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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: 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. Central banks can quickly make and implement decisions while discretionary fiscal policy may take time to pass and even longer to carry out. Macroeconomics descended from the once divided fields of business cycle theory and monetary theory. It took many forms, including the version based on the work of Irving Fisher:. In the typical view of the quantity theory, money velocity V and the quantity of goods produced Q would be constant, so any increase in money supply M would lead to a direct increase in price level P.
The quantity theory of money was a central part of the classical theory of the economy that prevailed in the early twentieth century. Ludwig Von Mises 's work Theory of Money and Credit , published in , was one of the first books from the Austrian School to deal with macroeconomic topics. Macroeconomics, at least in its modern form,  began with the publication of John Maynard Keynes 's General Theory of Employment, Interest and Money.
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 — also called Keynesianism or Keynesian theory. In Keynes's 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.
By the s, most economists had accepted the synthesis view of the macroeconomy. Milton Friedman 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 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.
Monetarism was particularly influential in the early s. 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 macroeconomics further challenged the Keynesian school. A central development in new classical thought came when Robert Lucas introduced rational expectations 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. 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 and Finn E.
Kydland , created real business cycle RBC models of the macroeconomy. RBC models were created by combining fundamental equations from neo-classical microeconomics. In order to generate macroeconomic fluctuations, RBC models explained recessions and unemployment with changes in technology instead of changes in the markets for goods or money.
Critics of RBC models argue that money clearly plays an important role in the economy, and the idea that technological regress can explain recent recessions is implausible.
Despite questions about the theory behind RBC models, they have clearly been influential in economic methodology. 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 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 , David Romer , 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 ,  which would not adjust, allowing monetary policy to impact quantities instead of prices. By the late s 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. From Wikipedia, the free encyclopedia. Part of a series on Economics A supply and demand diagram, illustrating the effects of an increase in demand. History of economics Schools of economics Mainstream economics Heterodox economics Economic methodology Economic theory Political economy Microeconomics Macroeconomics International economics Applied economics Mathematical economics Econometrics.
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A Glossary of Macroeconomics Terms The Accelerator -- A parameter that defines the relationship between national income and required capital stock. An Asset -- Anything of value owned by an individual, institution or economic agent.
(G) Expenditures by government for goods and services tat government consumes in providing public goods and services that government consumes in providing public goods and for public (social) capital that has a long lifetime; the expenditures of all governments in .
the branch of economics that studies the overall working of a national economy aggregate output The total quantity of goods and services produced in an economy in a given period. This is the simplest yardstick of economic performance. If one person, firm or country can produce more of something with the same amount of effort and resources, they have an absolute advantage.
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. Macroeconomics definition is - a study of economics in terms of whole systems especially with reference to general levels of output and income and to the interrelations among sectors of the economy.