All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

The Basics of Macroeconomics: An Overview
"The electoral cycle causes substantial macroeconomic fluctuations. In the United States, the electoral-economic cycle from 1948 to 1976 (other than the Eisenhower years) has consisted of a four-year presidential cycle in the unemployment rate, with downturns in unemployment in the months before the presidential election and upturns in the unemployment rate usually beginning from twelve to eighteen months after the election. These patterns are consistent with the character of the economic tools..."

How are things going? This is a question we hear often - one which you may have responded to recently, or one which you may have recently asked a friend.  It is an open question, one where an individual's response depends on a diverse set of factors including age, gender, occupation, economic status, political view, and marital status. But there seems to be some common themes in the answers. One theme is emotional well-being, which very often focuses on interpersonal relationships. As you listen to the answers of others, you seem to sense they have translated the question into;  How's the boyfriend? How are the kids? How is the divorce going ? Why do I have the blahs? How is my wife,

A second theme is physical well-being. Conversations that flow from this opening are often centered on nagging sports injuries, colds or the flu, headaches or backaches, or the success or failure of a new diet.

And then there is the economic well-being angle.  Being passed over for a raise, a promotion that came through, a big deal that was closed, and a stock that performed better than expected are also responses that the question is likely to elicit. You are also likely to hear concerns with rising prices including rising tuition rates, falling wages that make it harder to pay your bills, high interest rates that make that student loan or car payment a little bigger, or anger and possibly a sense of betrayal over your being laid off from work.  

Is there a common denominator here in these answers? Is one's sense of emotional well-being tied to one's physical well-being and are these related to one's financial well-being? Is it likely that things will be better in your personal life if your financial life is in order? And what about the link between your health and your financial condition? I suspect we might be able to agree that there is a link, albeit an imperfect link. For example, there are studies that indicate "high unemployment has been linked to higher incidence of certain types of crimes, psychological disorders, divorce - even suicide." There is also a positive relationship between income and life expectancy. Furthermore, I suspect one's perceptions are strongly influenced by health. Things always seem worse when you do not feel well.

It seems safe to conclude, therefore, that there is a complex interrelationship between one's emotional, physical, and financial well-being and if our goal is to improve one's overall sense of well-being,  we could start anywhere. If we launch an attack on disease and malnutrition, we can expect to see more productive efforts in the workplace. Similarly, if we could begin the cycle of improvement by an income grant, this would allow for better nutrition.

Given that we could start anywhere, we are going to start with the economic well-being angle. In fact you can think of Macroeconomics as the branch of economic analysis most closely identified with "economic well-being".

Macroeconomics is based upon two premises. First, there must be some indicators of a nation's economic performance that provides a basis for inferring information about the economic conditions of individuals - there is a link between macroeconomic aggregates and individuals' well-being.   We see some evidence of this in the correlation between macroeconomic variables and election results - a strongly performing economy favors the incumbent, while a weak one favors the challenger.  We might even look here for some understanding of the nation's support for Bill Clinton in the midst of the scandal in 1998.  The public support numbers would likely be quite different if more people were out of work.  Some of the more popular variables designed to capture macroeconomic performance are the Employment and Unemployment rate, Interest rates and the Inflation rate, Gross Domestic Product (GDP) and the Exchange rate.  If many people are out of work, things are not good and this is likely to be captured in high unemployment rates.  Similarly, if workers find their paychecks are growing but they seem to be buying less, this would be reflected in higher inflation rates.

One example of the impact of the macro economy can be seen in the sales data for Sam's market.  Sam ran a supermarket and in 1973 he had developed a forecast of sales based on past experiences (projected sales).  Actual sales never reached his goals and Sam wants to know why.  How would one explain the sales decline that Sam experienced in the 1973-75 period? Some of the obvious candidates would be new super markets moving into the area, changes in Sam's advertising strategies, or major construction in the area that reduced access to Sam's store. 

Another place to look for answers would be the 'macro' environment.  Anyone familiar with macroeconomics would tell you that 1973 marked the beginning of the OPEC induced recession that hit the New England region hard.  The result was that many businesses suffered losses as the unemployment rate rose sharply and the overall health of the economy had a serious negative impact on many industries and firms. 

A second example of the impact of the macro economy on individuals would be unemployment.  For example, consider the plight of George who is unemployed.  How do you feel about this?  One of the similarities between the 1990s and the 1920s is that in both periods it was popular to view unemployment as 'self-inflicted.'  A person was unemployed because the person did not work hard enough - for people looking hard for work and willing to work hard, there were jobs and these people would not end up among the unemployed.  As a result, there was no real support for government protection from unemployment - no sense of responsibility for those unfortunate enough to be unemployed.  

