PART 6
CHAPTER 16
Could better economic policies have prevented the Great Depression?Source: National Archives
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Discuss the broad issues that macroeconomists study and the types of data they use and interpret.
2. LO2Identify the three major types of macroeconomic policy and discuss the difference between positive and normative analyses of macroeconomic policy.
3. LO3Understand the difference between microeconomics and macroeconomics and how aggregation is used.
In 1929, the economy of the United States slowed dramatically. Between August of 1929 and the end of 1930, the nation’s factories and mines, facing sharp declines in sales, cut their production rates by a remarkable 31 percent. These cutbacks led in turn to mass layoffs: Between 1929 and 1930, the number of people without jobs almost tripled, from about 3 percent of the workforce to nearly 9 percent.1 Financial markets were equally shaky. The stock market crashed in October 1929, and stocks lost nearly a third of their value in just three weeks.
At first, policymakers and the general public (except for those people who had put their life savings into the stock market) were concerned but not panic stricken. Americans remembered that the nation had experienced a similar slowdown only eight years earlier, in 1921–1922. That episode had ended quickly, apparently on its own, and the decade that followed (popularly known as the Roaring Twenties) had been one of unparalleled prosperity. But the fall in production and the rise in unemployment that began in 1929 continued into 1931. In the spring of 1931, the economy seemed to stabilize briefly, and President Herbert Hoover optimistically proclaimed that “prosperity is just around the corner.” But in mid-1931, the economy went into an even steeper dive. What historians now call the Great Depression had begun in earnest.
Labor statistics tell the story of the Great Depression from the worker’s point of view. Unemployment was extremely high throughout the 1930s, despite government attempts to reduce it through large-scale public employment programs. At the worst point of the Depression, in 1933, one out of every four American workers was unemployed. Joblessness declined gradually to 17 percent of the workforce by 1936 but remained stuck at that level through 1939. Of those lucky enough to have jobs, many were able to work only part-time, while others worked for near-starvation wages.
In some other countries, conditions were even worse. In Germany, which had never fully recovered from its defeat in World War I, nearly a third of all workers were without jobs, and many families lost their savings as major banks collapsed. Indeed, the desperate economic situation was a major reason for Adolf Hitler’s election as chancellor of Germany in 1933. Introducing extensive government control over the economy, Hitler rearmed the country and ultimately launched what became the most destructive war in history, World War II.
How could such an economic catastrophe have happened? One often-heard hypothesis is that the Great Depression was caused by wild speculation on Wall Street, which provoked the stock market crash. But though stock prices may have been unrealistically high in 1929, there is little evidence to suggest that the fall in stock prices was a major cause of the Depression. A similar crash in October 1987, when stock prices fell a record 23 percent in one day—an event comparable in severity to the crash of October 1929—did not slow the economy significantly. Another reason to doubt that the 1929 stock market crash caused the Great Depression is that, far from being confined to the United States, the Depression was a worldwide event, affecting countries that did not have well-developed stock markets at the time.
What did cause the Great Depression, then? Today most economists who have studied the period blame poor economic policymaking both in the United States and in other major industrialized countries. Of course, policymakers did not set out to create an economic catastrophe. Rather, they fell prey to misconceptions of the time about how the economy worked. In other words, the Great Depression, far from being inevitable, might have been avoided—if only the state of economic knowledge had been better. From today’s perspective, the Great Depression was to economic policymaking what the voyage of the Titanic was to ocean navigation.
One of the few benefits of the Great Depression was that it forced economists and policymakers of the 1930s to recognize that there were major gaps in their understanding of how the economy works. This recognition led to the development of a new subfield within economics, called macroeconomics. Macroeconomics is the study of the performance of national economies and the policies governments use to try to improve that performance.
This chapter will introduce the subject matter and some of the tools of macroeconomics. Although understanding episodes like the Great Depression and, more recently, the Great Recession remains an important concern of macroeconomists, the field has expanded to include the analysis of many other aspects of national economies. Among the issues macroeconomists study are the sources of long-run economic growth and development, the causes of high unemployment, and the factors that determine the rate of inflation. Appropriately enough in a world in which economic “globalization” preoccupies businesspeople and policymakers, macroeconomists also study how national economies interact. Since the performance of the national economy has an important bearing on the availability of jobs, the wages workers earn, the prices they pay, and the rates of return they receive on their saving, it’s clear that macroeconomics addresses bread-and-butter issues that affect virtually everyone.
In light of the nation’s experience during the Great Depression, macroeconomists are particularly concerned with understanding how macroeconomic policies work and how they should be applied. Macroeconomic policies are government actions designed to affect the performance of the economy as a whole (as opposed to policies intended to affect the performance of the market for a particular good or service, such as sugar or haircuts). The hope is that by understanding more fully how government policies affect the economy, economists can help policymakers do a better job—and avoid serious mistakes, such as those that were made during the Great Depression. On an individual level, educating people about macroeconomic policies and their effects will make for a better-informed citizenry, capable of making well-reasoned decisions in the voting booth.
THE MAJOR MACROECONOMIC ISSUES
We defined macroeconomics as the study of the performance of the national economy as well as the policies used to improve that performance. Let’s now take a closer look at some of the major economic issues that macroeconomists study.
