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Essay on Keynesian Economics
Essay Contents:
- Essay on the Introduction to Keynesian Economics
- Essay on the Keynesian Theory of Effective Demand
- Essay on General Equilibrium Approach by Keynes
- Essay on Theory Vs. Policy
- Essay on the Compensatory Fiscal Policy
- Essay on the Criticisms of Keynesian Economics
Essay # 1. Introduction to Keynesian Economics:
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Keynesian economics is a body of economic theory and related policy associated with J. M. Keynes. Keynes was one of the greatest intellectual innovators of the first half of the 20th century. Keynes wrote many books, but the phrase “Keynesian economics” refers especially to The General Theory of Employment, Interest and Money. The ideas and analytical techniques of the GT stimulated what came to be known as the Keynesian Revolution.
Keynes challenged the fundamental tenets of the classical and neo-classical economics stemming from Adam Smith, David Ricardo, J.S. Mill, Alfred Marshall and A.C. Pigou. Classical and neo-classical economists hold that a private enterprise economy based on a market system is normally in equilibrium only at full employment.
Classical and neo-classical economics allows for voluntary unemployment, by the idle rich and the lazy poor, and frictional unemployment arising from circumstances such as changing jobs; but it does not allow for involuntary unemployment by those wage-earners willing and able to work and actively seeking employment. This self-adjusting system was associated with a policy of laissez-faire in a general way.
In contrast, Keynes’ general theory of employment postulates that a capitalist economy may be in equilibrium at less than full employment and that the classical/neo-classical economics is a special case in this more general theory.
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Keynes did not accept the automatic, self-adjusting nature of capitalism and believed that, under laissez-faire, chronic, large scale unemployment is likely to occur. In this sense, his general theory repudiates the theoretical foundations of laissez faire capitalism. He recommended positive fiscal and monetary policies as a means to alleviate unemployment.
In his GT, Keynes laid the foundation for the development of monetary theory into macroeconomic theory and defined the analytical framework for decades to come. The General Theory had an impact on the thinking of economists and, within a few years, on the formulation of economic policy.
While the policy impact is important, the significance of The General Theory lies in the revolutionary theoretical argument. Because of the Great Depression (1929— 1933), Keynes was concerned with understanding and delineating the factors that determined the level of output and employment.
The classical economists argued that savings determined investment, which, in turn, determined output and employment. Keynes, on the other hand, argued that effective demand—that is, consumption, private investment and government spending—determined output and employment while savings adjusted to investment.
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Moreover, he diminished the role of the interest rate in coordinating investment and savings and it was determined in the financial markets. In addition, with the interest rate being determined in the financial markets, Keynes conceived the economy as a monetary rather than a barter economy. Finally, he argued that uncertainty, conceived in terms of the future being unknowable, was an inherent feature of a monetary economy and, hence, affected all business decisions.
These four innovations produced a number of theoretical surprises. The first was that money mattered in a money-using economy, in that financial activities had a real impact on economic activity. Second, effective demand rather than prices or interest rate coordinated economic activity, allocated resources in the economy and determined output and employment. Third, the entrepreneurs’ desire to invest, rather than the interest rate, had the dominant impact upon business investment decisions.
Lastly, there was no market mechanism that would ensure that effective demand would be sufficient to drive a capitalist economy towards full utilisation of its resources and the employment of labour. Instead, full employment could only be achieved through the intervention of an external i.e., non-market, institution, such as the state.
In fact, Keynes first pointed out that the visible hand of the government had to replace, at least partly, the invisible hand of the market. Just as the central bank was the lender of the last resort, the government was the employer of the last resort. Thus, when the private sector is unable to create sufficient jobs, the government should supplement the effort of the private sector and push forward with its public works programmes to create jobs and incomes.
In fact, Keynes was the first economist to suggest the use of discretionary (compensatory) fiscal policy to fight depression and unemployment. And, if necessary, budgetary deficits would have to be used to stimulate the economy. In truth, government expenditure would add to private expenditure in determining aggregate effective demand which would determine the level of employment and income in a capitalist economy.
