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Macro Economics

Notes money supply, general price level, unemployment, economic growth rate, economic
development, etc. In this unit, you will be introduced to the knowledge area of macro economics.

1.1 Developments of Macro Economics

The Great Depression of the 1930s gave birth to a branch of economics that in 1933 Ragnar Frisch
called Macro Economics. The developments in Macro Economics can be studied under three
distinct heads:

Classical Macro Economics
Keynesian Macro Economics
Post-Keynesian Macro Economics

1.1.1 Classical Macro Economics

The classical economists took a simple view of Macro Economic environment of an economy to
champion the cause of 'laissez faire' capitalism guided by free market price mechanism, private
property rights and commercial profit motive. There are three pillars of classical Macro Economics.

JB Say's Law of Market

Say's law argued that an economy is self-regulating provided that all prices, including wages,
are flexible enough to maintain it in equilibrium. In a more simplistic, and somewhat inaccurate
form, Say's law states that supply creates its own demand and over-production is impossible.
This theory has major implications for how governments respond to periods of high
unemployment or widespread underemployment.

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Caution Say's law was accepted as a major plank in classical Macro Economic theory until
English economist John Maynard Keynes challenged its applicability in modern economies.

Fisher's Quantity Theory of Money

If free market price mechanism has to play its role and responsibility, then price must come to
exist so as to reflect the relative position of either scarcity or abundance in the market. Price
itself is measured in terms of money. In fact, price is the value of something expressed in a
monetary unit. Thus, we may have rupee price or dollar price or yen price, which was stated by
Fisher. Starting from his 'equation of exchange', we worked out earlier that the money is an
instrumental variable to control prices.

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Caution A reduction of money by 10% may bring about deflation, i.e., price reduction by
exactly 10%. Otherwise, when money increases in the system, more money chases few
goods, people's propensity to spend money goes up and this is reflected in a price rise,
called inflation.
In other words, when prices are required to fall during inflation time, the Central Bank must
reduce money supply. Thus, the quantity of money matters. However, money should always be
treated as a servant rather than as a master. The economy needs to keep money stock under
control so that the general free level does not get disturbed and price mechanism functions to
ensure an optimal allocation of resources.

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