational expectations In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" and on average take the model's predictions as valid. Rational expectations ensure internal consistency in ...
to macroeconomics. Prior to Lucas, economists had generally used adaptive expectations where agents were assumed to look at the recent past to make expectations about the future. Under rational expectations, agents are assumed to be more sophisticated. A consumer will not simply assume a 2% inflation rate just because that has been the average the past few years; they will look at current monetary policy and economic conditions to make an informed forecast. When new classical economists introduced rational expectations into their models, they showed that monetary policy could only have a limited impact. Lucas also made an influential critique of Keynesian empirical models. He argued that forecasting models based on empirical relationships would keep producing the same predictions even as the underlying model generating the data changed. He advocated models based on fundamental economic theory that would, in principle, be structurally accurate as economies changed. Following Lucas's critique, new classical economists, led by
Edward C. Prescott Edward Christian Prescott (December 26, 1940 – November 6, 2022) was an American economist. He received the Nobel Memorial Prize in Economics in 2004, sharing the award with Finn E. Kydland, "for their contributions to dynamic macroeconomics: ...
and Finn E. Kydland, created real business cycle (RB C) models of the macro economy.Blanchard (2011), 587. RB C models were created by combining fundamental equations from neo-classical microeconomics. In order to generate macroeconomic fluctuations, RB C models explained recessions and unemployment with changes in technology instead of changes in the markets for goods or money. Critics of RB C models argue that money clearly plays an important role in the economy, and the idea that technological regress can explain recent recessions is implausible. However, technological shocks are only the more prominent of a myriad of possible shocks to the system that can be modeled. Despite questions about the theory behind RB C models, they have clearly been influential in economic methodology.


New Keynesian response

New Keynesian economists responded to the new classical school by adopting rational expectations and focusing on developing micro-founded models that are immune to the Lucas critique.
Stanley Fischer Stanley Fischer ( he, סטנלי פישר; born October 15, 1943) is an Israeli American economist who served as the 20th Vice Chair of the Federal Reserve from 2014 to 2017. Fisher previously served as the 8th governor of the Bank of Israel ...
and John B. Taylor produced early work in this area by showing that monetary policy could be effective even in models with rational expectations when contracts locked in wages for workers. Other new Keynesian economists, including Olivier Blanchard, Julio Rotemberg,
Greg Mankiw Nicholas Gregory Mankiw (; born February 3, 1958) is an American macroeconomist who is currently the Robert M. Beren Professor of Economics at Harvard University. Mankiw is best known in academia for his work on New Keynesian economics. Mankiw ...
,
David Romer David Hibbard Romer (born March 13, 1958) is an American economist, the Herman Royer Professor of Political Economy at the University of California, Berkeley, and the author of a standard textbook in graduate macroeconomics as well as many infl ...
, and Michael Woodford, expanded on this work and demonstrated other cases where inflexible prices and wages led to monetary and fiscal policy having real effects. Like classical models, new classical models had assumed that prices would be able to adjust perfectly and monetary policy would only lead to price changes. New Keynesian models investigated sources of sticky prices and wages due to
imperfect competition In economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfil all the necessary conditions of a perfectly competitive market. Imperfect competition will cause market inefficiency when it hap ...
, which would not adjust, allowing monetary policy to impact quantities instead of prices. By the late 1990s, economists had reached a rough consensus. The nominal rigidity of new Keynesian theory was combined with rational expectations and the RBC methodology to produce dynamic stochastic general equilibrium (DSGE) models. The fusion of elements from different schools of thought has been dubbed the new neoclassical synthesis. These models are now used by many central banks and are a core part of contemporary macroeconomics. New Keynesian economics, which developed partly in response to new classical economics, strives to provide microeconomic foundations to Keynesian economics by showing how imperfect markets can justify demand management.


