Attempts by the Bank of Japan to increase the money supply simply added to already ample bank reserves and public holdings of cash Hicks showed how to analyze Keynes' system when liquidity preference is a function of income as well as of the rate of interest. Less classically he extends this generalization to the schedule of the marginal efficiency of capital.
Hicks has now repented and changed his name from J. Hicks subsequently relapsed. Keynes argued that the solution to the Great Depression was to stimulate the country "incentive to invest" through some combination of two approaches:. If the interest rate at which businesses and consumers can borrow decreases, investments that were previously uneconomic become profitable, and large consumer sales normally financed through debt such as houses, automobiles, and, historically, even appliances like refrigerators become more affordable.
A principal function of central banks in countries that have them is to influence this interest rate through a variety of mechanisms collectively called monetary policy. This is how monetary policy that reduces interest rates is thought to stimulate economic activity, i. Expansionary fiscal policy consists of increasing net public spending, which the government can effect by a taxing less, b spending more, or c both.
Investment and consumption by government raises demand for businesses' products and for employment, reversing the effects of the aforementioned imbalance. If desired spending exceeds revenue, the government finances the difference by borrowing from capital markets by issuing government bonds. This is called deficit spending. Two points are important to note at this point. First, deficits are not required for expansionary fiscal policy, and second, it is only change in net spending that can stimulate or depress the economy.
But — contrary to some critical characterizations of it — Keynesianism does not consist solely of deficit spending , since it recommends adjusting fiscal policies according to cyclical circumstances. Keynes's ideas influenced Franklin D. Roosevelt 's view that insufficient buying-power caused the Depression. During his presidency, Roosevelt adopted some aspects of Keynesian economics, especially after , when, in the depths of the Depression, the United States suffered from recession yet again following fiscal contraction.
But to many the true success of Keynesian policy can be seen at the onset of World War II , which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official in social-democratic Europe after the war and in the U. The Keynesian advocacy of deficit spending contrasted with the classical and neoclassical economic analysis of fiscal policy. They admitted that fiscal stimulus could actuate production. But, to these schools, there was no reason to believe that this stimulation would outrun the side-effects that " crowd out " private investment: first, it would increase the demand for labour and raise wages, hurting profitability ; Second, a government deficit increases the stock of government bonds, reducing their market price and encouraging high interest rates , making it more expensive for business to finance fixed investment.
Thus, efforts to stimulate the economy would be self-defeating. The Keynesian response is that such fiscal policy is appropriate only when unemployment is persistently high, above the non-accelerating inflation rate of unemployment NAIRU. In that case, crowding out is minimal. Further, private investment can be "crowded in": Fiscal stimulus raises the market for business output, raising cash flow and profitability, spurring business optimism. To Keynes, this accelerator effect meant that government and business could be complements rather than substitutes in this situation.
Second, as the stimulus occurs, gross domestic product rises—raising the amount of saving , helping to finance the increase in fixed investment. Finally, government outlays need not always be wasteful: government investment in public goods that is not provided by profit-seekers encourages the private sector's growth. That is, government spending on such things as basic research, public health, education, and infrastructure could help the long-term growth of potential output. In Keynes's theory, there must be significant slack in the labour market before fiscal expansion is justified.
Keynesian economists believe that adding to profits and incomes during boom cycles through tax cuts, and removing income and profits from the economy through cuts in spending during downturns, tends to exacerbate the negative effects of the business cycle. This effect is especially pronounced when the government controls a large fraction of the economy, as increased tax revenue may aid investment in state enterprises in downturns, and decreased state revenue and investment harm those enterprises. In the last few years of his life, John Maynard Keynes was much preoccupied with the question of balance in international trade.
He was the leader of the British delegation to the United Nations Monetary and Financial Conference in that established the Bretton Woods system of international currency management. He was the principal author of a proposal — the so-called Keynes Plan — for an International Clearing Union. The two governing principles of the plan were that the problem of settling outstanding balances should be solved by 'creating' additional 'international money', and that debtor and creditor should be treated almost alike as disturbers of equilibrium.
