Introduction to Macroeconomics

Macroeconomics is the study of the aggregate performance of the economy. The unemployment rate, which measures the ratio of the number of people unsuccessfully looking for work to the total labor force, is one important indicator. Another key macroeconomic indicator is the the rate of inflation, which you will recall is the average rate of change of the prices for all goods and services.

The theory of economic growth, which we covered as our first major topic in this course, explains the growth of potential output, assuming that the economy's resources are fully utilized. However, economies have spent long periods of time operating below potential, giving rise to the issues of macroeconomics.

Although the Great Depression of the 1930's was not the first business cycle downturn, it was dramatic in terms of its severity, particularly in contrast with the prosperity of the previous decade. In the middle of this crisis, British economist John Maynard Keynes created a new theoretical framework that became the basis for what we teach as macroeconomics. Prior to Keynes, what theories there were about unemployment offered little guidance for how to cure it. Keynes showed how the government can use budget policy and monetary policy to prevent the sort of long, severe slump that occurred in the 1930's.

Macroeconomics is filled with controversy. There are intelligent, well-trained economists whose beliefs about macro are diametrically opposed to those of other intelligent, well-trained economists. This poses a dilemma for a teacher. Do I try to give equal time to all points of view, or do I focus on what I believe? In these lecture notes, I adopt the latter approach. When you take macroeconomics in college, you can gain more exposure to the various doctrinal disputes that arose in the past and that still persist.

A Basic Macroeconomic Equation System

Here is a basic model to explain the behavior of aggregate output (Y) and aggregate consumption (C). Start with some definitions:

[1] Y = Gross Domestic Product, the total value of all goods and services produced annually in the economy.

[2] C = Consumer Expenditures, the total value of all goods and services bought by consumers annually

[3] I = Business Investment, the total value of all capital goods purchased by businesses annually

Next, we introduce the concept of circular flow. It means that one person's spending is another person's income. When I buy a meal at a restaurant, the money I spend ends up as income for restaurant owners, cooks, wholesale food distributers, farmers, and so on. What circular flow means in terms of our definitions is that Y equals total income as well as total expenditures.

Using circular flow, we can write

[4] Y = C + I

In this simple economy, all output is either sold to consumers or to businesses. (There is no government or foreign trade sector.) Consumer spending plus business investment equals total output. Also, because of circular flow, the sum of consumer spending and business investment is equal to income.

In the United States, consumer spending is about \$6.7 trillion per year, and investment is about \$1.8 trillion per year. If we were to treat this as the entire U.S. economy, then Y for the U.S. would be \$8.5 trillion.

Next, we let consumer spending be a function of income. This consumption function can be written as

[5] C = C0 + cY

This is an ordinary linear equation, of the kind that you met in middle school when you took algebra. c is the slope, and C0 (pronounced "C-nought") is the intercept. It seems simple, but when I was a graduate student and taught this at Harvard, about eight students came up to me after class and said, "I don't understand C-nought. I'm lost." I think you should catch on easier than those algebra-phobic Harvard freshmen, but don't be embarrassed to ask questions.

As a numerical example, let c equal 0.6, and let C0 equal \$1.6 trillion. Then we have

C = \$1.6 + (0.6)(\$8.5) = \$6.7 trillion

I have cleverly chosen the parameters so that the consumption function fits our economy, in which consumer spending is \$6.7 trillion and income is \$8.5 trillion.

Equations [4] and [5] make up a system of two equations in two unknowns. The two unknowns are Y and C. Any time something else in the system changes, new values of Y and C are determined.

For example, we said that business investment is \$1.8 trillion per year. What would happen if investment rose to \$2 trillion per year?

Looking just at equation [4], we have

Y = C + I = \$6.7 + \$2.0 = \$8.7 trillion

However, we cannot stop there, because the consumption function is not satisifed if we leave consumer spending at \$6.7 trillion. With the new income of \$8.7 trillion, equation [5] gives

C = \$1.6 + (0.6)(\$8.7) = \$6.82 trillion

However, we cannot stop there! We need to plug the new figure for C into equation [4], which will give us a new Y, and then a new C, and so on. Keynes termed this process the multiplier.

Does the multiplier ever stop? Yes. We can use ordinary algebra to solve [4] and [5] for C and Y, given values of I, C0, and c.

In this example, plugging in the given numbers, we have

Y = C + \$2.0 and C = \$1.6 + 0.6Y

Using simple substitution, we have Y = \$1.6 + 0.6Y + \$2.0 = \$3.6 + 0.6Y

Solving for Y, we have 0.4Y = \$3.6, or Y = \$9.0 trillion

Forget the numerical example, and go back to the general equations

Y = C + I and C = C0 + cY

Solve these general equations for Y as a function of I, C0, and c.

Terminology

A macroeconomic model consists of a set of equations with variables and coefficients. A variable is a measured economic statistic. In this model, the variables are Y (total output), C (consumer expenditures), and I (business investment).

A coefficient is an estimate of a component of a behavioral relationship. In this model, the coefficients are C0, and c. A synonym for coefficient is "parameter." (In fact, using the term "parameter" in this context is correct. 99% of the time when you hear the word "parameters," it is being mis-used as if it were a synonym for perimeters. Every time I hear the word "parameter" used incorrectly, I cringe.)

