Science of Macroeconomics

how macroeconomics affect business,how macroeconomics affects everyday life,how macroeconomics is related to microeconomics
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CHAPTER 1 The Science of Macroeconomics The whole of science is nothing more than the refinement of everyday thinking. —Albert Einstein 1-1 What Macroeconomists Study hy have some countries experienced rapid growth in incomes over the past century while others stay mired in poverty? Why do some Wcountries have high rates of inflation while others maintain stable prices? Why do all countries experience recessions and depressions—recurrent periods of falling incomes and rising unemployment—and how can government policy reduce the frequency and severity of these episodes? Macroeconomics, the study of the economy as a whole, attempts to answer these and many relat- ed questions. To appreciate the importance of macroeconomics, you need only read the newspaper or listen to the news. Every day you can see headlines such as INCOME GROWTH REBOUNDS, FED MOVES TO COMBAT INFLA- TION, or STOCKS FALL AMID RECESSION FEARS. These macroeconomic events may seem abstract, but they touch all of our lives. Business executives fore- casting the demand for their products must guess how fast consumers’ incomes will grow. Senior citizens living on fixed incomes wonder how fast prices will rise. Recent college graduates looking for jobs hope that the economy will boom and that firms will be hiring. Because the state of the economy affects everyone, macroeconomic issues play a central role in national political debates. Voters are aware of how the economy is doing, and they know that government policy can affect the economy in pow- erful ways. As a result, the popularity of the incumbent president often rises when the economy is doing well and falls when it is doing poorly. Macroeconomic issues are also central to world politics, and if you read the international news, you will quickly start thinking about macroeconomic ques- tions. Was it a good move for much of Europe to adopt a common currency? Should China maintain a fixed exchange rate against the U.S. dollar? Why is the United States running large trade deficits? How can poor nations raise their standard of living? When world leaders meet, these topics are often high on their agenda. 34 PA R T I Introduction Although the job of making economic policy belongs to world leaders, the job of explaining the workings of the economy as a whole falls to macroecono- mists. Toward this end, macroeconomists collect data on incomes, prices, unem- ployment, and many other variables from different time periods and different countries. They then attempt to formulate general theories to explain these data. Like astronomers studying the evolution of stars or biologists studying the evo- lution of species, macroeconomists cannot conduct controlled experiments in a laboratory. Instead, they must make use of the data that history gives them. Macroeconomists observe that economies differ across countries and that they change over time. These observations provide both the motivation for develop- ing macroeconomic theories and the data for testing them. To be sure, macroeconomics is a young and imperfect science. The macroecon- omist’s ability to predict the future course of economic events is no better than the meteorologist’s ability to predict next month’s weather. But, as you will see, macro- economists know quite a lot about how economies work. This knowledge is use- ful both for explaining economic events and for formulating economic policy. Every era has its own economic problems. In the 1970s, Presidents Richard Nixon, Gerald Ford, and Jimmy Carter all wrestled in vain with a rising rate of inflation. In the 1980s, inflation subsided, but Presidents Ronald Reagan and George Bush presided over large federal budget deficits. In the 1990s, with Pres- ident Bill Clinton in the Oval Office, the economy and stock market enjoyed a remarkable boom, and the federal budget turned from deficit to surplus. But as Clinton left office, the stock market was in retreat, and the economy was heading into recession. In 2001 President George W. Bush reduced taxes to help end the recession, but the tax cuts also contributed to a reemergence of budget deficits. President Barack Obama moved into the White House in 2009 in a period of heightened economic turbulence. The economy was reeling from a financial crisis, driven by a large drop in housing prices and a steep rise in mortgage defaults. The crisis was spreading to other sectors and pushing the overall economy into anoth- er recession. The magnitude of the downturn was uncertain as this book was going to press, but some observers feared the recession might be deep. In some minds, the financial crisis raised the specter of the Great Depression of the 1930s, when in its worst year one out of four Americans who wanted to work could not find a job. In 2008 and 2009, officials in the Treasury, Federal Reserve, and other parts of gov- ernment were acting vigorously to prevent a recurrence of that outcome. Macroeconomic history is not a simple story, but it provides a rich motivation for macroeconomic theory. While the basic principles of macroeconomics do not change from decade to decade, the macroeconomist must apply these principles with flexibility and creativity to meet changing circumstances. CASE STUDY The Historical Performance of the U.S. Economy Economists use many types of data to measure the performance of an econo- my. Three macroeconomic variables are especially important: real gross domes- tic product (GDP), the inflation rate, and the unemployment rate. Real GDPCHAPTER 1 The Science of Macroeconomics 5 measures the total income of everyone in the economy (adjusted for the level of prices). The inflation rate measures how fast prices are rising. The unem- ployment rate measures the fraction of the labor force that is out of work. Macroeconomists study how these variables are determined, why they change over time, and how they interact with one another. Figure 1-1 shows real GDP per person in the United States. Two aspects of this figure are noteworthy. First, real GDP grows over time. Real GDP per per- son today is about eight times higher than it was in 1900. This growth in aver- age income allows us to enjoy a much higher standard of living than our great-grandparents did. Second, although real GDP rises in most years, this growth is not steady. There are repeated periods during which real GDP falls, the most