In the event, though, the plans were rejected, in part because "American opinion was naturally reluctant to accept the principle of equality of treatment so novel in debtor-creditor relationships". The new system is not founded on free-trade liberalisation  of foreign trade  but rather on regulating international trade to eliminate trade imbalances. Nations with a surplus would have a powerful incentive to get rid of it, which would automatically clear other nations deficits.
Every country would have an overdraft facility in its bancor account at the International Clearing Union. He pointed out that surpluses lead to weak global aggregate demand — countries running surpluses exert a "negative externality" on trading partners, and posed far more than those in deficit, a threat to global prosperity. Keynes thought that surplus countries should be taxed to avoid trade imbalances. His view, supported by many economists and commentators at the time, was that creditor nations may be just as responsible as debtor nations for disequilibrium in exchanges and that both should be under an obligation to bring trade back into a state of balance.
Failure for them to do so could have serious consequences. In the words of Geoffrey Crowther , then editor of The Economist , "If the economic relationships between nations are not, by one means or another, brought fairly close to balance, then there is no set of financial arrangements that can rescue the world from the impoverishing results of chaos. These ideas were informed by events prior to the Great Depression when — in the opinion of Keynes and others — international lending, primarily by the U.
Influenced by Keynes, economic texts in the immediate post-war period put a significant emphasis on balance in trade. For example, the second edition of the popular introductory textbook, An Outline of Money ,  devoted the last three of its ten chapters to questions of foreign exchange management and in particular the 'problem of balance'. However, in more recent years, since the end of the Bretton Woods system in , with the increasing influence of Monetarist schools of thought in the s, and particularly in the face of large sustained trade imbalances, these concerns — and particularly concerns about the destabilising effects of large trade surpluses — have largely disappeared from mainstream economics discourse  and Keynes' insights have slipped from view.
Keynes's ideas became widely accepted after World War II , and until the early s, Keynesian economics provided the main inspiration for economic policy makers in Western industrialized countries. In the early era of social liberalism and social democracy , most western capitalist countries enjoyed low, stable unemployment and modest inflation, an era called the Golden Age of Capitalism. In terms of policy, the twin tools of post-war Keynesian economics were fiscal policy and monetary policy.
While these are credited to Keynes, others, such as economic historian David Colander , argue that they are, rather, due to the interpretation of Keynes by Abba Lerner in his theory of functional finance , and should instead be called "Lernerian" rather than "Keynesian". Through the s, moderate degrees of government demand leading industrial development, and use of fiscal and monetary counter-cyclical policies continued, and reached a peak in the "go go" s, where it seemed to many Keynesians that prosperity was now permanent.
Beginning in the late s, a new classical macroeconomics movement arose, critical of Keynesian assumptions see sticky prices , and seemed, especially in the s, to explain certain phenomena better. It was characterized by explicit and rigorous adherence to microfoundations , as well as use of increasingly sophisticated mathematical modelling. With the oil shock of , and the economic problems of the s, Keynesian economics began to fall out of favour.
During this time, many economies experienced high and rising unemployment, coupled with high and rising inflation, contradicting the Phillips curve 's prediction. This stagflation meant that the simultaneous application of expansionary anti-recession and contractionary anti-inflation policies appeared necessary. This dilemma led to the end of the Keynesian near-consensus of the s, and the rise throughout the s of ideas based upon more classical analysis, including monetarism , supply-side economics ,  and new classical economics.
However, by the late s, certain failures of the new classical models, both theoretical see Real business cycle theory and empirical see the "Volcker recession"  hastened the emergence of New Keynesian economics , a school that sought to unite the most realistic aspects of Keynesian and neo-classical assumptions and place them on more rigorous theoretical foundation than ever before. One line of thinking, utilized also as a critique of the notably high unemployment and potentially disappointing GNP growth rates associated with the new classical models by the mids, was to emphasize low unemployment and maximal economic growth at the cost of somewhat higher inflation its consequences kept in check by indexing and other methods, and its overall rate kept lower and steadier by such potential policies as Martin Weitzman's share economy.
