The term communist society should be distinguished from the Western concept of the communist state, the latter referring to a state ruled by a party which professes a variation of Marxism–Leninism.
Karl Marx distinguishes between two phases of marketless communism: an initial phase, with labor vouchers, and a higher phase, with free access.
Economic aspects
A communist economic system would be characterized by advanced
productive technology that enables material abundance, which in turn
would enable the free distribution of most or all economic output and
the holding of the means of producing this output in common. In this
respect communism is differentiated from socialism, which, out of economic necessity, restricts access to articles of consumption and services based on one's contribution.
In further contrast to previous economic systems, communism would
be characterized by the holding of natural resources and the means of
production in common as opposed to them being privately owned (as in the
case of capitalism)
or owned by public or cooperative organizations that similarly restrict
their access (as in the case of socialism). In this sense, communism
involves the "negation of property" insofar as there would be little
economic rationale for exclusive control over production assets in an
environment of material abundance.
The fully developed communist economic system is postulated to
develop from a preceding socialist system. Marx held the view that
socialism—a system based on social ownership
of the means of production—would enable progress toward the development
of fully developed communism by further advancing productive
technology. Under socialism, with its increasing levels of automation,
an increasing proportion of goods would be distributed freely.
Social aspects
Individuality, freedom and creativity
A communist society would free individuals from long working hours by
first automating production to an extent that the average length of the
working day is reduced
and second by eliminating the exploitation inherent in the division
between workers and owners. A communist system would thus free
individuals from alienation in the sense of having one's life structured
around survival (making a wage or salary in a capitalist system), which
Karl Marx
referred to as a transition from the "realm of necessity" to the "realm
of freedom". As a result, a communist society is envisioned as being
composed of an intellectually-inclined population with both the time and
resources to pursue its creative
hobbies and genuine interests, and to contribute to creative social
wealth in this manner. Marx considered "true richness" to be the amount
of time one has at his disposal to pursue one's creative passions.Marx's notion of communism is in this way radically individualistic.
In fact, the realm of freedom actually begins only where labor which
is determined by necessity and mundane considerations ceases; thus in
the very nature of things it lies beyond the sphere of actual material
production.
Marx's concept of the "realm of freedom" goes hand-in-hand with his idea of the ending of the division of labor,
which would not be required in a society with highly automated
production and limited work roles. In a communist society, economic
necessity and relations would cease to determine cultural and social
relations. As scarcity is eliminated, alienated labor would cease and people would be free to pursue their individual goals.
Additionally, it is believed that the principle of "from each according
to his ability, to each according to his needs" could be fulfilled due
to scarcity being non-existent.
Politics, law and governance
Marx
and Engels maintained that a communist society would have no need for
the state as it exists in contemporary capitalist society. The
capitalist state mainly exists to enforce hierarchical economic
relations, to enforce the exclusive control of property, and to regulate
capitalistic economic activities—all of which would be non-applicable
to a communist system.
Engels noted that in a socialist system the primary function of
public institutions will shift from being about the creation of laws and
the control of people into a technical role as an administrator of
technical production processes, with a decrease in the scope of
traditional politics as scientific administration overtakes the role of
political decision-making.
Communist society is characterized by democratic processes, not merely
in the sense of electoral democracy, but in the broader sense of open
and collaborative social and workplace environments.
Marx never clearly specified whether or not he thought a communist society would be just;
other thinkers have speculated that he thought communism would
transcend justice and create society without conflicts, thus, without
the needs for rules of justice.
Transitional stages
Marx also wrote that between capitalist and communist society, there would be a transitory period known as the dictatorship of the proletariat.
During this preceding phase of societal development, capitalist
economic relationships would gradually be abolished and replaced with
socialism. Natural resources would become public property, while all manufacturing centers and workplaces would become socially owned and democraticallymanaged. Production would be organized by scientific assessment and planning,
thus eliminating what Marx called the "anarchy in production". The
development of the productive forces would lead to the marginalization
of human labor to the highest possible extent, to be gradually replaced
by automated labor.
Open-source and peer production
Many aspects of a communist economy have emerged in recent decades in the form of open-source software and hardware,
where source code and thus the means of producing software is held in
common and freely accessible to everyone; and to the processes of peer production where collaborative work processes produce freely available software that does not rely on monetary valuation.
Ray Kurzweil
posits that the goals of communism will be realized by advanced
technological developments in the 21st century, where the intersection
of low manufacturing costs, material abundance and open-source design
philosophies will enable the realization of the maxim "from each
according to his ability, to each according to his needs".
The communist economic system was officially enumerated as the ultimate goal of the Communist Party of the Soviet Union in its party platform. According to the 1986 Programme of the CPSU:
Communism is a classless social
system with one form of public ownership of the means of production and
with full social equality of all members of society. Under communism,
the all-round development of people will be accompanied by the growth of
the productive forces on the basis of continuous progress in science
and technology, all the springs of social wealth will flow abundantly,
and the great principle "From each according to his ability, to each
according to his needs" will be implemented. Communism is a highly
organised society of free, socially conscious working people a society
in which public self-government will be established, a society in which
labour for the good of society will become the prime vital requirement
of everyone, a clearly recognised necessity, and the ability of each
person will be employed to the greatest benefit of the people.
The material and technical foundation of communism presupposes
the creation of those productive forces that open up opportunities for
the full satisfaction of the reasonable requirements of society and the
individual. All productive activities under communism will be based on
the use of highly efficient technical facilities and technologies, and
the harmonious interaction of man and nature will be ensured.
In the highest phase of communism the directly social character
of labor and production will become firmly established. Through the
complete elimination of the remnants of the old division of labor and
the essential social differences associated with it, the process of
forming a socially homogeneous society will be completed.
Communism signifies the transformation of the system of socialist
self-government by the people, of socialist democracy into the highest
form of organization of society: communist public self-government. With
the maturation of the necessary socioeconomic and ideological
preconditions and the involvement of all citizens in administration, the
socialist state—given appropriate international conditions—will, as
Lenin noted, increasingly become a transitional form "from a state to a
non-state". The activities of state bodies will become non-political in
nature, and the need for the state as a special political institution
will gradually disappear.
