Chapter 1: Introduction
For U.C. Berkeley instructional purposes only. Copyright 1999.
Version 2.0 1999-07-20
J. Bradford DeLong
How much richer are we than our parents were when they were our age?
How much richer will our children be than our grandparents were?
Will we find it easy to change jobs in five years? Or will we find it hard to change jobs, and feel pretty much trapped doing whatever we are doing?
Will the businesses we work for suddenly vanish?
Will inflation impoverish us as higher prices erode the real purchasing power of savings?
Or will inflation enrich us as higher prices erode the real value of our debts?
To answer these questions, we study macroeconomics. The answers depend on what happens to the economy as a whole: the economy-in-the-large the macroeconomy. (Macro is, after all, is just a Greek-derived prefix for "large".)
Thus macroeconomics tries tounderstand the economy-in-the-large: the total value of all production in the economy in-the-large, the total number of people employed, the total number of people unemployed, the overall level of consumer prices and how rapidly these prices are changing--the inflation rate. And alongside these quantities that give the pulse of the economy in-the-large, macroeconomics studies variables--like interest rates, stock market index prices, and exchange rates--that have major effects on the overall level of production and employment.
Why should we care about the questions at the heart of macroeconomics? A first important reason is that the macroeconomy matters to us. Each of us are individually interested in particular microeconomic issues--the price of wheat, or peaches, or microprocessors. At least one of us is very interested in the price of economics professors. But what happens to the macroeconomy shapes all of our lives, so we are all interested (or should be interested) in it.
It is much easier to get a job during a high-employment boom than a recession. Real incomes rise faster when government policies accelerate long-run growth. If you are unlucky enough to lose your job during a deep recession, you have a high chance of staying unemployed for a long time and seeing you income fall by a lot when you do find another job.
There is a second important reason to care about the macroeconomy. We can make the answers to these macroeconomic questions better. We elect a government. The government has a macroeconomic policy. Macroeconomic policy matters because it can accelerate (or decelerate) long-run economic growth and can stabilize (or destabilize) the course of the macroeconomy.
Growth policy is important: in the long run few things matter more for the quality of life than whether public policies enhance or retard economic growth. Think of a country like Argentina--one of the most prosperous nations in the world in 1929, ranking perhaps fifth among all nations in the number of automobiles per capita--now ranked well down, among the "developing" countries, because of nearly half a century of economic policies destructive of growth. Or think of countries like Norway and Sweden, relatively poor at the start of the twentieth century, where economic policies supportive of growth throughout the century have led to extraordinary prosperity.
Source: Angus Maddison (1995), Monitoring the
World Economy (Paris: OECD), as updated.
Stabilization policy is important as well: the historical record does not show a steady, stable, smooth upward march as higher production, better technology, and higher employment make all of us better-off. The levels of production and employment (and the rate of unemployment) fluctuate above and below their long-run trends. Production can easily rise several percent above, or fall five percent or more below its long-run trend.
These fluctuations about trend have long been called business cycles. Periods in which production grows and unemployment falls are booms, or macroeconomic expansions. Periods in which production falls and unemployment rises are recessions, or--worse--depressions. Booms are to be welcomed; recessions are to be feared.
Today's governments have powerful abilities to improve economic growth or reduce the size of the business cycle. Good macroeconomic policy can make almost everyone's life better. Bad macroeconomic policy can make almost everyone's life much worse. Thus the stakes at risk in the study of macroeconomics can be high. Bad doctrines and ways of thinking--for example, excessive attachment to the gold standard as an international monetary system in the years of the Great Depression--can be the source of enormous human catastrophe.
[Possible Photo: bread lines during the Great Depression]
Business cycle fluctuations are not felt only in the levels of production and employment. The overall level of consumer prices fluctuates too. Booms usually bring inflation--rising prices. Recessions bring either a slowing-down of the rate of inflation--"disinflation"--or absolute declines in the overall level of prices: deflation. Interest rates, the level of the stock market, and other economic variables as well rise and fall roughly in phase with the principal business cycle fluctuations about trend in production and employment.
