Great Questions of Economics
Arnold Kling
Applying Introductory Economics Every Day


An Introduction

by Arnold Kling

April 27, 2002

Macroeconomics looks at the relationships and policy choices that pertain to macroeconomic performance. Unemployment and inflation are two of the central macroeconomic indicators.

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. In this introduction, I will spell out what I believe, starting with what is relatively certain, and moving progressively to areas where we are less and less certain.


The Economic Report of the President contains a statistical appendix that collects much of the relevant macroeconomic information. Table B-1 gives the standard breakdown of total output (gross domestic product) into personal consumption expenditures, investment, government purchases, and net exports. In the calendar year 2000, it shows (in billions of dollars)

Total Gross Domestic Product9872.9the total value of all goods and services produced in the U.S.
Personal Consumption Expenditures6728.4Consumer purchases of cars, movie tickets, haircuts, etc.
Investment1767.5New homes, factories, machine tools and other goods that provide value over several years
Government Purchases1741.0Spending by government on military, education, etc.
Exports - Imports-364.0Goods and services sold abroad ($1102.9 billion) minus those purchased from abroad ($1466.9 billion)

Some propositions in macroeconomics are relatively safe from controversy, because they are grounded in definitions. For example, the fact that national output equals national income is true by definition. The value of output is equal to the income paid to all of the factors that produced the output.

For a case of a closed, private economy (meaning no foreign sector and no government), we have

Consumption + Investment = Consumption + Saving

Output is in a form that can be consumed now (food, haircuts) or in a form that yields output later (factories, blast furnaces). Income is used either to consume now or to save for later.

If we add government to this economy, then the government can purchase output while some consumer income must go to taxes. Thus, we have

Consumption + Investment + Government spending = Consumption + Saving + Taxes

Next, if we add a foreign sector to this economy, then we add exports to output and subtract imports from output.

Consumption + Investment + Government spending + Exports - Imports = Consumption + Saving + Taxes

We can subtract Consumption from both sides of this equation and re-arrange terms to get.

(Exports - Imports) = (Saving - Investment) + (Taxes - Government spending)

What this last equation says is that our balance of trade surplus is equal to net private sector saving plus net public sector saving. Among other things, this equation means that a country cannot run a trade surplus without also running either a government surplus or a private saving surplus. This implication is derived from the definitions of the terms involved.

Table B-32 in the Economic Report gives the values for the components in this last equation for the calendar year 2000, in billions of dollars.

Net Foreign Investment -430.5Exports minus imports plus some other items
Private Saving Minus Private Investment-444.5Personal saving plus corporate retained earnings minus private investment
Government Saving minus Government Investment144.4Government receipts minus transfers minus government spending on current goods and services

According to the equation, we should have(in billions of dollars) -430.5 = -444.5 + 144.4, which clearly is not correct. In 2000, there was a statistical discrepancy of -$130.4 billion, which was the largest such discrepancy in history. What this means is that the statistical measures of output differed from the statistical measures of income by that amount.

If you go to Table B32 in the Economic Report, you will see the statistical discrepancy listed as a separate item, with its historical behavior. The table does not show private saving minus private investment, but it does show total private saving ($1323.0 billion) and private investment ($1767.5 billion), from which I derived the difference. I did a similar calculation for government saving ($462.7 billion) minus government investment ($318.3 billion).

Money, Prices, and Hyperinflation

Often, a government will want to have its expenditures exceed its tax revenues. There are two ways for the government to finance a deficit.

First, the government can borrow money. This means selling government bonds, which promise to repay principal plus interest at a later date.

The second way that a government can finance its deficit is by printing money. By printing money and using that money to buy resources from the private sector, the government is engaging in a subtle form of taxation.

The money-printing tax only can be used up to a point. The problem with overdoing it is that as more money circulates, prices tend to rise. When the prices of all goods rise together, this is called inflation. We measure inflation by looking at the annualized percentage change of a weighted average of the prices for a large cross-section of goods and services in the economy.

For example, we look at the Consumer Price Index, which is a weighted average of the prices of goods and services purchased by a typical consumer. According to Table B-63 of the Economic Report, the Consumer Price Index rose 3.4 percent in 2000. This means that the market basket of goods and services in the Index cost 3.4 percent more at the end of the year than at the beginning.

The government can increase the nominal amount of money in circulation, but it cannot increase the real money supply (the amount of money divided by a price index) beyond a natural limit. Economists like to write the equation

where M is the amount of money outstanding, V is the "velocity" of money (so-called because you can think of V as the speed with which the currency circulates in the economy), P is the price level, and Y is the amount of real output in the economy. The natural limit of M/P is Y/V.

When a government is stuck in circumstances where it is impossible to reduce spending (without causing civil unrest) and impossible to finance spending with taxes and borrowing, it begins to print more money. Merchants find that they can raise prices--indeed they have to raise prices, because otherwise people will empty their shelves with purchases.

