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Keynesian Economics 
Macroeconomics is a branch of economics concerned with the aggregate, or overall,
economy. Macroeconomics deals with economic factors such as total national output and
income, unemployment, balance of payments, and the rate of inflation. It is distinct from
microeconomics, which is the study of the composition of output such as the supply and
demand for individual goods and services, the way they are traded in markets, and the
pattern of their relative prices. 
At the basis of macroeconomics is an understanding of what constitutes national output,
or national income, and the related concept of gross national product (GNP). The GNP is
the total value of goods and services produced in an economy during a given period of
time, usually a year. The measure of what a country's economic activity produces in the
end is called final demand. The main determinants of final demand are consumption,
investment, government spending, and net exports. Macroeconomic theory is largely
concerned with what determines the size of GNP, its stability, and its relationship to
variables such as unemployment and inflation. The size of a country's potential GNP at
any moment in time depends on its factors of production-labor and capital-and its
technology. Over time the country's labor force, capital stock, and technology will
change, and the determination of long-run changes in a country's productive potential is
the subject matter of one branch of macroeconomic theory known as growth theory. 
The study of macroeconomics is relatively new, generally beginning with the ideas of
British economist John Maynard Keynes in the 1930s. Keynes's ideas revolutionized
thinking in several areas of macroeconomics, including unemployment, money supply, and
inflation. Keynesian Theory and Unemployment causes a great deal of social distress and
concern; as a result, the causes and consequences of unemployment have received the most
attention in macroeconomic theory. Until the publication in 1936 of The General Theory of
Employment, Interest and Money by Keynes, large-scale unemployment was generally
explained in terms of rigidity in the labor market that prevented wages from falling to a
level at which the labor market would be in equilibrium. Equilibrium would be reached
when pressure from members of the labor force seeking work had bid down the wage to the
point where either some dropped out of the labor market (the supply of labor fell) or
firms became willing to take on more labor given that the lower wage increased the
profitability of hiring more workers (demand increased). If, however, some rigidity
prevented wages from falling to the point where supply and demand for labor were at
equilibrium, then unemployment could persist. Such an obstacle could be, for example,
trade union action to maintain minimum wages or minimum-wage legislation. Keynes's major
innovation was to argue that persistent unemployment might be caused by a deficiency in
demand for production or services, rather than by disequilibria in the labor market. Such
a deficiency of demand could be explained by a failure of planned (intended) investment
to match planned (intended) savings. Savings constitute a leakage in the circular flow by
which the incomes earned in the course of producing goods or services are transferred
back into demand for other goods and services. A leakage in the circular flow of incomes
would tend to reduce the level of total demand. Real investment, known as capital
formation (the production of machines, factories, housing, and so on), has the opposite
effect-it is an injection into the circular flow relating income to output-and tends to
raise the level of demand. In the earlier classical models of unemployment, such as the
one described above, deficiency of demand in the aggregate market for goods and services
(known by the short-hand term as the goods market) was ruled out. It was believed that
any discrepancy between planned savings and planned investment would be eliminated by
changes in the rate of interest. Thus, for example, if planned savings exceeded planned
investment, the rate of interest would fall, which would reduce the supply of savings
and, at the same time, increase the desire of companies to borrow money to invest in
machines, buildings, and so on. In other words, changes in the rate of interest would
provide the equilibrating force bringing the overall (aggregate) goods market into
equilibrium in the same way that changes in, say, the price of apples would be the
equilibrating force bringing the supply and demand for apples into equilibrium. In the
Keynesian model, changes in the level of output and income bring planned savings and
investment into equilibrium, and thereby lead to equilibrium in total national income and
output. However, this equilibrium level of income and output is not necessarily the level
of output at which the demand for labor equals the supply of labor. Furthermore, Keynes
maintained, a cut in wages in such a situation would not help eliminate unemployment.
