Unit 1: Thinking Macro

Welcome to the Principles of Macroeconomics

Portrait of John Maynard KeynesThe ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.  Indeed the world is ruled by little else.  Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.
–John Maynard Keynes, 1883-1946


Welcome to Principles of Macroeconomics.  This should be at least your second college course in economics — you should have already taken Principles of Microeconomics.  I realize that for most of you this is a “required” course, but I think you’ll find it very interesting and very helpful.  In micro, we studied how people made economic choices – people like you, business firms, other consumers, and even politicians.  Micro studied and, I hope, shed some light on the Alfred Marshall’s “everyday business” of life.  Many students have found that studying micro helped them make better everyday decisions.

In macro, we are going to shift the focus of our studies.  We’re now going to look at the “big picture” — what news announcers and politicians and businesspeople talk about when they use the phrase “THE ECONOMY”.  You’ve heard that phrase before.  You’ve heard it when your friends complain they can’t get a job (or lost their job) because of “THE ECONOMY”.  Or, you’ve heard it when a politician claims we need to raise or lower taxes in order to “boost THE ECONOMY”.  Or, you’ve heard it when a news announcer says “the government announced THE ECONOMY slowed last month”.  We’re going to study this thing called “THE ECONOMY”. We’re going to look at the big picture.

We live in some interesting times.  In 2007-09, not very long ago, the U.S. and the world suffered the longest, most serious recession/depression and financial crisis since the Great Depression in the 1930’s.  We haven’t fully recovered from it yet. Unemployment is distressingly high and slow to improve. Political and business “leaders” offer us conflicting advice about what we need to do to “get the economy going again”. Some say cut government spending, others say increase it. Some say raise interest rates, others say make money available.  It’s very confusing.  Yet it doesn’t have to be all that confusing.  As John Maynard Keynes (see above quote) observed during the last great economic crisis, the previously mentioned Great Depression,  our political and business “leaders” are in fact followers of what some long-ago economist wrote and theorized.  All we need to do is re-trace some steps and figure out what those now “defunct” economists were really saying.  That’s what we’ll do in this course.

I’m Jim Luke, your professor, and I’ll be your guide. Many students in the past have commented that they “really learned a lot” and that macro was “much more interesting than” they expected. This may be a required course, but if you put in the effort, you’ll find it rewarding and useful.  You’ll learn how to make sense of what we hear on the news, TV, and even from friends and relatives. You’ll also come to recognize nonsense, too.  There’s a lot of it around.  You’ll also sharpen your analytical and critical thinking skills in ways that will prove useful in fields outside economics.

In this first Unit, I want to cover two topics.  First, I want to describe how I’ve structured this course  (it’s a bit different from most online courses you’ve taken, unless you’ve taken one from me!), what you have to do to succeed, and what the resources are that I’ve provided. You’ve got a lot more than just a textbook to help you and it’s all designed to help you succeed in this course. I also want to give you some tips and suggestions on how to study for this course and how to get the most out of it.

Second, I want to introduce you to the discipline called “Macroeconomics” with a little bit of historical and social context.  Most textbooks don’t discuss this part.  They tend to present economics  as if it were some settled body of knowledge and facts to be transmitted from professor to student. It’s not. The field of macroeconomics is constantly changing.  It’s evolving as we learn more and researchers propose develop and refine theories.  But it’s also a difficult and confusing field.  It’s full of arguments and researchers/economists who actively disagree with each other.  Part of this is because the subject matter, the economy itself, is incredibly complex and constantly changing. In a physical science like physics at least gravity works the same way it did 400 years ago.  An economy keeps changing.  Carl Sagan, a famous astronomer, once remarked that people who describe large numbers as “astronomically large” really should call them “economically large”.  He said there “billions and billions of stars” in the observable universe, but economies are measured in the trillions and trillions of dollars.

Course Basics – What to Do, What You Need, How to Do It

Moving to Macro: What Do You Need to Remember From Micro?

Not much.  Probably the most important concept to take away from micro before studying macro is the idea of a market coordinating the activities of many independent decision-makers.  Macro is actually a different way to look at the economy by looking at the big picture.  Some schools actually teach macro first and then micro.  It doesn’t make a lot of difference.

How This Course is Structured – It’s Flexible!