Some coefficients are so significant that we give them special names. In our model, we call c the marginal propensity to consume. The marginal propensity to consume is important because it determines the size of the multiplier. The multiplier is

1/(1-c)

so that when the marginal propensity to consume is high, the multiplier is high, and conversely.

There are two types of macroeconomic equations. An identity is a relationship that is true by definition. For example, in this model Y = C + I is true by definition. Given the structure of our simple economy, we cannot violate this relationship. There is no controversy whatsoever about the validity of identities. Every economist agrees that identities are true.

The other type of equation is a behavioral equation. In our model, the consumption function

C = C0 + cY

is a behavioral equation. It represents a hypothesis about how a key economic variable (in this case, consumer spending), is determined. Unlike identities, behavioral equations are not true with certainty. There is a margin of error in every behavioral equation. In fact, it gets worse. There is not a single behavioral equation that is beyond controversy. For every behavioral equation that I will present in this class, there is at least one very different alternative equation which some economists believe better represents reality.

In macroeconomic models, some variables are called exogenous, or pre-determined variables. This means that their values are taken as given. For example, in our simple model, business investment (I) is exogenous. We are simply told that investment is \$1.8 trillion, or \$2.0 trillion, or what have you.

Other variables have their values determined by the equations in the model. These are called endogenous variables. In our model, income or output (Y) and consumer spending (C) are the endogenous variables. We solve the equations for the values of the endogenous variables, taking as given the values of the exogenous variables and the coefficients.

Treating some variables as exogenous and others as endogenous is a matter of arbitrary choice. Macroeconomic models that are used for teaching purposes will use relatively few equations and relatively few endogenous variables, in order to try to minimize confusion. Macroeconomic models that are used to make forecasts and to simulate alternative economic policies can have hundreds of equations and hundreds of endogenous variables, because the goal is accuracy rather than simplicity.

For most of the rest of this section of the course, we will be adding variables and equations to the macroeconomic model. Each new equation adds an important element of realism and teaches an important concept. However, before we go on from the simple two-equation model, it is worth looking at one of its interesting properties.

Suppose we start out with our basic two equations

Y = C + I and C = \$1.6 trillion + 0.6Y

If investment is \$1.8 trillion, then we know that solving for income gives \$8.5 trillion, with \$6.7 trillion in consumer spending. What is the aggregate level of saving?

All income has to be accounted for. Income that is not consumed is saved. If we subtract C from Y, we get saving. That means that S = I, so we know that saving will be \$1.8 trillion.

What happens if people try to save more? In particular, what happens if the marginal propensity to consume falls to 0.5, because people try to save more of their income?

Our equations are now

Y = C + I = C + \$1.8 trillion and C = \$1.6 trillion + 0.5Y

Solve for the new values of Y and C. What is the new value of saving? Were consumers successful in increasing their saving? Did it help the economy to have consumers attempt to save more of their income? Explain what happened, and why.

Fiscal Policy

In this lesson, we will add government spending and taxes to our system of equations. We will treat government spending, G, as fixed, like business investment. We will have tax revenues, T, depend on income, Y. Overall, we have

[1] Y = C + I + G
[2] C = C0 + c(Y-T)
[3] T = T0 + tY

Equation [1] says that total output is the sum of purchases by consumers, businesses (for investment), and the government. Equation [2] says that consumption depends on disposable income, which is income after taxes (Y-T). Equation [3] says that taxes are a linear function of income, with a slope of t and an intercept of T0.

In equations [1] - [3], what are the endogenous variables? What are the exogenous variables? What are the coefficients? Which equations are identities? Which equations are behavioral equations?

A numerical example of this system might be

[1'] Y = C + I + G = C + \$1.8 + \$1.7 = \$10.2 trillion
[2'] C = \$1.54 + (0.6)(Y-T) = \$1.54 + (0.6)(\$10.2 - \$1.6) = \$6.7 trillion
[3'] T = -\$0.44 + 0.2Y = -\$0.44 + 0.2(\$10.2) = \$1.6 trillion

In this example, all three equations are satisfied at the values shown.

Suppose that, in equation [1], investment is \$2.0 trillion instead of \$1.8 trillion. How does that change the solution to the three equations? (hint: substitute equations [3] into equation [2], then substitute this equation into equation [1], using \$2.0 instead of \$1.8)

We saw that with business investment of \$1.8 billion, government spending of \$1.7 billion, and the intercept and slope of the tax function of -\$0.44 and 0.2, respectively, the value of output will be \$10.2 trillion. What if potential output is higher, say \$12.0 trillion? In that case, the economy would be operating way below potential, in a deep recession, with high unemployment.

Keynes' insight was that the government could use fiscal policy (its choices of G, T0 and t in our model) to boost demand and bring output to potential. Prior to Keynes, fiscal policy consisted primarily of finding ways to raise money during war time and to pay off debts and achieve budget balance at other times. Note that in equations [1'] - [3'], the government budget surplus (T-G) is -\$0.1 billion, which means that the government runs a deficit.

Suppose that in equation [1'], investment is \$1.8 trillion and government spending is \$2.2 trillion. What are the new values of Y, C, and T? What is the government deficit? Does the government deficit increase by more, less, or the same amount as the increase in government spending? Explain why this occurs.

Suppose that the government cuts taxes, by changing T0 to -\$0.94. What does this do to Y, C, T, and the government deficit?