Multiple schools of economic thought that trace their legacy to Keynes currently exist, the notable ones being Neo-Keynesian economics , New Keynesian economics , and Post-Keynesian economics. Keynes's biographer Robert Skidelsky writes that the post-Keynesian school has remained closest to the spirit of Keynes's work in following his monetary theory and rejecting the neutrality of money. In the postwar era, Keynesian analysis was combined with neoclassical economics to produce what is generally termed the " neoclassical synthesis ", yielding Neo-Keynesian economics , which dominated mainstream macroeconomic thought.
Though it was widely held that there was no strong automatic tendency to full employment, many believed that if government policy were used to ensure it, the economy would behave as neoclassical theory predicted. This post-war domination by Neo-Keynesian economics was broken during the stagflation of the s. There was a lack of consensus among macroeconomists in the s. However, the advent of New Keynesian economics in the s, modified and provided microeconomic foundations for the neo-Keynesian theories.
These modified models now dominate mainstream economics. Post-Keynesian economists , on the other hand, reject the neoclassical synthesis and, in general, neoclassical economics applied to the macroeconomy. Post-Keynesian economics is a heterodox school that holds that both Neo-Keynesian economics and New Keynesian economics are incorrect, and a misinterpretation of Keynes's ideas. The Post-Keynesian school encompasses a variety of perspectives, but has been far less influential than the other more mainstream Keynesian schools.
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Interpretations of Keynes have emphasized his stress on the international coordination of Keynesian policies, the need for international economic institutions, and the ways in which economic forces could lead to war or could promote peace. In a paper, economist Alan Blinder argues that, "for not very good reasons," public opinion in the United States has associated Keynesianism with liberalism, and he states that such is incorrect.
Bush supported policies that were, in fact, Keynesian, even though both men were conservative leaders. And tax cuts can provide highly helpful fiscal stimulus during a recession, just as much as infrastructure spending can. Blinder concludes, "If you are not teaching your students that 'Keynesianism' is neither conservative nor liberal, you should be. The classical tradition of partial equilibrium theory had been to split the economy into separate markets, each of whose equilibrium conditions could be stated as a single equation determining a single variable.
The theoretical apparatus of supply and demand curves developed by Fleeming Jenkin and Alfred Marshall provided a unified mathematical basis for this approach, which the Lausanne School generalized to general equilibrium theory. For macroeconomics the relevant partial theories were: the Quantity theory of money determining the price level, the classical theory of the interest rate , and for employment the condition referred to by Keynes as the "first postulate of classical economics" stating that the wage is equal to the marginal product, which is a direct application of the marginalist principles developed during the nineteenth century see The General Theory.
Keynes sought to supplant all three aspects of the classical theory. Although Keynes's work was crystallized and given impetus by the advent of the Great Depression , it was part of a long-running debate within economics over the existence and nature of general gluts. A number of the policies Keynes advocated to address the Great Depression notably government deficit spending at times of low private investment or consumption , and many of the theoretical ideas he proposed effective demand, the multiplier, the paradox of thrift , had been advanced by various authors in the 19th and early 20th centuries.
Keynes's unique contribution was to provide a general theory of these, which proved acceptable to the economic establishment.
An intellectual precursor of Keynesian economics was underconsumption theories associated with John Law , Thomas Malthus , the Birmingham School of Thomas Attwood ,  and the American economists William Trufant Foster and Waddill Catchings , who were influential in the s and s. Underconsumptionists were, like Keynes after them, concerned with failure of aggregate demand to attain potential output, calling this "underconsumption" focusing on the demand side , rather than " overproduction " which would focus on the supply side , and advocating economic interventionism.