The Macroeconomy and Your Quality of Life
At the end of 1982 the U.S. macroeconomy was in its worst shape of the post-World War II period. The unemployment rate was more than ten percent. In an average week in 1983, some 10.7 million Americans were unemployed--actively seeking work, but unable to find a job that seemed to them to be worth taking. The average unemployed American during 1983 had already been unemployed for more than twenty weeks. And the average American household's income was some eight percent below its long-run trend value.
By contrast, at the end of 1998 U.S. unemployment is not ten percent but 4.2 percent. And the average unemployed American during 1968 had been unemployed for less than ten weeks. And the average American household's income is perhaps three percent above its long-run trend value.
Which year would you rather be trying to find a job in?
Bad macroeconomic policy makes years like 1982-1983 much more common. Good macroeconomic policy cannot make the business cycle as benevolent every year as it was in 1998, but it can all but eliminate the prospect of bad years like 1982-1983.
Macroeconomics is by itself only half of economics. For more than half a century economics has been divided into two branches--macroeconomics and microeconomics .
Macroeconomics examines the economy in-the-large, focuses on feedback from one component of the economy to another, and studies what determines the total level of production and employment. By contrast microeconomics, which was (probably) the subject of your last economics course, deals with the economy in-the-small. Microeconomics studies markets for single commodities. It examines the behavior of individual households and businesses. It focuses on how competitive markets work to efficiently allocate resources and create producer and consumer surplus, and on how markets can go wrong.
The Two Branches of Economics
|Focuses on the economy as a whole.||Focuses on markets for individual commodities, and on the decisions of single economic agents.|
|Considers the possibility that decision makers might change the quantities they produce before they change the prices they charge.||Assumes that economic adjustment occurs first through prices: prices move to restore equilibrium by balancing supply and demand, and only afterwards do producers and consumers react to the changed prices by changing the quantities they make, buy, or sell.|
|Spends much time analyzing how total incomes change, and how changes in income cause changes in other modes of economic behavior.||Holds total incomes constant.|
|Spends a great deal of time and energy investigating how expectations are formed and change over time.||Doesn't worry too much about how decision makers form their expectations.|
Microeconomics assumes that imbalances between demand and supply are resolved by changes in prices. Rises in prices bring forth additional supply and falls in prices that bring forth additional demand until they are once again in balance. Macroeconomics considers the possibility that imbalances between supply and demand can be resolved by changes in quantities rather than in prices. Businesses may be slow to change the prices they charge, and faster to expand or contract production until supply balances demand.
This difference means that less may carry over from micro to macro than one might expect or hope. Be careful when you try to apply principles and conclusions gained in micro to macro questions--and vice versa! Every generation of economists attempts to integrate microeconomics and macroeconomics. Every generation tries to provide "microfoundations" for macroeconomic topics of inflation, business cycles, and long-run growth.
No one believes that the bridge between microeconomics and macroeconomics has been soundly built. Economists are divided--roughly evenly--between those who think that the failure (so far) to successfully integrate microeconomics and macroeconomics is a horrible flaw that needs to be corrected as rapidly as possible, and those who think it is regrettable but not terribly relevant.
There are three principal reasons that you might want to learn about macroeconomics.
One is that you need macroeconomics to be culturally literate. A lot of conversation--in the newspapers, on television, and at cocktail parties--in this society deals with the economy. This is not surprising: the economy in the twentieth century was an extraordinarily, wildly successful institution, delivering increases in material prosperity and living standards that no previous generations had ever seen. But it does mean that the economy has a cultural salience today that it did not have in previous centuries, when productivity growth was slow and changes in material standards of living miniscule.
If you want to understand these debates and discussions--to know what it means when newscasters read from their scripts about the stock market, interest rates, unemployment rates, consumer price inflation, or exchange rates--you first need to understand macroeconomics.
