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The Long and Short of Macroeconomics

Become familiar with the focus of macroeconomics.

Explain how economists approach macroeconomic questions.

Become familiar with key macroeconomic issues and questions.

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Learning Objectives
After studying this chapter, you should be able to:
1.1
1.2
1.3

When you enter the job market can matter a lot

Job market entrants in 2005 had more employment opportunities.

Expanding labor force, low and falling unemployment

Job market entrants in 2008-2011 had a much harder time.

Unemployment rate at highest level in 25 years

Over 600,000 more firms closed than opened during 2008-2009

Depressed home and stock prices led many older workers to delay retirement

Economic research has shown that students graduating during a recession accept jobs paying 9% less than those graduating during an expansion.

Lower average wages persist for 8-10 years on average.

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Understanding these fluctuations

Fluctuations in the economy can be understood by learning macroeconomics.

Microeconomics The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

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Become familiar with the focus of macroeconomics

1.1

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Learning Objective

Macroeconomics in the short run and in the long run

Short Run

Business cycle Alternating periods of economic expansion and economic recession.

Long Run

Long-run economic growth The process by which increasing productivity raises the average standard of living.

Labor productivity The quantity of goods and services that can be produced by one worker or by one hour of work.

One important determinant of growth is the ability of firms to expand and fund their operations; for this, a healthy financial system is critical.

Exploration of these concepts is the main focus of this class.

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May want to discuss the difference between a “growth” recession and a “classical” recession. Growth below trend for a sustained period might be considered a recession by some, but students typically think of sustained negative growth as a recession. This is important for when we discuss business cycles later, since growth below trend is considered an output gap and might be a recession in a “growth” sense, even though the economy may be experiencing positive growth. In a classical sense, a growth recession is not necessarily a classical recession since it might not fit the definition of an economic contraction that we typically relay to students.

Long-run growth in the United States

Real gross domestic product (GDP) The value of final goods and services adjusted for changes in the price level.

Long-run economic growth is often better measured by real gross domestic product per person.

Long-run growth between 1900 and 2012 improved the U.S. standard of living in many ways.

3% of homes had electricity in 1900 versus nearly all today.

Average consumption of water increased from 5 to 150 gallons/day.

Most homes used coal to heat and cook.

Seven tons per family per year on average.

Led to high levels of pollution.

Lack of modern items like TV, radio, computers, air conditioners.

Life expectancy increased from 47 to 78 years.

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The growth in real GDP per capita

By 2011, the average American was able to buy approximately eight times what they would have been able to buy in 1900.

The growth in real GDP per capita, 1900-2011

Figure 1.1

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Log scale on the y-axis implies a straight line here is constant growth.

Some countries have experienced less long-run growth

Differing levels of long-run economic growth have resulted in countries today having very different levels of GDP per capita.

Differing levels of GDP per capita, 2011

Figure 1.2

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You might note that while GDP in the U.S. is only about twice the size of China’s today, the per capita income in China is around 1/7th that of the United States.

Aging populations pose a challenge

Lower birthrates and increases in lifespans have resulted in aging populations; this trend it projected to continue.

Government spending on programs like Social Security, Medicare, and Medicaid is projected to grow to about 20% of GDP by 2050, which would be about the same size as the entire government today.

The aging of the population

Figure 1.3

(a) The world (b) The United States

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Unemployment in the United States

Labor force The sum of employed and unemployed workers in the economy.

Unemployment rate The percentage of the labor force that is unemployed.

Unemployment rate in the United States, 1890-2011

Figure 1.4

Unemployment rises and falls with the business cycle.

We will examine why it was so low during the Great Moderation.

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Unemployment rates differ across developed countries

Government policy and structural differences can lead to persistently higher unemployment rates across developed countries.

Between 2001 and 2010, unemployment rates were on average much higher in developed countries like France, Germany, and Spain compared to the U.S. The reasons for widely varying levels of unemployment is not entirely clear.

Average unemployment rates in the United States and other high income countries, 2002-2011

Figure 1.5

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Inflation rates fluctuate over time

Inflation rates have tended to peak during wartime, with the 1970s being a notable exception.

Deflation occurred in 2009 for the first time in 50 years.

Inflation rates have averaged below 5% annually since the mid 1980s.

Inflation rate The percentage increase in the price level from one year to the next.

Deflation A sustained decrease in the price level.