dramatic instance being the early 1930s. Such periods are called recessions if they are mild and depressions if they are more severe. Not sur- prisingly, periods of declining income are associated with substantial econom- ic hardship. FIGURE 1-1 Real GDP per person First oil price shock (2000 dollars) World Great World Korean Vietnam Second oil price shock 40,000 War I Depression War II War War 32,000 9/11 terrorist 16,000 attack 8,000 4,000 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Year Real GDP per Person in the U.S. Economy Real GDP measures the total income of everyone in the economy, and real GDP per person measures the income of the average person in the economy. This figure shows that real GDP per person tends to grow over time and that this normal growth is sometimes interrupted by periods of declining income, called recessions or depressions. Note: Real GDP is plotted here on a logarithmic scale. On such a scale, equal distances on the vertical axis represent equal percentage changes. Thus, the distance between 4,000 and 8,000 (a 100 percent change) is the same as the distance between 8,000 and 16,000 (a 100 percent change). Source: U.S. Department of Commerce and Economic History Services.6 PA R T I Introduction FIGURE 1-2 Percent First oil price shock 30 World Great World Korean Vietnam Second oil price shock War I Depression War II War War 25 20 Inflation 15 9/11 terrorist 10 attack 5 0 −5 −10 Deflation −15 −20 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Year The Inflation Rate in the U.S. Economy The inflation rate measures the percent- age change in the average level of prices from the year before. When the inflation rate is above zero, prices are rising. When it is below zero, prices are falling. If the inflation rate declines but remains positive, prices are rising but at a slower rate. Note: The inflation rate is measured here using the GDP deflator. Source: U.S. Department of Commerce and Economic History Services. Figure 1-2 shows the U.S. inflation rate. You can see that inflation varies substan- tially over time. In the first half of the twentieth century, the inflation rate averaged only slightly above zero. Periods of falling prices, called deflation, were almost as common as periods of rising prices. By contrast, inflation has been the norm dur- ing the past half century. Inflation became most severe during the late 1970s, when prices rose at a rate of almost 10 percent per year. In recent years, the inflation rate has been about 2 or 3 percent per year, indicating that prices have been fairly stable. Figure 1-3 shows the U.S. unemployment rate. Notice that there is always some unemployment in the economy. In addition, although the unemployment rate has no long-term trend, it varies substantially from year to year. Recessions and depressions are associated with unusually high unemployment. The highest rates of unemployment were reached during the Great Depression of the 1930s. These three figures offer a glimpse at the history of the U.S. economy. In the chapters that follow, we first discuss how these variables are measured and then develop theories to explain how they behave. ■CHAPTER 1 The Science of Macroeconomics 7 FIGURE 1-3 Percent unemployed First oil price shock World Great World Korean Vietnam War I Depression War II War War Second oil price shock 25 20 9/11 terrorist attack 15 10 5 0 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Year The Unemployment Rate in the U.S. Economy The unemployment rate measures the percentage of people in the labor force who do not have jobs. This figure shows that the economy always has some unemployment and that the amount fluctuates from year to year. Source: U.S. Department of Labor and U.S. Bureau of the Census (Historical Statistics of the United States: Colonial Times to 1970). 1-2 How Economists Think Economists often study politically charged issues, but they try to address these issues with a scientist’s objectivity. Like any science, economics has its own set of tools—terminology, data, and a way of thinking—that can seem foreign and arcane to the layman. The best way to become familiar with these tools is to prac- tice using them, and this book affords you ample opportunity to do so. To make these tools less forbidding, however, let’s discuss a few of them here. Theory as Model Building Young children learn much about the world around them by playing with toy versions of real objects. For instance, they often put together models of cars, trains, or planes. These models are far from realistic, but the model-builder8 PA R T I Introduction learns a lot from them nonetheless. The model illustrates the essence of the real object it is designed to resemble. (In addition, for many children, building models is fun.) Economists also use models to understand the world, but an economist’s model is more likely to be made of symbols and equations than plastic and glue. Economists build their “toy economies” to help explain economic vari- ables, such as GDP, inflation, and unemployment. Economic models illustrate, often in mathematical terms, the relationships among the variables. Models are useful because they help us to dispense with irrelevant details and to focus on underlying connections. (In addition, for many economists, building mod- els is fun.) Models have two kinds of variables: endogenous variables and exogenous vari- ables. Endogenous variables are those variables that a model tries to explain. Exogenous variables are those variables that a model takes as given. The pur- pose of a model is to show how the exogenous variables affect the endogenous variables. In other words, as Figure 1-4 illustrates, exogenous variables come from outside the model and serve as the model’s input, whereas endogenous variables are determined within the model and are the model’s output. FIGURE 1-4 Exogenous Variables Model Endogenous Variables How Models Work Models are simplified theories that show the key relationships among economic variables. The exogenous variables are those that come from outside the model. The endogenous variables are those that the model explains. The model shows how changes in the exogenous variables affect the endogenous variables. To make these ideas more concrete, let’s review the most celebrated of all eco- nomic models—the model of supply and demand. Imagine that an economist wanted to figure out what factors influence the price of pizza and the quantity of pizza sold. He or she would develop a model that described the behavior of pizza buyers, the behavior of