Suppose that the government cuts taxes by changing t from 0.2 to 0.18. What does this do to Y, C, T, and the government deficit?

Investment

Until now, we have been treating the amount of business investment as exogenous. However, investment responds to other macroeconomic variables, including the interest rate, which up until now has not appeared in our macroeconomic model.

The simplest way to introduce investment is to treat the interest rate as exogenous. Let us suppose that the interest rate is 2.0 percent. If the interest rate were higher, then the cost of capital would be higher. If the cost of capital is higher, then firms will substitute away from capital, which means investing less. Thus, investment is negatively related to the interest rate. For example, if we let r stand for the interest rate, we could have

[4'] I = \$2.8 - \$0.5r = \$2.8 - \$0.5(2.0) = \$1.8 trillion

More generally, if we let I0 be the intercept and h be the slope of the investment equation, then we have

[4] I = I0 - hr

This is equation [4], because we could combine it with our previous three equations.

[1] Y = C + I + G
[2] C = C0 + c(Y-T)
[3] T = T0 + tY

Now, we have four equations. What are the four endogenous variables? What are the exogenous variables? What are the coefficients?

Substitute equations [2], [3], and [4] back into equation [1], and solve for Y as a function of the coefficients and the exogenous variables.

We can combine the numerical values of equations [1'] - [4']. That is, we have

[1'] Y = C + I + G = C + I + \$1.7 = \$10.2 trillion
[2'] C = \$1.54 + (0.6)(Y-T) = \$1.54 + (0.6)(\$10.2 - \$1.6) = \$6.7 trillion
[3'] T = -\$0.44 + 0.2Y = -\$0.44 + 0.2(\$10.2) = \$1.6 trillion
[4'] I = \$2.8 - 0.5r = \$2.8 - 0.5(2.0) = \$1.8 trillion

Monetary and Fiscal Policy

The government can influence the interest rate through its use of monetary policy. In the United States, monetary policy is conducted by the Federal Reserve Board, under its current Chairman, Alan Greenspan.

Suppose that the interest rate falls from 2.0 percent to 1.8 percent. What happens to the level of investment? What happens to the level of income? Solve for the new values in the numerical example.

We now have identified the two main policy levers that the Federal government has available for raising the level of output. Fiscal policy is the government's use of tax cuts or increases in government spending to boost the economy (or the use of tax increases and spending cuts to cool the economy). Monetary policy is the use of lower interest rates to stimulate the economy (or higher interest rates to cool the economy).

The Determinants of Investment

In classical economics, the desire to invest and the desire to save both stem from the same source: a willingness to forego consumption now in order to have more in the future. Saving is the means of setting aside output, and investment is the means of transforming output that is set aside today into capital that will produce output in the future. Classical economists saw desired saving and investment as naturally balanced.

Keynes saw saving and investment as two different psychological mechanisms. He saw saving as the desire to hoard or accumulate wealth, which is motivated by fear or pessimism. He saw investment as the desire to create, which is motivated by optimism or what Keynes called the "animal spirits" of the entrepreneur. Keynes thought that much of the time the "animal spirits" would be too weak, and the strength of the hoarding motive would create an excess of desired saving over investment.

The Keynesian analysis can be applied to the Internet Bubble or "dotcom mania" and its aftermath. In Keynesian terms, optimism about the prospects for Internet companies, particularly in 1999 and early 2000, meant that "animal spirits" were strong and investment was high. This raised the level of output and caused a powerful economic expansion. Once the bubble popped, the hoarding instinct took over, and the economy slumped.

Nobel laureate James Tobin elaborated on Keynes' theory of investment. He introduced a concept, now called Tobin's q, which is the ratio of the market value of capital to its replacement cost. The market value of capital is the value of stock prices. The replacement cost of capital is the cost of buying all of the plant and equipment needed to build the companies that are traded on the stock market.

The natural value for q is 1.0, which means that stocks are neither under-valued nor overvalued. When q is higher than 1.0, there is strong motivation to undertake capital investment. When q is below 1.0, there is little motivation to undertake capital investment.

For example, during the dotcom mania, companies with few assets other than some computers and software programs to run on the Web were valued at billions of dollars. Thus, the ratio of their market value to their replacement cost was enormous. This led to many Internet companies being started by entrepreneurs and funded by venture capitalists. However, once the bubble burst and the value of q fell from its stratospheric levels, investment in dotcoms ground to a halt.

The theories of Keynes and Tobin are rather at odds with the theory of efficient markets that we looked at in finance. If Keynes and Tobin are correct, then the stock market is subject to strong psychological mood swings that cause prices to far away from fundamental values. It is still impossible to make a profit from short-term trading, but if Keynes and Tobin are correct then buying stocks when price-earnings ratios are unusually low and selling when P/E ratios are unusually high will be a winning long-term strategy.

Another component of the basic macroeconomic identity is the trade balance. Exports add to aggregate demand, and imports subtract from aggregate demand. The difference between the two, exports minus imports, is net exports, which we will call X. For the U.S. economy, X has been negative for many years, which means that we have been running a deficit in the balance of trade.

Including net exports in the basic macroeconomic identity, we have

[1] Y = C + I + G + X

How can we export more than we import? Our trade deficit is financed by what is called the capital account. Foreigner purchase American assets (stock and bonds), and we purchase foreign assets. In recent years, foreigners have purchases of our assets have exceeded our purchases of foreign assets. In effect, we have traded paper assets for real goods and services. Eventually, foreigners will be able to cash in their paper assets and receive American goods and services in return.