ECONOMIC GROWTH AND LIVING STANDARDS
Although the wealthy industrialized countries (such as the United States, Canada, Japan, and the countries of western Europe) are certainly not free from poverty, hunger, and homelessness, the typical person in those countries enjoys a standard of living better than at any previous time or place in history. By standard of living, we mean the degree to which people have access to goods and services that make their lives easier, healthier, safer, and more enjoyable. People with a high living standard enjoy more and better consumer goods: technologically advanced cars, laptop and tablet computers, smartphones, and the like. But they also benefit from a longer life expectancy and better general health (the result of high-quality medical care, good nutrition, and good sanitation), from higher literacy rates (the result of greater access to education), from more time and opportunity for cultural enrichment and recreation, from more interesting and fulfilling career options, and from better working conditions. Of course, the Scarcity Principle will always apply—even for the citizen of a rich country: Having more of one good thing means having less of another. But higher incomes make these choices much less painful than they would be otherwise. Choosing between a larger apartment and a nicer car is much easier than choosing between feeding your children adequately and sending them to school, the kind of hard choice people in the poorest nations face.
Scarcity
Americans sometimes take their standard of living for granted, or even as a “right.” But we should realize that the way we live today is radically different from the way people have lived throughout most of history. The current standard of living in the United States is the result of several centuries of sustained economic growth, a process of steady increase in the quantity and quality of the goods and services the economy can produce. The basic equation is simple: The more we can produce, the more we can consume. Of course, not everyone in a society shares equally in the fruits of economic growth and economists are rightly concerned by the increase in economic inequality that has sometimes accompanied economic growth. That said, in most cases growth brings an improvement in the average person’s standard of living.
To get a sense of the extent of economic growth over time, examine Figure 16.1, which shows how the output of the U.S. economy has increased since 1929. (We discuss the measure of output used here, real gross domestic product, in the next chapter.) Although output fluctuates at times, the overall trend has been unmistakably upward. Indeed, in 2016 the output of the U.S. economy was more than 15 times what it was in 1929 and more than 4 times its level in 1965. What caused this remarkable economic growth? Can it continue? Should it? These are some of the questions macroeconomists try to answer.
FIGURE 16.1 Output of the U.S. Economy, 1929–2016.The output of the U.S. economy has increased by more than 15 times since 1929 and by more than 4 times since 1965.Source: https://fred.stlouisfed.org/series/GDPCA
One reason for the growth in U.S. output over the last century has been the rapid growth of the U.S. population, and hence the number of workers available. Because of population growth, increases in total output cannot be equated with improvements in the general standard of living. Although increased output means that more goods and services are available, increased population implies that more people are sharing those goods and services. Because the population changes over time, output per person is a better indicator of the average living standard than total output.
Figure 16.2 shows output per person in the United States since 1929 (the blue line). Note that the long-term increase in output per person is smaller than the increase in total output shown in Figure 16.1 because of population growth. Nevertheless, the gains made over this long period are still impressive: In 2016, a typical U.S. resident consumed almost six times the quantity of goods and services available to a typical resident at the onset of the Great Depression. To put this increase into perspective, according to the U.S. Census Bureau, in 2013, 84 percent of U.S. households reported that they owned a computer (desktop, laptop, or handheld), and 74 percent reported Internet use. And in 2009, there were more than 90 cellular phone subscribers for each 100 people in the United States. These goods and services, now available to so many people, could hardly be imagined a few decades ago.
FIGURE 16.2 Output per Person and per Worker in the U.S. Economy, 1929–2016.The red line shows the output per worker in the U.S. economy since 1929, and the blue line shows output per person. Both have risen substantially. Relative to 1929, output per person today is nearly six times greater, and output per worker is almost five times greater.Source: Data from 1913 to 1952: www.census.gov/popest/data/national/totals/pre-1980/tables/popclockest.txt. Data from 1952 to Present: https://research.stlouisfed.org/fred2/series/POP/#
Nor has the rise in output been reflected entirely in increased availability of consumer goods. For example, as late as 1960, only 41 percent of U.S. adults over age 25 had completed high school, and less than 8 percent had completed four years of college. Today, about 90 percent of the adult population have at least a high school diploma, and about 34 percent have a college degree. More than two-thirds of the students currently leaving high school will go on to college. Higher incomes, which allow young people to continue their schooling rather than work to support themselves and their families, are a major reason for these increases in educational levels.
PRODUCTIVITY
While growth in output per person is closely linked to changes in what the typical person can consume, macroeconomists are also interested in changes in what the average worker can produce. Figure 16.2 shows how output per employed worker (that is, total output divided by the number of people working) has changed since 1929 (red line). The figure shows that in 2016 a U.S. worker could produce almost five times the quantity of goods and services produced by a worker at the beginning of the Great Depression, despite the fact that the workweek is now much shorter than it was 87 years ago.
Economists refer to output per employed worker as average labor productivity. As Figure 16.2 shows, average labor productivity and output per person are closely related. This relationship makes sense—as we noted earlier, the more we can produce, the more we can consume. Because of this close link to the average living standard, average labor productivity and the factors that cause it to increase over time are of major concern to macroeconomists.