Numerous concepts were developed earlier and independently of Keynes by the Stockholm school during the s; these accomplishments were described in a article, published in response to the General Theory, sharing the Swedish discoveries. The paradox of thrift was stated in by John M. Robertson in his The Fallacy of Saving, in earlier forms by mercantilist economists since the 16th century, and similar sentiments date to antiquity.
In Keynes published his first contribution to economic theory, A Tract on Monetary Reform , whose point of view is classical but incorporates ideas that later played a part in the General Theory In particular, looking at the hyperinflation in European economies, he drew attention to the opportunity cost of holding money identified with inflation rather than interest and its influence on the velocity of circulation. In he published A Treatise on Money , intended as a comprehensive treatment of its subject "which would confirm his stature as a serious academic scholar, rather than just as the author of stinging polemics",  and marks a large step in the direction of his later views.
In it, he attributes unemployment to wage stickiness  and treats saving and investment as governed by independent decisions: the former varying positively with the interest rate,  the latter negatively. Keynes's younger colleagues of the Cambridge Circus and Ralph Hawtrey believed that his arguments implicitly assumed full employment, and this influenced the direction of his subsequent work. At the time that Keynes's wrote the General Theory , it had been a tenet of mainstream economic thought that the economy would automatically revert to a state of general equilibrium: it had been assumed that, because the needs of consumers are always greater than the capacity of the producers to satisfy those needs, everything that is produced would eventually be consumed once the appropriate price was found for it.
This perception is reflected in Say's law  and in the writing of David Ricardo ,  which states that individuals produce so that they can either consume what they have manufactured or sell their output so that they can buy someone else's output. This argument rests upon the assumption that if a surplus of goods or services exists, they would naturally drop in price to the point where they would be consumed. Given the backdrop of high and persistent unemployment during the Great Depression, Keynes argued that there was no guarantee that the goods that individuals produce would be met with adequate effective demand, and periods of high unemployment could be expected, especially when the economy was contracting in size.
He saw the economy as unable to maintain itself at full employment automatically, and believed that it was necessary for the government to step in and put purchasing power into the hands of the working population through government spending. Thus, according to Keynesian theory, some individually rational microeconomic-level actions such as not investing savings in the goods and services produced by the economy, if taken collectively by a large proportion of individuals and firms, can lead to outcomes wherein the economy operates below its potential output and growth rate.
Prior to Keynes, a situation in which aggregate demand for goods and services did not meet supply was referred to by classical economists as a general glut , although there was disagreement among them as to whether a general glut was possible. Keynes argued that when a glut occurred, it was the over-reaction of producers and the laying off of workers that led to a fall in demand and perpetuated the problem.
Keynesians therefore advocate an active stabilization policy to reduce the amplitude of the business cycle, which they rank among the most serious of economic problems. According to the theory, government spending can be used to increase aggregate demand, thus increasing economic activity, reducing unemployment and deflation. The Liberal Party fought the General Election on a promise to "reduce levels of unemployment to normal within one year by utilising the stagnant labour force in vast schemes of national development".
The multiplier of Kahn's paper is based on a respending mechanism familiar nowadays from textbooks. Samuelson puts it as follows:. The producers of these goods will now have extra incomes Samuelson's treatment closely follows Joan Robinson 's account of  and is the main channel by which the multiplier has influenced Keynesian theory.
It differs significantly from Kahn's paper and even more from Keynes's book.
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The designation of the initial spending as "investment" and the employment-creating respending as "consumption" echoes Kahn faithfully, though he gives no reason why initial consumption or subsequent investment respending shouldn't have exactly the same effects. Henry Hazlitt , who considered Keynes as much a culprit as Kahn and Samuelson, wrote that The word "investment" is being used in a Pickwickian, or Keynesian, sense. Jens Warming recognised that personal saving had to be considered,  treating it as a "leakage" p. The textbook multiplier gives the impression that making society richer is the easiest thing in the world: the government just needs to spend more.