[Possible Graphic: collage of newspaper headlines concerned with the macroeconomy]
A second reason is that what happens to the macroeconomy affects what happens to you. Taking out a mortgage at a lower interest rate but with a large number of "points" attached--essentially a front-end payment by you back to the bank--may be extremely unwise and costly if interest rates are likely to fall. The prudent allocation of your savings to different investment vehicles depends on the current state of the macroeconomy. And your bargaining power vis-à-vis your employer--or if you are on the other side of the table your bargaining power vis-à-vis your employee--is all but completely determined by the state of the business cycle.
You cannot control the macroeconomy, but at least you can understand what it is doing and how macroeconomic events are affecting your options. To some degree forewarned is forearmed: whether you judge your options appropriately may depend on how much attention you pay to your macroeconomics teachers.
Thus the second answer to the question "why should I be interested in the macroeconomy?" is--to paraphrase the Russian revolutionary Leon Trotsky--"you may not be interested in the macroeconomy, but the macroeconomy is interested in you."
There is a third reason to be interested in macroeconomics. If you are not literate in macroeconomics, you cannot be a good citizen. You vote. You thus help choose the officials of our government. This is one of the most precious rights and capabilities members of human societies have ever had.
And one of the most important things the government does is manage the macroeconomy--or, rather, try to manage the macroeconomy. In election after election over your life, different candidates will present themselves seeking your vote. After the election, the winning candidates will then have to try to manage the macroeconomy.
If you are literate in macroeconomics, you can judge which candidates for office give signs of understanding the issues, and could become effective macroeconomic managers. You will be able to judge which candidates for office are essentially clueless, or are cynically promising much more than they could possibly deliver.
If not, not.
But isn't it better to take your responsibility as a voter seriously? If so, pay attention in your macroeconomics classes.
The State of the Economy and Political Popularity
Politicians strongly believe that their success at reelection depends on the economy doing well when they are in office. They think that--fairly and unfairly--they get the credit when the economy does well, and suffer the blame when the economy does badly.
The political leader who was most outspoken about this was American politician Richard M. Nixon, who blamed his defeat in the 1960 American presidential election on an economic slump and on the Eisenhower administration's unwillingness to take preemptive action:
Economic historians continue to dispute the degree to which the "stagflation"--the combination of relatively high inflation and relatively high unemployment--was the result of Richard Nixon's determination, as president, never again to run for office in a recession year.
[Possible Graphic: voting booths]
Macroeconomics could not exist without the economic statistics systematically collected and disseminated by governments. Estimates of the value and composition of economic activity, principally those contained in the so-called National Income and Product Accounts [NIPA], are the fundamental data of macroeconomics. You cannot try to explain fluctuations in production, unemployment, and prices unless you know what the economy-wide fluctuations in production, unemployment, and prices are.
The Flow of Economic Data
[To be written...]
The NIPA (and other, related statistical data-gathering and economic-measurement systems) were built to provide estimates of the overall level and composition of economic activity. But what is "economic activity"?
Whenever you work for someone and get paid, that is economic activity. Whenever you buy something at a store, that is economic activity. Whenever the government taxes you and spends its money building a bridge, that is economic activity. In general, if there is a flow of money involved in any transaction, economists will count that transaction as "economic" activity.
"Economic activity" is the pattern of transactions in which things of real useful value--resources, labor, goods, and services--are created, transformed, and exchanged. If it is not a transaction in which something of useful value is exchanged for money, odds are that the NIPA will not count it as part of "economic activity."
You can get a very good idea of the pulse of economic activity by looking at only six key economic variables: six variables that together give a very large chunk of the significant information about the macroeconomy. These six variables are:
The first key quantity is the level of real Gross Domestic Product, called "real GDP" for short, and often referred to as just "GDP."
Let's unpack the definition of real GDP word-by-word. "Real" means that this measure corrects for changes in the level of prices: if total spending doubles because the average level of prices doubles but the total flow of commodities does not change, then real GDP does not change. "Gross" means that this measure includes investments that merely replace worn-out and obsolete pieces of already existing capital (in contrast to "net" measures which count only the addition to the capital stock: "net" measures are better, but the information to do a good job of constructing them does not exist.)