Inflation in the United States, 1775-2011

Figure 1.6

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Inflation rates vary across countries

Different countries experience widely different inflation rates. Some countries like Ireland and Norway are experiencing mild inflation, while others face high inflation.

Extreme example: in 2008, Zimbabwe experienced 15 billion percent inflation.

Inflation rates around the world, 2011

Figure 1.7

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Economic policy can help stabilize the economy

High unemployment is associated with economic downturns.

Expansions have become longer and recessions shorter since 1950.

Recessions accompanied by financial crises are particularly deep and prolonged

Fluctuations in U.S. real GDP, 1900-2011

Figure 1.8

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Economic policy can help stabilize the economy

The two types of government policy used to stabilize the economy are:

Monetary policy The actions that central banks take to manage the money supply and interest rates to pursue macroeconomic policy objectives.

Fiscal policy Changes in government taxes and purchases that are intended to achieve macroeconomic policy objectives.

A major focus of this class is on these two types of policy, and on their role in stabilizing the economy. The severe recession of 2007-2009 will also be a focus, with its roots in the financial crisis.

Financial crisis involves a significant disruption in the flow of funds from lenders to borrowers.

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International factors have become more important

International factors have become more important in explaining macroeconomic events.

Example: Fed Chairman Ben Bernanke spoke of a “global savings glut” that had driven down U.S. interest rates.

International trade has been becoming more and more significant for the United States.

International trade is of increasing importance to the United States

Figure 1.9a

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International factors have become more important

International trade is even more important for many other—especially smaller—countries.

Economic openness has increased in the U.S. and other developed countries.

Countries like S. Korea and Germany are highly dependent on trade.

China has dramatically increased its openness in the past few decades.

International trade as a percentage of GDP for several countries, 2011

Figure 1.9b

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The increasing importance of global financial markets

Just as markets for goods and services have become more open, so have global financial markets.

Foreigners now invest more in the United States; and U.S. investors invest more overseas also.

Markets affect one another; the recession of 2007-2009 reduced Chinese exports, and the Greek debt crisis caused worldwide stock market declines.

Growth of foreign financial investment in the United States

Figure 1.10

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Explain how economists approach macroeconomic questions

1.2

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Learning Objective

Macroeconomics happens to us all

Everyone is affected by macroeconomics:

Job loss due to recessions

Stock market gains and losses

Obtaining loans

Misperceptions about macroeconomics are common in the general public:

What causes inflation? “Corporate greed!”

How would an increase in inflation affect wages and salaries? “No effect!”

What causes recessions? “Government mistakes!”

How do foreign imports affect unemployment rates? “Permanent increase!”

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What is the best way to analyze macroeconomic issues?

Economists study economic problems systematically.

Gather data relevant to the problem.

Form models capable of analyzing data.

Could inflation be caused by corporate greed?

Inflation has varied a great deal since 1775.

Most recent 50 years inflation was below 3% in the 1950s and 1960s and well above 10% in the late 1970s and early 1980s.

If corporate greed were the cause, greed would have to fluctuate over time.

Just inspecting data can give misleading results.

Rather than rejecting an explanation, it is useful to provide an alternative explanation.

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Macroeconomic models

Models are very important to the study of macroeconomics.

Economists study economic problems systematically by gathering data relevant to the problem and then building a model capable of analyzing the data.

Simple explanations are often not satisfying.

Solved Problems are in each chapter of the textbook. These problems show you how to solve an applied macroeconomic problem by breaking it down step by step.

Visit www.myeconlab.com to practice using more Solved Problems.

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Rising imports and U.S. employment

Do rising imports lead to a permanent reduction in U.S. employment?

Opinion polls show that many people believe that imports of foreign goods lead to a reduction in employment in the United States. On the surface, this claim may seem plausible: If U.S. automobile firms use more imported steel, production at U.S. steel firms declines, and U.S. steel firms will lay off workers. Briefly describe how you might evaluate the claim that employment in the United States has been reduced as a result of imports.

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Solved Problem

Rising imports and U.S. employment

Do rising imports lead to a permanent reduction in U.S. employment?

Step 1 Review the chapter material

Step 2 Discuss what data you might use in evaluating this claim. The Bureau of Economic Analysis (BEA) at www.bea.gov collects data on GDP and trade. The Bureau of Labor Statistics (BLS) at www.bls.gov can provide employment data.