Economics is about choices, costs & benefits, and planning.  I have structured this course so that not only will you learn economics, but you have to practice the principles of economics.  I am providing you with a lot of flexibility regarding timing and scheduling of work so you can fit it into your schedule. I try to only schedule hard deadlines when I absolutely must.  For example, there’s a hard deadline to complete Unit 1 including its quizzes and forums.  That deadline exists because I need to know by that date whether you fully understand what to do and intend to complete the course, or whether I should drop you as a no-show. Despite the few hard deadlines, I recommend that you discipline yourself to follow the recommended schedule (see link in your school’s learning management system –  Desire2Learn at LCC). Students who follow the schedule have much higher success rates.  Students who procrastinate or think they can cram a lot into a little calendar time usually find it becomes much harder, takes longer, and they often don’t succeed.  I want you to succeed.

Most of the activities or readings in this course are required. Please do them in sequence. They are designed to build upon each other to make it easier to learn.  Flexibility combined with this being an online course means (I hope) that you won’t experience this course as the poor souls in this cartoon do.

Comic of an unending economics seminar in hellHow This Course is Organized

This course has 15 “Units” that you need to complete. The material you are reading right now is part of Unit 1.  All non-graded assignments, materials, and “content” is located here at macro.econproph.net, the website you are reading right now.  All graded assignments, such as quizzes and discussion forums, is in your school’s learning management system (Desire2Learn at LCC).  Links to macro.econproph.net exist in your learning management system and that may be how you got here.

All Units are grouped and labelled as “Parts I-IV”.

  • Part I consists of Units 1-6.  It starts by looking at the structure of a modern economy, the circular flow of money and transactions  through the economy, and division of the economy into goods, resource, and financial markets.  Part I continues then to look at what goals we want for an economy and  how we can measure the performance of the economy.  This part will contain a lot of terminology, definitions, and measures.
  • Part II consists of Units 7-10.  Part II looks at two major theories of how the “real sector” behaves.  The “real” economy deals with producing and consuming actual goods and services.  One theory, the Classical theory, will suggest that government should take a “hands-off” approach to the economy, while the other theory, Keynesian theory, suggests that a modern economy needs to be managed by the government.  In Unit 8 we will examine how successful this approach has been.
  • Part III consists of Units 11-13 and a study of the financial and monetary sectors.   We will start by looking at the history of money, how money is created, and how banks work.  Unit 12 takes a look at The Federal Reserve System and how it affects the economy.  We conclude by looking at how different monetary policies affect the economy.
  • Part IV consists of Units 14 and 15.  This brings our analysis of the economy up-to-date to reflect current issues and challenges such as globalization,  the effect of international oil markets, and modern macro theory.  The last unit also summarizes and prepares you for the final exam.

What to Do and What to Study

Always start a unit at this Jim’s Guide website.

There are two ways to access the Jim’s Guide. You can log into your learning management system (Desire2Learn at LCC) and follow the links there.  Or, you can go directly to this Econproph on Macro – Jim’s Guide to Macroeconomics website from your browser.

Here’s how the two websites, your school’s learning management system (D2L at LCC) and this macro.econproph.net website, divide the work.  You will need to access BOTH sites.  All graded work, graded quizzes, worksheet questions, graded discussion forums, and midterm tests, are ONLY available on the learning management system. Only the learning management system requires you to log in so your grades will be recorded.


Any purely reading or study material that doesn’t record your answers or require a login is located here at macro.econproph.net.  This website is a site I own and operate.  I keep my Jim’s Guide, tutorials, and other study materials here for two reasons.  First, it’s a lot easier for me to maintain and keep the content current and backed up.  Second, it allows you to access the Jim’s Guide and study materials without having to always log into the learning management system. The website adapts for mobile devices so it should be easier to read on your smart phone or tablet computer it you have one (just think of all the places you can study your economics now!).


