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Now, prior to the Great Depression in the 1930s, there was really no such thing as macroeconomics and the prevailing orthodoxy of the time, which which we refer to as neoclassical economics, believe that if you understood what happens at an individual consumer level or an individual firm level, or then you could just aggregate that up, add that all up, and you would get the same understanding of what would happen at a system level for the whole economy.

And this was no mere curiosity because it led to a policy. And in the start of the Great Depression, when the stock market crashed and confidence plummeted and spending started to collapse in the private sectors around the world and unemployment started to rise like never before, the economists of the day recommended that you cut wages to increase employment demand.

And of course, the British treasury followed the advice of the economists and they cut wages and unemployment got worse. And John Maynard Keynes, who was a Cambridge Professor, who published in 1936 the very famous The General Theory, he saw through the logic that had led to that policy failure and the general term for this logic failure is the Fallacy of Composition.

And what that means is that what's right for an individual may not be right for the all entire society. And so trying to aggregate up from what you might understand would happen at an individual level, to talk about system dynamics and what would happen at the macroeconomic level is invalid.

And this was the beginning of macroeconomics.

As a study of the system as a whole, this was where it began. So let's do an example to allow you to understand the basis of this fallacy. So imagine that you're at a theatre or sporting event and we've all been there. We've been enjoying the the performances of the sports people or the the the actors or the musicians. And some wise person decides that they're going to improve their view and they stand up.

And of course, for the time they're standing up, their view is improved dramatically. And of course, they're getting howls from behind - sit down, sit down - and then everybody gives up and decides they'll stand up too. And so while the individual could get a better view while they were doing it alone, it doesn't work if everybody stands up.

And so the logic of what applies to the individual doesn't necessarily and doesn't usually apply at the system level.

Now, how do we apply that logic, that fallacy? How do we apply that knowledge to economics? Well, two very significant applications that emerged in Keynes' writing and have been at the centrepiece of macroeconomic thinking.

The first one is the Paradox of Thrift. Now think about yourself. You might want to have a nice holiday when we can finally travel again.

And you know that if you are disciplined enough to save more out of your current income, you will be able to accumulate funds and you'll be able to go on the holiday. Good idea. Now, imagine if everybody in society had the same idea at the same time. And so we all start saving in a disciplined way. Well, at a macroeconomic level, if we all start saving more out of our income, it means that we've got less to consume and one of the standard rules of macroeconomics is that spending equals income equals output.

And so if all of us are spending less, business firms are going to be accumulating unsold inventories and they'll then say, "Gosh, we better we're overproducing, we'll start producing less and laying off workers." And so the payments they're giving to workers falls. And as a consequence, incomes fall, obviously. And because saving is a direct function of income, when we have higher income, we have higher saving. Savings overall in that situation falls and so even though at the individual level, you could achieve a successful savings strategy because your withdrawal of consumption didn't really matter for the system as a whole.

Whereas if everybody does it, then consumption spending falls, output falls, employment falls, income falls and savings falls. That was called the paradox of thrift.

And the second really important example, which was very significant in the Great Depression was the wages cutting argument that the British treasury actually implemented. So I think about an individual firm. If they can persuade their small number of workers to take a wage cut, their wages will fall, the costs of production will fall.

And because the small number of workers have lower income, that's unlikely now because the wages are lower, that's unlikely to affect the sales of that particular firm and so its profits rise. And as a consequence, it may well employ more workers. That's undecided, but it might. Now think about it if the government forces the whole society to take a wage cut.

All firms cut their workers wages, which, as I often suggested, policy by mainstream economists. Well, in that case, we all have lower income. Costs again fall but so do profits now because sales fall across the board and as a consequence of sales falling, firms start laying off workers and the problem then gets spirals into recession because laying off workers, less income, less spending, less sales and so on, so forth.

So what we've learnt in this segment is that logic that applies at the individual level, which may or may not be true even at that level, doesn't necessarily and will not usually apply at the system level, at the macroeconomic level. And so we've got to start thinking in macroeconomic terms, in terms of systems, in terms of system dynamics and all of these terms. And so the starting part of this course is going to start teaching you and coaxing you to start thinking in system terms.

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