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Composition and distribution of growth also matter. . Poverty is a multidimensional problem that goes beyond economics to . double-digit inflation rates, and stagnant or declining GDP) or stability (for example, current account and.
Table of contents

Its main concern is the instability of aggregate variables. Whereas early economics concentrated on equilibrium in individual markets, Keynes introduced the simultaneous consideration of equilibrium in three interrelated sets of markets—for goods, labor, and finance. His approach was taken up by other leading economists and developed rapidly into what is now known as macroeconomics.

Microeconomics is based on models of consumers or firms which economists call agents that make decisions about what to buy, sell, or produce—with the assumption that those decisions result in perfect market clearing demand equals supply and other ideal conditions.

Macroeconomics, on the other hand, began from observed divergences from what would have been anticipated results under the classical tradition. Microeconomics, in its examination of the behavior of individual consumers and firms, is divided into consumer demand theory, production theory also called the theory of the firm , and related topics such as the nature of market competition, economic welfare, the role of imperfect information in economic outcomes, and at the most abstract, general equilibrium, which deals simultaneously with many markets.

Much economic analysis is microeconomic in nature.

Micro and Macro: The Economic Divide

It concerns such issues as the effects of minimum wages, taxes, price supports, or monopoly on individual markets and is filled with concepts that are recognizable in the real world. It has applications in trade, industrial organization and market structure, labor economics, public finance, and welfare economics. Microeconomic analysis offers insights into such disparate efforts as making business decisions or formulating public policies. Macroeconomics is more abstruse. It describes relationships among aggregates so big as to be hard to apprehend—such as national income, savings, and the overall price level.

The field is conventionally divided into the study of national economic growth in the long run, the analysis of short-run departures from equilibrium, and the formulation of policies to stabilize the national economy—that is, to minimize fluctuations in growth and prices. Those policies can include spending and taxing actions by the government or monetary policy actions by the central bank.

Like physical scientists, economists develop theory to organize and simplify knowledge about a field and to develop a conceptual framework for adding new knowledge. Following the approach of physics, for the past quarter century or so, a number of economists have made sustained efforts to merge microeconomics and macroeconomics. They have tried to develop microeconomic foundations for macroeconomic models on the grounds that valid economic analysis must begin with the behavior of the elements of microeconomic analysis: individual households and firms that seek to optimize their conditions.

There have also been attempts to use very fast computers to simulate the behavior of economic aggregates by summing the behavior of large numbers of households and firms. It is too early to say anything about the likely outcome of this effort. But within the field of macroeconomics there is continuing progress in improving models, whose deficiencies were exposed by the instabilities that occurred in world markets during the global financial crisis that began in Contemporary microeconomic theory evolved steadily without fanfare from the earliest theories of how prices are determined.

Macroeconomics, on the other hand, is rooted in empirical observations that existing theory could not explain. How to interpret those anomalies has always been controversial. There are no competing schools of thought in microeconomics—which is unified and has a common core among all economists. The same cannot be said of macroeconomics—where there are, and have been, competing schools of thought about how to explain the behavior of economic aggregates.

Those schools go by such names as New Keynesian or New Classical. Microeconomics and macroeconomics are not the only distinct subfields in economics. Econometrics , which seeks to apply statistical and mathematical methods to economic analysis, is widely considered the third core area of economics. Without the major advances in econometrics made over the past century or so, much of the sophisticated analysis achieved in microeconomics and macroeconomics would not have been possible.

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Understanding economic growth - AP Macroeconomics - Khan Academy

Receive emails when we post new items of interest to you. But that depends on a host of assumptions: a if the public expenditure goes to public capital goods or human capital or technology which are complementary to private capital goods, it can crowd in private capital accumulation; b in an economy at a zero lower bound, the government can just print money to finance the expenditures.

At such times, one is often worried about deflation; any inflationary effects of such money-printing are thus beneficial. If that is the case, policies aimed more directly at increasing credit availability to those borrowers for whom it is constrained may prove more effective than conventional monetary policy.

The central point is that there is a wide range of policies with significant macroeconomic effects that governments consider, and we have to be able to tailor-make models—building off the core model described earlier—to ascertain the effects. Having a simple model that can analyse these effects is crucial. Building such a model from a DSGE framework is unlikely to be as helpful as building one from the framework described above.

The economy today is going through a structural transformation. The result may be that with current levels and forms of government expenditure and taxation and private expenditures, the economy might fall short of full employment. For all the reasons discussed above and others, the adjustment to a full employment equilibrium may be slow.

But even with sticky wages and prices, there exists a set of fiscal policy interventions over time taxes, expenditures which could bring the economy back to full employment in the short run, or at least bring it back to full employment faster than would otherwise be the case: not just one, but a multiplicity of such paths, differing, for instance, in their levels of public investment and growth in the short run. Even if one were concerned about the level of debt, there is a balanced budget multiplier—and if the taxes and expenditures are chosen carefully, that multiplier can be quite large.

