No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seventeen: A Short History of Macroeconomics 423 trade. In contrast to the mercantilists who argued that the key to wealth was amassing the largest hoard of gold, Smith argued that the secret to the wealth of nations was the division of labor and that the division of labor was limited by the number of market participants. So Smith was very much interested in how to make the overall economy grow by expanding trade to other geographic areas, which would allow further specialization. Likewise, David Ricardo focused on trade for the economy as a whole, but his principle of comparative advantage flowed out of individual behavior. These economic giants were not alone. Throughout the 1800s economists asked questions about the broader economy, often trying to explain business cycles. Early monetary economics pointed to times of easy credit as supportive of commerce, while slow times were associated with “tight money.” But was money the cause or the effect? Other early economists looked at agricultural cycles and even sunspots, since they could conceivably affect agricultural output! Karl Marx thought that business cycles were endemic to the capitalist system. What caused the business cycle, and what was the solution? While not called macroeconomics, this was definitely a study of the overall economy—a study of general business conditions. Why did the overall economy sometimes roar full steam ahead, while other times it was generally depressed? Let’s continue this short walk through economic history to understand how economists wrestled with this question. A SHORT WALK THROUGH ECONOMIC HISTOR Y 1 While Adam Smith offered the first systematic economic treatise in 1776, there were economists before him that contributed to our knowledge. Earlier in the eighteenth century, the French Physiocrats helped begin our understanding. Their initial ideas are now what modern economists call the circular flow diagram. This is a very simplistic look at the economy, omitting many important parts (e.g., government fiscal policies and finance), yet it nevertheless is useful. In Figure 17.1 , we can see the interdependence of supply and demand through individuals and firms. Individuals supply labor to firms, which firms use to make goods and services in exchange for income. The aggregate (or total) income received by individuals is sufficient to buy the aggregate output of firms. While this suggests that the economy can work fine in the aggregate, it also is suggestive of how problems might occur—if some part of the flow were to get choked, the Figure 17.1, Economic Circular Flow. The overall economy can be conceptualized as circular flow of both nominal variables (expenditures and income are money flows) and real variables (goods and services, labor). Individuals provide labor to firms, which pay them income. With the income they receive, individuals make purchases of goods and service. The circularity shows the interdependence between the two, and when we think of firms as suppliers and individuals as demanders, the aggregate totals show interdependence between supply and demand. If a break occurs anywhere in the circle, it will affect the entire flow. “Circular flow of income and expenditure” by Bureau of Economic Analysis (BEA), U.S. Department of Commerce, October 2014 – Measuring the Economy: A Primer on GDP and the National Income and Product Accounts. Licensed under Public Domain via Commons – https://commons.wikimedia.org/ wiki/File:Circular_flow_of_Income_and_expenditure.jpg The Circular Flow Goods and Services Expenditures Individuals Businesses Labor Income