In this website, which I’ll just call the “Jim’s Guide”, you have a menu bar.  All units are accessible from the menu bar.  Click or mouse over “Part I” or the other “Parts” and you’ll see the Units listed below.  If you click on the a Unit, you’ll be taken to the “Jim’s Guide” page for that Unit.  ALWAYS START EACH UNIT BY READING THE JIM’s GUIDE first. In addition to the Jim’s Guide you will see a list of links, either in the menu or on the right in the tree, that provide additional resources. Here’s what you should see for each Unit:

  • Jim’s Guide – the starting point for each unit.  Always read this first.
  • Jim’s Notes – this is a page of outlined notes.  It’s always better to write and take your own notes since the process of writing helps you remember.  However, these are the notes I use when I lecture to classes.  I make them available as a way for you to see what I think is important and what fits together.
  • Reading Guide – VERY IMPORTANT.  This page tells you what to read in your textbook for this unit.  Readings from the textbook don’t always consist of a chapter in text = unit in course.  Sometimes Units require material from multiple chapters and sometimes not in order.  I also  try to help figure out what’s really critical in the textbook vs. what can safely be “skimmed”.
  • Closer Look – Tutorials, videos, graphics, and other study aids are listed here for each unit.  These items take a close-up look at some particular element in the unit. For example, if the Unit introduces a new graphic model, I’ll have a tutorial that steps you through how to use it.  Starting in summer 2012, I’m trying to add some short videos to help explain key concepts or excerpts from lectures.  If a worksheet is assigned for this Unit, you’ll find a tip sheet, or list of formulas, or other help here.
  • Worksheets – Not all units have worksheets but some do.  Worksheets usually require some background story and an incomplete set of data.  You have to complete the data.  Then once you complete the data, you can go to the learning management system to answer some questions (graded) based on the data you calculated.  The purpose of worksheets is not to turn you into an economist.  Instead, it’s to help you understand the relationships between certain economic variables by working with them.
  • Quizzes – This page usually contains 2 or 3 links. One link will be to a practice quiz. Practice quizzes may be taken and re-taken an unlimited number of times.  You will be shown the correct answers.  You will also find directions here to take the graded quiz for the Unit and any midterm test, if it’s time for that.  Graded quizzes and midterms must be completed in the learning management system.
  • Econproph Posts – [this feature isn’t complete yet, but is under development]  This page will list excerpts and links from Jim’s public economics blog that are relevant to the topics of this unit.  This is optional reading, but many students find them useful.

You may wish to print the Jim’s Guide pages, especially since some of them are rather long. To print, either just print from your browser or click the “download as “pdf” button at the top right of each page.

How to Proceed and Succeed

Finally, I want to give you some tips and suggestions on how to study for this course and how to get the most out of it.- in other words, to understand later units, it’s necessary to know the earlier ones. A typical Unit consists of the following REQUIRED activities:

  • Jim’s Guide
  • Readings – parts are REQUIRED, other parts extra – see Reading Guide for specifics
  • Closer Look – many units (but not all) have a tutorial to explain a particular model, graphical analysis, or calculation.  If the unit has a grade worksheet, then it will usually have a tutorial or closer look that should help in solving the worksheet
  • PRACTICE Quizzes – Not strictly required, but so strongly suggested that you might as well consider them required!  Actually, previous students say you would be a fool to not do the Practice Quizzes since they are excellent predictors of the real Quiz.
  • Graded Assignments: each unit will have one or more of the following.
  • Worksheet – note all units have worksheets.  Worksheets may be submitted for a grade an unlimited number of times.
  • Unit Quizzes
  • Tests – end of each Part
  • Forums  – (Unit 1 and Unit 14 Forums are REQUIRED, the others are optional Help Forums for asking questions and getting help)

You should start each unit by reading Jim’s Guide.  The Jim’s Guide is intended to give you an introduction to the specific topic of that unit.  I try to focus on what the big question economists are trying to answer with the theories and models presented in each unit.  I try to provide some context, some of the “why”, and also some alternative heterodox perspectives on the topic that may not be covered in the textbook.  What you are reading right now is the Jim’s Guide for Unit 1. After the Jim’s Guide, you should proceed to the Reading Guide in each Unit.  The Reading Guide will tell you what parts of the textbook are required reading, which parts are extra, and which parts you can skip.  Then take a look at any Closer Look tutorials or videos. If there is Worksheet for this unit, you should next do the worksheet.  It’s better to complete worksheets before doing the Unit Quiz for a grade. Next, proceed to the PRACTICE Quiz.  Give it a shot.  How well you do on the PRACTICE Quiz will help you decide what sub-topics or issues you need to go back to the book or guides and study more.   If you feel adequately prepared, then attempt the Unit Quiz.  If you’re then satisfied with your score on the Unit Quiz, you’re done with the unit.  If you’re not satisfied, then take a look at what you missed.  You won’t be shown what the correct answers are, but you will see what you missed.  You can then go back, re-read the text or try some of the other links, tutorials, or exercises that might be available.  Finally, you take the Unit Quiz for the second time.  Then you are ready to move on to the next unit.