The inalienable feature of the communist mode of life is a high
level of consciousness, social activity, discipline, and self-discipline
of members of society, in which observance of the uniform, generally
accepted rules of communist conduct will become an inner need and habit
of every person.
Communism is a social system under which the free development of each is a condition for the free development of all.
In Vladimir Lenin's
political theory, a classless society would be a society controlled by
the direct producers, organized to produce according to socially managed
goals. Such a society, Lenin suggested, would develop habits that would
gradually make political representation unnecessary, as the radically
democratic nature of the Soviets would lead citizens to come to agree
with the representatives' style of management. Only in this environment,
Lenin suggested, could the state wither away, ushering in a period of stateless communism.
In Soviet ideology, Marx's concepts of the "lower and higher phases of communism" articulated in the Critique of the Gotha Program were reformulated as the stages of "socialism" and "communism". The Soviet state claimed to have begun the phase of "socialist construction" during the implementation of the first Five-Year Plans
during the 1930s, which introduced a centrally planned,
nationalized/collectivized economy. The 1962 Program of the Communist
Party of the Soviet Union, published under the leadership of Nikita Khrushchev,
claimed that socialism had been firmly established in the USSR, and
that the state would now progress to the "full-scale construction of
communism",
although this may be understood to refer to the "technical foundations"
of communism more so than the withering away of the state and the
division of labor per se. However, even in the final edition of its
program before the party's dissolution, the CPSU did not claim to have
fully established communism, instead claiming that the society was undergoing a very slow and gradual process of transition.
Several works of utopian fiction have portrayed versions of a communist society. Some examples include: Assemblywomen (391 BC) by Aristophanes,
an early piece of utopian satire which mocks Athenian democracy's
excesses through the story of the Athenian women taking control of the
government and instituting a proto-communistutopia; The Law of Freedom in a Platform (1652) by Gerrard Winstanley, a radical communist vision of an ideal state; News from Nowhere (1892) by William Morris, describing a future society based on common ownership and democratic control of the means of production; Red Star (1908, Russian: Красная звезда), Alexander Bogdanov's 1908 science fiction novel about a communist society on Mars; and The Dispossessed: An Ambiguous Utopia (1974) by Ursula K. Le Guin,
set between a pair of planets: one that like Earth today is dominated
by private property, nation states, gender hierarchy, and war, and the
other an anarchist society without private property.
The economy and society of the United Federation of Planets in the Star Trek
franchise has been described as a communist society where material
scarcity has been eliminated due to the wide availability of replicator
technology that enables free distribution of output, where there is no
need for money.
The Culture novels by Iain M Banks are centered on a communist post-scarcity economywhere technology is advanced to such a degree that all production is automated, and there is no use for money or property (aside from personal possessions with sentimental value).
Humans in the Culture are free to pursue their own interests in an open
and socially-permissive society. The society has been described by some
commentators as "communist-bloc" or "anarcho-communist". Banks' close friend and fellow science fiction writer Ken MacLeod
has said that The Culture can be seen as a realization of Marx's
communism, but adds that "however friendly he was to the radical left,
Iain had little interest in relating the long-range possibility of
utopia to radical politics in the here and now. As he saw it, what
mattered was to keep the utopian possibility open by continuing
technological progress, especially space development, and in the
meantime to support whatever policies and politics in the real world
were rational and humane."
Utopian socialism is the term often used to describe the first current of modern socialism and socialist thought as exemplified by the work of Henri de Saint-Simon, Charles Fourier, Étienne Cabet, and Robert Owen.
Utopian socialism is often described as the presentation of visions and
outlines for imaginary or futuristic ideal societies, with positive
ideals being the main reason for moving society in such a direction.
Later socialists and critics of utopian socialism viewed utopian
socialism as not being grounded in actual material conditions of
existing society. These visions of ideal societies competed with revolutionary and social democratic movements.
The term utopian socialism is most often applied to those socialists who lived in the first quarter of the 19th century by later socialists as a pejorative in order to dismiss their ideas as fanciful and unrealistic. A similar school of thought that emerged in the early 20th century which makes the case for socialism on moral grounds is ethical socialism.
Those anarchists and Marxists who dismissed utopian socialism did so because utopian socialists generally did not believe any form of class struggle or social revolution
was necessary for socialism to emerge. Utopian socialists believed that
people of all classes could voluntarily adopt their plan for society if
it was presented convincingly.
Cooperative socialism could be established among like-minded people in
small communities that would demonstrate the feasibility of their plan
for the broader society. Because of this tendency, utopian socialism was also related to classical radicalism, a left-wing liberal ideology.
Development
The term utopian socialism was introduced by Karl Marx in "For a Ruthless Criticism of Everything" in 1843 and then developed in The Communist Manifesto in 1848.
The term was used by later socialist thinkers to describe early
socialist or quasi-socialist intellectuals who created hypothetical
visions of egalitarian, communal, meritocratic, or other notions of perfect societies without considering how these societies could be created or sustained.
In The Poverty of Philosophy, Marx criticized the economic and philosophical arguments of Proudhon set forth in The System of Economic Contradictions, or The Philosophy of Poverty. Marx accused Proudhon of wanting to rise above the bourgeoisie. In the history of Marx's thought and Marxism,
this work is pivotal in the distinction between the concepts of utopian
socialism and what Marx and the Marxists claimed as scientific
socialism. Although utopian socialists shared few political, social, or
economic perspectives, Marx and Engels argued that they shared certain
intellectual characteristics. In The Communist Manifesto, Marx and Friedrich Engels wrote:
The
undeveloped state of the class struggle, as well as their own
surroundings, causes Socialists of this kind to consider themselves far
superior to all class antagonisms. They want to improve the condition of
every member of society, even that of the most favored. Hence, they
habitually appeal to society at large, without distinction of class;
nay, by preference, to the ruling class. For how can people, when once
they understand their system, fail to see it in the best possible plan
of the best possible state of society? Hence, they reject all political,
and especially all revolutionary, action; they wish to attain their
ends by peaceful means, and endeavor, by small experiments, necessarily
doomed to failure, and by the force of example, to pave the way for the
new social Gospel.
Marx and Engels associated utopian
socialism with communitarian socialism which similarly sees the
establishment of small intentional communities as both a strategy for
achieving and the final form of a socialist society. Marx and Engels used the term scientific socialism
to describe the type of socialism they saw themselves developing.