As L. Heilbroner has commented – “While Marx was the prophet of capitalism doomed, Keynes was the architect of capitalism viable.”
Essay # 2. Keynesian Theory of Effective Demand:
In fact, the theory of effective demand is the distinct analytical contribution of the General Theory and its central message.
As Keynes himself has commented: “The General Theory is primarily a study of the forces which determine changes in the scale of output and employment as a whole”.
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Fig. 1 is the standard Keynesian cross-diagram which has served to transmit the central message of the General Theory to generations of economists.
Keynes himself did not use the diagram. Correctly interpreted, the theory of effective demand does not only imply intersection of the aggregate demand curve E = F (Y) with the 45° line, which determines equilibrium real output Y0 at a level that may be below that of full employment YF; not only (as Alex Leijonhufvud has also emphasised) that disequilibrium between aggregate demand and supply causes a change in output and not price; but also that the change in output (and, hence, income) itself acts as an equilibrating force.
That is, if the economy is in a state of excess aggregate supply at (say) the level of output Y1, then the resulting decline in output, and, hence, income will depress supply more than demand and, thus, eventually brings the economy to equilibrium at Y0 or, in terms of the equivalent savings = investment equilibrium condition, the decline in income will decrease savings and, thus, eventually eliminates the excess of savings over investment that exists at Y1.
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In Keynes’s words, “The novelty in my treatment of savings and investment consists in the proposition that it is not the rate of interest but the level of income which ensures this equality.”
In Don Patinkin’s view, the theory of effective demand is concerned not only with the solution of the equilibrium equation F (Y)= Y but with demonstrating the stability of this equilibrium as determined by the dynamic adjustment equation
dY/dt = G [F (Y) – Y ], where G’ > 0
Correspondingly, a crucial assumption of Keynes’ analysis is that the marginal propensity to consume (MPC) is less than unity, which, in turn, implies that the marginal propensity to save (MPS) is greater than zero. For example, if the MPC were equal to unity, no equilibrating mechanism would be activated by the decline in output.
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Specifically, as income (output) decreased, spending would decrease by exactly the same amount, so that any initial difference between aggregate demand and supply would remain unchanged. Alternately, as income decreased, the initial excess of desired saving over investment would remain unchanged. Thus, the system would be unstable.
This is the major novel feature of the General Theory and its central message- the theory of effective demand as a theory which depends on the equilibrating effect of the decline in output itself to explain “why the economic system may find itself in stable equilibrium with employment at a level below full employment, namely, at the level given by the intersection of the aggregate demand function with the aggregate supply function”.
No doubt, the Keynesian theory of effective demand created an intellectual shock wave when it appeared first.
In GT, a decrease in consumption—or equivalently an increase in savings is represented by a downward shift of the aggregate demand curve in Fig. 1 to E’. The resulting decline in output will then cause a corresponding decline in the amount consumed-and. Hence, in the amount saved—until a new equilibrium is necessarily reached at Y2.
Keynes presented the theory of effective demand under the explicit simplifying assumptions of a constant level of investment (which presupposes a constant rate of interest) and a constant money wage rate.
Keynes has also identified the determinant of the consumption component of aggregate demand and discussed the related multiplier to provide a precise formula for measuring the ‘indirect effects’ of an increase in government expenditure.
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Keynes demonstrated that autonomous expenditure such as government spending would increase aggregate income by a greater amount through the multiplier mechanism and thus provided the analytical stimulus for demand management by the state. He saw an increasing role for the government in this respect as he expected the inducement to invest to decline in the future.
Keynes, however, admitted that the multiplier concept is of ‘immense importance’ but impossible of measurement ‘with any sort of precision’.
While discussing investment, Keynes drops the assumption of a constant level of investment and explains how this level is determined by the marginal efficiency of capital schedule in conjunction with the rate of interest, which rate is determined in turn by the liquidity preference schedule in conjunction with the quantity of money.
Don Patinkin noted that Keynes’ liquidity preference function—M = L1(Y) + L2 (r), where M and Y, respectively represent nominal money and nominal income—actually reflects money illusion. Keynes also highlighted the role of expectations in determining output and employment. To be more specific, he has emphasised the crucial influence of uncertainties on both the MEC and LP schedules—and, hence, the necessity to make decisions with respect to them on the basis of expectations.