Sectoral Saving

Another way to look at the basic national income accounting identity is in terms of sectoral saving. There are three sectors--the private sector, the government sector, and the foreign sector. Net private sector saving is S-I, which is private saving minus private investment. Government saving is T-G, which is taxes minus government spending. Our saving in the foreign sector is X. When we run a trade surplus (deficit), our foreign sector saving is positive (negative).

By definition, we have[1a] C + S + T = Y

We can combine [1a] and [1] to obtain

[1b] C + S + T = C + I + G + X

Subtracting C from both sides and re-arranging terms gives

[1c] (S - I) + (T - G) = X

This version of the basic accounting identity says that private saving plus government saving equals foreign sector saving. This identity always holds. It means that whenever our private saving is not sufficient to cover our government deficit, we are bound to run a trade deficit. In macroeconomics, we tend to view the trade deficit as resulting from an excess of domestic investment or domestic saving.

The Trade Balance and the Relative Price of Foreign Goods

Another aspect of the macroeconomic view of the trade balance is that "the capital account drives the trade account." That is, we believe that the relative demand for domestic and foreign assets is what determines the trade balance. The mechanism by which this occurs is the relative price of foreign goods.

For the United States, let e stand for the relative price of foreign goods in the United States. When e is high, foreign goods are expensive relative to our goods. This means that our exports are more competitive, so that we export more, while imports are less competitive, so that we import less. Thus, our trade balance, X, is positively related to the realtive price of foreign goods. A synonym for the relative price of foreign goods is the real exchange rate; hence, we call it e.

Calculating the Relative Price of Foreign Goods

Suppose that you had two job offers, one in Detroit and one in Toronto. Which job should you take?

To answer this question, you would want to compare how well you could live in Detroit with how well you could live in Toronto. You would need to know the cost of housing, food, and so on in Toronto. Since prices would be quoted in Canadian dollars, you would want to convert back to American dollars. Then you could compare the cost of living in Detroit in American dollars. The ratio of the cost of living in Toronto to the cost of living in Detroit, measured in a common currency, is one measure of the real exchange rate. The more it costs to live in Toronto relative to Detroit, the higher the salary you would need in Toronto. As the relative cost of foreign goods rises, the cost of living in Toronto rises.

When foreigners are eager to buy American assets, they must acquire dollars to do so. By bidding up dollars in the foreign exchange market, they cause the relative cost of American goods to rise. From our perspective, this means that the relative cost of foreign goods falls. When the relative price of foreign goods falls, our exports are less competitive, and our net exports fall. Other things equal, this tends to exert a drag on our economy.

(The dirty little secret of international economics is that when the dollar becomes more valuable, we say that e falls. I try to stay away from this as much as possible, by focusing on the relative price of foreign goods. )

The Relative Price of Foreign Goods as an Endogenous Variable

In the previous section, investors behaved mysteriously. When they want American assets, the relative cost of foreign goods falls. When they do not want our assets, then we must pay more for foreign goods.

In a complete macroeconomic model, the relative cost of foreign goods is endogenous. That is, the relative cost of foreign goods is determined by other variables in the model. A key variable is the real interest rate, r, which we already have used as a determinant of investment.

When the real interest rate is high, the demand for our assets will be high, which means that the relative cost of foreign goods will fall. Thus, an increase in our real interest rate will make our exports less competitive, which will reduce net exports and therefore reduce aggregate demand. This helps to strengthen monetary policy.

Recall that if monetary policy is used to raise the interest rate, this will reduce investment and reduce demand. Now, we see that with a higher interest rate, the trade sector also will swing toward deficit, reducing demand. So monetary policy is even more effective when we take the trade sector into account.

Here is a set of equations that describes an economy with an endogenous trade balance (X) and an endogenous relative price of foreign goods (e).

[1] (accounting identity) Y = C + I + G + X
[2] (consumption function) C = c0 + c(Y-T)
[3] (tax function) T = T0 + tY
[4] (investment function I = I0- hr
[5] (trade balance function) X = x0 + xe
[6] (price-of-foreign-goods function) e = e0 - fr

1. Name the 6 endogenous variables in this macro model.
2. Name the five parameters in the model that are intercept terms (also called constant terms).
3. Name the two exogenous variables in the model.
4. Name the five paramters in the model that are slope coefficients.

The model has two interest-sensitive sectors--investment and the trade balance. Putting the two together, and substituting equation [6] for the price of foreign goods in equation [5], we have

[7] (replaces [4]-[6]) I + X = I0 + X0 - (h + fx)r

In this model, the interest rate determines investment and the trade balance. Those variables, along with government spending, will determine income, taxes and consumption using equations [1] - [3].

In a more sophisticated model, the simplification of [7] would not be possible. That is because investment can depend on output, Y. As aggregate demand goes up, firms invest more. Also, the trade balance can depend negatively on Y. As demand goes up, more of it is satisfied by imports. Those real-world relationships make the model considerably more complex. It becomes a fully simultaneous 6-equation system, which takes a lot of work to solve.

The Real Interest Rate as an Endogenous Variable

Up until this point, we have been saying the real interest rate, r, is determined by monetary policy. However, that is a simplification, on at least two dimensions.