Macroeconomic models


Aggregate demand–aggregate supply

The AD-AS model has become the standard textbook model for explaining the macroeconomy. This model shows the price level and level of real output given the equilibrium in aggregate demand and aggregate supply. The aggregate demand curve's downward slope means that more output is demanded at lower price levels. The downward slope is the result of three effects: the Pigou or real balance effect, which states that as real prices fall, real wealth increases, resulting in higher consumer demand of goods; the Keynes or interest rate effect, which states that as prices fall, the demand for money decreases, causing interest rates to decline and borrowing for investment and consumption to increase; and the net export effect, which states that as prices rise, domestic goods become comparatively more expensive to foreign consumers, leading to a decline in exports. In the conventional Keynesian use of the AS-AD model, the aggregate supply curve is horizontal at low levels of output and becomes inelastic near the point of potential output, which corresponds with
full employment Full employment is a situation in which there is no cyclical or deficient-demand unemployment. Full employment does not entail the disappearance of all unemployment, as other kinds of unemployment, namely structural and frictional, may remain. Fo ...
. Since the economy cannot produce beyond the potential output, any AD expansion will lead to higher price levels instead of higher output. The AD–AS diagram can model a variety of macroeconomic phenomena, including inflation. Changes in the non-price level factors or determinants cause changes in aggregate demand and shifts of the entire aggregate demand (AD) curve. When demand for goods exceeds supply, there is an inflationary gap where demand-pull inflation occurs and the AD curve shifts upward to a higher price level. When the economy faces higher costs, cost-push inflation occurs and the AS curve shifts upward to higher price levels. The AS–AD diagram is also widely used as an instructive tool to model the effects of various macroeconomic policies.


IS-LM

The IS–LM model gives the underpinnings of aggregate demand (itself discussed above). It answers the question "At any given price level, what is the quantity of goods demanded?". This model shows what combination of interest rates and output will ensure equilibrium in both the goods and money markets. The goods market is modeled as giving equality between investment and public and private saving (IS), and the money market is modeled as giving equilibrium between the money supply and liquidity preference. The IS curve consists of the points (combinations of income and interest rate) where investment, given the interest rate, is equal to public and private saving, given output The IS curve is downward sloping because output and the interest rate have an inverse relationship in the goods market: as output increases, more income is saved, which means interest rates must be lower to spur enough investment to match saving. The LM curve is upward sloping because the interest rate and output have a positive relationship in the money market: as income (identically equal to output) increases, the demand for money increases, resulting in a rise in the interest rate in order to just offset the incipient rise in money demand. The IS-LM model is often used to demonstrate the effects of monetary and fiscal policy. Textbooks frequently use the IS-LM model, but it does not feature the complexities of most modern macroeconomic models. Nevertheless, these models still feature similar relationships to those in IS-LM.


Growth models

The
neoclassical growth model Neoclassical or neo-classical may refer to: * Neoclassicism or New Classicism, any of a number of movements in the fine arts, literature, theatre, music, language, and architecture beginning in the 17th century ** Neoclassical architecture, an a ...
of
Robert Solow Robert Merton Solow, GCIH (; born August 23, 1924) is an American economist whose work on the theory of economic growth culminated in the exogenous growth model named after him. He is currently Emeritus Institute Professor of Economics at th ...
has become a common textbook model for explaining economic growth in the long-run. The model begins with a
production function In economics, a production function gives the technological relation between quantities of physical inputs and quantities of output of goods. The production function is one of the key concepts of mainstream neoclassical theories, used to define ...
where national output is the product of two inputs: capital and labor. The Solow model assumes that labor and capital are used at constant rates without the fluctuations in unemployment and capital utilization commonly seen in business cycles. An increase in output, or economic growth, can only occur because of an increase in the capital stock, a larger population, or technological advancements that lead to higher productivity (
total factor productivity In economics, total-factor productivity (TFP), also called multi-factor productivity, is usually measured as the ratio of aggregate output (e.g., GDP) to aggregate inputs. Under some simplifying assumptions about the production technology, growt ...
). An increase in the savings rate leads to a temporary increase as the economy creates more capital, which adds to output. However, eventually the depreciation rate will limit the expansion of capital: savings will be used up replacing depreciated capital, and no savings will remain to pay for an additional expansion in capital. Solow's model suggests that economic growth in terms of output per capita depends solely on technological advances that enhance productivity. In the 1980s and 1990s
endogenous growth theory Endogenous growth theory holds that economic growth is primarily the result of endogenous and not external forces. Endogenous growth theory holds that investment in human capital, innovation, and knowledge are significant contributors to econo ...
arose to challenge neoclassical growth theory. This group of models explains economic growth through other factors, such as increasing returns to scale for capital and learning-by-doing, that are endogenously determined instead of the exogenous technological improvement used to explain growth in Solow's model. The quantity theory by Russian economist Vladimir Pokrovskii explains growth as a consequence of the dynamics of three factors, among them capital service as one of independent production factors in line with labour and capital.Pokrovski, V.N. (2003). Energy in the theory of production. Energy 28, 769-788. Capital service as production factor was interpreted by Ayres and Warr as useful work of production equipment, which makes it possible to reproduce historical rates of economic growth with considerable precision Pokrovski, V.N. (2003). Energy in the theory of production. Energy 28, 769-788.. and without recourse to exogenous and unexplained technological progress, thereby overcoming the major flaw of the Solow theory of economic growth.