pizza sellers, and their interaction in the market for pizza. For example, the economist supposes that the quantity of pizza demanded d by consumers Q depends on the price of pizza P and on aggregate income Y. This relationship is expressed in the equation d Q = D(P, Y ), where D( ) represents the demand function. Similarly, the economist supposes s that the quantity of pizza supplied by pizzerias Q depends on the price of pizza PCHAPTER 1 The Science of Macroeconomics 9 and on the price of materials P , such as cheese, tomatoes, flour, and anchovies. m This relationship is expressed as s Q = S(P, P ), m where S( ) represents the supply function. Finally, the economist assumes that the price of pizza adjusts to bring the quantity supplied and quantity demanded into balance: s d Q = Q . These three equations compose a model of the market for pizza. The economist illustrates the model with a supply-and-demand diagram, as in Figure 1-5.The demand curve shows the relationship between the quantity of pizza demanded and the price of pizza, holding aggregate income constant. The demand curve slopes downward because a higher price of pizza encourages con- sumers to switch to other foods and buy less pizza. The supply curve shows the relationship between the quantity of pizza supplied and the price of pizza, holding the price of materials constant. The supply curve slopes upward because a higher price of pizza makes selling pizza more profitable, which encourages pizzerias to produce more of it. The equilibrium for the market is the price and quantity at which the supply and demand curves intersect. At the equilibrium price, con- sumers choose to buy the amount of pizza that pizzerias choose to produce. This model of the pizza market has two exogenous variables and two endoge- nous variables. The exogenous variables are aggregate income and the price of FIGURE 1-5 Price of pizza, P The Model of Supply and Supply Demand The most famous economic model is that of supply and demand for a good or service—in this case, pizza. The demand curve is a downward-sloping curve relating the price of pizza to the quantity of pizza that con- Market sumers demand. The supply equilibrium curve is an upward-sloping Equilibrium curve relating the price of price pizza to the quantity of pizza that pizzerias supply. The Demand price of pizza adjusts until the Equilibrium quantity supplied equals the quantity quantity demanded. The point where the two curves Quantity of pizza, Q cross is the market equilibri- um, which shows the equilib- rium price of pizza and the equilibrium quantity of pizza.10 PA R T I Introduction materials. The model does not attempt to explain them but instead takes them as given (perhaps to be explained by another model). The endogenous variables are the price of pizza and the quantity of pizza exchanged. These are the variables that the model attempts to explain. The model can be used to show how a change in one of the exogenous vari- ables affects both endogenous variables. For example, if aggregate income increases, then the demand for pizza increases, as in panel (a) of Figure 1-6. The model shows that both the equilibrium price and the equilibrium quantity of pizza rise. Similarly, if the price of materials increases, then the supply of pizza decreases, as in panel (b) of Figure 1-6. The model shows that in this case the FIGURE 1-6 Changes in Equilibrium In (a) A Shift in Demand panel (a), a rise in aggregate Price of pizza, P income causes the demand for pizza to increase: at any S given price, consumers now want to buy more pizza. This is represented by a rightward shift in the demand curve from D to D . The market 1 2 moves to the new intersec- P 2 tion of supply and demand. The equilibrium price rises from P to P , and the equi- 1 2 P librium quantity of pizza rises 1 D 2 from Q to Q . In panel (b), 1 2 a rise in the price of materi- D 1 als decreases the supply of pizza: at any given price, Q Q Quantity of pizza, Q 1 2 pizzerias find that the sale of pizza is less profitable and (b) A Shift in Supply therefore choose to produce less pizza. This is represented Price of pizza, P S 2 by a leftward shift in the sup- ply curve from S to S . The 1 2 market moves to the new S 1 intersection of supply and demand. The equilibrium price rises from P to P , and 1 2 the equilibrium quantity falls P 2 from Q to Q . 1 2 P 1 D Q Q Quantity of pizza, Q 2 1 CHAPTER 1 The Science of Macroeconomics 11 equilibrium price of pizza rises and the equilibrium quantity of pizza falls. Thus, the model shows how changes either in aggregate income or in the price of materials affect price and quantity in the market for pizza. Like all models, this model of the pizza market makes simplifying assumptions. The model does not take into account, for example, that every pizzeria is in a different location. For each customer, one pizzeria is more convenient than the others, and thus pizzerias have some ability to set their own prices. The model assumes that there is a single price for pizza, but in fact there could be a differ- ent price at every pizzeria. How should we react to the model’s lack of realism? Should we discard the simple model of pizza supply and demand? Should we attempt to build a more complex model that allows for diverse pizza prices? The answers to these ques- tions depend on our purpose. If our goal is to explain how the price of cheese affects the average price of pizza and the amount of pizza sold, then the diversi- ty of pizza prices is probably not important. The simple model of the pizza mar- ket does a good job of addressing that issue. Yet if our goal is to explain why towns with ten pizzerias have lower pizza prices than towns with two, the sim- ple model is less useful. Using Functions to Express Relationships Among Variables All economic models express relationships among In this case, the demand function is economic variables. Often, these relationships are D(P, Y) = 60 − 10P + 2Y. expressed as functions. A function is a mathemati- For any price of pizza and aggregate income, this cal concept that shows how one variable depends function gives the corresponding quantity of on a set of other variables. For example, in the pizza demanded. For example, if aggregate model of the pizza market, we said that the quan- income is 10 and the price of pizza is 2, then tity of pizza demanded depends on the price of the quantity of pizza demanded is 60 pies; if the pizza and on aggregate income. To express this, price of pizza rises to 3, the quantity of pizza we use functional