1. monetary policy only affects the nominal interest rate, i, which is not adjusted for inflation. The real interest rate is the difference between the nominal interest rate and expected inflation, p*. We use p to denote the rate of inflation, and we use p* to denote the expected rate of inflation. That is the * means "expected" as opposed to actual.

The real interest rate is higher when i=3 and p* = 0 than when i = 8 and p* = 6. The real interest rate is what determines the demand for investment. If you remember the equation for profitability of investment--profitability equals rental rate plus appreciation minus interest cost, you can see that if a capital good is appreciating at the rate of expected inflation, then higher expected inflation reduces the cost of capital (holding the nominal interest rate constant).

2. Monetary policy only affects the short-term interest rate. Investment is determined by the long-term interest rate. The difference between long-term and short-term rates is called the "yield curve." When bond market investors have a different view of the economy from that of the monetary authority (which in the United States is the Federal Reserve), the yield curve may change in ways that offset changes in short-term interest rates.

The important point to remember is that there is sometimes slack in the connection between the interest rate that monetary policy can affect and the interest rate that matters for investment. The short-term nominal interest rate can change without affecting the real long-term interest rate. The latter is what is likely to affect investment and the trade balance (through the effect on the relative price of foreign goods).

Why Call it Monetary Policy?

Since we are talking about policies that affect interest rates, why do we call it monetary policy? Because the way that the monetary authority affects interest rates leads to changes in the quantity of money outstanding.

When the Federal Reserve wants to reduce interest rates, it makes short-term loans to banks in what is known as the Federal Funds market. The banks turn around and lend money to private investors, at a profit. The lending process has the effect of increasing the amount of money that is in circulation.

Why do banks not lend an infinite amount of funds, creating an infinite amount of money? Because they are constrained by reserve requirements. They are required to have a certain percentage of total deposits in the form of either currency or reserves that are the liabilities of the Federal Reserve, and hence fully guaranteed.

Defining Money

The total amount of currency plus non-currency reserves is called the monetary base. It is one of many possible measures of the supply of money. Another measure is M1, which is the sum of currency plus all money in bank checking accounts. Another measure is M2, which adds the sum of all money in bank savings accounts to M1. There are many measures of the money supply, and for a given period of history, at least one measure can be shown to track other economic variables really well. However, for forecasting purposes, you would have to pick a measure ahead of time, and that does not seem to be as easy to do.

Inflation as an Endogenous Variable

In the preceding section, we were introduced to p, the rate of inflation. What determines the rate of inflation?

For high inflation rates (above, say, 10 percent per year), most economists would focus on monetary growth as the determinant of inflation. In order for high inflation to persist, the monetary authorities must accomodate inflation by printing more money. Otherwise, interest rates rise, the economy slumps, and inflation dies away. In 1980, when inflation in the United States was approaching double-digit rates, Federal Reserve Chairman Paul Volcker began to raise interest rates and slow the rate of money growth, helping to bring the rate of inflation down to much lower levels seen today (between 1 and 3 percent in recent years).

At low rates of inflation, the best predictor of inflation seems to be "output gap," which is the gap between output at full employment (potential output) and actual output. When the "output gap" is close to zero or negative, meaning that aggregate demand matches capacity, there tends to be upward pressure on inflation. When the gap is large, meaning that aggregate demand falls short of capacity, there tends to be downward pressure on inflation.

Hyper-inflation

For very high rates of inflation, of 100 percent per year or more, the "output gap" does not seem to be a good predictor of inflation. Very high rates of inflation are associated with very high rates of money growth. However, another factor that is associated with very high rates of inflation is a government budget deficit that cannot be financed by borrowing.

What happens when a government cannot finance its deficit by borrowing is that it must print money to pay for goods and services. Printing money is a subtle form of taxation, sometimes called the "inflation tax," because financing a government deficit in this way almost always leads to excessive money creation and inflation. In fact, there have been many episodes of hyper-inflation in this century--most famously in Germany in the late 1920's. During a hyper-inflation, the government prints a lot of money, causing prices to rise, which forces it to print even more money to cover its spending, which leads to more inflation, etc. Hyper-inflations create crazy situations in which prices can rise by more than 100 percent in a single day!

The only cure for hyper-inflation is to cut back government spending to align with taxes. When governments are weak, this is not possible. Often, the goverment must fall and be replaced by a new, stronger government before hyper-inflation can be stopped.

Employment and Unemployment

A major macroeconomic indicator is the unemployment rate. In the United States, the Bureau of Labor Statistics (BLS) conducts a monthly survey of a sample of households in which it asks whether individuals in the household are employed or have searched for work recently. Those who have done neither are deemed to be out of the labor force. Of those in the labor force, the percent that is not working is the unemployment rate.

Another employment survey is called the payroll survey. The BLS asks all large employers and a sample of small employers to report the number of employees on their payrolls. This gives an alternative measure of total employment, one that is considered to be a bit more reliable than the household survey.

When aggregate demand (what we have been calling Y in our equations) goes up in the economy, employment goes up and unemployment goes down. This makes sense, because as firms must meet the need for more output, they have to hire more workers.

A typical unemployment rate for the U.S. economy might be 6 percent. However, it is important to realize that many more than 6 percent of workers experience spells of unemployment over the course of a year. Each month a large percentage of the labor force engages in transitions. Many people leave their old jobs. Some start new jobs right away, and others remain unemployed for a few months.