Humanity's economic system as a subsystem of the global environment

In the macroeconomic models in ecological economics, the economic system is a subsystem of the environment. In this model, the circular flow of income diagram is replaced in ecological economics by a more complex flow diagram reflecting the input of solar energy, which sustains natural inputs and environmental services which are then used as units of production. Once consumed, natural inputs pass out of the economy as pollution and waste. The potential of an environment to provide services and materials is referred to as an "environment's source function", and this function is depleted as resources are consumed or pollution contaminates the resources. The "sink function" describes an environment's ability to absorb and render harmless waste and pollution: when waste output exceeds the limit of the sink function, long-term damage occurs.Harris J. (2006). ''Environmental and Natural Resource Economics: A Contemporary Approach''. Houghton Mifflin Company. Some persistent pollutants, such as some organic pollutants and nuclear waste are absorbed very slowly or not at all; ecological economists emphasize minimizing "cumulative pollutants". Pollutants affect human health and the health of the ecosystem.


Basic macroeconomic concepts

Macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research. Macroeconomic theories usually relate the phenomena of output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also important to all economic agents including workers, consumers, and producers.


Output and income

National
output Output may refer to: * The information produced by a computer, see Input/output * An output state of a system, see state (computer science) * Output (economics), the amount of goods and services produced ** Gross output in economics, the value ...
is the total amount of everything a country produces in a given period of time. Everything that is produced and sold generates an equal amount of income. The total output of the economy is measured GDP per person. The output and income are usually considered equivalent and the two terms are often used interchangeably, output changes into income. Output can be measured or it can be viewed from the production side and measured as the total value of final goods and services or the sum of all
value added In business, total value added is calculated by tabulating the unit value added (measured by summing unit profit Price.html" ;"title="he difference between Price">sale price and production cost], unit depreciation cost, and unit Direct labor co ...
in the economy. Macroeconomic output is usually measured by
gross domestic product Gross domestic product (GDP) is a money, monetary Measurement in economics, measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjec ...
(GDP) or one of the other
national accounts National accounts or national account systems (NAS) are the implementation of complete and consistent accounting techniques for measuring the economic activity of a nation. These include detailed underlying measures that rely on double-entry ...
. Economists interested in long-run increases in output, study economic growth. Advances in technology, accumulation of machinery and other
capital Capital may refer to: Common uses * Capital city, a municipality of primary status ** List of national capital cities * Capital letter, an upper-case letter Economics and social sciences * Capital (economics), the durable produced goods used fo ...
, and better education and
human capital Human capital is a concept used by social scientists to designate personal attributes considered useful in the production process. It encompasses employee knowledge, skills, know-how, good health, and education. Human capital has a substanti ...
, are all factors that lead to increase economic output over time. However, output does not always increase consistently over time.
Business cycle Business cycles are intervals of expansion followed by recession in economic activity. These changes have implications for the welfare of the broad population as well as for private institutions. Typically business cycles are measured by exami ...
s can cause short-term drops in output called
recession In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
s. Economists look for macroeconomic policies that prevent economies from slipping into recessions, and that lead to faster long-term growth.


