1 Contents Macroeconomic Concepts 2 Schools of Thought 7 Output, GDP, and Sectoral Balances 11 Unemployment 23 Inflation 30 Links Between Macroeconomic Aggregates 42 Demand and Output: The Multiplier 42 Productivity and Factor Shares 47 Output and Unemployment: The Beveridge Curve and Okun’s Law 53 Business Cycles 60 Money and Finance 70 Debt Dynamics 80 Central Banks and Monetary Policy 84 Exchange Rates 105 Macroeconomics in an Open Economy 118 Glossary 124 2 Macroeconomic Concepts The economy is made up of economic units, which are grouped into sec- tors. An economic unit can be a government, a business, a household, or any other entity that can make and receive money payments, own as- sets and owe debts. Note: In economics, we usually refer to “house- holds" rather than people; a household consists of one or more indi- viduals who pool their income and share ownership of assets, and make many of their purchases together. We do this because families normally function as a single economic unit: They make economic decisions together, and don’t engage in market transactions with each other. The main economic sectors are households, nonfinancial busi- ness, finance, and government. Nonprofit institutions are normally grouped with households. Nonfinancial businesses are further di- vided into corporate and noncorporate business. All units outside the naitonal borders are usually treated as a single sector, referred to as the rest of the world. Outcomes that policymakers seek to influence are called policy targets. A policy target is a macroeconomic outcome that policymakers seek Target. An outcome that policymakers to influence. A policy instrument is a variable that is more or less wish to influence. The most important macroeconomic targets are output, in- under control of some public authority – either the executive or leg- flation, unemployment, the government islature of an elected government, or a central bank. At the most debt ratio, the balance of payments, income distribution, and financial general level, macroeconomic policy consists of picking the right val- stability. ues of the instruments to reach the desired levels of the targets. A Instrument. A variable that is directly fundamental challenge is that the sme instrument may have effects under the control of policymakers on more than one target, and the right value for one target is proba- and is adjusted in order to affect other bly not the right value for the other. This problem is summarized by macroeconomic outcomes. Tinbergen’s rule: You must have at least as many instruments as you Tinbergen’s rule. The principle that to have independent targets, if you want to be able to hit all the targets. hit a certain number of independent macroeconomic targets, the authorities If two target variables always move together, they are not indepen- must have at least that many different dent. For example, because there is such a close relationship between policy instruments. changes in output and changes in employment, many economists would not consider them two separate targets. It is important to distinguish between targets, which are the real- world outcomes we are concerned with, and aggregates, which are Aggregate. A variable measured at the variables we can actually measure. Because statistics are never the level of the economy as a whole. Common aggregates include GDP, the collected perfectly, and are often collected for different purposes consumer price index (CPI), and the and defined differently than in economic theory, no aggregate is an unemployment rate. exact measure of the corresponding target. And there are often a number of different aggregates that might be used to measure the 3 same target. For example, today output is normally measured by the aggregate GDP, but in the past it was more often measured by GNP. Debates about macroeconomic policy come down to three ques- tions: 1. What are the appropriate levels for each target? (For example, should inflation be kept to 2%, as most countries currently seek to, or are there reasons to prefer an inflation rate of 4-5%, or of 0%?) 2. Which targets are most important, given that there are not enough policy instruments to hit all of them? (For example, some people – often owners of financial assets – think that it is most important to avoid high inflation, while other people – often those who work for a living – think that is most important to avoid high unemploy- ment.) 3. How effective are the instruments available at moving the different target variables? (For example, does expansionary monetary policy have a strong effect on investment and thus on output, or only a weak one?) The most important targets for macroeconomic policy, are output, unem- ployment, inflation, government debt, distribution, the balance of payments, and financial stability. Almost all discussions of macroeconomic policy focus on one or more of the following seven targets. Output - total goods and services produced in the economy. Output. Total production of goods and All else equal, higher output is normally considered desirable services in an economy. – greater market production implies higher living standards and more resources available for public purposes. Keeping output near potential output is a central goal for macroeconomic policy, both Potential output. The level of output because it is important in itself and because the behavior of other targeted by macroeconomic policy. It is assumed to be the maximum targets is closely linked to the level of output. Output above po- the economy can produce without tential may be considered “overheating" in the sense that it cannot “overheating” – that is, without rising inflation, shortages of raw materials, be sustained for more than a few years, or because it is associated etc. Since potential output cannot be with rising inflation, and with changes in income distribution. In directly measured, it may be estimated practice, economists and policymakers worry more about output based either on the level of observable aggregates like unemployment or falling below potential than about output rising above potential. inflation, or on the long-run trend of Macroeconomic policy is primarily concerned with variations in output growth. output over a periods of a few years – recessions, booms, and busi- ness cycles. Output is normally measured by gross domestic product (GDP) Gross domestic product (GDP). The or some related variable, such as gross national product (GNP). most common measure of total output of an economy. It is defined as final There is no direct way to measure potential output. Statistically, goods produced for the market within the borders of the country in a given period. Gross national product (GNP). An alternative measure of total output of an economy. It is defined as final goods produced for the market by the labor and capital of a country, regardless of where production takes place. 4 it is estimated based on the trend of output growth in the past. In policy debates, the judgement about whether current output is above or below potential is based on the behavior of unemploy- ment and inflation. The growth rate of output is often considered a separate target from the current level of output. The majority of macroeconomists believe that the current level of output demands on demand-side factors (how much people and businesses wish to spend) while the long-run growth of output depends mostly or entirely on supply- side factors (the productive capabilities of the country’s workers and businesses.) This implies that different kinds of policies may be needed to get output to potential in the short run, and to boost the long-run growth rate of output. For instance, a higher savings rate may reduce current demand for goods and services, but free up resources for productive investment that will contribute to future growth. Not all economists agree that there is a conflict between rais- ing output in the short term and raising long term growth. Some Keynesian economics economists believe that higher demand con- Keynesian economics. A school of tributes to long-term growth as well as the current level of output. macroeconomics that emphasizes: the determination of output by aggregate Many other economists believe that macro policy instruments can- demand rather than the productive not reliably affect the long-run growth rate one way or the other capacity of the economy; the role of money and finance in shaping economic (since it depends more on technological change) and that policy outcomes; the uncertainty of the future; should therefore focus on stabilizing the economy in the short run. and the inherent instability of the economy, which must be managed by Unemployment - the fraction of the laborforce unable to find work. government. High unemployment is the problem that modern macroeco- Unemployment rate. The fraction of nomics was first developed to address, and the unemployment rate the laborforce unable to find work. is probably the single economic variable that policymakers pay In the US it is normally measured by U-3 – the fraction of the civilian, most attention to. Policy focuses on unemployment partly because noninstitutionalized population 16 it is important in itself – unemployment source of great personal and older who have zero hours of paid hardship, and when unemployment rate is high it often leads to employment and are actively looking for work. But other measures exist. political instability. Unemployment is also a focus for policy be- cause it is easy to measure the unemployment rate, while potential output cannot be measured directly. Unemployment in the US is usually measured by U-3 – the fraction of the civilian, noninstitutionalized population 16 and older who have zero hours of paid employment and are actively looking for work. But broader measures exist, such as U-6, which includes people who have given up looking for work and part- time workers who would prefer to work full-time.