According to Engels, socialism was not "an accidental discovery of this
or that ingenious brain, but the necessary outcome of the struggle
between two historically developed classes, namely the proletariat and
the bourgeoisie. Its task was no longer to manufacture a system of
society as perfect as possible, but to examine the historical-economic
succession of events from which these classes and their antagonism had
of necessity sprung, and to discover in the economic conditions thus
created the means of ending the conflict". Critics have argued that
utopian socialists who established experimental communities were in fact
trying to apply the scientific method to human social organization and were therefore not utopian. On the basis of Karl Popper's definition of science as "the practice of experimentation, of hypothesis and test", Joshua Muravchik
argued that "Owen and Fourier and their followers were the real
'scientific socialists.' They hit upon the idea of socialism, and they
tested it by attempting to form socialist communities". By contrast,
Muravchik further argued that Marx made untestable predictions about the
future and that Marx's view that socialism would be created by
impersonal historical forces may lead one to conclude that it is
unnecessary to strive for socialism because it will happen anyway.
Social unrest between the employee and employer in a society
results from the growth of productive forces such as technology and
natural resources are the main causes of social and economic
development.
These productive forces require a mode of production, or an economic
system, that's based around private property rights and institutions
that determine the wage for labor. Additionally, the capitalist rulers control the modes of production.
This ideological economic structure allows the bourgeoises to undermine
the worker's sensibility of their place in society, being that the
bourgeoises rule the society in their own interests. These rulers of
society exploit the relationship between labor and capital, allowing for
them to maximize their profit.
To Marx and Engels, the profiteering through the exploitation of
workers is the core issue of capitalism, explaining their beliefs for
the oppression of the working class. Capitalism will reach a certain
stage, one of which it cannot progress society forward, resulting in the
seeding of socialism.
As a socialist, Marx theorized the internal failures of capitalism. He
described how the tensions between the productive forces and the modes
of production would lead to the downfall of capitalism through a social
revolution.
Leading the revolution would be the proletariat, being that the
preeminence of the bourgeoise would end. Marx's vision of his society
established that there would be no classes, freedom of mankind, and the
opportunity of self-interested labor to rid any alienation. In Marx's view, the socialist society would better the lives of the working class by introducing equality for all.
Since the mid-19th century, Engels overtook utopian socialism in
terms of intellectual development and number of adherents. At one time
almost half the population of the world lived under regimes that claimed
to be Marxist. Currents such as Owenism and Fourierism
attracted the interest of numerous later authors but failed to compete
with the now dominant Marxist and Anarchist schools on a political
level. It has been noted that they exerted a significant influence on
the emergence of new religious movements such as spiritualism and occultism.
Utopian socialists were seen as wanting to expand the principles
of the French revolution in order to create a more rational society.
Despite being labeled as utopian by later socialists, their aims were
not always utopian and their values often included rigid support for the
scientific method and the creation of a society based upon scientific
understanding.
In literature and in practice
Utopian socialist pamphlet of Swiss social medical doctor Rudolf Sutermeister (1802–1868)
Edward Bellamy (1850–1898) published Looking Backward
in 1888, a utopian romance novel about a future socialist society. In
Bellamy's utopia, property was held in common and money replaced with a
system of equal credit for all. Valid for a year and non-transferable
between individuals, credit expenditure was to be tracked via
"credit-cards" (which bear no resemblance to modern credit cards which
are tools of debt-finance). Labour was compulsory from age 21 to 40 and
organised via various departments of an Industrial Army to which most
citizens belonged. Working hours were to be cut drastically due to
technological advances (including organisational). People were expected
to be motivated by a Religion of Solidarity and criminal behavior was
treated as a form of mental illness or "atavism". The book ranked as
second or third best seller of its time (after Uncle Tom's Cabin and Ben Hur). In 1897, Bellamy published a sequel entitled Equality as a reply to his critics and which lacked the Industrial Army and other authoritarian aspects.
William Morris (1834–1896) published News from Nowhere in 1890, partly as a response to Bellamy's Looking Backward,
which he equated with the socialism of Fabians such as Sydney Webb.
Morris' vision of the future socialist society was centred around his
concept of useful work as opposed to useless toil and the redemption of
human labour. Morris believed that all work should be artistic, in the
sense that the worker should find it both pleasurable and an outlet for
creativity. Morris' conception of labour thus bears strong resemblance
to Fourier's, while Bellamy's (the reduction of labour) is more akin to
that of Saint-Simon or in aspects Marx.
Many participants in the historical kibbutz movement in Israel were motivated by utopian socialist ideas. Augustin Souchy
(1892–1984) spent most of his life investigating and participating in
many kinds of socialist communities. Souchy wrote about his experiences
in his autobiography Beware! Anarchist! Behavioral psychologist B. F. Skinner (1904–1990) published Walden Two in 1948. The Twin Oaks Community was originally based on his ideas. Ursula K. Le Guin (1929-2018) wrote about an impoverished anarchist society in her book The Dispossessed,
published in 1974, in which the anarchists agree to leave their home
planet and colonize a barely habitable moon in order to avoid a bloody
revolution.
Utopian
communities have existed all over the world. In various forms and
locations, they have existed continuously in the United States since the
1730s, beginning with Ephrata Cloister, a religious community in what is now Lancaster County, Pennsylvania.
An economic model is a theoretical construct representing economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified, often mathematical, framework designed to illustrate complex processes. Frequently, economic models posit structural parameters. A model may have various exogenous variables,
and those variables may change to create various responses by economic
variables. Methodological uses of models include investigation,
theorizing, and fitting theories to the world.
Overview
In
general terms, economic models have two functions: first as a
simplification of and abstraction from observed data, and second as a
means of selection of data based on a paradigm of econometric study.
Simplification is particularly important for economics given the enormous complexity of economic processes.
This complexity can be attributed to the diversity of factors that
determine economic activity; these factors include: individual and cooperative decision processes, resource limitations, environmental and geographical constraints, institutional and legal requirements and purely random
fluctuations. Economists therefore must make a reasoned choice of which
variables and which relationships between these variables are relevant
and which ways of analyzing and presenting this information are useful.