Economists Bruce C. Fallick and Charles A. Fleischman estimated that about nine million employment relationships end each month, due either to quits by workers or lay-offs by firms. Also, about nine million new employment relationships start each month. The change in the unemployment rate represents the difference between relationships newly broken and relationships newly started. A change in the number of unemployed of 250,000 will move the unemployment rate by 0.2 percentage points (from, say 6.0 percent to 6.2 percent), which is enough to be remarked on in the news media. In other words, in a month where 9 million jobs are terminated and only 8.75 million jobs are created, the unemployment rate will rise noticeably.

Another way of looking at the delicacy of the unemployment rate is to think of it in terms of the average spell for those who are unemployed. Suppose that 24 percent of the labor force experiences a spell of unemployment over the course of a year, and that the average spell is three months, or 1/4 of the year. Then the average unemployment rate is 24/4 = 6 percent. If the average unemployment spell were to lengthen to four months (1/3 of the year), then the unemployment rate would rise to 24/3 = 8 percent.

From the foregoing, it should be evident that the key to maintaining full employment is job creation. As long as new jobs are being created at a sufficient rate to absorb people leaving old jobs as well as new entrants to the labor force, the economy can experience a large number of layoffs and yet not have an unusually high unemployment rate. The media was reporting massive layoffs at major corporations throughout the 1990's, as the unemployment rate persistently declined. For most of the 1990's new job creation was strong, so that average unemployment spells shortened, reducing the overall unemployment rate.

High Unemployment

If hyper-inflation is a particularly frustrating form of inflation, then its counterpart in unemployment is a severe recession or depression, in which the unemployment rate reaches double-digit levels and stays there. For example, in the Great Depression in the 1930's in the United States, the unemployment rate reached as high as 33 percent, and it was over 20 percent for nearly a decade.

It was the experience of the Great Depression, which was experienced by most economies of the developed world, that stimulated the development of macroeconomics, primarily the work of English economist John Maynard Keynes. Keynes focused on the link between aggregate demand and unemployment, and he provided the theory of the multiplier, which suggested that the government could alleviate high unemployment with stimulative fiscal and monetary policy.

Since World War II, the United States has not suffered anything close the the Great Depression. Although Keynes has gone in and out of favor, for the most part our political leaders accept responsibility for maintaining low unemployment and believe in the use of fiscal and monetary policy for that purpose.

Microeconomic Causes of Unemployment

In addition to macroeconomic factors, there are microeconomic causes of unemployment. Taxes, welfare policies, and regulatory policies can affect the unemployment rate. Here are some examples.

1. In many European countries, it is illegal for firms above a certain size (say, 20 employees) to lay off an employee without going through an approval process with the government. This makes firms very leery about hiring new workers, because the firm knows that it will be stuck with the worker even if demand falls off or the relationship does not work. Because firms are reluctant to add workers, new jobs are not created as fast as in the United States, and economists believe that the effect of these laws is to increase the unemployment rate in Europe.

2. During a recession, one policy issue that comes up is extending unemployment benefits to cover a longer period of time. While this often is the right thing to do for other reasons, it does reduce the incentive of unemployed workers to take new jobs, which tends to raise the unemployment rate.

3. Income and payroll taxes drive a wedge between the value of a worker's time and the income that a worker can receive from paid employment. If I only take home 50 cents of every dollar I earn, then I may choose to putter around the house more and work less. This can show up as an increase in the unemployment rate, as I look for work but get very picky about the jobs that I will accept.

Macroeconomic Policy Challenges

The basic idea of macroeconomic policy is to use fiscal and monetary policy to achieve an output gap that is neither so high that it leads to excessive unemployment and lost output nor too low that it leads to rising inflation. However, this is not nearly as simple as it sounds.

Model Uncertainty

We do not know the true macroeconomic model. We do not know the "natural rate of unemployment," which is the rate below which we would start to experience increasing inflation. We do not know the exact relationship between interest rates and aggregate demand. We do not know the exact relationship between fiscal policy and aggregate demand. Because of all this "model uncertainty," policy is more a matter of trial and error than exact science.

Time Lags

Time lags are another complicating factor in macroeconomic policy. First, there is recognition lag. Our economic data gives us a rearview mirror through which to view the economy. We may discover only after the fact that the economy has been in recession for a year, or that our estimate of the natural rate of unemployment is too optimistic. Second, there is implementation lag. Economists might recognize a recession, but it may take some time for Congress to enact a stimulative tax cut or spending program. Finally, there is impact lag. There may be a lag of several quarters between a cut in interest rates and the response of aggregate demand. For example, a drop in interest rates is supposed to raise the cost of foreign goods, but even if the exchange rate moves in the right direction it may take a while for foreign producers to mark up the prices of their exports to us. And even after prices change, it may take a while before domestic buyers switch from imported products to domestic products.

The combination of model uncertainty and time lags makes a mockery of the notion of "fine tuning" the economy to always be at optimum performance. Instead, policymakers try to adjust slowly and more-or-less grope to the best outcome that they can achieve.

Internal Vs. External Balance

There can be a conflict between internal and external balance. Internal balance means having the output gap be close to zero. External balance means having the trade balance be close to zero. If the output gap is negative, you want to raise interest rates in order to hold down inflation. If the trade balance is in deficit, you want to lower interest rates in order to increase the cost of foreign goods. If you have both problems at the same time, what do you do?