When the Work is Due

A very important part of the flexibility of this course is that there are few deadlines.  In fact, there are only four real deadlines.  Unit 1 Quiz and forums must be completed by the end of the second week (sooner in summer) or you may be dropped.  This is how I know you’re here, you understand what’s required of you, and that you’ve started.  There’s a deadline for approximately halfway through the semester when the first two midterms must be completed. There’s another deadline at the end of the 14th week (7th week in summer).  ALL DEADLINES ARE NOTED IN THE RECOMMENDED SCHEDULE AND THE SYLLABUS.  This third deadline exists so that I can then release correct answers to the quizzes so you can study for the final. Finally, everything,  all the REQUIRED assignments and the Final Exam must be complete by the end of the course.  For the specific date, you should look at the syllabus for this semester.  Check the syllabus for the specific dates.

This flexibility means that you need to plan and monitor your own progress.  A recommended schedule of work is shown in the Schedule tab and but only you know what you’ve got planned or scheduled each day or each week of the semester.  You might have a long-awaited vacation scheduled for some particular week.  Or your boss at work might want you to work double-shifts one week and not work another.  Or your Aunt Tillie, who you were very close to, dies suddenly and you feel you can’t concentrate for days.  In other words, I don’t know what you have to give up each week to study economics.  The cost might be great one week and lower another.

If you get seriously behind or if you are going to deviate significantly different from the recommended schedule (say you’re taking an extended trip), please email me and keep in contact.  I’m really not some old crotchety professor who relishes being “tough”.  I just want you to succeed, but it’s hard when I don’t know what’s going on with you.  Keep me posted.

Everybody’s opportunity cost is different, so I feel I can’t optimize by deciding your schedule for you.  I do not have a fixed deadline for completing each assignment.  Do them in order and pace yourself throughout the semester according to what best fits your schedule. What I do know, is that it is important to have a schedule and a routine.  DO NOT PROCRASTINATE!   Students who try to leave all the work to the end of the semester inevitably find the work to be much harder. Students who have left the work till the end also inevitably get lower scores and lower grades.  Do yourself a favor and work at it regularly each week.  Economics is easier to learn if you take it in chunks at a consistent pace.  It is much, much more difficult to learn (translation: grades are lower and life is more stressful) if you try to “cram” in a short period of time.

About The Textbook and the Reading Assignments

The textbook we are using is Tim Taylor’s Principles of Economics.  Taylor is a good writer, but like all textbooks, he makes many compromises in how he organizes the book.  The compromises are intended to allow the largest number of professors to choose the book.  Unfortunately, this leads to couple of problems.

First, is in how the many sub-topics of macro are organized into chapters. It is not necessarily how I would do it.  In addition to trying to explain the various macroeconomic theories and concepts, I try to tell a coherent story about how the economy is structured and how economists have come to develop these theories.  I think it’s easier to understand a theory if we first understand the questions and issues that led the economist to develop the theory in the first place.  Without this kind of context and “background story”, a lot of macroeconomic theories and ideas just sound like a lot of mish-mash that folks just made up. That’s not so.  Macroeconomic theories are developed to help policy makers figure out how to manage the economy and make it perform better.  So…

  • pay attention to the Reading Guide.  This course is not organized such that a “Unit” equals a “Chapter” in the book. Make sure you read the Jim’s Guide and the Reading Guide before reading the textbook assignments.
  • a particular chapter (or parts of a chapter) may be assigned more than once.  For example, you may be assigned to read Chapter 26 in Unit 3 and then later when you get to Unit 10 you will have to read part Chapter 26 again.  When I do this, please follow the Reading Guide and re-read the chapter as directed. Trust me, when you re-read it the second time, you will understand some details better that you either didn’t fully understand the first time you read it, or you may be directed to pay closer to attention to some sub-topic that wasn’t important the first time through.  I am very conscious of how valuable your time is and I only re-assign chapters (or parts) when I think it’s critical to understanding the material.  In the long run, you’ll save more time following the directions and re-reading parts than trying to assume you remember everything from the first reading.