Selection is important because the nature of an economic
model will often determine what facts will be looked at and how they
will be compiled. For example, inflation
is a general economic concept, but to measure inflation requires a
model of behavior, so that an economist can differentiate between
changes in relative prices and changes in price that are to be
attributed to inflation.
In addition to their professional academic interest, uses of models include:
Forecasting economic activity in a way in which conclusions are logically related to assumptions;
Proposing economic policy to modify future economic activity;
Presenting reasoned arguments to politically justify economic policy at the national level, to explain and influence company
strategy at the level of the firm, or to provide intelligent advice for
household economic decisions at the level of households.
In finance, predictive models have been used since the 1980s for trading (investment and speculation). For example, emerging market bonds were often traded based on economic models predicting the growth of the developing nation issuing them. Since the 1990s many long-term risk management
models have incorporated economic relationships between simulated
variables in an attempt to detect high-exposure future scenarios (often
through a Monte Carlo method).
A model establishes an argumentative framework for applying logic and mathematics
that can be independently discussed and tested and that can be applied
in various instances. Policies and arguments that rely on economic
models have a clear basis for soundness, namely the validity of the supporting model.
Economic models in current use do not pretend to be theories of everything economic; any such pretensions would immediately be thwarted by computational
infeasibility and the incompleteness or lack of theories for various
types of economic behavior. Therefore, conclusions drawn from models
will be approximate representations of economic facts. However, properly
constructed models can remove extraneous information and isolate useful
approximations
of key relationships. In this way more can be understood about the
relationships in question than by trying to understand the entire
economic process.
The details of model construction vary with type of model and its
application, but a generic process can be identified. Generally, any
modelling process has two steps: generating a model, then checking the
model for accuracy (sometimes called diagnostics). The diagnostic step
is important because a model is only useful to the extent that it
accurately mirrors the relationships that it purports to describe.
Creating and diagnosing a model is frequently an iterative process in
which the model is modified (and hopefully improved) with each iteration
of diagnosis and respecification. Once a satisfactory model is found,
it should be double checked by applying it to a different data set.
Types of models
According to whether all the model variables are deterministic, economic models can be classified as stochastic
or non-stochastic models; according to whether all the variables are
quantitative, economic models are classified as discrete or continuous
choice model; according to the model's intended purpose/function, it can
be classified as
quantitative or qualitative; according to the model's ambit, it can be
classified as a general equilibrium model, a partial equilibrium model,
or even a non-equilibrium model; according to the economic agent's
characteristics, models can be classified as rational agent models,
representative agent models etc.
Non-stochastic models may be purely qualitative (for example, relating to social choice theory) or quantitative (involving rationalization of financial variables, for example with hyperbolic coordinates, and/or specific forms of functional relationships
between variables). In some cases economic predictions in a coincidence
of a model merely assert the direction of movement of economic
variables, and so the functional relationships are used only stoical in a
qualitative sense: for example, if the price of an item increases, then the demand for that item will decrease. For such models, economists often use two-dimensional graphs instead of functions.
Qualitative models – although almost all economic models
involve some form of mathematical or quantitative analysis, qualitative
models are occasionally used. One example is qualitative scenario planning
in which possible future events are played out. Another example is
non-numerical decision tree analysis. Qualitative models often suffer
from lack of precision.
At a more practical level, quantitative modelling is applied to many
areas of economics and several methodologies have evolved more or less
independently of each other. As a result, no overall model taxonomy
is naturally available. We can nonetheless provide a few examples that
illustrate some particularly relevant points of model construction.
An accounting model is one based on the premise that for every credit there is a debit. More symbolically, an accounting model expresses some principle of conservation in the form
algebraic sum of inflows = sinks − sources
This principle is certainly true for money and it is the basis for national income accounting. Accounting models are true by convention, that is any experimental failure to confirm them, would be attributed to fraud,
arithmetic error or an extraneous injection (or destruction) of cash,
which we would interpret as showing the experiment was conducted
improperly.
Optimality and constrained optimization models – Other examples of quantitative models are based on principles such as profit or utility maximization. An example of such a model is given by the comparative statics of taxation on the profit-maximizing firm. The profit of a firm is given by
where is the price that a product commands in the market if it is supplied at the rate , is the revenue obtained from selling the product, is the cost of bringing the product to market at the rate , and is the tax that the firm must pay per unit of the product sold.
The profit maximization assumption states that a firm will produce at the output rate x if that rate maximizes the firm's profit. Using differential calculus we can obtain conditions on x under which this holds. The first order maximization condition for x is
Regarding x as an implicitly defined function of t by this equation (see implicit function theorem), one concludes that the derivative of x with respect to t has the same sign as
Thus the profit maximization model predicts something about the
effect of taxation on output, namely that output decreases with
increased taxation. If the predictions of the model fail, we conclude
that the profit maximization hypothesis was false; this should lead to
alternate theories of the firm, for example based on bounded rationality.
Borrowing a notion apparently first used in economics by Paul Samuelson, this model of taxation and the predicted dependency of output on the tax rate, illustrates an operationally meaningful theorem; that is one requiring some economically meaningful assumption that is falsifiable under certain conditions.
Aggregate models. Macroeconomics needs to deal with aggregate quantities such as output, the price level, the interest rate and so on. Now real output is actually a vector of goods and services, such as cars, passenger airplanes, computers, food items, secretarial services, home repair services etc. Similarly price
is the vector of individual prices of goods and services. Models in
which the vector nature of the quantities is maintained are used in
practice, for example Leontiefinput–output models
are of this kind. However, for the most part, these models are
computationally much harder to deal with and harder to use as tools for qualitative analysis. For this reason, macroeconomic models usually lump together different variables into a single quantity such as output or price.
Moreover, quantitative relationships between these aggregate variables
are often parts of important macroeconomic theories. This process of
aggregation and functional dependency between various aggregates usually
is interpreted statistically and validated by econometrics. For instance, one ingredient of the Keynesian model is a functional relationship between consumption and national income: C = C(Y). This relationship plays an important role in Keynesian analysis.
Problems with economic models
Most
economic models rest on a number of assumptions that are not entirely
realistic. For example, agents are often assumed to have perfect
information, and markets are often assumed to clear without friction.
Or, the model may omit issues that are important to the question being
considered, such as externalities.