A further complication is that sometimes it is desirable to have a stable exchange rate, in order to avoid harming companies with assets or liabilities denominated in foreign currency. If you need to maintain a stable exchange rate for financial stability, but you need to deal with a trade imbalance, what do you do?

The United States has tended to ignore the issue of external balance. We run a large trade deficit every year, which means that we build up large debts to foreign investors. Whether this is sustainable is unclear. However, unlike most other countries, we have less to fear from exchange rate changes, since our debts tend to be denominated in our domestic currency, the dollar.

Supply Shocks and Staglation

In the 1970's, we experienced two spikes in oil prices. The increase in energy costs, along with slow productivity, came to be called a "supply shock" by economists. A supply shock means an increase in the rate of unemployment at which higher inflation is triggered. What this means is that policymakers face an unappetizing choice: either accept higher unemployment than was typical before, or put up with higher inflation. The combination of high unemployment and high inflation is called stagflation.

When stagflation first appeared in the early 1970's, the first attempt to stop it was the imposition of wage and price controls late in 1971, during the Nixon Administration. In the short run, this kept inflation in check and allowed monetary stimulus to reduce the unemployment rate, but the price control regime broke down within a few years, and the economy sank quickly into worse staglation than before.

In fact, it was the decontrol of oil prices by the Reagan Administration in 1981, along with the anti-inflation efforts of Paul Volcker's Federal Reserve, that paved the way for the end of stagflation. Price controls have been discredited as a remedy. If stagflation were to break out again, economists might suggest "supply side" measures that would reduce taxes and regulations that are thought to raise prices. However, we do not have a handy macroeconomic solution to the problem.

Bubbles

It seems that periodically investors get swept away by euphoria. In Japan in the late 1980's, the prices of stocks were boosted to astronomical levels. Land prices also soared, so that Tokyo became worth more than the entire state of California. In the early 1990's, these "bubbles" popped, leading to a steep slump in output that persists to this day.

In the United States, the Internet produced a bubble, in which Internet stocks (the so-called "dotcoms") were valued at tens of billions of dollars, even though few of them ever earned any profits. In March of 2000, the Internet bubble popped, and most Internet stocks saw their market valuations fall by over 95 percent. Non-Internet stocks, which also had become overpriced, also fell off sharply between March of 2000 and the fall of 2002.

Asset bubbles appear to help the economy while they occur, but the economy suffers when the bubbles pop. A bubble in stock prices helps to raise Tobin's q, the ratio of the market value of capital to replacement cost. This is very stimulative for investment. However, when the bubble pops, investment falls off. MOreover, high stock prices give households a lot of paper wealth, which leads them to spend more and save less. After the bubble pops, households try to restore the value of their savings by cutting back on spending, which lowers aggregate demand.

What is the right policy prescription for asset bubbles? One school of thought is that the Federal Reserve should be pro-active in stopping bubbles during the euphoric phase. One approach would be to raise interest rates. Another approach would be to raise margin requirements, which might serve to dampen speculation in the stock market. (Speculators sometimes buy stock "on margin," meaning that they put up cash for part of the stock, and finance the rest with loans collateralized by the stock. Raising margin requirements means requiring investors to put up a higher percentage of cash and use loans for a lower share of the purchase.)

On the other hand, I think that most economists are doubtful that the Fed or another government agency can clearly distinguish a bubble from a case of justified optimism. After all, if it were obvious that stocks were over-valued, the market would be likely to drive prices down.

Another argument against trying to pop bubbles is the point of view that the macroeconomic damage of a bubble comes only when it pops. It would seem ideal if you could let the economy enjoy the ride when a bubble is taking place. Once the bubble pops, you would step in with stimulative macroeconomic policy to cushion the fall.

Theoretical Controversies in Macroeconomics

Earlier in this chapter, I remarked that every behavioral in macroeconomics is subject to dispute. Here, we examine two of the major issues.

Why is there unemployment?

In theory, the market for labor is like any market. There is supply, which comes from people willing to work. There is demand, which comes from firms with needs for work. And there is a price, the wage rate, which should clear the market.

In a typical market that is characterized by supply, demand, and a price, economic theory says that the price will adjust to "clear" the market, meaning that there is neither excess supply nor excess demand. One of the most elementary fallacies of non-economists is to predict that a "shortage" is going to last for many years, because this will not happen if prices adjust.

For example, a few years ago there was talk of a long-term "shortage" of technical workers in the United States. For example, there was a shortage of computer programmers who were skilled in the Java programming language. I pointed out that there had to be some wage rate for Java programmers (even if it had to be as high as \$300,000 a year) which would be high enough to reduce demand and increase supply to clear the market. In fact, today the "shortage" of technical workers seems to have disappeared, and technical workers complain of difficulty in finding new jobs.

High unemployment is just the reverse of a labor "shortage." The question that should occur to the student of economics is why an increase in unemployment is not cured by a reduction in wage rates. If Java programmers are now out of work, why doesn't the wage rate for Java programmers fall to \$40,000 a year, or whatever it takes to bring supply and demand into balance?

One answer (called the "freshwater" school of macroeconomics, because its adherents tend to be professors at Universities near the Great Lakes) is that in fact involuntary unemployment is something of an optical illusion. They argue that people choose not to work because they prefer working at home or continuing to search for a better job.