notation to write demanded falls to 50 pies. d Q = D(P, Y). Functional notation allows us to express the This equation says that the quantity of pizza general idea that variables are related, even when d demanded Q is a function of the price of pizza P we do not have enough information to indicate and aggregate income Y. In functional notation, the precise numerical relationship. For example, the variable preceding the parentheses denotes we might know that the quantity of pizza the function. In this case, D( ) is the function demanded falls when the price rises from 2 to expressing how the variables in parentheses 3, but we might not know by how much it falls. determine the quantity of pizza demanded. In this case, functional notation is useful: as long If we knew more about the pizza market, we as we know that a relationship among the vari- could give a numerical formula for the quantity ables exists, we can express that relationship of pizza demanded. For example, we might be using functional notation. able to write d Q = 60 − 10P + 2Y. FYI12 PA R T I Introduction The art in economics is in judging when a simplifying assumption (such as assuming a single price of pizza) clarifies our thinking and when it misleads us. Simplification is a necessary part of building a useful model: any model con- structed to be completely realistic would be too complicated for anyone to understand. Yet models lead to incorrect conclusions if they assume away features of the economy that are crucial to the issue at hand. Economic modeling there- fore requires care and common sense. The Use Of Multiple Models Macroeconomists study many facets of the economy. For example, they examine the role of saving in economic growth, the impact of minimum-wage laws on unemployment, the effect of inflation on interest rates, and the influence of trade policy on the trade balance and exchange rate. Economists use models to address all of these issues, but no single model can answer every question. Just as carpenters use different tools for different tasks, economists use different models to explain different economic phenomena. Stu- dents of macroeconomics, therefore, must keep in mind that there is no single “correct’’ model that is always applicable. Instead, there are many models, each of which is useful for shedding light on a different facet of the economy. The field of macroeconomics is like a Swiss army knife—a set of complementary but dis- tinct tools that can be applied in different ways in different circumstances. This book presents many different models that address different questions and make different assumptions. Remember that a model is only as good as its assumptions and that an assumption that is useful for some purposes may be mis- leading for others. When using a model to address a question, the economist must keep in mind the underlying assumptions and judge whether they are reasonable for studying the matter at hand. Prices: Flexible Versus Sticky Throughout this book, one group of assumptions will prove especially important— those concerning the speed at which wages and prices adjust to changing eco- nomic conditions. Economists normally presume that the price of a good or a service moves quickly to bring quantity supplied and quantity demanded into bal- ance. In other words, they assume that markets are normally in equilibrium, so the price of any good or service is found where the supply and demand curves inter- sect. This assumption is called market clearing and is central to the model of the pizza market discussed earlier. For answering most questions, economists use market-clearing models. Yet the assumption of continuous market clearing is not entirely realistic. For markets to clear continuously, prices must adjust instantly to changes in supply and demand. In fact, many wages and prices adjust slowly. Labor contracts often set wages for up to three years. Many firms leave their product prices the same for long periods of time—for example, magazine publishers typically changeCHAPTER 1 The Science of Macroeconomics 13 their newsstand prices only every three or four years. Although market-clearing models assume that all wages and prices are flexible, in the real world some wages and prices are sticky. The apparent stickiness of prices does not make market-clearing models use- less. After all, prices are not stuck forever; eventually, they adjust to changes in supply and demand. Market-clearing models might not describe the economy at every instant, but they do describe the equilibrium toward which the economy gravitates. Therefore, most macroeconomists believe that price flexibility is a good assumption for studying long-run issues, such as the growth in real GDP that we observe from decade to decade. For studying short-run issues, such as year-to-year fluctuations in real GDP and unemployment, the assumption of price flexibility is less plausible. Over short periods, many prices in the economy are fixed at predetermined levels. Therefore, most macroeconomists believe that price stickiness is a better assump- tion for studying the short-run behavior of the economy. Microeconomic Thinking and Macroeconomic Models Microeconomics is the study of how households and firms make decisions and how these decisionmakers interact in the marketplace. A central principle of microeconomics is that households and firms optimize—they do the best they can for themselves given their objectives and the constraints they face. In microeco- nomic models, households choose their purchases to maximize their level of sat- isfaction, which economists call utility, and firms make production decisions to maximize their profits. Because economy-wide events arise from the interaction of many households and firms, macroeconomics and microeconomics are inextricably linked. When we study the economy as a whole, we must consider the decisions of individual economic actors. For example, to understand what determines total consumer spending, we must think about a family deciding how much to spend today and how much to save for the future. To understand what determines total investment spending, we must think about a firm deciding whether to build a new factory. Because aggregate variables are the sum of the variables describing many indi- vidual decisions, macroeconomic theory rests on a microeconomic foundation. Although microeconomic decisions underlie all economic models, in many models the optimizing behavior of households and firms is implicit rather than explicit. The model of the pizza market we discussed