"Domestic" means that this measure counts economic activity that happens in the United States, no matter whether the workers are legal residents or not or the factories are owned by Japanese, German, or American investors.
"Product" means that real GDP counts the production of final goods and services in the economy. It consists of the production of consumption goods, things that are useful to consumers--things that consumers buy, take home (or take out), and consume--plus the production of investment goods, things like machine tools, buildings, highways, and bridges that amplify the country's productive capital stock and thus aid our ability to produce in the future; plus what is produced for the government (acting as our collective agent) to buy for its purposes.
Real GDP divided by the number of workers in the economy is our best readily-available index of the status of the economy: how well the economy is doing as a social mechanism for producing goods and services that people find useful: the necessities, conveniences, and luxuries of life.
U.S. Real GDP per Worker
Measured at 1995 prices, all economic forecasts are that U.S. real GDP per worker--the total value of all final goods and services produced in the United States, divided by the number of workers in the labor force--will kiss $60,000 in the year 2000. This marks more than a quadrupling of real material standards of living since 1900, when real GDP per worker at 1995 prices was some $13,000 according to standard estimates.
Other features of macroeconomic history are visible on the graph below--the Great Depression of the 1930s, the World War II boom, the period of stagnation following the 1973 OPEC oil price increase punctuated by the 1974-75 and the 1980-82 recessions--but there is no doubt that the principal event of the twentieth century was the more-than-quadrupling of real GDP per worker.
The second key quantity is the unemployment rate. The unemployed are all people looking actively looking for jobs who have not yet found one (or not yet found one that they find attractive enough to take rather than continue to look for a better). The number of unemployed divided by the total labor force--the unemployed plus those people at work--is the unemployment rate.
In the United States every month the Labor Department's Bureau of Labor Statistics conducts the Current Population Survey: a random survey of America's households. The estimated of unemployed from the survey is then divided by the estimated labor force from the survey, and the result is that month's unemployment rate. Last month's unemployment rate is usually the biggeset single piece of economic news when it is released, on the first Friday of every month.
An economy with no unemployment would not be a good economy. Just as an economy needs inventories of goods--goods in transit, goods in processes, goods in warehouses and sitting on store shelves--in order to function smoothly, so an economy needs "inventories" of jobs-looking-for-workers ("vacancies") and of workers-looking-for-jobs ("the unemployed"). An economy in which each business grabbed the first person who came in the door to fill a newly-open job and in which each worker went and took the job associated with the first help-wanted sign that he or she saw would be a less productive economy. We want workers to be somewhat choosy about what jobs they take--to be willing to think that "this job pays too little", or "this job would be too unpleasant", or "when the employers find out how unqualified I am to do this they will be very unhappy." We want employers to be somewhat choosy about which workesr they hire. Such frictional unemployment is an inevitable part of any process that will make good matches between workers and firms--match workers qualified to do jobs with jobs that use their qualifications.
But there are recessions, and depressions, during which unemployment is definitely not "frictional." In business cycle downturns the unemployment rate can rise very high above any level that anyone could claim reflects a normal and healthy process of job search and job matching. The market economy's matching of the supply of workers willing and able to work with businesses that could put their skills and labor-power to making useful goods and services breaks down. In the United States and in Germany during the Great Depression the share of workers unemployed rose to between one-quarter and one-third: between twenty-five and thirty percent.
When the unemployment rate is relativley high, the market economy is not working well. The unemployment rate is perhaps the best indicator of how well the economy is living up to the potential created by the current level of technology and the current stock of productive capital.
U.S. Unemployment in the Twentieth Century
The unemployment rate in the United States has dipped as low as one and a half percent during World War II and as high as twenty-five percent during the Great Depression--the principal macroeconomic catastrophe of the past century. No other recession or depression--not even the depression of the early 1890s--comes close to the Great Depression.
Since World War II, the U.S. unemployment rate has fluctuated between three and ten percent, with the decades of the 1970s and 1980s seeing relatively high rates of unemployment.