In Kahn's paper, it is harder. On page , Kahn rejects the claim that the effect of public works is at the expense of expenditure elsewhere, admitting that this might arise if the revenue is raised by taxation, but says that other available means have no such consequences. As an example, he suggests that the money may be raised by borrowing from banks, since This assumes that banks are free to create resources to answer any demand. But Kahn adds that A respending multiplier had been proposed earlier by Hawtrey in a Treasury memorandum "with imports as the only leakage" , but the idea was discarded in his own subsequent writings.
Some Dutch mercantilists had believed in an infinite multiplier for military expenditure assuming no import "leakage" , since For if money itself is "consumed", this simply means that it passes into someone else's possession, and this process may continue indefinitely. As the election approached "Keynes was becoming a strong public advocate of capital development" as a public measure to alleviate unemployment. It is the orthodox Treasury dogma, steadfastly held Keynes pounced on a chink in the Treasury view.
Cross-examining Sir Richard Hopkins, a Second Secretary in the Treasury, before the Macmillan Committee on Finance and Industry in he referred to the "first proposition" that "schemes of capital development are of no use for reducing unemployment" and asked whether "it would be a misunderstanding of the Treasury view to say that they hold to the first proposition". Hopkins responded that "The first proposition goes much too far.
The first proposition would ascribe to us an absolute and rigid dogma, would it not? Later the same year, speaking in a newly created Committee of Economists, Keynes tried to use Kahn's emerging multiplier theory to argue for public works, "but Pigou's and Henderson's objections ensured that there was no sign of this in the final product". Pigou was at the time the sole economics professor at Cambridge. Nor were his practical recommendations very different: "on many occasions in the thirties" Pigou "gave public support Keynes was seeking to build theoretical foundations to support his recommendations for public works while Pigou showed no disposition to move away from classical doctrine.
Referring to him and Dennis Robertson , Keynes asked rhetorically: "Why do they insist on maintaining theories from which their own practical conclusions cannot possibly follow? The Keynesian schools of economics are situated alongside a number of other schools that have the same perspectives on what the economic issues are, but differ on what causes them and how to best resolve them. Today, most of these schools of thought have been subsumed into modern macroeconomic theory. The Stockholm school rose to prominence at about the same time that Keynes published his General Theory and shared a common concern in business cycles and unemployment.
The second generation of Swedish economists also advocated government intervention through spending during economic downturns  although opinions are divided over whether they conceived the essence of Keynes's theory before he did. There was debate between monetarists and Keynesians in the s over the role of government in stabilizing the economy. Both monetarists and Keynesians agree that issues such as business cycles, unemployment, and deflation are caused by inadequate demand.
However, they had fundamentally different perspectives on the capacity of the economy to find its own equilibrium, and the degree of government intervention that would be appropriate. Keynesians emphasized the use of discretionary fiscal policy and monetary policy , while monetarists argued the primacy of monetary policy, and that it should be rules-based.
The debate was largely resolved in the s. Since then, economists have largely agreed that central banks should bear the primary responsibility for stabilizing the economy, and that monetary policy should largely follow the Taylor rule — which many economists credit with the Great Moderation.
Some Marxist economists criticized Keynesian economics. Sweezy argued that Keynes had never been able to view the capitalist system as a totality. He argued that Keynes regarded the class struggle carelessly, and overlooked the class role of the capitalist state, which he treated as a deus ex machina , and some other points. In the article Kalecki predicted that the full employment delivered by Keynesian policy would eventually lead to a more assertive working class and weakening of the social position of business leaders, causing the elite to use their political power to force the displacement of the Keynesian policy even though profits would be higher than under a laissez faire system: The erosion of social prestige and political power would be unacceptable to the elites despite higher profits.
James M. Buchanan  criticized Keynesian economics on the grounds that governments would in practice be unlikely to implement theoretically optimal policies. The implicit assumption underlying the Keynesian fiscal revolution, according to Buchanan, was that economic policy would be made by wise men, acting without regard to political pressures or opportunities, and guided by disinterested economic technocrats.