As P. A. Samuelson has noted, Keynes’ discussion ‘paves the way for theory of expectations but it hardly provides one’. In any event, Keynes emphasises that the uncertainties in question are not subject to probability calculation, so that long-run investment decisions, in particular, may instead be the result of ‘animal spirits’.
No doubt, the uncertainties are a major source of the effectively low interest elasticity of the MEC schedule, as well as the source of speculative demand for money, and, hence, the effectively high (though not infinite) interest elasticity of the liquidity preference schedule.
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Keynes did not base his theory on the ‘liquidity trap’. In his words- “Whilst this limiting case might become practically important in future, I know of no example of it hitherto.” However, it is because of high interest-elasticity of demand for money that the monetary policy was found to be inadequate to the task of eliminating unemployment.
The reason is that an increase in the quantity of money will not significantly reduce the rate of interest; and, to the extent that there is such a reduction, it will not generate a significant increase in investment and, hence, in aggregate demand.
Essay # 3. General Equilibrium Approach by Keynes:
Keynes also provides a general equilibrium analysis of the determination (as of a given money- wage rate and nominal quantity of money) of the equilibrium level of national income by the interactions between the commodity (consumption and investment goods) and money markets
Thus, a basic contribution of the GT is that it is in effect the first practical application of the Walrasian theory of general equilibrium in the sense of reducing Walras’ formal model of ‘n’ simultaneous equations in ‘n’ unknown to a manageable model from which implications for the real world could be drawn.
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Furthermore, like Walras’ model, Keynes’ model in the GT is one that integrates the real and monetary sectors of the economy. It is this general equilibrium aspect of the GT that Hicks (1937) developed subsequently and formalized in his influential IS-LM interpretation of the GT.
Finally, Keynes drops the assumption of a contract money-wage rate and applies the theory of effective demand that he had developed to an analysis of the effect of decline in this rate. Keynes regarded such a decline not as an abstract theoretical possibility, but as what had actually happened to money wages in the years immediately preceding the GT.
Keynes’ basic argument is that a decline in money wages can increase the level of employment only by first increasing the level of effective demand; that the primary way it can generate such an increase is through its effect in increasing the quantity of money in terms of wage units, thereby decreasing the rate of interest and stimulating investment; that accordingly the policy of attempting to eliminate unemployment by reducing money wages is equivalent to a policy of attempting to do so by increasing the quantity of money at an unchanged wage rate and is accordingly subject to the limitations as the latter; namely, that a moderate change may exert an inadequate influence over long-term rate of interest; while an immediate one (even if it were practicable) may offset its other advantages by its disturbing effects on confidence.
Keynes’ major conclusion is that—and indeed the negative component of his central message—that ‘the economic system cannot be made self-adjusting along these lines.’ In this way, Keynes finally supplies the theoretical basis for his claim that, contrary to the ‘classical’ view, a willingness on the part of labour to accept lower money wages is not necessarily a remedy for unemployment.
Keynes’ acceptance of the ‘classical postulate’ that the wage is equal to the marginal product of labour enables us to understand a critical issue. Specifically, if the effect of a decline in the money wage rate on the level of effective demand, hence output, and, hence, employment, is indeterminate, then so too is its effect on the marginal product of labour and hence real wages.
Hence Keynes’ statement is simply a reflection of his basic view that “the propensity to consume and the rate of new investment determine between them the volume of employment, and the volume of employment is uniquely related to a given level of real wages— not the other way round.”
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And since Keynes also accepts the classical law of diminishing returns he contends that if a sharp decline in money wages should generate only a slight (though proportionately smaller) decrease in the price level. However, Keynes never explains the dynamic market forces that bring this about.
Accordingly, Keynes makes the policy recommendation that ‘the money-wage level as a whole should be maintained as stable as possible, at any rate in the short period.’
The Real Balance Effect:
Keynes also took account of the capital gains effect on consumption. But he did not take account of the positive real balance effect generated by a wage and price decline. However, Patinkin believes that taking account of it would have affected Keynes’s basic conclusion about the inefficiency of a wage decline as a means of increasing employment.