Although the long-term improvement in output per worker is impressive, the rate of improvement has slowed somewhat since the 1970s. Between 1950 and 1973 in the United States, output per employed worker increased by more than 2 percent per year. But from 1974 to 1995, the average rate of increase in output per worker was close to 1 percent per year. From 1996 to 2007, the pace of productivity growth picked up again, to nearly 2 percent per year before slowing down again to around 1 percent per year since 2008. Slowing productivity growth leads to less rapid improvement in living standards because the supply of goods and services cannot grow as quickly as it does during periods of rapid growth in productivity. Identifying the causes of productivity slowdowns and speedups is thus an important challenge for macroeconomists.
The current standard of living in the United States is not only much higher than in the past but also much higher than in many other nations today. Why have many of the world’s countries, including both the developing nations of Asia, Africa, and Latin America and some formerly communist countries of eastern Europe, for many decades, not enjoyed the same rates of economic growth as the industrialized countries? How can a country’s rate of economic growth be improved? Once again, these are questions of keen interest to macroeconomists.
EXAMPLE 16.1Productivity and Living Standards
How do China’s productivity and output per person compare with those of the United States?
According to data from the World Bank (http://data.worldbank.org), in 2015 the value of the output of the U.S. economy was about $18,037 billion. In the same year, the estimated value of the output of the People’s Republic of China was $11,065 billion (U.S.). The populations of the United States and China in 2015 were about 321 million and 1,371 million, respectively, while the numbers of employed workers in the two countries were, respectively, approximately 148 million and 765 million.
Find output per person and average labor productivity for the United States and China in 2015. What do the results suggest about comparative living standards in the two countries?
Output per person is simply total output divided by the number of people in an economy, and average labor productivity is output divided by the number of employed workers. Doing the math we get the following results for 2015:
Note that, although the total output of the Chinese economy is more than 60 percent that of the U.S. output, output per person and average labor productivity in China are each less than 15 and 12 percent, respectively, of what they are in the United States. Thus, though the Chinese economy is predicted in the next 10 or 15 years to surpass the U.S. economy in total output, for the time being there remains a large gap in productivity. This gap translates into striking differences in the average person’s living standard between the two countries—in access to consumer goods, health care, transportation, education, and other benefits of affluence.
RECESSIONS AND EXPANSIONS
Economies do not always grow steadily; sometimes they go through periods of unusual strength or weakness. A look back at Figure 16.1 shows that although output generally grows over time, it does not always grow smoothly. Particularly striking is the decline in output during the Great Depression of the 1930s, followed by the sharp increase in output during World War II (1941–1945). But the figure shows many more moderate fluctuations in output as well.
Slowdowns in economic growth are called recessions; particularly severe economic slowdowns, like the one that began in 1929, are called depressions. In the United States, major recessions occurred in 1973–1975, 1981–1982, and 2007–2009 (find those recessions in Figure 16.1). More modest downturns occurred in 1990–1991 and 2001. During recessions economic opportunities decline: Jobs are harder to find, people with jobs are less likely to get wage increases, profits are lower, and more companies go out of business. Recessions are particularly hard on economically disadvantaged people, who are most likely to be thrown out of work and have the hardest time finding new jobs.
Sometimes the economy grows unusually quickly. These periods of rapid economic growth are called expansions, and particularly strong expansions are called booms. During an expansion, jobs are easier to find, more people get raises and promotions, and most businesses thrive.
The alternating cycle of recessions and expansions raises some questions that are central to macroeconomics. What causes these short-term fluctuations in the rate of economic growth? Can government policymakers do anything about them? Should they try? These questions are discussed further in Chapter 24, Short-Term Economic Fluctuations: An Introduction.
UNEMPLOYMENT
The unemployment rate, the fraction of people who would like to be employed but can’t find work, is a key indicator of the state of the labor market. When the unemployment rate is high, work is hard to find, and people who do have jobs typically find it harder to get promotions or wage increases.
Figure 16.3 shows the unemployment rate in the United States since 1929. Unemployment rises during recessions—note the dramatic spike in unemployment during the Great Depression, as well as the increases in unemployment during the 1973–1975, 1981–1982, and 2007–2009 recessions. But even in the so-called good times, such as the 1960s and the 1990s, some people are unemployed. Why does unemployment rise so sharply during periods of recession? And why are there always unemployed people, even when the economy is booming?
FIGURE 16.3 The U.S. Unemployment Rate, 1929–2016.The unemployment rate is the percentage of the labor force that is out of work. Unemployment spikes upward during recessions and depressions, but the unemployment rate is always above zero, even in good times.Source: Bureau of Labor Statistics, http://data.bls.gov
EXAMPLE 16.2Unemployment and Recessions
By how much did unemployment increase during five recent U.S. recessions?
Using monthly data on the national civilian unemployment rate, find the increase in the unemployment rate between the onset of recession in November 1973, January 1980, July 1990, January 2001, and December 2007 and the peak unemployment rate in the following years. Compare these increases in unemployment to the increase during the Great Depression.