Any analysis of the results of an economic model must therefore
consider the extent to which these results may be compromised by
inaccuracies in these assumptions, and a large literature has grown up
discussing problems with economic models, or at least asserting that their results are unreliable.
History
One of
the major problems addressed by economic models has been understanding
economic growth. An early attempt to provide a technique to approach
this came from the French physiocratic school in the eighteenth century. Among these economists, François Quesnay was known particularly for his development and use of tables he called Tableaux économiques. These tables have in fact been interpreted in more modern terminology as a Leontiev model, see the Phillips reference below.
All through the 18th century (that is, well before the founding
of modern political economy, conventionally marked by Adam Smith's 1776 Wealth of Nations), simple probabilistic models were used to understand the economics of insurance. This was a natural extrapolation of the theory of gambling, and played an important role both in the development of probability theory itself and in the development of actuarial science. Many of the giants of 18th century mathematics contributed to this field. Around 1730, De Moivre addressed some of these problems in the 3rd edition of The Doctrine of Chances. Even earlier (1709), Nicolas Bernoulli studies problems related to savings and interest in the Ars Conjectandi. In 1730, Daniel Bernoulli studied "moral probability" in his book Mensura Sortis,
where he introduced what would today be called "logarithmic utility of
money" and applied it to gambling and insurance problems, including a
solution of the paradoxical Saint Petersburg problem. All of these developments were summarized by Laplace in his Analytical Theory of Probabilities (1812). Thus, by the time David Ricardo came along he had a well-established mathematical basis to draw from.
Tests of macroeconomic predictions
In the late 1980s, the Brookings Institution compared 12 leading macroeconomic models
available at the time. They compared the models' predictions for how
the economy would respond to specific economic shocks (allowing the
models to control for all the variability in the real world; this was a
test of model vs. model, not a test against the actual outcome).
Although the models simplified the world and started from a stable,
known common parameters the various models gave significantly different
answers. For instance, in calculating the impact of a monetary loosening on output some models estimated a 3% change in GDP after one year, and one gave almost no change, with the rest spread between.
Partly as a result of such experiments, modern central bankers no
longer have as much confidence that it is possible to 'fine-tune' the
economy as they had in the 1960s and early 1970s. Modern policy makers
tend to use a less activist approach, explicitly because they lack
confidence that their models will actually predict where the economy is
going, or the effect of any shock upon it. The new, more humble,
approach sees danger in dramatic policy changes based on model
predictions, because of several practical and theoretical limitations in
current macroeconomic models; in addition to the theoretical pitfalls, (listed above) some problems specific to aggregate modelling are:
Limitations in model construction caused by difficulties in
understanding the underlying mechanisms of the real economy. (Hence the
profusion of separate models.)
The law of unintended consequences, on elements of the real economy not yet included in the model.
The time lag in both receiving data and the reaction of economic variables to policy makers attempts to 'steer' them (mostly through monetary policy) in the direction that central bankers want them to move. Milton Friedman
has vigorously argued that these lags are so long and unpredictably
variable that effective management of the macroeconomy is impossible.
The difficulty in correctly specifying all of the parameters (through econometric measurements) even if the structural model and data were perfect.
The fact that all the model's relationships and coefficients are
stochastic, so that the error term becomes very large quickly, and the
available snapshot of the input parameters is already out of date.
Modern economic models incorporate the reaction of the public and market to the policy maker's actions (through game theory), and this feedback is included in modern models (following the rational expectations revolution and Robert Lucas, Jr.'s Lucas critique of non-microfounded models). If the response to the decision maker's actions (and their credibility) must be included in the model then it becomes much harder to influence some of the variables simulated.
Comparison with models in other sciences
Complex systems specialist and mathematician David Orrell wrote on this issue in his book Apollo's Arrow
and explained that the weather, human health and economics use similar
methods of prediction (mathematical models). Their systems—the
atmosphere, the human body and the economy—also have similar levels of
complexity. He found that forecasts fail because the models suffer from
two problems: (i) they cannot capture the full detail of the underlying
system, so rely on approximate equations; (ii) they are sensitive to
small changes in the exact form of these equations. This is because
complex systems like the economy or the climate consist of a delicate
balance of opposing forces, so a slight imbalance in their
representation has big effects. Thus, predictions of things like
economic recessions are still highly inaccurate, despite the use of
enormous models running on fast computers.
See Unreasonable ineffectiveness of mathematics § Economics and finance.
Effects of deterministic chaos on economic models
Economic and meteorological simulations may share a fundamental limit to their predictive powers: chaos. Although the modern mathematical work on chaotic systems began in the 1970s the danger of chaos had been identified and defined in Econometrica as early as 1958:
"Good theorising consists to a large extent in avoiding
assumptions ... [with the property that] a small change in what is
posited will seriously affect the conclusions."
It is straightforward to design economic models susceptible to butterfly effects of initial-condition sensitivity.
However, the econometric
research program to identify which variables are chaotic (if any) has
largely concluded that aggregate macroeconomic variables probably do not
behave chaotically.
This would mean that refinements to the models could ultimately produce
reliable long-term forecasts. However, the validity of this conclusion
has generated two challenges:
In 2004 Philip Mirowski challenged this view and those who hold it, saying that chaos in economics is suffering from a biased "crusade" against it by neo-classical economics in order to preserve their mathematical models.
The variables in finance may well be subject to chaos. Also in 2004, the University of Canterbury study Economics on the Edge of Chaos concludes that after noise is removed from S&P 500 returns, evidence of deterministic chaos is found.
More recently, chaos (or the butterfly effect) has been identified as
less significant than previously thought to explain prediction errors.
Rather, the predictive power of economics and meteorology would mostly
be limited by the models themselves and the nature of their underlying
systems (see Comparison with models in other sciences above).
Critique of hubris in planning
A key strand of free market economic thinking is that the market's invisible hand guides an economy to prosperity more efficiently than central planning using an economic model. One reason, emphasized by Friedrich Hayek,
is the claim that many of the true forces shaping the economy can never
be captured in a single plan. This is an argument that cannot be made
through a conventional (mathematical) economic model because it says
that there are critical systemic-elements that will always be omitted
from any top-down analysis of the economy.