Rigidity of Money Wages:
In truth, the whole Keynesian analysis does not depend on the assumption of absolutely rigid money wages. Due to adverse effect of flexibility, the relative stability of money wages is Keynes’ concluding policy recommendation. It must also be emphasised that were the GT to depend on the assumption of wage rigidity, there would be no novelty to its message for the fact that such rigidity can generate unemployment was a commonplace of classical economics. This, however, does not mean that Keynes went to the opposite extreme of assuming wages to be perfectly flexible.
Instead, his view of the real world was that ‘moderate changes in employment are not associated with very great changes in money wages’ At the same time, Keynes emphasises that there exists an ‘asymmetry’ between the respective degrees of upward and downward wage flexibility: that, in particular, ‘workers are disposed to resist a reduction in their money rewards, and that there is no corresponding motive to resist an increase’
Essay # 4. Theory Vs. Policy:
From the foregoing discussion, it is clear that the primary concern of the GT is theory and not policy—though Keynes makes brief use of the theory to explain the necessity for public works programmes to combat severe unemployment.
It is also clear that the primary concern of his theory is output (or employment) and not prices. Furthermore, the primary concern of its theory of output is the explanation of equilibrium at less-than-full employment and not cyclical variations of output.
Another point is that, in the strict sense of the term, the GT is a theory of unemployment disequilibrium. It analyses the working of an economy in which money (nominal) wages and, hence, the rate of interest, may be slowly falling, but in which chronic unemployment, nevertheless, continuous to prevail.
This interpretation seems to contradict Keynes’ emphasis that one of his major accomplishments in his book was to have demonstrated the possible existence of underemployment equilibrium.
It is precisely the attempt to interpret the GT as prescribing a theory of unemployment equilibrium in the fullest sense of the term that has led to its interpretation as being based on the special assumptions of absolutely rigid money wages and or the ‘liquidity trap’. For, by definition, there cannot be a state of long-run unemployment equilibrium in the sense that nothing in the system tends to change as long as wages are rigid.
Alternatively, if money wages are not rigid, then a necessary condition for equilibrium—in the sense of the level of employment remaining constant over time—is that the rate of interest remains constant; and a necessary condition for the rate of interest to remain constant in the face of an ever-declining money wage and, hence, ever-increasing real quantity of money, is that the economy be caught in the ‘liquidity trap’.
Correspondingly, once we recognise that the GT is concerned, strictly speaking, with a situation of underemployment disequilibrium, we also understand that the validity of its analysis does not depend on the existence of either one of these special assumptions.
Received opinion that Keynes’ GT is a contribution to ‘disequilibrium’ analysis is prevalent in the arguments of Axel Leijonhufuerd. In his view- “Keynes used the term unemployment equilibrium. But it is not an equilibrium in the strict sense at all. It is preferable to use some more neutral term which does not carry the connotation that no equilibrating forces at all are at work. The real question is why the forces tending to bring the system back are so weak”.
Similarly, Patinkin has commented that Keynes’ GT is not ‘strictly speaking’ one of ‘unemployment equilibrium’. Following the same line of argument, James Tobin has argued that Keynes showed that ‘disequilibrium can be protracted and stubborn’.
The notion of ‘disequilibrium’ is dependent on the abstract concept of equilibrium to which it is attached one received opinion is that the Keynesian disequilibrium is taken as a deviation from the long-period equilibrium of the system. However, J.R. Hicks in his (Value and Capital) considers it to be concerned with the possible failure of the market to achieve full inter-temporal equilibrium.
To the extent Keynesian cases are located in situations where full inter-temporal equilibrium fails to emerge, they are no different in general character from the view which holds Keynesian cases to be located in situations where long-period equilibrium is not achieved.
The whole of Keynes’ theoretical argument is, of course, built around the idea that the reconciliation of otherwise incompatible investment decisions and saving plans is ensured by variations in the level of income (output). This process determines the aggregate level of employment on the basis of the principle of effective demand.