Unemployment data are collected by the U.S. Bureau of Labor Statistics (BLS) and can be obtained from the BLS website (www.bls.gov/bls/unemployment.htm). Periodic publications include the Survey of Current Business, the Federal Reserve Bulletin, and Economic Indicators. Monthly data from the BLS website yield the following comparisons:
Unemployment increased significantly following the onset of each recession, although the impact of the 1990 and 2001 recessions on the labor market was clearly less serious than that of the 1973, 1980, and 2007 recessions. (Actually, the 1980 recession was a “double dip”—a short recession in 1980, followed by a longer one in 1981–1982.) In comparison, during the Great Depression the unemployment rate rose from about 3 percent in 1929 to about 25 percent in 1933, as we mentioned in the introduction to this chapter. Clearly, the 22 percentage point change in the unemployment rate that Americans experienced in the Great Depression dwarfs the effects of more recent postwar recessions.
One question of great interest to macroeconomists is why unemployment rates sometimes differ markedly from country to country. During the 1980s and 1990s, unemployment rates in western Europe were more often than not measured in the “double digits.” On average, more than 10 percent of the European workforce was out of a job during that period, a rate roughly double that in the United States. The high unemployment was particularly striking, because during the 1950s and 1960s, European unemployment rates were generally much lower than those in the United States. Most recently, from 2010 to 2016 (following the global financial crisis), the euro area’s unemployment rate has been close to or in the “double digits,” with dramatic differences between countries within the common currency area. What explains these differences in the unemployment rate in different countries at different times? The measurement of unemployment will be discussed further in the next chapter.
CONCEPT CHECK 16.1
Find the most recent unemployment rates for France, Germany, Spain, and the United Kingdom, and compare them to the most recent unemployment rate for the United States. A useful source is the home page of the Organization for Economic Cooperation and Development (OECD), an organization of industrialized countries (www.oecd.org). See also the OECD’s publication Main Economic Indicators. Is unemployment still lower in the United States than in western Europe?
INFLATION
Another important economic statistic is the rate of inflation, which is the rate at which prices in general are increasing over time. As we will discuss in Chapter 18, Measuring the Price Level and Inflation, inflation imposes a variety of costs on the economy. And when the inflation rate is high, people on fixed incomes, such as pensioners who receive a fixed dollar payment each month, can’t keep up with the rising cost of living.
In recent years, inflation has been relatively low in the United States, but that has not always been the case (see Figure 16.4 for data on U.S. inflation since 1929). During the 1970s, inflation was a major problem; in fact, many people told poll takers that inflation was “public enemy number one.” Why was inflation high in the 1970s, and why is it relatively low today? What difference does it make to the average person?
FIGURE 16.4 The U.S. Inflation Rate, 1929–2016.The U.S. inflation rate has fluctuated over time. Inflation was high in the 1970s but has been quite low recently.Source: Bureau of Labor Statistics, http://data.bls.gov
As with unemployment rates, the rate of inflation can differ markedly from country to country. For example, during the 1990s, the inflation rate averaged 3 percent per year in the United States, but the nation of Ukraine averaged over 400 percent annual inflation for the whole decade. And in 2008, when annual inflation in the United States was less than 4 percent, inflation in Zimbabwe was estimated in the hundreds of millions, and then billions, of percent, and quickly rising! What accounts for such large differences in inflation rates between countries?
Inflation and unemployment are often linked in policy discussions. One reason for this linkage is the oft-heard argument that unemployment can be reduced only at the cost of higher inflation and that inflation can be reduced only at the cost of higher unemployment. Must the government accept a higher rate of inflation to bring down unemployment, and vice versa?
ECONOMIC INTERDEPENDENCE AMONG NATIONS
National economies do not exist in isolation but are increasingly interdependent. The United States, because of its size and the wide variety of goods and services it produces, is one of the most self-sufficient economies on the planet. Even so, in 2016 the United States exported about 12 percent of all the goods and services it produced and imported from abroad 15 percent of the goods and services that Americans used. Merely 50 years earlier, in 1966, neither figure was above 5 percent.
Sometimes international flows of goods and services become a matter of political and economic concern. For example, some politicians maintain that low-priced imports threaten the farming and manufacturing jobs of their constituents. Are free trade agreements, in which countries agree not to tax or otherwise block the international flow of goods and services, a good or bad thing?
A related issue is the phenomenon of trade imbalances, which occur when the quantity of goods and services that a country sells abroad (its exports) differs significantly from the quantity of goods and services its citizens buy from abroad (its imports). Figure 16.5 shows U.S. exports and imports since 1929, measured as a percentage of the economy’s total output. Prior to the 1970s, the United States generally exported more than it imported. (Notice the major export boom that occurred after World War II, when the United States was helping to reconstruct Europe.) Since the 1970s, however, imports to the United States have outstripped exports, creating a situation called a trade deficit. Other countries—China, for example—export much more than they import. A country such as China is said to have a trade surplus. What causes trade deficits and surpluses? Are they harmful or helpful?