earlier is an example. Households’ decisions about how much pizza to buy underlie the demand for pizza, and pizzerias’ decisions about how much pizza to produce underlie the supply of pizza. Presumably, households make their decisions to maximize utili- ty, and pizzerias make their decisions to maximize profit. Yet the model does not focus on how these microeconomic decisions are made; instead, it leaves these decisions in the background. Similarly, although microeconomic decisions underlie macroeconomic phenomena, macroeconomic models do not necessar- ily focus on the optimizing behavior of households and firms, but instead some- times leave that behavior in the background.14 PA R T I Introduction Nobel Macroeconomists The winner of the Nobel Prize in economics is ing an infinite discounted sum of one-period util- announced every October. Many winners have ities, but you couldn’t prove it by me. To me it been macroeconomists whose work we study in felt as if I were saying to myself: ‘What the hell.’” this book. Here are a few of them, along with Robert Lucas (Nobel 1995): “In public school sci- some of their own words about how they chose ence was an unending and not very well organized their field of study: list of things other people had discovered long ago. Milton Friedman (Nobel 1976): “I graduated from In college, I learned something about the process college in 1932, when the United States was at the of scientific discovery, but what I learned did not bottom of the deepest depression in its history attract me as a career possibility. . . . What I liked before or since. The dominant problem of the time thinking about were politics and social issues.” was economics. How to get out of the depression? George Akerlof (Nobel 2001): “When I went to How to reduce unemployment? What explained the Yale, I was convinced that I wanted to be either an paradox of great need on the one hand and unused economist or an historian. Really, for me it was a resources on the other? Under the circumstances, distinction without a difference. If I was going to becoming an economist seemed more relevant to be an historian, then I would be an economic his- the burning issues of the day than becoming an torian. And if I was to be an economist I would applied mathematician or an actuary.” consider history as the basis for my economics.” James Tobin (Nobel 1981): “I was attracted to Edward Prescott (Nobel 2004): “Through discus- the field for two reasons. One was that economic sion with my father, I learned a lot about the way theory is a fascinating intellectual challenge, on the businesses operated. This was one reason why I order of mathematics or chess. I liked analytics and liked my microeconomics course so much in my logical argument. . . . The other reason was the first year at Swarthmore College. The price theory obvious relevance of economics to understanding that I learned in that course rationalized what I and perhaps overcoming the Great Depression.” had learned from him about the way businesses Franco Modigliani (Nobel 1985): “For awhile it was operate. The other reason was the textbook used thought that I should study medicine because my in that course, Paul A. Samuelson’s Principles of Eco- father was a physician. . . . I went to the registration nomics. I loved the way Samuelson laid out the the- window to sign up for medicine, but then I closed ory in his textbook, so simply and clearly.” my eyes and thought of blood I got pale just think- Edmund Phelps (Nobel 2006): “Like most Ameri- ing about blood and decided under those condi- cans entering college, I started at Amherst College tions I had better keep away from medicine. . . . without a predetermined course of study or without Casting about for something to do, I happened to even a career goal. My tacit assumption was that I get into some economics activities. I knew some would drift into the world of business—of money, German and was asked to translate from German doing something terribly smart. In the first year, into Italian some articles for one of the trade associ- though, I was awestruck by Plato, Hume and James. ations. Thus I began to be exposed to the economic I would probably have gone into philosophy were it problems that were in the German literature.” not that my father cajoled and pleaded with me to Robert Solow (Nobel 1987): “I came back to try a course in economics, which I did the second college after being in the army and, almost with- year. . . . I was hugely impressed to see that it was out thinking about it, signed up to finish my possible to subject the events in those newspapers I undergraduate degree as an economics major. had read about to a formal sort of analysis.” The time was such that I had to make a decision If you want to learn more about the Nobel 1 in a hurry. No doubt I acted as if I were maximiz- Prize and its winners, go to www.nobelprize.org. 1 The first five quotations are from William Breit and Barry T. Hirsch, eds., Lives of the Laureates, 4th ed. (Cambridge, Mass.: MIT Press, 2004). The next two are from the Nobel Web site. The last one is from Arnold Heertje, ed., The Makers of Modern Economics, Vol. II (Aldershot, U.K.: Edward Elgar Publishing, 1995). FYICHAPTER 1 The Science of Macroeconomics 15 1-3 How This Book Proceeds This book has six parts. This chapter and the next make up Part One, the Intro- duction. Chapter 2 discusses how economists measure economic variables, such as aggregate income, the inflation rate, and the unemployment rate. Part Two, “Classical Theory: The Economy in the Long Run,” presents the classical model of how the economy works. The key assumption of the classical model is that prices are flexible. That is, with rare exceptions, the classical model assumes that markets clear. Because the assumption of price flexibility describes the economy only in the long run, classical theory is best suited for analyzing a time horizon of at least several years. Part Three, “Growth Theory: The Economy in the Very Long Run,” builds on the classical model. It maintains the assumptions of price flexibility and market clearing but adds a new emphasis on growth in the capital stock, the labor force, and technological knowledge. Growth theory is designed to explain how the economy evolves over a period of several decades. Part Four, “Business Cycle Theory: The Economy in the Short Run,” exam- ines the behavior of the economy when prices are sticky. The non-market-clearing model developed here is designed to analyze short-run issues, such as the reasons for economic