But what would happen if all of a sudden you became unemployed?  Now you are confronted with two possibilities - all of a sudden you have lost the work ethic and you have adopted the behavior of the unemployed or you have been the victim of a set of forces that are beyond your control.  Not surprisingly, when one-quarter of the nation's population finds themselves unemployed, as they did in the Great Depression, the second option begins to look real attractive.  More importantly, what you will find is that once people accept that they may not have complete control, then they are willing to consider government policies designed to reduce unemployment and protect them from the ravages of the macroeconomy.  If you are too small to have control over these macroeconomic factors, maybe the government will be able to protect you, or at least soften the impact of theses macroeconomic events. 

The second premise upon which macroeconomics is based is that there are identifiable and stable relationships between these macroeconomic aggregates and there are stable relationships between these macroeconomic aggregates and policy tools.  Macro economists busy themselves testing their theories of business cycles and economic growth and trying to identify key macroeconomic relationships.  Some of the questions that they would deal with here would be: How did the recession in Japan in 1998 affect consumer spending?  How did lowering interest rates in the US in late 1998 affect business spending?  Will deflation lead to increases in unemployment?  How will a fall in the value of the rupiah affect consumer prices in Indonesian?  Will a fall in the Korean won lead to unemployment in Korea and how will it affect the US?  Where is the stock market headed and will a 'crash' in the market send the economy into a recession? 

As interesting as these issues may be - and I do know you are restraining your enthusiasm for the exploration of these issues in great detail - if we could not go beyond this it might very well be a very short story.  It is one thing to talk about these things, to talk about the Great Depression of the 1930s, the stagflation of the 1970s, or the Asian financial crises of 1998, but it is completely another to talk about how to design appropriate public policies to avoid another Depression, to reduce unemployment and inflation simultaneously, and to keep the Asian crises from triggering a remake of the Great Depression.

It is these latter questions that will be our primary concern as we explore the linkages between the aggregate measures of the economy's performance and the policy tools - the tools of the monetary and the fiscal authorities. For a discussion of monetary policy to be fruitful, we need to understand the nature of the relationship between the money supply (policy tool) and various macroeconomic measure such as the number of jobs, interest rates, and inflation. If we are to understand the debate over fiscal policy and the balanced budget, meanwhile, we need to understand the relationship between government spending, national income, and the trade deficit.

Before delving into the story of modern macroeconomics in detail, we must step back and take some time 'leveling the playing field' in the The Basics of Macroeconomics unit where you will be introduced to a few basic models and concepts that are integral parts of the story.

The first section of unit is devoted to a brief introduction to the three models we will be using repeatedly during the story.  They are the foundation upon which the course will be built and will provide the link between the various chapters in this "macroeconomics story." The value of the course to you is likely to be determined early on, when you make those choices as to whether to make the investment in understanding these three models. 

The first of the models is the Circular Flow Diagram of income and expenditure designed to help one visualize the entire economic system that links 250 + million Americans together as a system of four interrelated aggregate markets - output, labor, capital, and foreign exchange. This model will also provide some structure for the discussion of the mass of macroeconomic data that are reported regularly in the main section of newspapers and on the national and local news channels.

As useful as the Circular Flow Diagram is for providing a framework for macroeconomic analysis, it is a bit cumbersome. Fortunately, the relationships between the concepts that appear in the diagram can also be represented more efficiently by an equation - the National Income Identity - which is the second important model.

A valuable complement to the Circular Flow Diagram and the National Income Identity is the third model, the Aggregate Supply - Aggregate Demand Model.  Just as we "reduced" the "real world" to the Circular Flow Diagram, we can reduce it still further to the AS -AD graph. The good news here is that it looks and operates very much like the supply - demand model you have seen if you have taken any economics course since it is economists' favorite model.

The story will then switch to a more detailed treatment of the primary measures of the macroeconomy's four markets - the unit on Macromeaurement.  You have probably heard on the news mention of some of the measures in the output market (GDP and inflation rate), the labor market (earnings and unemployment rate), the capital market (money supply and interest rates), and the foreign exchange market (exchange rate and trade deficit).  The focus in this unit will be on the what these macroeconomic variables measure - and what they do not.  This is where we will look for measures to help us answer questions such as: How well is the economy performing? How fast is the economy growing? Are we in a recession? What's happening to the value of a dollar? What is happening to the standard of living of the American worker? How many people cannot find work? How many people cannot find meaningful work? To answer these questions you could turn to the "experts" or you could go directly to the "numbers" which the US government collects on all facets of the US economy.  We will look at where you can gather the data.  First, however, let's look at the basic macroeconomic models that you will see used throughout the course.

 

 

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