FIGURE 16.5 Exports and Imports as a Share of U.S. Output, 1929–2016.The blue line shows U.S. exports of goods as a percentage of U.S. output. The red line shows U.S. imports of goods relative to U.S. output. For much of its history, the United States has exported more than it imported, but over the past decades, imports have greatly outstripped exports.Source: Import data: https://fred.stlouisfed.org/series/IMPGSA and Export data: https://fred.stlouisfed.org/series/EXPGSA
RECAP
THE MAJOR MACROECONOMIC ISSUES
· Economic growth and living standards. Over the last century, the industrialized nations have experienced remarkable economic growth and improvements in living standards. Macroeconomists study the reasons for this extraordinary growth and try to understand why growth rates vary markedly among nations.
· Productivity. Average labor productivity, or output per employed worker, is a crucial determinant of living standards. Macroeconomists ask: What causes slowdowns and speedups in the rate of productivity growth?
· Recessions and expansions. Economies experience periods of slower growth (recessions) and more rapid growth (expansions). Macroeconomists examine the sources of these fluctuations and the government policies that attempt to moderate them.
· Unemployment. The unemployment rate is the fraction of people who would like to be employed but can’t find work. Unemployment rises during recessions, but there are always unemployed people even during good times. Macroeconomists study the causes of unemployment, including the reasons why it sometimes differs markedly across countries.
· Inflation. The inflation rate is the rate at which prices in general are increasing over time. Questions macroeconomists ask about inflation include, Why does inflation vary over time and across countries? Must a reduction in inflation be accompanied by an increase in unemployment, or vice versa?
· Economic interdependence among nations. Modern economies are highly interdependent. Related issues studied by macroeconomists include the desirability of free trade agreements and the causes and effects of trade imbalances.
MACROECONOMIC POLICY
We have seen that macroeconomists are interested in why different countries’ economies perform differently and why a particular economy may perform well in some periods and poorly in others. Although many factors contribute to economic performance, government policy is surely among the most important. Understanding the effects of various policies and helping government officials develop better policies are important objectives of macroeconomists.
TYPES OF MACROECONOMIC POLICY
We defined macroeconomic policies as government policies that affect the performance of the economy as a whole, as opposed to the market for a particular good or service. There are three major types of macroeconomic policy: monetary policy, fiscal policy, and structural policy.
The term monetary policy refers to the determination of the nation’s money supply. (Cash and coin are the basic forms of money, although as we will see, modern economies have other forms of money as well.) For reasons that we will discuss in later chapters, most economists agree that changes in the money supply affect important macroeconomic variables, including national output, employment, interest rates, inflation, stock prices, and the international value of the dollar. In virtually all countries, monetary policy is controlled by a government institution called the central bank. The Federal Reserve System, often called the Fed for short, is the central bank of the United States.
Fiscal policy refers to decisions that determine the government’s budget, including the amount and composition of government expenditures and government revenues. The balance between government spending and taxes is a particularly important aspect of fiscal policy. When government officials spend more than they collect in taxes, the government runs a deficit, and when they spend less, the government’s budget is in surplus. As with monetary policy, economists generally agree that fiscal policy can have important effects on the overall performance of the economy. For example, many economists believe that the large deficits run by the federal government during the 1980s were harmful to the nation’s economy. Likewise, many would say that the balancing of the federal budget that occurred during the 1990s contributed to the nation’s strong economic performance during that decade. Since the early 2000s, the federal budget has moved once again into deficit. The deficit increased dramatically during and after the 2007–2009 recession.
Finally, the term structural policy includes government policies aimed at changing the underlying structure, or institutions, of the nation’s economy. Structural policies come in many forms, from minor tinkering to ambitious overhauls of the entire economic system. The move away from government control of the economy and toward a more market- oriented approach in many formerly communist countries, such as Poland, the Czech Republic, and Hungary, is a large-scale example of structural policy. Many developing countries have tried similar structural reforms. Supporters of structural policy hope that, by changing the basic characteristics of the economy or by remaking its institutions, they can stimulate economic growth and improve living standards.
CONCEPT CHECK 16.2
The Congressional Budget Office (CBO) is the government agency that is charged with projecting the federal government’s surpluses or deficits. From the CBO’s home page (www.cbo.gov), find the most recent value of the federal government’s surplus or deficit and the CBO’s projected values for the next five years. How do you think these projections are likely to affect congressional deliberations on taxation and government spending?
POSITIVE VERSUS NORMATIVE ANALYSES OF MACROECONOMIC POLICY
Macroeconomists are frequently called upon to analyze the effects of a proposed policy. For example, if Congress is debating a tax cut, economists in the Congressional Budget Office or the Treasury may be asked to prepare an analysis of the likely effects of the tax cut on the overall economy, as well as on specific industries, regions, or income groups. An objective analysis aimed at determining only the economic consequences of a particular policy—not whether those consequences are desirable—is called a positive analysis. In contrast, a normative analysis includes recommendations on whether a particular policy should be implemented. While a positive analysis is supposed to be objective and scientific, a normative analysis involves the values of the person or organization doing the analysis—conservative, liberal, or middle-of-the-road.
While pundits often joke that economists cannot agree among themselves, the tendency for economists to disagree is exaggerated. When economists do disagree, the controversy often centers on normative judgments (which relate to economists’ personal values) rather than on positive analysis (which reflects objective knowledge of the economy). For example, liberal and conservative economists might agree that a particular tax cut would increase the incomes of the relatively wealthy (positive analysis). But they might vehemently disagree on whether the policy should be enacted, reflecting their personal views about whether wealthy people deserve a tax break (normative analysis).