Tips and Suggestions on How to Study

  • Plan your work schedule.  Check the Schedule Tab for more help in planning a realistic schedule.  Don’t let it all pile up on you.
  • When reading the textbook, look at the Reading Guide for the unit first.  Not all of every chapter is required.  Parts of some chapters go into too much detail and may unnecessarily confuse you.  The Reading Guide will tell you what’s really “core” and essential to the course.  It is probably a good idea to print out the Reading Guide pages and have them with you when you read the textbook.
  • In the textbook, focus on the “core” narrative.
  • When you encounter a graphical model, before you jump to the center of attention (the line or curve or intersection in the middle), look at the axes.  Make sure you understand what two variables are being graphed first.  Then make sure you understand what each point in the graph-space means – in other words, imagine what economic choice or activity is represented by different points in the graph.  Then focus on the curves and intersections.  They’ll make more sense then.  In macro, I put less emphasis on many of the graphs, but a few models (circular flow and AD-AS) are really, really important. Again, use the Reading Guide.
  • Use the “Closer Look” materials listed for each Unit in the Jim’s Guide.   I designed or selected these materials for a reason.  Often, a tutorial will give you clear or simple formulas that are useful in completing your Worksheet (think Units 3 , 4 or 5).  In other cases, the tutorial may explain material that is not in your textbook (think Unit 2 and the Circular Flow in particular).
  • Don’t be afraid to read and re-read multiple times. Economics is not easy for most students. (heck the last few years have shown it’s not easy for most economists!).  It involves a way of thinking about problems and questions.  Often it is a way of thinking and learning that students have not encountered very often in their earlier schooling. This is a good thing. You’re learning new thinking skills.
  • Don’t be afraid to ask a question or seek help with some idea on the Help Forums.  Your fellow students may be able to help you. I also monitor those forums and will offer help and guidance, too.
  • If you find yourself struggling or suffering with some concept or a worksheet, don’t suffer alone.  Ask for help! Contact me or another student.  We can (and will) help.  I’m committed to seeing each of you get through the course successfully and emerge with a good understanding of economy.
  • The economy is often in the news (duh, like everyday!).   I have a blog (econproph.com) where I offer some comments, insights, and explanation of economic news.  Although there’s no graded assignment using the blog, if you check it often it will help you understand what you’re studying and see it in action everyday.  You can view it by going to econproph.com directly, or by clicking on the “Econproph Blog” tab or subscribe to the RSS feed on the blog.  Feel free to comment on stories on the blog.

Who Is This Guy ‘Jim Luke’?

He’s your professor, me.  I also go by the name “Econproph” on the Web. I’m not the most interesting man in the world but so far I’ve made it into the top 10, at least in my own mind.  If you don’t believe me, click here for my bio or here for my teaching portfolio.  I also have a sense of humor, although some tell me it’s a warped sense of humor.  I’m serious about economics but I don’t see why we can’t have some fun along the way.

Introduction to Thinking about Macroeconomics

How do nations get wealthier?

Markets and trade have existed since before mankind began recording history. However, for most of history, markets haven’t been the primary means of organizing and coordinating economic activity. Political authority and power has been the most common. In other words, people produced whatever the King/Emperor/Ruler/Tribal Chief said they would. Distribution of goods was often settled by force – whoever was stronger took what they wanted and the others fought over the left overs. Overall, it wasn’t very motivating to say the least.

Gradually at first, and then much more rapidly in recent centuries, markets have come to play an increasingly important role in economies. In the last 200-300 years, markets have come to be the dominant economic institution in most economies around the world, particularly the developed & industrialized countries. Along with this growing importance of markets has been an explosion of economic growth and improvement in standards of living.

The increasing role of markets hasn’t been without controversy, though. One of the unique aspects about markets as social institutions is that nobody is in charge. There’s no central boss or authority who’s ultimately responsible for everything that happens. When there’s a clear authority figure, it’s easy to believe things will get better or that we’ll get richer. We place our trust in the authority figure – the King, the President, the Emperor, whoever. Historically, people have been more reluctant to trust markets. After all, there’s no clear “plan” where the market is taking the nation. There’s nobody to pin the blame on if we don’t grow richer. Another issue with markets as the leading economic institution, is that it’s not clear just exactly what the ruler (or government) should be doing economically. Are there economic decisions the government should continue to make? Or should the ruler/government completely get out of the picture?