Macroeconomics takes a big-picture view of the
entire economy, including examining the roles of, and relationships
between, firms, households and governments, and the different types of
markets, such as the financial market and the labour market
Macroeconomics and microeconomics are the two most general fields in economics.
The focus of macroeconomics is often on a country (or larger entities
like the whole world) and how its markets interact to produce
large-scale phenomena that economists refer to as aggregate variables.
In microeconomics the focus of analysis is often a single market, such
as whether changes in supply or demand are to blame for price increases
in the oil and automotive sectors.
From introductory classes in "principles of economics" through doctoral
studies, the macro/micro divide is institutionalized in the field of
economics. Most economists identify as either macro- or
micro-economists.
Macroeconomics is traditionally divided into topics along
different time frames: the analysis of short-term fluctuations over the business cycle,
the determination of structural levels of variables like inflation and
unemployment in the medium (i.e. unaffected by short-term deviations)
term, and the study of long-term economic growth. It also studies the
consequences of policies targeted at mitigating fluctuations like fiscal or monetary policy,
using taxation and government expenditure or interest rates,
respectively, and of policies that can affect living standards in the
long term, e.g. by affecting growth rates.
Macroeconomics
encompasses a variety of concepts and variables, but above all the
three central macroeconomic variables are output, unemployment, and
inflation.
Besides, the time horizon varies for different types of macroeconomic
topics, and this distinction is crucial for many research and policy
debates.A further important dimension is that of an economy's openness, economic theory distinguishing sharply between closed economies and open economies.
the medium run (e.g. a decade): Over the medium run, the
economy tends to an output level determined by supply factors like the
capital stock, the technology level and the labor force, and
unemployment tends to revert to its structural (or "natural") level.
These factors move slowly, so that it is a reasonable approximation to
take them as given in a medium-term time scale, though labour market policies and competition policy are instruments that may influence the economy's structures and hence also the medium-run equilibrium
the long run (e.g. a couple of decades or more): On this time scale, emphasis is on the determinants of long-run economic growth like accumulation of human and physical capital, technological innovations and demographic changes. Potential policies to influence these developments are education reforms, incentives to change saving rates or to increase R&D activities.
Output and income
National output
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 net output of the economy is usually measured as gross domestic product (GDP). Adding net factor incomes from abroad to GDP produces gross national income
(GNI), which measures total income of all residents in the economy. In
most countries, the difference between GDP and GNI are modest so that
GDP can approximately be treated as total income of all the inhabitants
as well, but in some countries, e.g. countries with very large net foreign assets (or debt), the difference may be considerable.
Economists interested in long-run increases in output study
economic growth. Advances in technology, accumulation of machinery and
other capital, and better education and human capital,
are all factors that lead to increased economic output over time.
However, output does not always increase consistently over time. Business cycles can cause short-term drops in output called recessions. Economists look for macroeconomic policies that prevent economies from slipping into either recessions or overheating and that lead to higher productivity levels and standards of living.
A chart using US data showing the relationship between economic growth and unemployment expressed by Okun's law. The relationship demonstrates cyclical unemployment. High short-run GDP growth leads to a lower unemployment rate.
The amount of unemployment in an economy is measured by the unemployment rate, i.e. the percentage of persons in the labor force who do not have a job, but who are actively looking for one. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are not part of the labor force and consequently not counted as unemployed, either.
Unemployment has a short-run cyclical component which depends on
the business cycle, and a more permanent structural component, which can
be loosely thought of as the average unemployment rate in an economy
over extended periods, and which is often termed the natural or structural rate of unemployment.
Cyclical unemployment occurs when growth stagnates. Okun's law represents the empirical relationship between unemployment and short-run GDP growth. The original version of Okun's law states that a 3% increase in output would lead to a 1% decrease in unemployment.
The structural or natural rate of unemployment is the level of
unemployment that will occur in a medium-run equilibrium, i.e. a
situation with a cyclical unemployment rate of zero. There may be
several reasons why there is some positive unemployment level even in a
cyclically neutral situation, which all have their foundation in some
kind of market failure:
Search unemployment (also called frictional unemployment) occurs when workers and firms are heterogeneous and there is imperfect information, generally causing a time-consuming search and matching process when filling a job vacancy in a firm, during which the prospective worker will often be unemployed.
Sectoral shifts and other reasons for a changed demand from firms for
workers with particular skills and characteristics, which occur
continually in a changing economy, may also cause more search
unemployment because of increased mismatch.
Efficiency wage
models are labor market models in which firms choose not to lower wages
to the level where supply equals demand because the lower wages would
lower employees' efficiency levels.
Trade unions, which are important actors in the labor market in some countries, may exercise market power in order to keep wages over the market-clearing level for the benefice of their members even at the cost of some unemployment
Legal minimum wages may prevent the wage from falling to a market-clearing level, causing unemployment among low-skilled (and low-paid) workers. In the case of employers having some monopsony power, however, employment effects may have the opposite sign.
Inflation and deflation
Changes
in the ten-year moving averages of price level and growth in money
supply (using the measure of M2, the supply of hard currency and money
held in most types of bank accounts) in the US from 1880 to 2016. Over
the long run, the two series show a clear positive correlation.
A general price increase across the entire economy is called inflation. When prices decrease, there is deflation. Economists measure these changes in prices with price indexes.
Inflation will increase when an economy becomes overheated and grows
too quickly. Similarly, a declining economy can lead to decreasing
inflation and even in some cases deflation.
Central bankers conducting monetary policy
usually have as a main priority to avoid too high inflation, typically
by adjusting interest rates. High inflation as well as deflation can
lead to increased uncertainty and other negative consequences, in
particular when the inflation (or deflation) is unexpected.
Consequently, most central banks aim for a positive, but stable and not
very high inflation level.
Changes in the inflation level may be the result of several factors. Too much aggregate demand in the economy will cause an overheating, raising inflation rates via the Phillips curve because of a tight labor market leading to large wage increases which will be transmitted
to increases in the price of the products of employers. Too little
aggregate demand will have the opposite effect of creating more
unemployment and lower wages, thereby decreasing inflation. Aggregate supply shocks will also affect inflation, e.g. the oil crises of the 1970s and the 2021–2023 global energy crisis. Changes in inflation may also impact the formation of inflation expectations, creating a self-fulfilling inflationary or deflationary spiral.