He argued that this was an unrealistic assumption about political, bureaucratic and electoral behaviour. Buchanan blamed Keynesian economics for what he considered a decline in America's fiscal discipline. First, he thought whatever the economic analysis, benevolent dictatorship is likely sooner or later to lead to a totalitarian society.
Second, he thought Keynes's economic theories appealed to a group far broader than economists primarily because of their link to his political approach. In response to this argument, John Quiggin ,  wrote about these theories' implication for a liberal democratic order. He thought that if it is generally accepted that democratic politics is nothing more than a battleground for competing interest groups, then reality will come to resemble the model. He argued, "if you have a problem with politicians - criticize politicians," not Keynes.
Brad DeLong has argued that politics is the main motivator behind objections to the view that government should try to serve a stabilizing macroeconomic role. Another influential school of thought was based on the Lucas critique of Keynesian economics. This called for greater consistency with microeconomic theory and rationality, and in particular emphasized the idea of rational expectations. Lucas and others argued that Keynesian economics required remarkably foolish and short-sighted behaviour from people, which totally contradicted the economic understanding of their behaviour at a micro level.
New classical economics introduced a set of macroeconomic theories that were based on optimizing microeconomic behaviour. These models have been developed into the real business-cycle theory , which argues that business cycle fluctuations can to a large extent be accounted for by real in contrast to nominal shocks. Beginning in the late s new classical macroeconomists began to disagree with the methodology employed by Keynes and his successors.
Keynesians emphasized the dependence of consumption on disposable income and, also, of investment on current profits and current cash flow. In addition, Keynesians posited a Phillips curve that tied nominal wage inflation to unemployment rate. To support these theories, Keynesians typically traced the logical foundations of their model using introspection and supported their assumptions with statistical evidence.
The result of this shift in methodology produced several important divergences from Keynesian macroeconomics: . From Wikipedia, the free encyclopedia. Part of a series on Capitalism Concepts. Economic systems.
About the Book
Economic theories. What causes inflation? What creates or stimulates economic growth? Macroeconomics attempts to measure how well an economy is performing, to understand what forces drive it, and to project how performance can improve. Macroeconomics deals with the performance, structure, and behavior of the entire economy, in contrast to microeconomics , which is more focused on the choices made by individual actors in the economy like people, households, industries, etc.
There are two sides to the study of economics: macroeconomics and microeconomics.
As the term implies, macroeconomics looks at the overall, big-picture scenario of the economy. Put simply, it focuses on the way the economy performs as a whole and then analyzes how different sectors of the economy relate to one another to understand how the aggregate functions. This includes looking at variables like unemployment, GDP, and inflation. Macroeconomists develop models explaining relationships between these factors.
Such macroeconomic models, and the forecasts they produce, are used by government entities to aid in the construction and evaluation of economic, monetary and fiscal policy; by businesses to set strategy in domestic and global markets; and by investors to predict and plan for movements in various asset classes. Given the enormous scale of government budgets and the impact of economic policy on consumers and businesses, macroeconomics clearly concerns itself with significant issues.
Properly applied, economic theories can offer illuminating insights on how economies function and the long-term consequences of particular policies and decisions. Macroeconomic theory can also help individual businesses and investors make better decisions through a more thorough understanding of what motivates ot, andarties and how to best maximize utility and scarce resources. It is also important to understand the limitations of economic theory.
Theories are often created in a vacuum and lack certain real-world details like taxation, regulation and transaction costs. The real world is also decidedly complicated and their matters of social preference and conscience that do not lend themselves to mathematical analysis. Even with the limits of economic theory, it is important and worthwhile to follow the major macroeconomic indicators like GDP, inflation and unemployment.
The performance of companies, and by extension their stocks, is significantly influenced by the economic conditions in which the companies operate and the study of macroeconomic statistics can help an investor make better decisions and spot turning points. Likewise, it can be invaluable to understand which theories are in favor and influencing a particular government administration. The underlying economic principles of a government will say much about how that government will approach taxation, regulation, government spending, and similar policies.