fluctuations and the influence of gov- ernment policy on those fluctuations. It is best suited for analyzing the changes in the economy we observe from month to month or from year to year. Part Five, “Macroeconomic Policy Debates,” builds on the previous analysis to consider what role the government should have in the economy. It considers how, if at all, the government should respond to short-run fluctuations in real GDP and unemployment. It also examines the various views of how government debt affects the economy. Part Six, “More on the Microeconomics Behind Macroeconomics,” presents some of the microeconomic models that are useful for analyzing macroeconom- ic issues. For example, it examines the household’s decisions regarding how much to consume and how much money to hold and the firm’s decision regarding how much to invest. These individual decisions together form the larger macroeco- nomic picture. The goal of studying these microeconomic decisions in detail is to refine our understanding of the aggregate economy. Summary 1. Macroeconomics is the study of the economy as a whole, including growth in incomes, changes in prices, and the rate of unemployment. Macroecono- mists attempt both to explain economic events and to devise policies to improve economic performance. 2. To understand the economy, economists use models—theories that simplify reality in order to reveal how exogenous variables influence endogenous variables. The art in the science of economics is in judging whether a16 PA R T I Introduction model captures the important economic relationships for the matter at hand. Because no single model can answer all questions, macroeconomists use different models to look at different issues. 3. A key feature of a macroeconomic model is whether it assumes that prices are flexible or sticky. According to most macroeconomists, models with flexible prices describe the economy in the long run, whereas models with sticky prices offer a better description of the economy in the short run. 4. Microeconomics is the study of how firms and individuals make decisions and how these decisionmakers interact. Because macroeconomic events arise from many microeconomic interactions, all macroeconomic models must be consistent with microeconomic foundations, even if those founda- tions are only implicit. KEY C ONCEPT S Macroeconomics Recession Exogenous variables Real GDP Depression Market clearing Inflation and deflation Models Flexible and sticky prices Unemployment Endogenous variables Microeconomics QUES TIONS F OR REVIEW 1. Explain the difference between macroeconomics 3. What is a market-clearing model? When is it and microeconomics. How are these two fields appropriate to assume that markets clear? related? 2. Why do economists build models? PROBLEMS AND APPLICATIONS 1. What macroeconomic issues have been in the affect the price of ice cream and the quantity of news lately? ice cream sold. In your explanation, identify the exogenous and endogenous variables. 2. What do you think are the defining characteris- tics of a science? Does the study of the economy 4. How often does the price you pay for a haircut have these characteristics? Do you think macro- change? What does your answer imply about the economics should be called a science? Why or usefulness of market-clearing models for analyz- why not? ing the market for haircuts? 3. Use the model of supply and demand to explain how a fall in the price of frozen yogurt wouldCHAPTER 2 The Data of Macroeconomics It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to fit facts. —Sherlock Holmes cientists, economists, and detectives have much in common: they all want to figure out what’s going on in the world around them. To do this, they Srely on theory and observation. They build theories in an attempt to make sense of what they see happening. They then turn to more systematic observa- tion to evaluate the theories’ validity. Only when theory and evidence come into line do they feel they understand the situation. This chapter discusses the types of observation that economists use to develop and test their theories. Casual observation is one source of information about what’s happening in the economy. When you go shopping, you see how fast prices are rising. When you look for a job, you learn whether firms are hiring. Because we are all par- ticipants in the economy, we get some sense of economic conditions as we go about our lives. A century ago, economists monitoring the economy had little more to go on than casual observations. Such fragmentary information made economic policy- making all the more difficult. One person’s anecdote would suggest the econo- my was moving in one direction, while a different person’s anecdote would suggest it was moving in another. Economists needed some way to combine many individual experiences into a coherent whole. There was an obvious solu- tion: as the old quip goes, the plural of “anecdote” is “data.” Today, economic data offer a systematic and objective source of information, and almost every day the newspaper has a story about some newly released sta- tistic. Most of these statistics are produced by the government. Various govern- ment agencies survey households and firms to learn about their economic activity—how much they are earning, what they are buying, what prices they are charging, whether they have a job or are looking for work, and so on. From these surveys, various statistics are computed that summarize the state of the economy. Economists use these statistics to study the economy; policymakers use them to monitor developments and formulate policies. This chapter focuses on the three statistics that economists and policymakers use most often. Gross domestic product, or GDP, tells us the nation’s total 1718 PA R T I Introduction income and the total expenditure on its output of goods and services. The con- sumer price index, or CPI, measures the level of prices. The unemployment rate tells us the fraction of workers who are unemployed. In the following pages, we see how these statistics are computed and what they tell us about the economy. 