Keynes made his celebrated claim for the principle of effective demand in relation to earlier theory:
The postulates of classical theory are applicable to a special case only and not to the general case, the situation which it assumes being the limiting point of the possible positions of equilibrium. Moreover, the characteristics of the special case assumed by classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt-to apply it to the facts of experience.
If we retain, following Keynes, two of the basic postulates of classical theory—the interest elastic demand schedule for investment (expressed in the MEC schedule), and the relationship between the marginal productivity of labour and the real wage (expressed in the usual demand schedule for labour)—the only fully consistent theoretical basis for the idea that the possibility of unemployment was non-negligible (and, that, if it should actually appear, then it could well be of long duration) had to be set in terms of an argument whereby the effective demand mechanism should come into play in disequilibrium (arising from interest-rate or wage-rate inflexibility).
In such circumstances, aggregate income (output) would not be at its full employment level, and every view of Keynes, whether about the theory of employment or the price level or about the effectiveness of government deficit spending as a remedy for unemployment, held good.
But Keynes’ theory is also not a general theory. It is a theory which holds only during depression. Keynes’ theory cannot be treated as a ‘general’ theory of employment, at least in the formal sense of being a theory about the full equilibrium of a market system. Keynes’ general theory could be defended as being ‘general’ only on the grounds of its practical relevance. Indeed, much of the practical appeal of Keynesianism seems to stem from the optimistic prospect it offers for ‘measure of collective action to eliminate unemployment’.
Essay # 5. Compensatory Fiscal Policy:
Compensatory fiscal policy is the programme most closely associated with Keynesian economics. If the amount of effective demand generated by the private sector is insufficient for securing full employment, the deficiency can be compensated for by increased expenditure in the public sector. In Keynes’ view, government deficits are desirable only when spending in the private sector is insufficient to generate demand for the desired level of employment. If demand in the private sector is brisk, there is no need for government deficits and government spending should be paid for entirely out of current taxes.
Three Comments:
Don Patinkin has made three important comments on the General Theory which are highly relevant in making an overall assessment of Keynesian revolution:
1. Employment:
The exposition of the theory of effective demand was carried out, not in terms of national income to which concept Keynes even expresses methodological objectives but in terms of the level of employment. This was partly due to the fact that the level of employment was indeed his major concern.
2. Historian:
Second, in the General Theory, Keynes also appears as a historian of economic thought. He appears as a historian of thought in the areas in which he was emotionally involved as a protagonist and prophet.
Insofar as Keynes’ treatment of classical economics is concerned, Keynes’ discussion of Ricardo and Say’s law, on the one hand, and Malthus’ concern with the possibility of the inadequacy of aggregate demand, on the other constitutes important contributions to the history of economic thought.
3. Revolutionary Impact:
Third, Keynes’ GT had such a revolutionary impact mainly due to the circumstances that prevailed when it first appeared. In the early 1930s, the Western world was desperately searching for an explanation of the bewildering and seemingly endless depression that was creating untold misery for millions of unemployed and even threatening the viability of its democratic institutions. And the appearance of GT in 1936 offered not only an explanation, but also a confident and theoretically-supported prescription for ending depressions within a democratic framework by proper government policies.
Thus, the GT provided an answer not only to a theoretical problem, but to a burning political and social one as well. The theoretical revolution embodied in Keynes’ GT took place concurrently with the Colin Clark- Simon Kuznets revolution in national income measurement and further enhanced its impact on the profession: for those measurements made possible the quantification of the analytical categories of the GT, hence the empirical estimation of its functional relationships, and, thus, its application to policy problems.
The Keynesian system has led to:
(1) The growth of macroeconomic models based on the formulation of the new economic problem of determining the level of economic activity;
(2) The use of national income-expenditure approach to describing the economy; and
(3) Demand management by political and monetary authorities. Its acceptance has been the subject of concern of contemporary macroeconomics.
Its generality has been questioned in recent years and the reformulation of the Keynesian system by J.R. Hicks and others has tended to reduce Keynes’ contribution to a special case of neoclassical equilibrium with rigid money wages and a liquidity trap.