These concerns have motivated the study and development of Macroeconomics. The way this course is laid out, we will retrace some of the key arguments, controversies, and theories about how a market-based economy can best grow and be managed. A critical issue will be trying to figure the best role for government in a market economy. Some understanding of how industrialized economies (like the US) have grown and evolved over the last 200-300 years is important to understanding these ideas.

Adam Smith’s famous book in 1776  An Inquiry into the Nature and Causes of the Wealth of Nations. That is, in essence, what macroeconomics is about:

  • How can a nation, or the people of a nation, get richer?
  • Why do some countries and nations get richer and others don’t?
  • Is there anything we can all do to make sure we all get richer and have a better life?
  • What should the government do about “the economy”?
  • How do we make the economy better and more predictable?

An economy is a very complex thing. After all, it’s the total of all the economic behavior and decisions of everybody in the economy. If we’re talking about the US economy, that means the behavior and decisions of over 310 million of us!

Disruption, Structure,  and Change in Economic History

The history of most economies is one of disruption and change.  Historically, economies are extremely unpredictable and highly variable. Equilibrium, a state where the circular flow is constant and unchanging is rarely occurs, if ever.  Yet the concept of an economy at equilibrium can be very useful.  It allows us to analyze and focus on how specific disruptions are going to change macro-economic performance.

For example, suppose the weather is particularly bad during some year in a heavily agricultural country.  Crops are likely to be poor.  Farm land will be less productive than normal.  Farmers will have fewer goods (food) to sell.  It’s likely that with less crops to sell, farmers will receive less money from the goods markets.  Their profits will be smaller.  The smaller profits will mean the farm households have less money to spend on other goods and services.  When the farmers stop buying other people’s goods (clothing, vehicles, entertainment, etc) then the other businesses also receive less money.  Their profits and wages decline – they pay their workers and owners less.  Now those workers have to cut back their spending and standard of living.  And of course, since the flow is circular, the impact of a change in the weather ripples through all parts of the economy and eventually affects everybody in the society, even if they aren’t a farmer.  Just how much the change in the weather will reduce the flow is the kind of question a macro-economist studies.

Changes in the weather or in the amount of available resources are often visible, although the full potential impact is not.  Other kinds of changes happen to economies subtly and their impacts are noticed at first.  These kinds of changes are often called “structural” changes.  Our economy is going through a very dramatic structural in recent years.  A few decades ago, computers were non-existent.  Much of the work currently done by computers was done in businesses by large numbers of clerks, secretaries, and paper-pushers.  The introduction of computers into businesses has had many profound effects on how firms and households operate.  It affects the circular flow and it affects how the macro-economy performs.

Macroeconomic Theory Changes, Too

Economists can only build models or theories to explain the economies we observe.  When the structure of the economy changes, it sometimes means that the assumptions upon which economic models/theories were built are no longer valid.  This means that the macro-economic theories that may have adequately described or predicted economic performance for years or decades suddenly no longer work very well.  When this happens, it’s time for economists to “go back to the drawing board” and either modify existing models or create new ones that explain things better.   Many macroeconomic models and theories are easier to understand if we know what was happening to the economy and in the economy at the time the theory was developed.  In other words, knowing the motivation for the theory and the assumptions of the theory often make it easier to understand.

Goals:  What’s  a “Good” Economy Look Like?

We can never “solve” the economic problem — we’ll always face unlimited wants but only have limited or scarce resources to use in satisfying those wants.  Although we can’t ever have everything that we want, it’s certainly possible to do better — or worse. Individually, our standard of living depends on what we individually produce, what resources we have available, and what opportunities we have. Much of how well off we are and what opportunities we have depends on the functioning of our economic system. So what makes for a good economic system or policy? We also want to know how to measure an economy so that we know how well our policies are performing, but before we measure anything we need to know what our goals are.

In broad terms, we want an economic system to accomplish four things on a regular basis:

  1. achieve full employment of all our productive assets,
  2. keep the value of our money stable so that prices & markets can function,
  3. grow the amount of goods & services
  4. make the growth somewhat predictable and steady, not erratic and unpredictable.

Economic Measures and Economic Goals

Any economic policy or system that achieves these goals is a really successful one. People will thrive, prosper, and live long under it. Of course, there’s a catch (this is economics, after all). Individually, it’s not too hard to design policies that will substantially achieve each goal. Unfortunately, it’s tremendously difficult to design and implement policies that achieve all four at the same time.