The next time you hear or read about a debate over economic issues, try to determine whether the differences between the two positions are primarily positive or normative. If the debate focuses on the actual effects of the event or policy under discussion, then the disagreement is over positive issues. But if the main question has to do with conflicting personal opinions about the desirability of those effects, the debate is normative. The distinction between positive and normative analyses is important, because objective economic research can help to resolve differences over positive issues. When people differ for normative reasons, however, economic analysis is of less use.
CONCEPT CHECK 16.3
Which of the following statements are positive and which are normative? How can you tell?
a. A tax increase is likely to lead to lower interest rates.
b. Congress should increase taxes to reduce the inappropriately high level of interest rates.
c. A tax increase would be acceptable if most of the burden fell on those with incomes over $100,000.
d. Higher tariffs (taxes on imports) are needed to protect American jobs.
e. An increase in the tariff on imported steel would increase employment of American steelworkers.
RECAP
MACROECONOMIC POLICY
Macroeconomic policies affect the performance of the economy as a whole. The three types of macroeconomic policy are monetary policy, fiscal policy, and structural policy. Monetary policy, which in the United States is under the control of the Federal Reserve System, refers to the determination of the nation’s money supply. Fiscal policy involves decisions about the government budget, including its expenditures and tax collections. Structural policy refers to government actions to change the underlying structure or institutions of the economy. Structural policy can range from minor tinkering to a major overhaul of the economic system, as with the formerly communist countries that converted to market-oriented systems.
The analysis of a proposed policy can be positive or normative. A positive analysis addresses the policy’s likely economic consequences but not whether those consequences are desirable. A normative analysis addresses the question of whether a proposed policy should be used. Debates about normative conclusions inevitably involve personal values and thus generally cannot be resolved by objective economic analysis alone.
AGGREGATION
In Chapter 1, Thinking Like an Economist, we discussed the difference between macroeconomics, the study of national economies, and microeconomics, the study of individual economic entities, such as households and firms, and the markets for specific goods and services. The main difference between the fields is one of perspective: Macroeconomists take a “bird’s-eye view” of the economy, ignoring the fine details to understand how the system works as a whole. Microeconomists work instead at “ground level,” studying the economic behavior of individual households, firms, and markets. Both perspectives are useful—indeed essential—to understanding what makes an economy work.
Although macroeconomics and microeconomics take different perspectives on the economy, the basic tools of analysis are much the same. In the chapters to come you will see that macroeconomists apply the same principles as microeconomists in their efforts to understand and predict economic behavior. Even though a national economy is a much bigger entity than a household or even a large firm, the choices and actions of individual decision makers ultimately determine the performance of the economy as a whole. So, for example, to understand saving behavior at the national level, the macroeconomist must first consider what motivates an individual family or household to save.
CONCEPT CHECK 16.4
Which of the following questions would be studied primarily by macroeconomists? By microeconomists? Explain.
a. Does increased government spending lower the unemployment rate?
b. Does Google’s dominance of Internet searches harm consumers?
c. Would a school voucher program improve the quality of education in the United States? (Under a voucher program, parents are given a fixed amount of government aid, which they may use to send their children to any school, public or private.)
d. Should government policymakers aim to reduce inflation still further?
e. Why is the average rate of household saving low in the United States?
f. Does the increase in the number of consumer products being sold over the Internet threaten the profits of conventional retailers?
While macroeconomists use the core principles of economics to understand and predict individual economic decisions, they need a way to relate millions of individual decisions to the behavior of the economy as a whole. One important tool they use to link individual behavior to national economic performance is aggregation, the adding up of individual economic variables to obtain economywide totals.
For example, macroeconomists don’t care whether consumers drink Pepsi or Coke, go to the movie theater or download HD videos, or drive a convertible or a sports utility vehicle. These individual economic decisions are the province of microeconomics. Instead, macroeconomists add up consumer expenditures on all goods and services during a given period to obtain aggregate, or total, consumer expenditure. Similarly, a macroeconomist would not focus on plumbers’ wages versus electricians’ but would concentrate instead on the average wage of all workers. By focusing on aggregate variables, like total consumer expenditures or the average wage, macroeconomists suppress the mind-boggling details of a complex modern economy to see broad economic trends.
EXAMPLE 16.3Aggregation (Part 1): A National Crime Index
Is crime in the United States getting better or worse?
To illustrate not only why aggregation is needed, but also some of the problems associated with it, consider an issue that is only partly economic: crime. Suppose policymakers want to know whether in general the problem of crime in the United States is getting better or worse. How could an analyst obtain a statistical answer to that question?
Police keep detailed records of the crimes reported in their jurisdictions, so in principle a researcher could determine precisely how many purse snatchings occurred last year on New York City subways. But data on the number of crimes of each type in each jurisdiction would produce stacks of computer output. Is there a way to add up, or aggregate, all the crime data to get some sense of the national trend?