Keynes was not the first economist to explain unemployment in terms of an aggregate
deficiency of demand in the goods market. The 19th-century British economist Thomas
Robert Malthus and others had advanced similar explanations. The Keynesian revolution
implied that, in the terminology of macroeconomics, the goods market could be at an
underemployment equilibrium, in that it did not ensure equilibrium in the labor market.
In such a labor market, employers would not employ workers up to the point where it would
have been profitable for them to do so had there been adequate demand for their output.
Concepts of underemployment equilibrium, and related concepts of constrained demand for
labor were extensively developed in subsequent years. Keynes's emphasis on demand as the
key determinant of output in the short run stimulated developments in many other fields
of macroeconomics. It was partly instrumental in the development of national income
accounting, which measures the components of GNP-consumption, investment, government
spending and net exports. The Keynesian approach also stimulated analysis of the factors
influencing these components of GNP. For example, economists have analyzed how aggregate
consumer demand is related to income levels and how likely it is to change when rates of
interest change. Money Supply Theories regarding the money supply are central to
macroeconomics. They are also the subject of debate between Keynesians and monetarists
(economists who believe that growth in the money supply is the most important factor that
determines economic growth). The classical or pre-Keynes view was that the interest rate
led to a balance between savings and investment, which in turn would cause equilibrium in
the goods market. Keynes disagreed and believed that the interest rate was largely a
monetary phenomenon; its chief function was to balance the unpredictable supply and
demand for money, not savings and investment. This view explained why the amount of
savings was not always correlated with the amount of investment or the interest rate.
Keynesians and monetarists also disagree about how changes in the money supply affect
employment and output. Some economists argue that an increase in the supply of money will
tend to reduce interest rates, which in turn will stimulate investment and total demand.
Therefore, an alternative way of reducing unemployment would be to expand the money
supply. Keynesians and monetarists disagree on how successful this method of raising
output would be. Keynesians believe that under conditions of underemployment, the
increased spending will lead to greater output and employment. Monetarists, however,
generally believe that an increase in the money supply will lead to inflation in the long
run. Inflation For several decades after World War II (1939-1945) the main inflation
theories were demand-pull and cost-push. The cost-push theory basically emphasized the
role of excessive increases in wages relative to productivity increases as a cause of
inflation, whereas the demand-pull theory tended to attribute inflation more to excess
demand in the goods market caused by expansion of the money supply. A central concept in
inflationary theory since the mid-1950s has been the Phillips curve, which relates the
level of unemployment to the rate of inflation. The Phillips curve suggests that society
can make a choice between various combinations of inflation rate and unemployment level.
Many economists, however, dispute whether such a choice really exists, saying that in
order to keep unemployment under control it will be necessary to accept continuously
increasing inflation. At the same time many other economists dispute whether a stable
relationship between unemployment and the level of real wage demands exists. Modern
Theories During the last few decades there have been numerous refinements of the
Keynesian theory of unemployment. For example, although there is still much disagreement
as to the importance of wage rigidity, significant progress has been made in explaining
it without recourse to trade union behavior or government regulation. At first it seemed
difficult to reconcile the notion of wage rigidity with the usual economist's assumption
that people seek to maximize utility or satisfaction and would be willing to accept a
lower wage in order to get a job. However, by widening the range of variables over which
individuals optimize to include variables such as loyalty and self-respect, it has become
easier to reconcile labor market disequilibrium with the usual assumptions of optimizing
behavior. Macroeconomic theories regarding the way that the determinants of total final
demand operate form the basis of large macroeconomic models of the economy that are used
in economic forecasting to make predictions of output and employment and related
variables. During the last few years, the record of most such predictions has been poor,
and an analysis of the errors has led to continual revisions of the basic models and
refinements of the theory. Phillips curve The Phillips curve illustrates the trade-off
found by economist A. W. Phillips between lower unemployment and increased inflation. If
unemployment is low at 4 percent, inflation is slightly high at 6 percent (point a). If
inflation is eliminated, unemployment increases to 8 percent (point b). The trade-off
poses a dilemma for policy-makers, although economists disagree on whether this
relationship exists. Microsoft Chart