Essay # 6. Criticisms of Keynesian Economics:
During the 1970s, Keynesian economics came under increasing criticism because of ‘stagflation’; the coexistence of stagnation (high unemployment) and persistent inflation. The coexistence of recession and inflation presented an apparent dilemma in terms of remedies along Keynesian lines. If demand were stimulated in order to reduce unemployment, inflation would accelerate; and if demand were deliberately curtailed to control inflation, unemployment would rise.
Keynesian theory and policy were designed to deal with inflation caused by excess general demand but not with inflation resulting from increases in demand for individual items such as food and fuel. It is not easy to separate cost-push inflation from general demand inflation. Thus, Keynesian economics failed to provide satisfactory answers to the perplexing problems of the inflation ridden semi-stagnant 1970s.
An oft-cited criticism of Keynesian economics is that its very application to policy has led to inflation.
The following three points are to be noted in this context:
1. Increases in effective demand may at first increase employment, but, beyond a critical point, they will lead to a sharp rise in prices. The critical point is known as the natural rate of unemployment.
2. If Keynesian policies are credited with eliminating major depression in the post-Second World War (1939-1945) period, they may be blamed for contributing to inflation in the sense that in pre-Keynesian times, depression was a market-oriented form of price control.
3. The flexibility required for successful fiscal policy may not be politically feasible, or may work with such long political lags as to render otherwise sound fiscal policy ineffectual. Presumably, to increase tax rates is politically more difficult than to lower tax rates, and to decrease governmental expenditures is politically more difficult than to raise them. These political conditions impart an inflationary bias to Keynesian type of fiscal policies.
The monetarist school became the chief critic of Keynesian fiscal policies. Monetarists recommend only a steady and modest increase in the quantity of money. Keynesians viewed monetary policy as a necessary complement to fiscal policy. When employment expands in response to fiscal expansionary measures or for other reasons, an increase in the money supply is needed to finance the additional transactions demand.
The Keynesian framework provides a mechanism for testing the conditions under which purely monetary policy might be effective. During the Great Depression of the 1930s, when Keynes wrote the GT, he felt that monetary policy would have little effect either on the interest rate directly or on investment and employment indirectly. A main reason for this pessimism about monetary policy was that any change in the rate of interest would be insignificant in relation to wide fluctuations in the marginal efficiency of capital.
Keynes was more hopeful about monetary policy in economic conditions other than a deep depression. However, Keynes believed that monetary policy remained important primarily as a complement to fiscal policy.
A leading criticism at a purely theoretical level is that Keynes failed to demonstrate that the economic system can be in equilibrium at less than full employment. If Keynes’s theory is dependent on special assumptions such as inflexible wages and prices, it has to be viewed as a special and not as a general theory.
Moreover, the theory can be applied only in times of depression and not at other times. Thus, Keynesian theory can be treated as the economic theory of depression. It is a special theory in still another sense. It can be applied to solve the problems of advanced capitalist countries. It has hardly any relevance to the contemporary problems of developing countries like India.
Conclusion:
Keynesian economics originated as a response to a deeply felt need at a time when traditional economics, resting on the premise that the economy tends always towards full employment, had very little to offer by way of explaining the Great Depression. Keynes’ seminal ideas made him the most influential economist of the 20th century in both economic theory and economic policy. With passing decades, Keynesian economics required modifications in order to remain relevant to changing economic and historical conditions.
As Robert E. Lucas, Jr, and Thomas J. Sargent comment:
“Existing Keynesian macroeconomic models cannot provide reliable guidance in the formulation of monetary, fiscal or other types of policy. There is no hope that minor or even major modifications of these models will lead to significant improvements in their reliability.”
Despite the various criticisms and discussions of the GT that followed its publication, its basic analytical structure not only remained intact, but also defined the research programme for both theoretical and empirical macroeconomics for the following five decades and more. Keynes’ work was truly a scientific achievement of the first order.
And, as with the passage of time we gain a more critical view of the accomplishments and deficiencies of ‘monetarism’ and of ‘the new classical macroeconomics’, an appropriately modified Keynesian model that will take advantage of what we have learned from these developments may yet regain its place as the leading one for macroeconomic analysis.