Inflation and Unemployment

An interesting implication of the wage stickiness hypothesis is that a little inflation may help to keep unemployment low. The late Nobel Laureate James Tobin pointed this out over thirty years ago.

Here is a contemporary illustration of Tobin's argument. Think of our economy as having two job markets, one for webmasters and one for home health care assistants. 2-1/2 years ago, we had full employment in both markets, with webmasters making \$35 an hour and home health care assistants making \$15 an hour.

Next came the collapse of the dotcom bubble, which caused a drop in the demand for webmasters. Eventually, for equilibrium to be restored, the ratio of the webmaster wage to the home health care wage has to fall and on the margin some webmasters have to change careers to become home health care workers.

The fundamental problem of macroeconomics is how this transition takes place. In a zero-inflation environment, the webmaster wage must fall and the home health care wage must rise. In a deflation environment, both wages must fall, with the webmaster wage falling more. In an inflation environment, both wages may rise, with the health care wage rising faster, although in real (inflation-adjusted) terms, the wages of webmasters will fall.

What Tobin argued is that the the relative wage adjustment will occur most quickly in an inflationary environment. He said that it is difficult to reduce nominal wages, so that in a zero-inflation or deflationary environment wages will be sticky in the short term, leading to unemployment. Webmaster wages will remain above their market-clearing level, and unemployed webmasters will remain unemployed hoping to get jobs at those unrealistic wages, rather than taking pay cuts or changing careers.

"Saltwater" economists (from universities near the Boston and San Francisco bays) believe that there is such a thing as involuntary unemployment. As Franco Modigliani once put it, "was the Great Depression an outbreak of laziness?"

The challenge for "saltwater" economists is to explain why the labor market, unlike other markets, stays out of adjustment for long periods. One hypothesis is that wage rates are sticky downward. For a variety of reasons that relate to social psychology, people do not tolerate pay cuts. Therefore, when the demand for labor falls in one sector, people are laid off and remain unemployed, with wages failing to adjust to clear the market.

Downward wage stickiness might explain another mystery of macroeconomics, which is that when productivity is rising faster, the economy is able to sustain lower rates of unemployment without triggering faster inflation. That is, the "natural rate" of unemployment seems to fall when productivity rises quickly, and it seems to rise when productivity growth is slow.

Suppose that inflation is 2 percent per year, and the average pay raise needed to keep workers happy is 3 percent per year. What firms care about is the ratio of price to unit labor cost. If output is Y, labor input is L, the wage rate is W, then unit labor cost is WL/Y. The ratio of price to unit labor cost is P/(WL/Y).

The change in the ratio of price to unit labor cost is the rate of change in prices (inflation) minus the rate of change in unit labor cost. If productivity growth is 1 percent, that means that Y/L is rising at just the rate needed to keep the demand for labor constant when price inflation is 2 percent and wages grow by 3 percent. However, if productivity were to pick up to 2 percent per year, workers could still be getting their 3 percent raises and firms would be increasing their demand for labor. This would cause the unemployment rate to fall.

On the other hand, when productivity rises slowly, workers might be reluctant to revise downward their wage expectations. As a result, wages are sticky and firms have to cut their demand for labor. The natural rate of unemployment rises.

Why is there an output gap?

Even if we can use wage stickiness to explain why the labor market fails to clear, there is still a challenge of explaining how aggregate demand can fall. Why does the demand for goods get out of balance with the supply?

The controversy centers around the balance between saving and investment. In principle, if I choose to save, that is because I have a demand for output some time in the future. If a company chooses to invest in capital goods, that is because it believes that the capital will yield output in the future. Thus, saving and investment represent demand and supply in the market for future output. The price that should clear this market is the interest rate.

In the Keynesian multiplier theory, aggregate demand can fall because desired saving is greater than desired investment. When this happens, why doesn't the interest rate fall, leading to more investment by increasing the profitability of capital, and leading to less saving by reducing the return on saving?

Keynes himself argued that investment was relatively inelastic with respect to the interest rate. He said that investment depended on the "state of long-run expectations" or on "animal spirits." If entrepreneurs were optimistic, investment would be high. Otherwise, investment would be low, regardless of what might happen to the interest rate.

Keynes also argued that as the rate of inflation gets close to zero, the economy can fall into what he called a "liquidity trap." Because people can always earn at least a zero rate of interest by keeping currency in a mattress, the interest rate can never be negative. However, it could be that if desired investment is low compared with desired saving, a negative real interest rate is needed to clear the market. Recall that the real interest rate is i-p, where p is the rate of inflation. If the nominal interest rate, i, cannot fall below zero, then you can only have a negative real interest rate if inflation is greater than 0.

The behavior of the U.S. economy during and after the Internet Bubble appears to validate Keynes' ideas about investment. It seems that when "animal spirits" were high in the venture capital community and on Wall Street, investment spending soared. Most of the slowdown in the economy in 2001 and 2002 represents a decline in investment, following the collapse of the dotcom bubble and declines in stock prices in general.

Some economists believe that the idea of a liquidity trap also is relevant currently. For example, Paul Krugman believes that Japan, which has very low interest rates, is in the liquidity trap. However, even when the short-term interest rate is zero, monetary policy could still work by having the monetary authorities purchase long-term bonds, including corporate securities. Such purchases would lower the interest rate faced by firms that are contemplating investment.