The third key quantity is the inflation rate: a measure of how fast the overall level of money prices is rising. If the inflation rate this year is five percent, that means that this year things-in-general cost five percent more--in money terms, in terms of the symbols printed on dollar bills, not in sweat or toil.
A very high inflation rate--more than twenty percent a month, say--can cause massive economic destruction, as the price system breaks down and the possibility of using profit-and-loss to make rational decisions about what should be produced vanishes. Such hyperinflations are one of the worst economic disasters that can befall an economy.
[Photo: effects of hyperinflation: wheelbarrows of money during the German 1920s inflation]
Moderate inflation rates--more than ten percent a year, say--are very unsettling to consumers and to business managers. This leaves economists scratching their heads to some degree: moderate rates of inflation should not do too much damage to consumers' investors' and managers' ability to figure out what the best use of their financial resources is. Yet all such groups appear strongly averse to inflation, and they vote: politicians in the industrialized economies have learned over the past generation that expressing a lack of commitment to low and stable inflation gets them a quick ticket out of office.
The fourth key quantity is the interest rate. Economists speak of "the" interest rate because different interest rates move up or down together. But in actual fact there are a very large number of different interest rates, applying to loans that mature at different times in the future, and to loans of different degrees of risk. (After all, the person or business entity to whom you loaned your money may find themselves unable to pay it back: that is a risk you accept when you make a loan.) Those people or business enterprises who think that they could make good use of additional financial resources now borrow. Those business enterprises or people who have no sufficiently productive or utilitarian use for their financial resources today lend. When interest rates are low--money is "cheap"--investment tends to be high, because businesses find that even less-profitable investments will still generate the cash flow needed to pay the interest and repay the principal sum borrowed.
Real Interest Rates
Interest rates on long-term debt--like the ten-year notes issued by the U.S. Treasury--are almost always higher than interest rates on short-term debt instruments like the three-month Treasury Bills issued by the U.S. Treasury.
Interest rates have fluctuated widely in the U.S. since 1960. Real interest rates--that is, interest rates adjusted for inflation--have even been negative. During the 1970s nominal--money--interest rates were so low and inflation so high that the interest and principal on a short-term loan bought fewer commodities when the loan was repaid than the original loaned-out principal had purchased when the loan was originally made.
Interest rates in the United States increased radically in the early 1980s--the Volcker disinflation again--and have not yet returned to their levels of the 1950s and 1960s.
The level of the stock market is the key economic quantity that you likely hear about most--you most likely hear about it every single day on the news. The level of the stock market is an index of expectations of how bright the economic future is likely to be. When the stock market is high, average opinion expects economic growth to be rapid, profits high, and unemployment relatively low in the future. (Note, however, that there is a certain mirror-like and tail-chasing element in the stock market: perhaps it would be better to say that the stock market is high when average opinion expects that average opinion will expect that economic growth will be rapid in the future.) When the stock market is low, average opinion expects the economic future to be relatively gloomy.
The Stock Market
The United States has had a relatively thick market in equities--the "stocks" of a corporation, the pieces of paper that carry shares of its ownership--for more than a century and a quarter. One of the major indices that tracks the performance of the stock market as a whole is the Standard and Poor's composite index--the S&P 500.
Over the past century, on average a share of stock has traded for about fifteen times its "trailing" earnings per share--the profits of the corporation in the previous year, divided by the number of shares of stock the corporation has outstanding. But companies with good prospects for growth sell for more than fifteen times their earnings, and corporations seen as in decline sell for less.
There are some years in which expectations of the future of the economy are relatively depressed, and stock indices--a measure of the stock market as a whole--sell for much less than the fifteen-times-earnings rule-of-thumb that has been normal over the past century. Look at 1982, when the stock market as a whole was undervalued by perhaps 40 percent on the basis of the fifteen-times-earnings rule-of-thumb.
And their are times--like the end of the 1960s, or today--when the stock market appears significantly overvalued on the basis of standard historical patterns. During such episodes in which the stock market is high, investors are implicitly forecasting a major boom and the continuation of rapid productivity growth--or else many people are going to be very disappointed with their stock market investments.
