Basics of Macro

Macro: The Basics

In economics, there are several ways to look at the economy. The approaches we begin with in principles courses are microeconomics and macroeconomics. As we have done over the last few weeks, we have looked at the micro questions. How might choices be made given a limited budget, or how might a firm respond to a price change. We looked at how the forces of supply and demand work to bring about an equilibrium price in a single market. This takes a worm’s eye view of the economy. We are looking at very detailed, specific parts of the economy. The individual consumer or the individual firm are the objects of analysis in microeconomics.

In macroeconomics we take a bird’s eye view. In a way, we are looking down on the economy from space and trying to examine how the interactions of all those individuals living and working together, result in measurable economic phenomena as a whole.

So what phenomena are we looking for here?


There are  three broad macroeconomic goals: economic growth, full employment, and price stability.

Underlying these goals are real, measurable phenomena that emerge as a result of the complex interaction of the millions of agents in the economy living out their economic lives.

We measure growth by looking at changes in our national income, we look at the degree to which we attain full employment by looking at employment and capacity utilization statistics, and look at price stability by how the consumer price index changes year on year.

We would prefer more growth to less growth, full employment, and price stability, because these are the conditions under which society maximizes its income.

But wait! Why (always ask why in economics) do we prefer more growth? Doesn’t growth stand at odds with ecological sustainability?

That's an important question to ask. Economists need to ask the question: Can we have growth that does not impinge upon the natural environment?

For now, let's just accept that we desire economic growth. Why? When the economy grows it means that the flow rate of output is increasing, which means the level of income is increasing, and more of the society's productive potential is realized. Remember the production possibilities curve? When we have growth we are either 1) approaching the state at which we are operating on the PPF, or 2) the PPF itself is pushed further from the origin, and we are now producing at a higher  level than, say, a lower rate of growth. In either case, we are using more of society's available resources during periods of growth, which increases incomes for the economy as a whole. Growth increases the wealth of nations.

Growth defined: This is simply the increase in output of goods and services over time.

Full employment: Everyone willing and able to work can find employment. This can also refer to the full employment of capital as well. Full employment as a macro goal means that we need to examine the causes and extent of unemployment.

Unemployment: (The number of people who would like to work) / (number of people in the labor force - approx. 157 million).

Types of unemployment:

1. Frictional: arises from a mismatch of employees and employers
2. Seasonal: results from temporary nature of certain jobs – e.g. farm work, ski towns, etc.
3. Structural: More serious. Permanent displacement of jobs as a result of structural changes in economy. Outsourcing, technical changes (automobile manufacturing).
4. Cyclical unemployment: due to decrease in demand for labor during a recession
5. Hidden unemployment: forms of unemployment not captured in the stats. Discouraged workers – technically outside of labor force, so this actually makes the numbers look better than they are. See evidence of this when the labor force participation rate rises as economy recovers. 

Price Stability: stable prices are necessary for a smooth functioning capitalist economy. We measure the variability of price changes with the consumer price index. There are other indices, but this one is used most frequently.

CPI Defined: takes average level of prices in one year or period as a percentage of the average price level in some base period:

CPI = current cost of basket/cost of basket in base year * 100

What constitutes a “basket?” BLS surveys different markets 50 urban areas each month for the prices of 400 “typical consumer goods and services.

When the average level of prices is rising, we say there is inflation. When the average level of prices is falling, we say there is deflation. [note: This is not the same as debasement! Often times people confuse “debasing the currency” with both inflation and deflation.]  We will come back to this issue in more detail when we cover money. For now, the above rule of thumb should suffice.

In general we want some inflation, but not too much. This becomes a point of debate in economics and policy circles in general - what is the appropriate level of inflation? We agree (well mostly, economists that do not account for debt in their models, will see falling prices as the mechanism through which economies should recovery from a recession) though that never should we see deflation – that indicates that very bad things are happening in the economy. Example: house prices fall, but mortgages do not. Wages fall, but debt commitments do not. This can cause a depression. More on this later.

Deflation hurts people that work for a living; including people who own businesses and make a living from profits that are generated actively. Inflation hurts people who do not work and live off savings, fixed income annuities, pensions, or dividends, rents, and royalties, or whatever financial product you can imagine. People across all income spectrums are impacted, but those that worry the most about inflation are those that generally hold a vast wealth of bonds, stocks, and other financial assets. Cost of living adjustments in pensions or social security, for instance, can offset all of the losses to inflation, but inflation erodes wealth held in financial terms. The erosion of some of this paper wealth through inflation is not really a problem for the macroeconomy as whole, but it's sure to make some people angry who derive their status through their wealth.

Measuring GDP

GDP Defined: The total dollar value of all goods and services produced in a given year. Currently $15.6 T (up from $2 T in 1978). GDP = C + I + G + (X-M)

Gross Domestic Product is the term we use to describe the level of output an economy generates over a period of time. How do we measure this? This is an accounting problem that relies upon the principles of double-entry: there are two parties to a transaction. One party spends money which generates a flow of income to the other party. One person’s expenditure is another’s income. So, we have two ways of counting up all the value of the final output of goods and services for the economy as a whole:

Expenditures - flow approach: focuses on the prices and quantities of goods and services sold.
Income – flow approach: focuses on income paid to those producing goods and services.

I prefer the expenditures approach when I talk about this.

GDP: C + I + G + (X –M)

C: Personal Consumption (this is generally less than the full amount of disposable income households earn).
I: Gross Private Domestic Investment (injection)
G: Government Consumption Expenditures (injection)
(X-M): Net exports (If X > M, then this is an injection.

Demand: At this point we need to talk about the role demand plays in the economy. The engine of growth is demand. The entire economy can be conceived of as constituting a flow of transactions that take place periodically. Demand is what drives this whole process. There can be injections of the demand, and leakages of demand. If injections are greater than leakages, then the system grows – swells. If leakages are greater than injections, then the system contracts and shrinks. See the Heilbroner readings on this.

Injections: Investment, government spending, exports
Leakages: Saving, taxation, imports

Notice: For government spending (G in the GDP equation above) to be positive, then the following condition must be true:

Government Spending > Taxation

Therefore, if G > T, then injections from government spending outweigh the leakages from taxation.