On September 29, 2008, the United States experienced one of the largest economic shocks in its history; the stock market plunged by over 777 points, wiping out over $1 trillion in stock value. The market continued to plummet over the following week, setting off a deep recession. Home prices fell, foreclosures rose, and unemployment soared. Toxic financial products flooded the international marketplace, pushing many of the world’s largest financial companies to the brink of bankruptcy.
Almost immediately, political leaders took action to limit the severity of the recession. They provided government funds to save large banks and connected institutions from default. They created a program to buy up the toxic assets that were dragging down the market. The Federal Reserve expanded the nation’s money supply to cover public debts and loosen credit markets. The president enacted a stimulus plan to get money to consumers in hopes of revitalizing the economy by increasing demand for goods and services.
Today, with the economy functioning but sluggish, U.S. politicians battle over the next course of action. Would another stimulus plan get consumers buying again? Should Congress pass a jobs bill to reduce unemployment? Would printing more money for debts help, or cause out-of-control inflation? Could new trade agreements provide an answer to the nation’s economic woes?
Whatever the solution, all of these measures, both implemented and debated, involve macroeconomics. The prefix “macro-,” meaning “big,” in the word “macroeconomics” refers to how economists in this field analyze the structure and function of large-scale economies as a whole, whether regional, national or global. Macroeconomics examines the complex interplay between factors such as national income and savings, gross domestic product, gross national product, consumer and producer price indexes, consumption, unemployment, foreign trade, inflation, investment and international finance. Economists in this field seek to understand fluctuations in business cycles and the elements that contribute to long-term economic growth, which are vital to the creation of sound economic policies by governments and businesses.
The underpinnings of macroeconomic theory emerged in the early 1800s with the work of Swiss writer Jean Charles Léonard de Sismondi. Sismondi proposed that markets experienced natural economic fluctuations apart from those caused by external events, such as war. It was a radical theory at the time, but a major peacetime recession in 1825 proved it valid. Later, in 1860, French economist Clement Juglar took Sismondi’s idea further by identifying specific cycles occurring with fixed investments. These 7-to-11-year cycles became known as Juglar Cycles.
Soon other cycles were observed, such as the lag in feedback on business production (Kitchin Cycle), increased infrastructural investment resulting from demographic expansion (Kuznets wave) and prolonged periods of technological growth (Kondratiev wave). Around 1930, Austrian-American economist Joseph Schumpeter described the four stages of a business cycle: expansion, crisis, recession and recovery.
The concept of business cycles became the basis of macroeconomic theory established by British economist John Maynard Keynes in 1936. Keynes found that classical economics failed to explain prolonged unemployment and recessions, so he proposed examining the economy as a whole to find the answer. What he discovered was that businesses and individuals hoard cash during tough times, restricting the supply of cash available to satisfy demand through consumption. This causes a surplus of goods and labor and slows economic recovery.
Before, economists assumed that markets naturally tended toward satisfying demand, eventually resolving product surpluses and unemployment. Keynes not only challenged such beliefs, he suggested that government intervention could be used to counteract disruptive economic fluctuations through deficit spending, reduced taxes, expansion of the money supply, lower interest rates and other monetary policies.
Unemployment is a major concern of macroeconomists, as it is detrimental to a country’s productivity and prosperity. While classical economists in Keynes’s day blamed unemployment on high labor costs, Keynes argued that chronic unemployment results from underconsumption–meaning that individuals and businesses are not spending enough to fuel demand for labor.
Keynes proposed that money moves in cycles: the payment for a product goes to pay the wages of an employee. In an economy burdened by underconsumption, businesses simply reduce production instead of lowering prices, giving consumers no incentive to buy, increasing unemployment further and causing recession through decreased national output. If prices remain high during recession, then workers have little incentive to settle for reduced wages since they would still lack the purchasing power needed to jump-start demand. Keynes believed the government could counteract underconsumption, prevent recession and encourage rapid economic growth by getting more money into the hands of consumers when markets failed to adequately redistribute wealth.
Keynes’s theory was revolutionary not just because it offered a more valid explanation of why recessions and unemployment occur, but also because it suggested that such events could be controlled through strategic monetary policy. Economists who supported traditional laissez-faire capitalism found Keynes’s notion of policy-driven economic growth distasteful, to say the least. Nevertheless, Keynesian macroeconomics rose to become the dominant economic theory among capitalist nations for nearly 40 years, especially in the U.S. It was most famously used during World War II to keep unemployment at historically low levels. Macroeconomics also led to the creation of the International Monetary Fund and the World Bank in the 1940s.
In 1956, U.S. economist Milton Friedman modified macroeconomic theory to include an equilibrium approach to regulating the money supply, citing Keynes’s disregard for inflation caused by printing too much money. Then, in the 1970s, Keynesian macroeconomics was largely abandoned when it failed to prevent stagflation. It was replaced by supply-side macroeconomics, which seeks to augment demand by cutting taxes, reducing regulations on businesses and lowering prices through increased production. With the recent global economic crisis, however, Keynesian macroeconomics is experiencing a resurgence in popularity.
Modern macroeconomic theory has enjoyed some success in the past, though exactly how much remains the subject of much debate. Critics of macroeconomic policies say that government intervention in markets exacerbates, rather than corrects, economic fluctuations through unforeseen consequences. Some point out that Keynesian macroeconomics assumes irrational behavior from economic actors, putting itself in direct conflict with microeconomic theory. Others claim that macroeconomic policies have little affect on market performance.
Of course, macroeconomics is not just employed at the federal level. Banks, industries and local governments look to macroeconomists for data to guide their economic activities. For instance, central bankers, who are responsible for controlling inflation, rely heavily on macroeconomic analyses to determine whether to release more currency into the marketplace or remove some of it. Industries or businesses struggling to find skilled employees likewise turn to macroeconomists to solve the problem.
Macroeconomists perform analyses by constructing models to simulate or predict market behavior. Such models are usually mathematical in nature, but they can also be logical or computational. Generally, models show the relationship between various economic components, such as a country’s exchange rate, interest rate and output, or inflation and unemployment. Economists may draw diagrams based on models to illustrate market dynamics or the flow of money in an economy. Such aids can be useful for those who create and modify monetary policies.
However, macroeconomic models are far from infallible. Models that only examine a few aspects of an economy when testing the potential effects of a new monetary policy may be excluding dozens of mitigating factors. Random, irrational behavior that seems insignificant at the microeconomic stage may be highly magnified at the national or global scene. Though macroeconomics is largely an extension of microeconomic activity, the aggregation of microeconomic forces creates an other-worldly level of complexity that’s tough for even brilliant economists to untangle. Inventing a macroeconomic model that takes all economic factors into account would be impossible.
Where macroeconomics fails at predicting future economic outcomes, though, it often does quite well at describing past and current market situations. It has, for example, been particularly useful in helping U.S. leaders and historians understand the factors that contributed to the start and severity of the Great Depression in the 1930s. It has also been used to create strategies to deal with chronic unemployment and increase GDP. Despite the controversy surrounding macroeconomic policies, they likely won’t be abandoned anytime soon.