2-1 Measuring the Value of Economic Activity: Gross Domestic Product Gross domestic product, or GDP, is often considered the best measure of how well the economy is performing. This statistic is computed every three months by the Bureau of Economic Analysis, a part of the U.S. Department of Commerce, from a large number of primary data sources. The primary sources include both administrative data, which are byproducts of government functions such as tax collection, education programs, defense, and regulation, and statistical data, which come from government surveys of, for example, retail establishments, manufacturing firms, and farm activity. The purpose of GDP is to summarize all these data with a single number representing the dollar value of economic activity in a given period of time. There are two ways to view this statistic. One way to view GDP is as the total income of everyone in the economy. Another way to view GDP is as the total expendi- ture on the economy’s output of goods and services. From either viewpoint, it is clear why GDP is a gauge of economic performance. GDP measures something people care about—their incomes. Similarly, an economy with a large output of goods and ser- vices can better satisfy the demands of households, firms, and the government. How can GDP measure both the economy’s income and its expenditure on output? The reason is that these two quantities are really the same: for the econ- omy as a whole, income must equal expenditure. That fact, in turn, follows from an even more fundamental one: because every transaction has a buyer and a sell- er, every dollar of expenditure by a buyer must become a dollar of income to a seller. When Joe paints Jane’s house for 1,000, that 1,000 is income to Joe and expenditure by Jane. The transaction contributes 1,000 to GDP, regardless of whether we are adding up all income or all expenditure. To understand the meaning of GDP more fully, we turn to national income accounting, the accounting system used to measure GDP and many related statistics. Income, Expenditure, and the Circular Flow Imagine an economy that produces a single good, bread, from a single input, labor. Figure 2-1 illustrates all the economic transactions that occur between households and firms in this economy. The inner loop in Figure 2-1 represents the flows of bread and labor. The households sell their labor to the firms. The firms use the labor of their workersCHAPTER 2 The Data of Macroeconomics 19 FIGURE 2-1 The Circular Flow Income () This figure illustrates the flows between firms and households in an Labor economy that produces one good, bread, from one input, labor. The inner loop represents the flows of labor and bread: households sell their labor to firms, and the firms sell the Households Firms bread they produce to households. The outer loop represents the cor- responding flows of dollars: households pay the firms for the bread, and the firms pay wages and profit to the Goods (bread) households. In this economy, GDP is both Expenditure () the total expenditure on bread and the total income from the pro- duction of bread. to produce bread, which the firms in turn sell to the households. Hence, labor flows from households to firms, and bread flows from firms to households. The outer loop in Figure 2-1 represents the corresponding flow of dollars. The households buy bread from the firms. The firms use some of the revenue from these sales to pay the wages of their workers, and the remainder is the prof- it belonging to the owners of the firms (who themselves are part of the house- hold sector). Hence, expenditure on bread flows from households to firms, and income in the form of wages and profit flows from firms to households. GDP measures the flow of dollars in this economy. We can compute it in two ways. GDP is the total income from the production of bread, which equals the sum of wages and profit—the top half of the circular flow of dollars. GDP is also the total expenditure on purchases of bread—the bottom half of the circular flow of dollars. To compute GDP, we can look at either the flow of dollars from firms to households or the flow of dollars from households to firms. These two ways of computing GDP must be equal because, by the rules of accounting, the expenditure of buyers on products is income to the sellers of those products. Every transaction that affects expenditure must affect income, and every transaction that affects income must affect expenditure. For example, sup- pose that a firm produces and sells one more loaf of bread to a household. Clear- ly this transaction raises total expenditure on bread, but it also has an equal effect20 PA R T I Introduction Stocks and Flows Many economic variables measure a quantity of but that water is coming out of the faucet at something—a quantity of money, a quantity of 5 gallons per minute. goods, and so on. Economists distinguish between GDP is probably the most important flow two types of quantity variables: stocks and flows. A variable in economics: it tells us how many dol- stock is a quantity measured at a given point in lars are flowing around the economy’s circular time, whereas a flow is a quantity measured per flow per unit of time. When you hear someone unit of time. say that the U.S. GDP is 14 trillion, you should A bathtub, shown in Figure 2-2, is the classic understand that this means that it is 14 trillion example used to illustrate stocks and flows. The per year. (Equivalently, we could say that U.S. amount of water in the tub is a stock: it is the GDP is 444,000 per second.) quantity of water in the tub at a given point in Stocks and flows are often related. In the time. The amount of water coming out of the bathtub example, these relationships are clear. faucet is a flow: it is the quantity of water being The stock of water in the tub represents the accu- added to the tub per unit of time. Note that we mulation of the flow out of the faucet, and the measure stocks and flows in different units. We flow of water represents the change in the stock. say that the bathtub contains 50 gallons of water, When building theories to explain economic vari- ables, it is often useful to determine whether the variables are stocks or flows and whether any relationships link them. Flow Stock Here are some examples of related stocks and flows that we study in future chapters: ➤ A person’s wealth is a stock; his income and expenditure are flows. ➤ The number of unemployed people is a stock; the number of people losing their jobs is a flow. Figure 2-2 Stocks and Flows The amount of ➤ The amount of capital in the economy is a water in a bathtub is a stock: it is a quantity mea- stock; the amount of investment is a flow. sured at a given moment in time. The amount of ➤ The government debt is a stock; the govern- water coming out of the faucet is a flow: it is a quantity measured per unit of time. ment budget deficit is a flow. on total income. If the firm produces the extra loaf without hiring any more labor (such as by making the production process more efficient), then profit increases. If the firm produces the extra loaf by hiring more labor, then wages increase. In both cases, expenditure and income increase equally. Rules for Computing GDP In an economy that produces only bread, we can compute GDP by adding up the total expenditure on bread. Real economies, however, include the pro- duction and sale of a vast number of goods and services. To compute GDP for such a complex economy, it will be helpful to have a more precise definition: FYICHAPTER 2 The Data of Macroeconomics 21 Gross domestic product (GDP) is the market value of all final goods and services pro- duced within an economy in a given period of time. To see how this definition is applied, let’s discuss some of the rules that economists follow in constructing this statistic. Adding Apples and Oranges The U.S. economy produces many different goods and services—hamburgers, haircuts, cars, computers, and so on. GDP com- bines the value of these goods and services into a single measure. The diversity of products in the economy complicates the calculation of GDP because differ- ent products have different values. Suppose, for example, that the economy produces four apples and three oranges. How do we compute GDP? We could simply add apples and oranges and conclude that GDP equals seven pieces of fruit. But this makes sense only if we thought apples and oranges had equal value, which is generally not true. (This would be even clearer if the economy had produced four watermelons and three grapes.) To compute the total value of different goods and services, the national income accounts use market prices because these prices reflect how much peo- ple are willing to pay for a good or service. Thus, if apples cost 0.50 each and oranges cost 1.00 each, GDP would be GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges) = (0.50 × 4) + (1.00 × 3) = 5.00. GDP equals 5.00—the value of all the apples, 2.00, plus the value of all the oranges, 3.00. Used Goods When the Topps Company makes a package of baseball cards and sells it for 50 cents, that 50 cents is added to the nation’s GDP. But what about when a collector sells a rare Mickey Mantle card to another collector for 500? That 500 is not part of GDP. GDP measures the value of currently produced goods and services. The sale of the Mickey Mantle card reflects the transfer of an asset, not an addition to the economy’s income. Thus, the sale of used goods is not included as part of GDP. The Treatment of Inventories Imagine that a bakery hires workers to pro- duce more bread, pays their wages, and then fails to sell the additional bread. How does this transaction affect GDP? The answer depends on what happens to the unsold bread. Let’s first suppose that the bread spoils. In this case, the firm has paid more in wages but has not received any additional revenue, so the firm’s profit is reduced by the amount that wages have increased. Total expenditure in the economy hasn’t changed because no one buys the bread. Total income hasn’t changed either—although more is distributed as wages and less as profit. Because the transaction affects neither expenditure nor income, it does not alter GDP.22 PA R T I Introduction Now suppose, instead, that the bread is put into inventory to be sold later. In this case, the transaction is treated differently. The owners of the firm are assumed to have “purchased’’ the bread for the firm’s inventory, and the firm’s profit is not reduced by the additional wages it has paid. Because the higher wages raise total income, and greater spending on inventory raises total expenditure, the econo- my’s GDP rises. What happens later when the firm sells the bread out of inventory? This case is much like the sale of a used good. There is spending by bread consumers, but there is inventory disinvestment by the firm. This negative spending by the firm offsets the positive spending by consumers, so the sale out of inventory does not affect GDP. The general rule is that when a firm increases its inventory of goods, this investment in inventory is counted as an expenditure by the firm owners. Thus, production for inventory increases GDP just as much as production for final sale. A sale out of inventory, however, is a combination of positive spending (the pur- chase) and negative spending (inventory disinvestment), so it does not influence GDP. This treatment of inventories ensures that GDP reflects the economy’s cur- rent production of goods and services. Intermediate Goods and Value Added Many goods are produced in stages: raw materials are processed into intermediate goods by one firm and then sold to another firm for final processing. How should we treat such products when computing GDP? For example, suppose a cattle rancher sells one-quarter pound of meat to McDonald’s for 0.50, and then McDonald’s sells you a ham- burger for 1.50. Should GDP include both the meat and the hamburger (a total of 2.00), or just the hamburger (1.50)? The answer is that GDP includes only the value of final goods. Thus, the ham- burger is included in GDP but the meat is not: GDP increases by 1.50, not by 2.00. The reason is that the value of intermediate goods is already included as part of the market price of the final goods in which they are used. To add the intermediate goods to the final goods would be double counting—that is, the meat would be counted twice. Hence, GDP is the total value of final goods and services produced. One way to compute the value of all final goods and services is to sum the value added at each stage of production. The value added of a firm equals the value of the firm’s output less the value of the intermediate goods that the firm purchases. In the case of the hamburger, the value added of the rancher is 0.50 (assuming that the rancher bought no intermediate goods), and the value added of McDonald’s is 1.50 – 0.50, or 1.00. Total value added is 0.50 + 1.00, which equals 1.50. For the economy as a whole, the sum of all value added must equal the value of all final goods and services. Hence, GDP is also the total value added of all firms in the economy. Housing Services and Other Imputations Although most goods and ser- vices are valued at their market prices when computing GDP, some are not sold in the marketplace and therefore do not have market prices. If GDP is to include the value of these goods and services, we must use an estimate of their value. Such an estimate is called an imputed value.

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