Again, as we noted earlier, building from a DSGE model, with its assumptions of common knowledge and rational expectations, is not likely to be as helpful in designing policies responding to the structural transformation as beginning with a model focusing on financial frictions, as described earlier. I have, for instance, alluded to the assumption of rational expectations.

Economic Conditions

I strongly believe that one cannot fully explain the growth of the housing bubble that played such a large role in the recent crisis within a rational expectations framework. Differences in beliefs, too, can play an important role in macroeconomic fluctuations, through what Guzman and Stiglitz call the creation and destruction of pseudo-wealth.

When two individuals differ in beliefs, they have an incentive to engage in a bet or economic transactions which are similar to bets. Until the bet gets resolved, there is an incentive for both to spend more than they otherwise would, if necessary going into debt. The resolution of the bet the occurrence of the event means that one side becomes wealthier, the other side less wealthy; but there is more than just a transfer of income: there is a destruction in aggregate wealth leading to a decrease in aggregate consumption.

Pseudo-wealth is being created and destroyed all the time, but certain changes—like the creation of new betting markets, e. Fluctuations in pseudo-wealth help explain one of the paradoxes of macroeconomics: the large fluctuations in the economy in spite of small changes in the physical state variables, the stock of capital, labour, and natural capital. One set of assumptions that is critical, and to which too little attention is given in macroeconomic analyses, concerns aggregation.

Long ago we learned the difficulties of constructing an aggregate production function. While earlier analyses provided a critique of the use of the standard model for equilibrium analysis, e. Even more important is perhaps the aggregation of the whole economy into a single sector, particularly when the underlying stress on the economy is one of structural change, requiring the movement of resources from one sector to another say agriculture to manufacturing , when there are market imperfections say in access to credit impeding the reallocation.

Policy analyses are also likely to be misguided. Monetary policy is typically presented as an efficient tool. But monetary policy has disproportionate effects on interest-sensitive sectors, thus inducing a distortion in the economy that simply is not evident in a one-sector model see Kreamer, Finally, the use of a representative agent represents an aggregation of the household sector. It is understandable that macroeconomists attempting to microfound macro-theory would want to impose some restrictions: otherwise, any set of demand functions could be claimed to be microfounded.

There is at least a significant body of thought that argues that the increase in inequality played some, and possibly a critical role, in the build-up to the crisis and to the slow recovery; there are large differences in the marginal propensity to consume between the top 1 per cent and the bottom 80 per cent and, accordingly, anything that affects distribution significantly affects aggregate demand, i.

The microeconomics of the basic competitive model—as formulated in Arrow and Debreu—has been shown to be flawed by 40 years of economic research.


Why should we expect a macroeconomic model based on such microfoundations to work? Most deeply, the standard model is intellectually incoherent and implicitly encourages society to move in a direction which would undermine both efficiency and well-being. It assumes that all individuals are purely selfish and yet that contracts are always fully honoured.

Individuals who are fully selfish know that there are enforcement costs, and will not honour their contracts fully, even if the consequence is a loss in reputation. Surely, both policies to prevent a recurrence of similar crises and analyses of market dynamics will need to take into account both market and regulatory responses. Most importantly, the inculcation and normalization of a culture of selfishness without moral bounds will lead to an economy that is less efficient with lower individual and societal well-being.

Behavioural economics has noted that most individuals systematically behave differently from that model but that embedding individuals within a culture of selfishness where that is taken as the norm leads to changes in behaviour in that direction. How selfish soever man may be supposed, there are evidently some principles in his nature which interest him in the fortunes of others, and render their happiness important to him, though he derives nothing from it except the pleasure of seeing it.

The earlier Smith was fortunately right, and modern macroeconomics should strive to incorporate behaviour which is consistent with these impulses, just as it does behaviour that is consistent with impulses that may be less noble. Assumptions matter. All models make simplifications.

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The question is, as we have said, what simplifications are appropriate for asking what questions. The danger is that the simplifications bias the answers, sometimes in ways that we are not aware of. The DSGE model ignored issues that turned out to be key in the crisis; not surprisingly, the model neither predicted the most important macroeconomic event in the past three-quarters of a century nor provided good guidance as to the appropriate policy responses. Given the way the models are structured, they could not have predicted such an event. In the run-up to the crisis, monetary authorities focused on inflation rather than on what they should have been focusing on—financial stability; and some of their especially deregulatory actions clearly contributed to financial instability.

The DSGE models provided them false assurance that they were doing the right thing. Of course, any good macroeconomic model has to be dynamic and stochastic, and present an analysis of the entire economy. But specific assumptions, as we have noted, went into each of these components. We have already discussed several aspects of the assumed dynamics.