Step 3 Draw a graph that shows total employment and imports as a percentage of GDP.

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Solved Problem

Rising imports and U.S. employment

Do rising imports lead to a permanent reduction in U.S. employment?

Step 4 Discuss what else you might do to evaluate this claim. Economists typically inspect data as only the first step in evaluating a claim about a macroeconomic event. By examining the data here, it appears that over the past 40 years, both imports and employment have risen. Thus, it seems unlikely that rising imports have led to reduced employment. However, employment might have risen faster if imports did not rise so much. In Chapter 7, we will study a model of the labor market in an attempt to better understand the long-run determinants of employment.

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Solved Problem

Macroeconomic models

Macroeconomic models are useful simplifications of reality

Economists typically assume that consumers buy goods and services that maximize their well-being or utility.

Firms are often assumed to maximize profits.

Abstraction from reality, since we do not describe the motives of all consumers and firms.

Reminders

Models and Theories

Used to analyze real-world issues.

Model and theory will be used interchangeably.

Models use assumptions to simplify reality by focusing on a few key variables.

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Macroeconomic models

Endogenous and Exogenous in a Model

If we assume the Federal Reserve determines the supply of money, then the money supply is exogenous.

Inflation would then be considered endogenous because we are attempting to explain how the Federal Reserve can control inflation.

Reminders

Economic Variables

Something measureable that can have different values, like the rate of inflation.

Endogenous variable A variable that is explained by an economic model.

Exogenous variable A variable that is taken as given and is not explained by an economic model.

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Macroeconomic models

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Decide on assumptions to be used in developing the model. Decide on endogenous and exogenous variables.

Formulate a testable hypothesis.

Use economic data to test the hypothesis.

Revise the model if it fails to explain the economic data well.

Retain the revised model to help answer similar economic questions in the future.

Formulating and testing hypotheses in economic models

Hypothesis A statement that may be either correct or incorrect.

Example: “Higher marginal tax rates on income lead to higher rates of unemployment.”

How to evaluate? Idea: collect data on unemployment and tax rates for several countries.

Causation vs. Correlation

Economic hypotheses are usually about causal relationships, showing that changes in one variable cause changes in another variable.

Proving correlation, that two variables are related, is much easier than causation.

Confounding variables may be related to both exogenous and endogenous variables

Example: Stringent labor laws limiting the firing of workers might be positively correlated with both high tax and high unemployment countries.

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Might note that hypotheses can never be confirmed true through statistical testing. We collect evidence that either fails to reject or rejects the hypothesis. Type I errors are those that are “false positives” when the null is not rejected but it should be. A type II error is a “false negative” when evidence rejects a hypothesis when it should not be rejected.

Formulating and testing hypotheses in economic models

Positive analysis Analysis concerned with “what is”.

Examining the world from an objective point of view.

Measuring the costs and benefits of different courses of action.

Economics is mostly concerned with positive analysis.

Normative analysis Analysis concerned with “what ought to be”.

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Why should the U.S. worry about the Euro crisis?

Euro zone: 17 member states of the European Union that adopted the euro as their currency.

Monetary policy conducted by European Central Bank.

Recession beginning 2007 worsened debt problems of several euro-zone members.

Austerity policies (economic reforms, spending cuts, tax increases) became common.

Effect on the U.S. economy?

Decreased exports to Europe.

U.S. banks hold European debt.

“A lack of confidence can be very contagious.” - Shawn DuBravac, Chief Economist, Consumer Electronics Association

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Making the Connection

Become familiar with key macroeconomic issues and questions

1.3

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Learning Objective

Key issues and questions of macroeconomics

Each chapter will highlight one key issue and a related key question.

Material from each chapter will use the concepts covered to answer that question.

Chapter 2: Measuring the Macroeconomy

Issue: The unemployment rate can rise even though a recession has ended.

Question: How accurately does the government measure the unemployment rate?

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Key issues and questions of macroeconomics

Chapter 3: The U.S. Financial System

Issue: The financial system moves funds from savers to borrowers, which promotes investment and the accumulation of capital goods.

Question: Why did the bursting of the housing bubble in 2006 cause the financial system to falter?

Chapter 4: The Global Financial System

Issue: Some governments allow the value of their currency to fluctuate in foreign-exchange markets, while other government fix the value of their currency.

Question: What are the advantages and disadvantages of floating versus fixed exchange rates?

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Key issues and questions of macroeconomics