The monetaristquantity theory of money holds that changes in the price level are directly caused by changes in the money supply.
Whereas there is empirical evidence that there is a long-run positive
correlation between the growth rate of the money stock and the rate of
inflation, the quantity theory has proved unreliable in the short- and
medium-run time horizon relevant to monetary policy and is abandoned as a
practical guideline by most central banks today.
Macroeconomics as a separate field of research and study is generally recognized to start with the publication of John Maynard Keynes' The General Theory of Employment, Interest, and Money in 1936. The terms "macrodynamics" and "macroanalysis" were introduced by Ragnar Frisch in 1933, and Lawrence Klein in 1946 used the word "macroeconomics" itself in a journal title in 1946.
but naturally several of the themes which are central to macroeconomic
research had been discussed by thoughtful economists and other writers
long before 1936.
When
the Great Depression struck, the reigning economists had difficulty
explaining how goods could go unsold and workers could be left
unemployed. In the prevailing neoclassical economics
paradigm, prices and wages would drop until the market cleared, and all
goods and labor were sold. Keynes in his main work, the General Theory, initiated what is known as the Keynesian revolution.
He offered a new interpretation of events and a whole intellectural
framework - a novel theory of economics that explained why markets might
not clear, which would evolve into a school of thought known as Keynesian economics, also called Keynesianism or Keynesian theory.
In Keynes' theory, aggregate demand
- by Keynes called "effective demand" - was key to determining output.
Even if Keynes conceded that output might eventually return to a
medium-run equilibrium (or "potential") level, the process would be slow
at best. Keynes coined the term liquidity preference (his preferred name for what is also known as money demand)
and explained how monetary policy might affect aggregate demand, at the
same time offering clear policy recommendations for an active role of
fiscal policy in stabilizing aggregate demand and hence output and
employment. In addition, he explained how the multiplier effect
would magnify a small decrease in consumption or investment and cause
declines throughout the economy, and noted the role that 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 1950s, most economists had accepted the synthesis view of the macroeconomy. Economists like Paul Samuelson, Franco Modigliani, James Tobin, and Robert Solow
developed formal Keynesian models and contributed formal theories of
consumption, investment, and money demand that fleshed out the Keynesian
framework.
Monetarism
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 original simple 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. 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, but fell out of favor when central banks found the
results disappointing when trying to target money supply instead of
interest rates as monetarists recommended, concluding that the
relationships between money growth, inflation and real GDP growth are
too unstable to be useful in practical monetary policy making.
New classical economics
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. Consumers 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. In
the new classical models with rational expectations, monetary policy
only had 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 (i.e. having an explicit microeconomic foundation) 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 macro economy. RBC models were created by combining
fundamental equations from neo-classical microeconomics to make
quantitative models. 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 technological changes, which typically diffuse
slowly throughout the economy, could hardly generate the large
short-run output fluctuations that we observe. In addition, there is
strong empirical evidence that monetary policy does affect real economic
activity, and the idea that technological regress can explain recent
recessions seems implausible.
Despite criticism of the realism in the RBC models, they have been very influential in economic methodology by providing the first examples of general equilibrium models based on microeconomic foundations
and a specification of underlying shocks that aim to explain the main
features of macroeconomic fluctuations, not only qualitatively, but also
quantitatively. In this way, they were forerunners of the later DSGE
models.
New Keynesian response
New Keynesian
economists responded to the new classical school by adopting rational
expectations and focusing on developing micro-founded models that were
immune to the Lucas critique. 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. 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, Janet Yellen, Julio Rotemberg, Greg Mankiw, David Romer, and Michael Woodford,
expanded on this work and demonstrated other cases where various market
imperfections caused inflexible prices and wages leading in turn to
monetary and fiscal policy having real effects. Other researchers
focused on imperferctions in labor markets, developing models of efficiency wages or search and matching (SAM) models, or imperfections in credit markets like Ben Bernanke.
By the late 1990s, economists had reached a rough consensus.
The market imperfections and nominal rigidities of new Keynesian theory
was combined with rational expectations and the RBC methodology to
produce a new and popular type of models called 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.
After the global financial crisis
The global financial crisis leading to the Great Recession led to major reassessment of macroeconomics, which as a field generally had neglected the potential role of financial institutions in the economy. After the crisis, macroeconomic researchers have turned their attention in several new directions:
the financial system and the nature of macrofinancial linkages
and frictions, studying leverage, liquidity and complexity problems in
the financial sector, the use of macroprudential tools and the dangers of an unsustainable public debt
interest in understanding the importance of heterogeneity among the economic agents, leading among other examples to the construction of heterogeneous agent new Keynesian models (HANK models), which may potentially also improve understanding of the impact of macroeconomics on the income distribution
understanding the implications of integrating the findings of the increasingly useful behavioral economics literature into macroeconomics and behavioral finance
Growth models
Research in the economics of the determinants behind long-run economic growth has followed its own course. The Harrod-Domar model from the 1940s attempted to build a long-run growth model inspired by Keynesian demand-driven considerations. The Solow–Swan model worked out by Robert Solow and, independently, Trevor Swan
in the 1950s achieved more long-lasting success, however, and is still
today a common textbook model for explaining economic growth in the
long-run. The model operates with a production function
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.
In this model, increases in output, i.e. 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).
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. The Solow model can be interpreted as a special case of the more general Ramsey growth model, where households' savings rates are not constant as in the Solow model, but derived from an explicit intertemporal utility function.
In the 1980s and 1990s endogenous growth theory
arose to challenge the neoclassical growth theory of Ramsey and Solow.
This group of models explains economic growth through 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. Another type of endogenous growth models endogenized the process of technological progress by modelling research and development activities by profit-maximizing firms explicitly within the growth models themselves.
Environmental and climate issues
Natural resources flow through the economy and end up as waste and pollution.
Since the 1970s, various environmental problems have been integrated
into growth and other macroeconomic models to study their implications
more thoroughly. During the oil crises of the 1970s when scarcity
problems of natural resources were high on the public agenda, economists
like Joseph Stiglitz and Robert Solow introduced non-renewable resources into neoclassical growth models to study the possibilities of maintaining growth in living standards under these conditions. More recently, the issue of climate change and the possibilities of a sustainable development are examined in so-called integrated assessment models, pioneered by William Nordhaus. In macroeconomic models in environmental economics, the economic system is dependant upon the environment. In this case, the circular flow of income diagram may be replaced 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.