It’s important to look at how we calculate these measures so we can understand what the data and the constantly changing numbers are really telling us. Sometimes, it isn’t obvious. For example, an increasing unemployment rate does not necessarily mean that increasing numbers of people have lost their jobs! But it might. The data and measures discussed in these chapters are widely publicized. We hear the latest numbers on the radio or TV news. We read about them in the newspaper or business magazines. After you read these chapters, you should be able to better understand what the data tell us about what’s happening in the economy. I don’t expect that many of my students will ever have a need to calculate these types of data in their career. But, you will all need to understand what they mean.

Goal: Economic Growth

More and faster is better — that means we have more stuff, more goods, more needs being satisfied.. No real surprise here. What’s difficult about monitoring the economy’s ability to achieve this goal is simply the sheer magnitude of the task: how in the world can we actually count how much stuff we produce? All 297+ million of us in the U.S?  The answer is a measure called GDP and a process called National Income Accounting. Gross Domestic Product, GDP, is a measure calculated as part of a system called National Income Accounting.

Goal: Economic Stability (Business Cycle)

We established earlier that the basic macroeconomic goals include growth, full employment, stable price level, and stable, predictable growth. The national income accounting system you studied in the previous chapter helps provide very useful, though not precise, information about growth. Simply put, if Real GDP increases from year-to-year, then it implies that we have more goods and services being produced and available to consume. In other words, we can evaluate whether our system has achieved our first goal: growth. If we track the ongoing changes in Real GDP over the years, we also have a way to measure how stable the growth is. In other words, if Real GDP never declines and consistently increases, then we will know how well we have achieved the last goal: stable growth (no recessions).

Goal:  Full Employment

There are still two major goals left: full employment and a stable price level. This chapter looks at the definitions and issues involved in measuring performance toward these goals. Both of these goals are very important to the political stability of a society, as well as the economic performance of the society. History shows that whenever any society lets either unemployment or inflation get too high, the society and it’s governments collapse, sometimes violently.

Typically, we measure how well a society achieves its goal of full employment of resources by looking at either the labor unemployment rate and/or the amount of total worker employment. Labor is the most important resource of any society, and it’s the resource that can’t be “stored up”. If we fail to utilize all the labor available to us, we won’t produce as many goods and services as possible.

Goal: Price Stability

The issue here is price stability. Here, the goal is really nothing. That is, the goal is to not have any inflation (rising price level) or deflation (decreasing price level). When the price level keeps changing (up=inflation, down=deflation), then the market system doesn’t work very well. The ability of relative prices and changes in relative prices to coordinate producers and consumers efficiently breaks down when inflation or deflation occurs. Compounding the problem is the tendency of both inflation and deflation to “spiral” – that is, to get worse over time, leading to hyperinflation or a crushing deflation.

Price indices are simply attempts to estimate approximately how much all prices have increased during a period of time. Think of it as a calculation of the “average” price of range of particular goods. Technically, it is a very sophisticated weighted averaging of prices, but the technical detail isn’t important. In any given year prices of goods change for two reasons: one, prices of different goods change relative to each. This is the kind of price change that a microeconomist observes people reacting to by changing buying habits. If the price of beef goes up relative to the price of chicken, people switch to eating more chicken.

There is another source of price changes in goods, though. It is inflation. It is when the price everything goes up because money itself is becoming less valuable. Price indices try to measure how much inflation is occurring in a group of products and while ignoring the relative-price changes.

When calculating an index, we choose a particular year  as the starting point. This is the “base year”. The index tries to measure the inflation in prices by showing the “level” or “average” of prices compared to the base year. The base year is always assumed to have an index of 100. If there is 10% inflation, then the next year’s index will be 110. If in the third year (base year + 2), there is again another 10% increase, then the index will become 121, since 121 is 110% of 110.

Finally, do not be concerned with the chain weights vs. base weights, etc. in the calculation.  I won’t ask you to calculate a price index from raw prices on a quiz. But, I will ask you to use and interpret the price index numbers themselves.

Policy and Macroeconomics

Unlike micro which tends to focus on explaining and describing behavior, in macro we want to do more than describe or explain how the economy works. We also want to make policy recommendations – recommendations for how government should behave to make economic conditions better. This complicates things greatly.  For one thing, it makes it easier for ideological bias to enter into theories. Instead of evaluating theories solely by whether they predict/explain actual data, theories are often favored or opposed for ideological biases.  This ideological bias explains a significant part of why there is often so much disagreement in macroeconomics.