Unemployment

The amount of
unemployment Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work during the refer ...
in an economy is measured by the unemployment rate, i.e. the percentage of workers without jobs in the
labor force The workforce or labour force is a concept referring to the pool of human beings either in employment or in unemployment. It is generally used to describe those working for a single company or industry, but can also apply to a geographic r ...
. The unemployment rate in the labor force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded. Unemployment can be generally broken down into several types that are related to different causes. * Classical unemployment theory suggests that unemployment occurs when wages are too high for employers to be willing to hire more workers. Other more modern economic theories suggest that increased wages actually decrease unemployment by creating more consumer demand. According to these more recent theories, unemployment results from reduced demand for the goods and services produced through labor and suggest that only in markets where profit margins are very low, and in which the market will not bear a price increase of product or service, will higher wages result in unemployment. * Consistent with classical unemployment theory,
frictional unemployment Frictional unemployment is a form of unemployment reflecting the gap between someone voluntarily leaving a job and finding another. As such, it is sometimes called search unemployment, though it also includes gaps in employment when transferring ...
occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment. *
Structural unemployment Structural unemployment is a form of involuntary unemployment caused by a mismatch between the skills that workers in the economy can offer, and the skills demanded of workers by employers (also known as the skills gap). Structural unemployment i ...
covers a variety of possible causes of unemployment including a mismatch between workers' skills and the skills required for open jobs. Large amounts of structural unemployment commonly occur when an economy shifts to focus on new industries and workers find their previous set of skills are no longer in demand. Structural unemployment is similar to frictional unemployment as both reflect the problem of matching workers with job vacancies, but structural unemployment also covers the time needed to acquire new skills in addition to the short-term search process. * While some types of unemployment may occur regardless of the condition of the economy, cyclical unemployment occurs when growth stagnates.
Okun's law In economics, Okun's law is an empirically observed relationship between unemployment and losses in a country's production. It is named after Arthur Melvin Okun, who first proposed the relationship in 1962. The "gap version" states that for ever ...
represents the empirical relationship between unemployment and economic growth. The original version of Okun's law states that a 3% increase in output would lead to a 1% decrease in unemployment.


Inflation and deflation

A general price increase across the entire economy is called
inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
. When prices decrease, there is
deflation In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflati ...
. Economists measure these changes in prices with price indexes. Inflation can occur when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to deflation.
Central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a centra ...
ers, who manage a country's money supply, try to avoid changes in price level by using
monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often ...
. Raising interest rates or reducing the supply of money in an economy will reduce inflation. Inflation can lead to increased uncertainty and other negative consequences. Deflation can lower economic output. Central bankers try to stabilize prices to protect economies from the negative consequences of price changes. Changes in price level may be the result of several factors. The
quantity theory of money In monetary economics, the quantity theory of money (often abbreviated QTM) is one of the directions of Western economic thought that emerged in the 16th-17th centuries. The QTM states that the general price level of goods and services is directl ...
holds that changes in price level are directly related to changes in the
money supply In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include Circulation (curren ...
. Most economists believe that this relationship explains long-run changes in the price level. Short-run fluctuations may also be related to monetary factors, but changes in aggregate demand and aggregate supply can also influence price level. For example, a decrease in demand due to a recession can lead to lower price levels and deflation. A negative supply shock, such as an oil crisis, lowers aggregate supply and can cause inflation.


Macroeconomic policy

Macroeconomic policy is usually implemented through two sets of tools: fiscal and monetary policy. Both forms of policy are used to stabilize the economy, which can mean boosting the economy to the level of GDP consistent with full employment.Mayer, 495. Macroeconomic policy focuses on limiting the effects of the business cycle to achieve the economic goals of price stability, full employment, and growth. According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism." Nakamura and Steinsson write that macroeconomics struggles with long-term predictions, which is a result of the high complexity of the systems it studies.


Monetary policy

Central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a centra ...
s implement monetary policy by controlling the money supply through several mechanisms. Typically, central banks take action by issuing money to buy bonds (or other assets), which boosts the supply of money and lowers interest rates, or, in the case of contractionary monetary policy, banks sell bonds and take money out of circulation. Usually policy is not implemented by directly targeting the supply of money. Central banks continuously shift the money supply to maintain a targeted fixed interest rate. Some of them allow the interest rate to fluctuate and focus on targeting inflation rates instead. Central banks generally try to achieve high output without letting loose monetary policy that create large amounts of inflation. Conventional monetary policy can be ineffective in situations such as a
liquidity trap A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rat ...
. When interest rates and inflation are near zero, the central bank cannot loosen monetary policy through conventional means. Central banks can use unconventional monetary policy such as
quantitative easing Quantitative easing (QE) is a monetary policy action whereby a central bank purchases predetermined amounts of government bonds or other financial assets in order to stimulate economic activity. Quantitative easing is a novel form of monetary p ...
to help increase output. Instead of buying government bonds, central banks can implement quantitative easing by buying not only government bonds, but also other assets such as corporate bonds, stocks, and other securities. This allows lower interest rates for a broader class of assets beyond government bonds. In another example of unconventional monetary policy, the United States Federal Reserve recently made an attempt at such a policy with
Operation Twist This is a list of historical rate actions by the United States Federal Open Market Committee (FOMC). The FOMC controls the supply of credit to banks and the sale of treasury securities. The Federal Open Market Committee meets every two months d ...
. Unable to lower current interest rates, the Federal Reserve lowered long-term interest rates by buying long-term bonds and selling short-term bonds to create a flat
yield curve In finance, the yield curve is a graph which depicts how the Yield to maturity, yields on debt instruments - such as bonds - vary as a function of their years remaining to Maturity (finance), maturity. Typically, the graph's horizontal or ...
.