Macroeconomic policy
The
division into various time frames of macroeconomic research leads to a
parallel division of macroeconomic policies into short-run policies
aimed at mitigating the harmful consequences of business cycles (known
as stabilization policy) and medium- and long-run policies targeted at improving the structural levels of macroeconomic variables.
Stabilization policy is usually implemented through two sets of
tools: fiscal and monetary policy. Both forms of policy are used to stabilize the economy, i.e. limiting the effects of the business cycle by conducting expansive policy when the economy is in a recession or contractive policy in the case of overheating.
Structural policies may be labor market policies which aim to
change the structural unemployment rate or policies which affect
long-run propensities to save, invest, or engage in education or
research and development.
Central banks conduct monetary policy mainly by adjusting short-term interest rates.[39]
The actual method through which the interest rate is changed differs
from central bank to central bank, but typically the implementation
happens either directly via administratively changing the central bank's
own offered interest rates or indirectly via open market operations.
In developed countries, most central banks follow inflation targeting, focusing on keeping medium-term inflation close to an explicit target, say 2%, or within an explicit range. This includes the Federal Reserve and the European Central Bank,
which are generally considered to follow a strategy very close to
inflation targeting, even though they do not officially label themselves
as inflation targeters. In practice, an official inflation targeting often leaves room for the central bank to also help stabilize output and employment, a strategy known as "flexible inflation targeting". Most emerging economies focus their monetary policy on maintaining a fixed exchange rate regime, aligning their currency with one or more foreign currencies, typically the US dollar or the euro.
Conventional monetary policy can be ineffective in situations such as a liquidity trap.
When nominal interest rates are near zero, central banks cannot loosen
monetary policy through conventional means. In that situation, they may
use unconventional monetary policy such as quantitative easing
to help stabilize output. Quantity easing can be implemented 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. A similar
strategy is to lower long-term interest rates by buying long-term bonds
and selling short-term bonds to create a flat yield curve, known in the US as Operation Twist.
Fiscal policy is the use of government's revenue (taxes) and expenditure as instruments to influence the economy.
For example, if the economy is producing less than potential output,
government spending can be used to employ idle resources and boost
output, or taxes could be lowered to boost private consumption which has
a similar effect. Government spending or tax cuts do not have to make
up for the entire output gap. There is a multiplier effect
that affects 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 partial or full crowding out.
When the government takes on spending projects, it limits the amount of
resources available for the private sector to use. Full crowding out
occurs in the extreme case when government spending simply replaces
private sector output instead of adding additional output to the
economy. A crowding out effect may also occur if government spending
should lead to higher interest rates, which would limit investment.
Some fiscal policy is implemented through automatic stabilizers without any active decisions by politicians. 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 tax revenues decrease, which shelters private income and consumption from part of the fall in market income.
Comparison of fiscal and monetary policy
There
is a general consensus that both monetary and fiscal instruments may
affect demand and activity in the short run (i.e. over the business
cycle).
Economists usually favor monetary over fiscal policy to mitigate
moderate fluctuations, however, 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 be subject to political
pressures for overly expansionary policies. Second, monetary policy may
suffer shorter inside lags and outside lags than fiscal policy.
There are some exceptions, however: Firstly, in the case of a major
shock, monetary stabilization policy may not be sufficient and should be
supplemented by active fiscal stabilization. Secondly, in the case of a very low interest level, the economy may be in a liquidity trap in which monetary policy becomes ineffective, which makes fiscal policy the more potent tool to stabilize the economy. Thirdly, in regimes where monetary policy is tied to fulfilling other targets, in particular fixed exchange rate
regimes, the central bank cannot simultaneously adjust its interest
rates to mitigate domestic business cycle fluctuations, making fiscal
policy the only usable tool for such countries.
Macroeconomic teaching, research and informed debates normally evolve around formal (diagrammatic or equational) macroeconomic models
to clarify assumptions and show their consequences in a precise way.
Models include simple theoretical models, often containing only a few
equations, used in teaching and research to highlight key basic
principles, and larger applied quantitative models used by e.g.
governments, central banks, think tanks and international organisations
to predict effects of changes in economic policy or other exogenous factors or as a basis for making economic forecasting.
In
this example of a traditional IS–LM chart, the IS curve moves to the
right, causing higher interest rates (i) and expansion in the "real"
economy (real GDP, or Y).
The IS–LM model, invented by John Hicks
in 1936, gives the underpinnings of aggregate demand (itself discussed
below). It answers the question "At any given price level, what is the
quantity of goods demanded?" The graphic model shows combinations of
interest rates and output that ensure equilibrium in both the goods and
money markets under the model's assumptions.
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 (equivalent to money demand).
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 traditional 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 in a closed economy) 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 in elementary textbooks to
demonstrate the effects of monetary and fiscal policy, though it ignores
many complexities of most modern macroeconomic models.
A problem related to the LM curve is that modern central banks largely
ignore the money supply in determining policy, contrary to the model's
basic assumptions.
In some modern textbooks, consequently, the traditional IS-LM model has
been modified by replacing the traditional LM curve with an assumption
that the central bank simply determines the interest rate of the economy
directly.
AD-AS model
A traditional AD–AS diagram showing a shift in AD, and the AS curve becoming inelastic beyond potential output
The AD–AS model is a common textbook model for explaining the macroeconomy. The original version of the 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 can be explained as 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 many representations of the AD–AS 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.
Since the economy cannot produce beyond the potential output, any AD
expansion will lead to higher price levels instead of higher output.
In modern textbooks, the AD–AS model is often presented sligthly
differently, however, in a diagram showing not the price level, but the
inflation rate along the vertical axis, making it easier to relate the diagram to real-world policy discussions.
In this framework, the AD curve is downward sloping because higher
inflation will cause the central bank, which is assumed to follow an inflation target,
to raise the interest rate which will dampen economic activity, hence
reducing output. The AS curve is upward sloping following a standard
modern Phillips curve
thought, in which a higher level of economic activity lowers
unemployment, leading to higher wage growth and in turn higher
inflation.
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