Governments and societies have essentially five different types of policy options to use to improve the performance of the economy.  Different theories promote or emphasize one or another policy approach. The types of policy options are:

  • Laissez-Faire – This is really the no-policy option. Actually what it means is that government shouldn’t do much of anything at all.  In reality, strict laissez-faire is impossible.  The government still has to, at a minimum, enforce contracts and define what is money.
  • Monetary Policy – Government or its representative, the central bank, adjust the supply of money and credit to the economy, including changing interest rates with an aim to improve economic performance.
  • Fiscal Policy – Government (usually the national level) adjusts its own budget, it’s spending and taxes, with the objective of improving economic performance.  This is the question of whether the government should balance its budget or run deficits or surpluses.
  • Institutional and Financial Regulation – Society and government must decide how activities can be legally organized and governed.  For example, are corporations allowed? If so, what can they do? Society’s institutions are constantly evolving and that’s part of why macroeconomic theories have to evolve also.
  • Nationalization – In some respects this is polar opposite of laissez-faire.  Government always has the option to either take-over or to operate economic activities on its own instead of having the private sector operate them.  It may wish to do so temporarily or it may wish to do it permanently. It may wish to do nationalize only a few activities (the military in the U.S. for example), or it may wish to nationalize wide swaths of the economy.

Most of this course will focus on the first three policy options.  We will discuss a little about Institutional and Financial Regulation in a later unit.  We won’t spend much time on nationalization.

Ideological Spectrum

The popular description of economic systems as being either “pro-market capitalist” or “communist-socialist” is really, really too simplistic. In fact, it’s highly misleading.  [TIP: anyone who talks in such simple dichotomies is likely trying to push some propaganda on you!]  Instead, I think it’s much better to think in terms of a spectrum with at least four distinct viewpoints.  There are macroeconomic theories that align with each different viewpoint. These theories are also evolving over time.  The four different viewpoints, in very simple terms, are as follows in order moving across the spectrum.

  • Extreme libertarian/Austrian. This viewpoint, most closely associated with many “extreme conservatives or libertarians” in our political sphere, tends to promote laissez-faire, the smallest government possible, and the least policy-making possible. This view tends to assume a private capitalist economy is inherently stable and that any problems are the result of government. Government is seen as always worse than any private activity.  Macroeconomic theories tend to be extreme Classical or Austrian (many of the great economists, such von Mises, Hayek, Schumpeter, and Menger, who developed these theories were Austrian).
  • Classical – A laissez-faire approach is preferred on regulation and the active use of fiscal policy is opposed.  The economy is assumed to be relatively stable on its own, although it is often necessary for central bank monetary policy to smooth out the rough spots.  Economic theories are often called Classical, New Classical, Neoclassical, Monetarist, or Rational Expectations school. These approaches are most closely associated with the University of Chicago among others.  This approach is sometimes called “freshwater”‘ by other economists (Chicago is on Lake Michigan).
  • Keynesian – The private economy is seen as inherently unstable but capable of great growth.  The government is seen as needed to create the right macro conditions so that private enterprise and activity can thrive.  Keynesians advocate an active use of both monetary and fiscal policy to stabilize the economy, but tend to favor fiscal policy. Theories related to this are called simple Keynesianism, Post-Keynesianism, and Modern Monetary Theory (MMT).  Economists of this view are sometimes called “saltwater” since there’s a concentration of them at MIT, Princeton, Berkeley, and Cambridge, which are all near the ocean. Despite the political attacks in the media in recent years, Keynesian theory is NOT socialist.
  • Radical – Radical economists see the private capitalist economy as so inherently unstable that it cannot even be stabilized or corrected by monetary/fiscal policy.  Radical economists advocate radical institutional, regulatory, or nationalization to build a sustainable, stable system.  In the past, this view included communism, socialism (the two are different), and mercantilism.  Few economists promote those theories today.  The most prominent current examples of this viewpoint would be environmental/sustainable economics theories, Chinese government economists, or Venezuelan economists.

Looking Forward

In the next Unit we start by describing a model that lets us aggregate all our economic activities into a few flows that we can wrap our minds around.  It’s called the Circular Flow.  It sets the stage for following units where we establish measures towards our goals. Then we’ll get into the battles between the theories.