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The macroeconomic pages of this site explain six different frameworks that economists have used to make sense of the world around them. All seem to have a kernel or two of truth to them, but none seems to be completely satisfactory all itself.

The framework that dominated introductory economics until recently has been the simple Keynesian framework of the income-expenditure model. This framework suggests that the way to understand total spending is to divide it into parts and then study the parts. When one understands the parts--consumption, investment, government spending, and net exports--one should understand the whole. This framework has introduced millions of students to the multiplier process and the notion of fiscal policy. However, it is poorly suited to analyze changes in price level well, and it does not mesh well with the approach taken in microeconomics. Microeconomics assumes that people's actions are motivated by a desire to achieve goals, but there is no evidence of goal seeking in the simple income-expenditure framework.

The quantity-theory framework is far older than the Keynesian framework and has undergone a revival since the 1960s. It suggests that we look at all transactions as involving the purchase or sale of money. When you go to the store and buy potato chips, you think of that transaction as the buying of potato chips. The quantity theory tells you to think of it as a transaction in which you sell money and the store buys your money (by giving you potato chips).

Once we start thinking of all transactions as the purchase and sale of money, it is natural to ask what happens when the amount of money available to buy and sell changes. If it decreases, we expect its value to increase, just as when there are fewer apples to buy and sell, we expect the price of apples to increase. When the value of money increases, a fixed amount of money buys more, which can happen only if prices of goods and services fall. The quantity theory argues that changes in the amount of money affect the volume and value of transactions that involve money.

If changes in the amount of money are important, then we have to ask what alters the amount of money in circulation. This question takes us to the banking system, for in modern economies money is bank debt, and also to monetary policy, for in modern economies governments can control the money-creating ability of banks.

A limitation of the simple quantity theory framework is that it does not explain output fluctuations, which are obviously very important in modern economies, and money itself is elusive because what people use for money changes over time.

A third framework, the ISLM framework, merges the simple Keynesian framework and the quantity theory framework allowing us talk about both fiscal and monetary policy. It has been a very popular framework among economists, but increasingly economists have begun to worry about what it leaves out.

The business-cycle framework asks us to appreciate disequilibrium. It suggests that we should not always try to analyze the economy in terms of equilibrium positions. The economy is like a rocking chair--if either is set rocking, readjusting to equilibrium takes a long time. In contrast, the ISLM framework encourages us to analyze in terms of equilibrium positions.

A fifth framework, that of aggregate-supply aggregate-demand, attempts to expand ISLM, which is purely demand driven, to include production-side problems. If, for example, the supply of a key resource suddenly drops, what will happen to the economy? ISLM does not tell us. By including production-side problems, economists can begin talking about the effects of flexible prices as opposed to sticky prices, and in turn can discuss a whole series of questions that are difficult to discuss in other frameworks.

A final framework, the one that we began with, is the general equilibrium framework, which encourages us to see the economy as a set of interdependent markets. A change in one market can affect other markets, even those that seems totally unrelated. This framework has firm roots in microeconomics, and lets us see why aggregation is necessary. The other five approaches can be seen as a special cases of the general equilibrium case, each with a different emphasis on what is important. We also briefly mentioned the new-classical or real business cycle view, which can be seen as a direct use of the general-equilibrium framework with the assumption that there are no lags in adjustment.

Because each of these frameworks can give us insights, we have looked at them all. Perhaps someday a new framework will be developed that will simplify the study of macroeconomics by giving us all the important insights of these six separate but not necessarily contradictory frameworks. That day does not seem to be near at hand.

Macroeconomic theory is based on people's actions that make these frameworks work. There are five classes of behaviors that have been especially emphasized.

First, the decision to spend or save is important in the income-expenditure approach and any framework built on it. We argued that people want both a high standard of living, and one that does not vary much over time, which leads to the life-cycle and permanent-income hypotheses.

Second, two areas of portfolio choice, or how people structure their balance sheets, are important in any approach that argues that the amount of money matters. People make decisions about how large they want their cash balances, which affects the velocity of circulation. The better money served as a store of wealth, the more cash people would want to hold. Banks also make portfolio choices, and their decisions can create or destroy money.

Third, we looked at investment spending, a form of behavior that is important in income-expenditure approaches, and has also been a key ingredient in some business-cycle theories. We argued that the benefits of additional capital rise when business sales rise, and therefore the amount of investment should be sensitive to changes in spending. This idea was called the accelerator. We also argued that investment should be sensitive to the real interest rate. This was a key idea in developing the ISLM model.

Fourth, we have looked at how policy makers respond to economic conditions. Just as businesses and consumers respond in regular and systematic ways to economic conditions, so do policy makers. When the economy enters a recession, will policymakers will try to ease policy, and when inflation is seen as a serious problem, they will try to tighten policy? By looking at policy rules, we can talk about the importance of lags and information, about the role of the exchange rate on fiscal and monetary policy. We can also look at the difficulties of measuring policy and we can ask how people's expectations of government policy will affect their behavior.

Finally, we have looked at how people adjust prices to different economic conditions. The size of output fluctuations seems to depend a great deal on whether prices are flexible or sticky. If they are sticky, we need to explain why they are, and we attempted to do that by arguing that changing price could be costly, or it could be a result of poor information or of information that is not shared by all.

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Copyright Robert Schenk