Law enforcement agencies such as the FBI use aggregation to obtain national crime rates, which are typically expressed as the number of “serious” crimes committed per 100,000 population. For example, the FBI reported that in 2015, some 9.2 million serious crimes (both violent crimes and property crimes) occurred in the United States (www.fbi.gov). Dividing the number of crimes by the U.S. population in 2015, which was about 321 million, and multiplying by 100,000 yields the crime rate for 2015, equal to about 2,860 crimes per 100,000 people. This rate represented a substantial drop from the crime rate in 2000, which was about 4,100 crimes per 100,000 people. So aggregation (the adding up of many different crimes into a national index) indicates that, in general, serious crime decreased in the United States between 2000 and 2015.
Although aggregation of crime statistics reveals the “big picture,” it may obscure important details. The FBI crime index lumps together relatively minor crimes such as petty theft with very serious crimes such as murder and rape. Most people would agree that murder and rape do far more damage than a typical theft, so adding together these two very different types of crimes might give a false picture of crime in the United States. For example, although the U.S. crime rate fell 30 percent between 2000 and 2015, the murder rate fell by less than 12 percent. Because murder is the most serious of crimes, the reduction in crime between 2000 and 2015 was probably less significant than the change in the overall crime rate indicates. The aggregate crime rate glosses over other important details, such as the fact that the most dramatic reductions in crime occurred in urban areas. This loss of detail is a cost of aggregation, the price analysts pay for the ability to look at broad economic or social trends.
EXAMPLE 16.4Aggregation (Part 2): U.S. Exports
How can we add together Kansas grain with Hollywood movies?
The United States exports a wide variety of products and services to many different countries. Kansas farmers sell grain to Russia, Silicon Valley programmers sell software to France, and Hollywood movie studios sell entertainment the world over. Suppose macroeconomists want to compare the total quantities of American-made goods sold to various regions of the world. How could such a comparison be made?
Economists can’t add bushels of grain, lines of code, and movie tickets—the units aren’t comparable. But they can add the dollar values of each—the revenue farmers earned from foreign grain sales, the royalties programmers received for their exported software, and the revenues studios reaped from films shown abroad. By comparing the dollar values of U.S. exports to Europe, Asia, Africa, and other regions in a particular year, economists are able to determine which regions are the biggest customers for American-made goods.
RECAP
AGGREGATION
Macroeconomics, the study of national economies, differs from microeconomics, the study of individual economic entities (such as households and firms) and the markets for specific goods and services. Macroeconomists take a “bird’s-eye view” of the economy. To study the economy as a whole, macroeconomists make frequent use of aggregation, the adding up of individual economic variables to obtain economywide totals. For example, a macroeconomist is more interested in the determinants of total U.S. exports, as measured by total dollar value, than in the factors that determine the exports of specific goods. A cost of aggregation is that the fine details of the economic situation are often obscured.
STUDYING MACROECONOMICS: A PREVIEW
This chapter introduced many of the key issues of macroeconomics. In the chapters to come we will look at each of these issues in more detail. We will start with the measurement of economic performance, including key variables like the level of economic activity, the extent of unemployment, and the rate of inflation. Obtaining quantitative measurements of the economy, against which theories can be tested, is the crucial first step in answering basic macroeconomic questions like those raised in this chapter.
Next, we will study economic behavior over relatively long periods of time. We will examine economic growth and productivity improvement, the fundamental determinants of the average standard of living in the long run. We will then discuss the long-run determination of employment, unemployment, and wages; and study saving and its link to the creation of new capital goods, such as factories and machines. The role played in the economy by money, and its relation to the rate of inflation and to the central bank, will then be discussed, as will both domestic and international financial markets and their role in allocating saving to productive uses, in particular their role in promoting international capital flows.
John Maynard Keynes, a celebrated British economist, once wrote, “In the long run, we are all dead.” Keynes’s statement was intended as an ironic comment on the tendency of economists to downplay short-run economic problems on the grounds that “in the long run,” the operation of the free market will always restore economic stability. Keynes, who was particularly active and influential during the Great Depression, correctly viewed the problem of massive unemployment, whether “short run” or not, as the most pressing economic issue of the time.
So why start our study of macroeconomics with the long run? Keynes’s comment notwithstanding, long-run economic performance is extremely important, accounting for most of the substantial differences in living standards and economic well-being the world over. Furthermore, studying long-run economic behavior provides important background for understanding short-term fluctuations in the economy.
We turn to those short-term fluctuations by first providing background on what happens during recessions and expansions, as well as some historical perspective, before discussing one important source of short-term economic fluctuations, variations in aggregate spending. We will also show how, by influencing aggregate spending, fiscal policy may be able to moderate economic fluctuations. The second major policy tool for stabilizing the economy, monetary policy, will then be discussed, along with the circumstances under which macroeconomic policymakers may face a short-term trade-off between inflation and unemployment.
The international dimension of macroeconomics will be highlighted throughout the discussion. We will introduce topics such as exchange rates between national currencies and discuss how they are determined and how they affect the workings of the economy and macroeconomic policy.
SUMMARY
· Macroeconomics is the study of the performance of national economies and of the policies governments use to try to improve that performance. Some of the broad issues macroeconomists study are: (LO1)
· Sources of economic growth and improved living standards.
· Trends in average labor productivity, or output per employed worker.
· Short-term fluctuations in the pace of economic growth (recessions and expansions).
· Causes and cures of unemployment and inflation.
