The Uncertainty Trap: Effectiveness of macroeconomic policy

In this paper, we explore the effectiveness of macroeconomic policy. To achieve this goal, we first discuss the theoretical framework of macroeconomics in Section 2. We explain why the standard microeconomic foundations of macroeconomics are mistaken and argue that Keynesian economics or what Tobin (1993) called the Old Keynesian view, according to which real aggregate demand determines aggregate production, can best explain the actual macroeconomy. We then briefly explain the microeconomic foundation of Keynes’ principle of effective demand based on methods used in statistical physics in Section 3. Using this model, we explore the effectiveness of macroeconomic policy in Section 4. In the model, the difference between micro demand shocks and macro demand shocks is significant. Individual micro demand shocks cannot be observed. In fact, only the aggregate fluctuations caused by such unobservable micro shocks are observed. This is analogous to the observation of thermal fluctuations governed by temperature in physics. By contrast, macro demand shocks are observable in various forms, one of which is macroeconomic policy such as fiscal/monetary policy. We demonstrate that macroeconomic policy becomes ineffective with very low levels of aggregate demand. This result holds true irrespective of macroeconomic model specifics and is generic. Section 5 provides concluding remarks.