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Macroeconomic Theory Correlation Between Gross Domestic Product

The macroeconomic theory studies the correlation between Gross Domestic Product (GDP), inflation, unemployment, and fiscal policy which includes government spending and taxation policies. In this article the U.S Treasury department was contemplating raising the debt limit to prevent the governments’ default in meeting its financial obligations which would result in a financial crisis. Experts had warned that by May 16 the U.S would hit its debt limit which stood at $14.29 trillion and democrats wanted to raise it to prevent an economic catastrophe. This would delay the default to at least August 2. The government had $14.231 trillion in debt as of April 28 which was $63 billion under the debt limit.

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The macroeconomic theory was formulated by John Maynard Keynes in the 1930s.His argument was that the state can regulate aggregate components such as wages, prices, national income, consumption and savings, inflation and employment to avert depression. The macroeconomic theory can be summarized in two ways: the first recession is signaled by low inflation and unemployment and the government can revert to full employment by injecting cash into the economy. This is done through:(a) the Fiscal policy which involves tax cuts so that consumers can increase their spending power and (b) monetary policy in which the Treasury lowers the interest rates to encourage businesses to borrow money and invest in different sectors of the economy thus creating more employment opportunities. Secondly, at times of overheated economy escalating prices of household goods and labor scarcity, the state increases taxes and interest rates to produce a counter effect. Keynes added another concept by studying aggregate prices and wages rather than individual prices and wages (microeconomics).

According to macroeconomic theory, the government acts as a financial intermediary which issues debt to private investors, then levies a tax on interest and principal amount of the debt/bonds. In a competitive equilibrium the interest rate on a government bond is the same as the rate on capital (Bairoch, 1752). Assuming the quantity of debt is fixed, the budgetary constraint for the government is revenues generated from new issues of bonds and taxes which is equal to interest and principal paid on bonds for the same period of time. Consequently, the treasury department stopped the issuing of securities to state and local government, delayed payments to pension funds and cashing in of Treasury securities.

The theory has faced major challenges and many economists doubt its relevance since its based on econometric models that were formulated several years ago. After the Great Depression it was necessary to develop something and this gave rise to the development of the modern macroeconomic theory. In 1970 there was a financial crisis in which Keynes’ assumptions fell apart. Unemployment and inflation escalated significantly and Keynes had assumed that disinflation is inversely proportional to unemployment, and the remedy would be to lower taxes and interest in order to stimulate the market by injecting more cash. Doing this would be catastrophic as it would increase inflation. They were a period from 1987-94 where economists advocated for monetarist policies and the crucial test came in 1982 when unemployment and inflation were very high. Keynesian theory insisted on lowering interest rates to curb the unemployment menace while monetarist policy advocated for increasing interest rates to curb the inflation though the recession was on. The monetarist policy worked and inflation and unemployment drastically reduced. The macroeconomic models are outdated and it is only logical to replace static computations with dynamic ones (Milton, 1994).

References

Bairoch, P. (1993). Economics and World History: Myths and Paradoxes, New York, NY: Harvester-Wheatsheaf.

Milton, P. (1994). The Origins of Endogenous Growth, Journal Of Economic Perspectives, 3-22. Treasury steps to Avoid Default.

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StudyCorgi. (2021, December 17). Macroeconomic Theory Correlation Between Gross Domestic Product. Retrieved from https://studycorgi.com/macroeconomic-theory-correlation-between-gross-domestic-product/

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