Sixth and last of the key economic quantities is the exchange rate: the rate at which the moneys of different countries can be exchanged one for another. The exchange rate governs the terms on which international trade and international investment takes place. When the dollar is appreciated, the value of the dollar in terms of other currencies is high: this means that foreign-produced goods are relatively cheap to American buyers, but that American-made goods are relatively expensive for foreigners. When the dollar has depreciated the opposite is the case: American goods are cheap to foreign buyers--thus exports from America are likely to be high or at least about to rise--but Americans' power to purchase foreign-made goods is limited.
Source: Author's calculations from Economic Report of the President.
Know the values today of these six key economic variables in their context--both their levels today relative to their average or normal levels, and their recent trends and reversals of trends--and you have a remarkably complete picture of the current state of the macroeconomy.
The Current Situation: The United States
As of the summer of 1999, economic growth in the United States continued to be strong. Forecasters predicted that 1999 would see real GDP in the United States rise by 4.0%, as a 1.2% increase in the number of workers was accompanied by extremely strong growth--2.8% per year--in labor productivity. Democratic policymakers and economists advocating the Clinton deficit-reduction program in the early 1990s had claimed that deficit reduction would make possible a high-investment economic expansion, which would then become a high productivity growth expansion.
Up until 1996 there had been no signs that high investment was leading to high productivity growth. But by the summer of 1999 people were beginning to hope that perhaps the political claims of the early 1990s were becoming true.
In the United States, strong growth in production and sales had pushed the unemployment rate down to a level--4.2%--not seen in a generation. Such a tight labor market was good news for workers: employers appeared eager to pour resources into training them for their jobs. Yet the tight labor market and the strong demand for employees was not showing up in strong real wage growth. Real wages in the year up to June 1999 had grown at only 1.7 percent.
On the other hand, relatively slow nominal wage growth--3.7 percent in the year up to June 1999--meant that inflation was low as well. This proved a puzzle to economists: practically all had confidently forecast that unemployment below 4.5 percent would surely lead to accelerating inflation. Yet it did not seem to do so--and hence the likelihood that the Federal Reserve would find it necessary to sharply raise interest rates to restrict demand and fight inflation seemed low.
[To be written]
The Current Situation: Europe
As of the summer of 1999, industrial production in the eleven countries belonging to the European Monetary Union--and having the "euro" for their principal currency--was 1.2 percent below what it had been a year before. Europe was not in recession exactly: GDP had grown by one percent over the preceding year. But with falling industrial production, high unemployment of ten percent of the labor force or more, and stagnant retail sales the European economy could hardly be said to be healthy.
There was certainly room for economic expansion in Europe as of the summer of 1999. The preceding year had seen consumer prices throughout the euro zone rise by only 0.9 percent, and had seen producer prices actually fall by 1.4 percent. Yet central bankers seemed reluctant to engage in policies to expand demand, and eager to blame the social welfare state and an absence of incentives for high unemployment.
[To be written]
The Current Situation: Emerging Markets
[To be written]
1. Macroeconomics is the study of the economy in the large--the determination of the economy-wide levels of production, of employment and unemployment, and of rates of inflation or deflation.
2. There are three key reasons to study macroeconomics: first, to gain cultural literacy; second, to understand important aspects of the economic world in which you live; third, so that you can gain the capability to be a good voter and citizen.
3. There are six key variables, understanding of which will take you a long way toward success in macroeconomics. These six are: real GDP, the unemployment rate, the inflation rate, the interest rate, the level of the stock market, and the exchange rate.
The unemployment rate
The (real) exchange rate
The interest rate
The stock market
1. What are the key differences between microeconomics and macroeconomics?
2. Why are real GDP and the unemployment rate important macroeconomic variables?
3. What macroeconomic issues are in the newspaper headlines this morning? Has chapter one of this textbook been any use in understanding them?
4. Why are inflation and deflation important economic variables?
5. Why are the interest rate and the level of the stock market important economic variables?
[To be written, and revised for each
year within editions]