· Economic interdependence among nations.
· To help explain differences in economic performance among countries, or in economic performance in the same country at different times, macroeconomists study the implementation and effects of macroeconomic policies. Macroeconomic policies are government actions designed to affect the performance of the economy as a whole. Macroeconomic policies include monetary policy (the determination of the nation’s money supply), fiscal policy (relating to decisions about the government’s budget), and structural policy (aimed at affecting the basic structure and institutions of the economy). (LO2)
· In studying economic policies, economists apply both positive analysis (an objective attempt to determine the consequences of a proposed policy) and normative analysis (which addresses whether a particular policy should be adopted). Normative analysis involves the values of the person doing the analysis. (LO2)
· Macroeconomics is distinct from microeconomics, which focuses on the behavior of individual economic entities and specific markets. Macroeconomists make heavy use of aggregation, which is the adding up of individual economic variables into economywide totals. Aggregation allows macroeconomists to study the “big picture” of the economy, while ignoring fine details about individual households, firms, and markets. (LO3)
KEY TERMS
aggregation
average labor productivity
fiscal policy
macroeconomic policies
monetary policy
normative analysis
positive analysis
standard of living
structural policy
REVIEW QUESTIONS
1. How did the experience of the Great Depression motivate the development of the field of macroeconomics? (LO1)
2. Generally, how does the standard of living in the United States today compare to the standard of living in other countries? To the standard of living in the United States a century ago? (LO1)
3. Why is average labor productivity a particularly important economic variable? (LO1)
4. True or false: Economic growth within a particular country generally proceeds at a constant rate. Explain. (LO1)
5. True or false: Differences of opinion about economic policy recommendations can always be resolved by objective analysis of the issues. Explain. (LO2)
6. What type of macroeconomic policy (monetary, fiscal, structural) might include each of the following actions? (LO2)
a. A broad government initiative to reduce the country’s reliance on agriculture and promote high-technology industries.
b. A reduction in income tax rates.
c. Provision of additional cash to the banking system.
d. An attempt to reduce the government budget deficit by reducing spending.
e. A decision by a developing country to reduce government control of the economy and to become more market-oriented.
7. Baseball statistics, such as batting averages, are calculated and reported for each individual player, for each team, and for the league as a whole. What purposes are served by doing this? Relate to the idea of aggregation in macroeconomics. (LO3)
PROBLEMS
1. Over the next 50 years the Japanese population is expected to decline, while the fraction of the population that is retired is expected to increase sharply. What are the implications of these population changes for total output and average living standards in Japan, assuming that average labor productivity continues to grow? What if average labor productivity stagnates? (LO1)
2. Is it possible for average living standards to rise during a period in which average labor productivity is falling? Discuss, using a numerical example for illustration. (LO1)
3. The Bureau of Economic Analysis, or BEA, is a government agency that collects a wide variety of statistics about the U.S. economy. From the BEA’s website (www.bea.gov), find data for the most recent year available on U.S. exports and imports of goods and services. Is the United States running a trade surplus or deficit? Calculate the ratio of the surplus or deficit to U.S. exports. (LO1)
4. Which of the following statements are positive and which are normative? (LO2)
a. If the Federal Reserve raises interest rates, demand for housing is likely to fall.
b. The Federal Reserve should raise interest rates to keep inflation at an acceptably low level.
c. Stock prices are likely to fall over the next year as the economy slows.
d. A reduction in the capital gains tax (the tax on profits made in the stock market) would lead to a 10 to 20 percent increase in stock prices.
e. Congress should not reduce capital gains taxes without also providing tax breaks for lower-income people.
5. Which of the following would be studied by a macroeconomist? By a microeconomist? (LO3)
a. The worldwide operations of General Motors.
b. The effect of government subsidies on sugar prices.
c. Factors affecting average wages in the U.S. economy.
d. Inflation in developing countries.
e. The effects of tax cuts on consumer spending.
ANSWERS TO CONCEPT CHECKS
16.1Your answer will depend upon the current unemployment rate available at the OECD website. (LO1)
16.2Your answer will depend upon the current CBO budget data. (LO2)
16.3
a. Positive. This is a prediction of the effect of a policy, not a value judgment on whether the policy should be used.
b. Normative. Words like should and inappropriately express value judgments about the policy.
c. Normative. The statement is about the desirability of certain types of policies, not their likely effects.
d. Normative. The statement is about desirability of a policy.
e. Positive. The statement is a prediction of the likely effects of a policy, not a recommendation on whether the policy should be used. (LO2)
16.4
a. Macroeconomists. Government spending and unemployment are aggregate concepts pertaining to the national economy.
b. Microeconomists. Google, though large, is an individual firm.
c. Microeconomists. The issue relates to the supply and demand for a specific service, education.
d. Macroeconomists. Inflation is an aggregate, economywide concept.
e. Macroeconomists. Average saving is an aggregate concept.
f. Microeconomists. The focus is on a relatively narrow set of markets and products rather than on the economy as a whole. (LO3)
1The source for these and most other pre-1960 statistics cited in this chapter is the U.S. Bureau of the Census, Historical Statistics of the United States: Colonial Times to 1970, Washington, D.C., 1975.