Fiscal policy

Fiscal policy is the use of government's revenue and expenditure as instruments to influence the economy. Examples of such tools are
expenditure An expense is an item requiring an outflow of money, or any form of fortune in general, to another person or group as payment for an item, service, or other category of costs. For a tenant, rent is an expense. For students or parents, tuitio ...
, taxes,
debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The d ...
. For example, if the economy is producing less than potential output, government spending can be used to employ idle resources and boost output. Government spending does not have to make up for the entire output gap. There is a multiplier effect that boosts the impact of government spending. For instance, when the government pays for a bridge, the project not only adds the value of the bridge to output, but also allows the bridge workers to increase their consumption and investment, which helps to close the output gap. The effects of fiscal policy can be limited by crowding out. When the government takes on spending projects, it limits the amount of resources available for the private sector to use. Crowding out occurs when government spending simply replaces private sector output instead of adding additional output to the economy. Crowding out also occurs when government spending raises interest rates, which limits investment. Defenders of fiscal stimulus argue that crowding out is not a concern when the economy is depressed, plenty of resources are left idle, and interest rates are low. Fiscal policy can be implemented through automatic stabilizers. Automatic stabilizers do not suffer from the policy lags of discretionary fiscal policy. Automatic stabilizers use conventional fiscal mechanisms but take effect as soon as the economy takes a downturn: spending on unemployment benefits automatically increases when unemployment rises and, in a progressive income tax system, the effective tax rate automatically falls when incomes decline.


Comparison

Economists usually favor monetary over fiscal policy because it has two major advantages. First, monetary policy is generally implemented by independent central banks instead of the political institutions that control fiscal policy. Independent central banks are less likely to make decisions based on political motives. Second, monetary policy suffers shorter inside lags and outside lags than fiscal policy. Additionally, central banks are able to make quick decisions with rapid implementation. Whereas fiscal policy will most likely move slowly through government bureaucracy and take longer to fully implement into the economy.


See also

* Business cycle accounting * Dynamic stochastic general equilibrium *
Economic development In the economics study of the public sector, economic and social development is the process by which the economic well-being and quality of life of a nation, region, local community, or an individual are improved according to targeted goals a ...
*
Growth accounting Growth accounting is a procedure used in economics to measure the contribution of different factors to economic growth and to indirectly compute the rate of technological progress, measured as a residual, in an economy. Growth accounting decomposes ...


Notes


References

* * Blanchard, Olivier. (2009).
The State of Macro
" ''Annual Review of Economics'' 1(1): 209-228. * * Blaug, Mark (1986), ''Great Economists before Keynes'', Brighton: Wheatsheaf. * * * Bouman, John
Principles of Macroeconomics – free fully comprehensive Principles of Microeconomics and Macroeconomics texts
Columbia, Maryland, 2011 * * * * * * Leijonhufvud, Axe
''The Wicksell Connection: Variation on a Theme''
UCLA The University of California, Los Angeles (UCLA) is a public university, public Land-grant university, land-grant research university in Los Angeles, California. UCLA's academic roots were established in 1881 as a Normal school, teachers colle ...
. November, 1979. * * * * * * * Nakamura, Emi and Jón Steinsson. (2018).
Identification in Macroeconomics.
''Journal of Economic Perspectives'' 32(3): 59-86. * * * Reed, Jacob (2016)
AP Economics Review
Macroeconomics. * * Snowdon, Brian, and Howard R. Vane, ed. (2002). ''An Encyclopedia of Macroeconomics''
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