By better understanding economics and the ramifications of economic decisions, investors can get at least a glimpse of the probable future and act accordingly with confidence. Macroeconomics is a rather broad field, but two specific areas of research are representative of this discipline. The first area is the factors that determine long-term economic growth , or increases in the national income. The other involves the causes and consequences of short-term fluctuations in national income and employment, also known as the business cycle.
Economic growth refers to an increase in aggregate production in an economy. Macroeconomists try to understand the factors that either promote or retard economic growth in order to support economic policies that will support development, progress, and rising living standards. Adam Smith's classic 18th-century work, An Inquiry into the Nature and Causes of the Wealth of Nations, which advocated free trade, laissez-faire economic policy, and expanding the division of labor , was arguably the first, and cetainly one of the seminal works in this body of research.
By the 20 th century, macroeconomists began to study growth with more formal mathematical models. Growth is commonly modeled as a function of physical capital, human capital, labor force, and technology. Superimposed over long term macroeconomic growth trends, the levels and rates-of-change of major macroeconomic variables such as employment and national output go through occasional fluctuations up or down, expansions and recessions, in a phenomenon known as the business cycle.
The financial crisis is a clear recent example, and the Great Depression of the s was actually the impetus for the development of most modern macroeconomic theory. While the term "macroeconomics" is not all that old going back to Ragnar Frisch in , many of the core concepts in macroeconomics have been the focus of study for much longer. Topics like unemployment, prices, growth, and trade have concerned economists almost from the very beginning of the discipline, though their study has become much more focused and specialized through the s and s.
Macroeconomics, as it is in its modern form, is often defined as starting with John Maynard Keynes and the publication of his book The General Theory of Employment, Interest and Money in Keynes offered an explanation for the fallout from the Great Depression , when goods remained unsold and workers unemployed. Keynes's theory attempted to explain why markets may not clear. Prior to the popularization of Keynes' theories, economists did not generally differentiate between micro- and macroeconomics. The same microeconomic laws of supply and demand that operate in individual goods markets were understood to interact between individuals markets to bring the economy into a general equilibrium, as described by Leon Walras.
The link between goods markets and large-scale financial variables such as price levels and interest rates was explained through the unique role that money plays in the economy as a medium of exchange by economists such as Knut Wicksell, Irving Fisher, and Ludwig von Mises. Throughout the 20 th century, Keynesian economics, as Keynes' theories became known, diverged into several other schools of thought.
The field of macroeconomics is organized into many different schools of thought, with differing views on how the markets and their participants operate. Classical Classical economists hold that prices, wages, and rates are flexible and markets always clear, building on Adam Smith's original theories.
Keynesian Keynesian economics was largely founded on the basis of the works of John Maynard Keynes. Keynesians focus on aggregate demand as the principal factor in issues like unemployment and the business cycle. Keynesian economists believe that the business cycle can be managed by active government intervention through fiscal policy spending more in recessions to stimulate demand and monetary policy stimulating demand with lower rates. Keynesian economists also believe that there are certain rigidities in the system, particularly sticky prices and prices, that prevent the proper clearing of supply and demand.
Monetarist The Monetarist school is largely credited to the works of Milton Friedman. Monetarist economists believe that the role of government is to control inflation by controlling the money supply. Monetarists believe that markets are typically clear and that participants have rational expectations. Monetarists reject the Keynesian notion that governments can "manage" demand and that attempts to do so are destabilizing and likely to lead to inflation.
New Keynesian The New Keynesian school attempts to add microeconomic foundations to traditional Keynesian economic theories. While New Keynesians do accept that households and firms operate on the basis of rational expectations, they still maintain that there are a variety of market failures, including sticky prices and wages. Because of this "stickiness", the government can improve macroeconomic conditions through fiscal and monetary policy. Neoclassical Neoclassical economics assumes that people have rational expectations and strive to maximize their utility.
This school presumes that people act independently on the basis of all the information they can attain.