If we fix output and velocity, then the increase in the money supply must increase prices proportionately. In fact, as inflation gets underway, the velocity of money increases, because people realize that they need to spend money before it goes down in value. Also, because inflation reduces the value of money, the government must print more money the next month in order to pay its bills. This causes more inflation, leading the government to print more money, and so on.

This frustrating process is called hyperinflation. It took place in Germany in the early 1920's. Before the hyperinflation was brought under control, people were bringing wheelbarrows full of currency just to buy groceries. Hyperinflation broke out most recently in Argentina in 2002, after a political crisis left the government unable to fund the spending necessary to remain in power.

Hyperinflation represents a political breakdown. The pressures for government spending exceed its ability to collect taxes. Hyperinflation can be stopped by a combination of lower government spending, higher tax rates, or more effective tax collection.

Even at low levels, inflation can be frustrating. People feel cheated. It is said that people see their wage increases as justified, but they view price increases as wrong.

The relationship between money growth and inflation is not precise. In fact, in a modern economy, the very definition of money can be difficult to pin down. (Think of all the ways that methods that people use to pay for goods and services that do not involve passing currency.) In hyperinflation, however, the rates of growth of money and prices are so high that it is clear that they are correlated.

In a country with a central bank (such as the Federal Reserve in the U.S.), that bank controls the supply of money. Thus, the Fed is responsible for keeping inflation under control. However, the process by which it controls inflation involves trial and error, because the relationship between money and inflation is not airtight. The Fed tries to find "leading indicators" of inflation, and when those indicators warn of rising inflation, the Fed tends to take actions that reduce the growth rate of money. When those indicators suggest falling inflation and recession, the Fed takes actions to expand the growth rate of money.

When the Fed wants to increase the growth rate of money, it usually buys securities in an inter-bank market for overnight loans, known as the "Fed funds" market. This reduces the interest rate (called the "Fed Funds rate") on those loans. In effect, the Fed is printing money in order to make short-term loans. An alternative is for the Fed to reduce its own lending rate (called the Federal Reserve discount rate) to commercial banks, which in turn encourages the banks to lower their interest rates and expand their lending activities.

When the Fed wants to lower the growth rate of money, it does the reverse. That is, it sells securities in the Fed Funds market and/or it raises its discount rate.

The U.S. has been able to maintain enough control over spending and taxes so that it does not have to resort to printing money to maintain essential government services. Thus, we have been able to avoid hyperinflation. However, in the 1970's inflation climbed to double-digit levels, as the Fed briefly let money growth get out of control. There were a number of policy blunders that contributed to this inflationary episode, including misguided attempts to regulate oil prices. As of 2002, there probably is more reason to fear that inflation will be too low (a liquidity trap) than to fear that it will soar out of control.

The Real Exchange Rate and the Trade Balance

Suppose that you had two job offers--one in San Francisco with a salary quoted in U.S. dollars and one in Vancouver with a salary quoted in Canadian dollars. Which one is more lucrative financially?

If you were trying to sort this out, you would need to know the value of a Canadian dollar in terms of American dollars. Moreover, you would need to know how much it costs to live in Vancouver and how much it costs to live in San Francisco. Taking all of these factors into account, you could calculate the ratio of the Canadian dollar salary in Vancouver to the equivalent American dollar salary in San Francisco. This ratio would be one version of what is known as the real exchange rate. The real exchange rate multiplies the rate at which you can exchange currencies with one another by the ratio of price indexes in the two countries.

If the U.S. has a strong real exchange rate, this means that it is more expensive to live in America, and it is more expensive to buy American goods. A strong real exchange rate is good for domestic wealth (we can afford to buy a lot of foreign goods) but bad for the tradable goods sector (our exports are not competitive, and imports are attractive).

Table B-110 of the Economic Report provides measures of the real exchange rate. The so-called "broad index" takes a weighted average of the real exchange rates with a group of countries that are our trading partners. The units are index numbers, fixed to equal 100 in 1973. In the year 2000, the real exchange rate index was 102.9, and we ran an enormous trade deficit of $364 billion. If it would take a drop of 1 percent in the value of the real exchange rate to reduce the trade deficit by $50 billion, then the value of the real exchange rate consistent with trade balance is about 95.

When the real exchange rate is strong, we run a trade deficit. When it is weak we run a trade surplus. A country's trade cannot stay out of balance forever. If we run a deficit, this implies ever-increasing foreign debts. Eventually, foreigners will lose their taste for our currency, and it will weaken.

In the short run, the exchange rate is affected by asset markets. If the world's investors want to increase the share of U.S. assets in their portfolios, then they will buy U.S. securities. This will raise the value of the dollar. This will strengthen the real exchange rate, unless the prices of our goods fall and/or the prices of foreign goods rise to counteract the change in the currency exchange rate. Typically prices do not adjust quickly to exchange rate changes. Thus, the real value of the dollar will rise, and we will run a trade deficit. The world's investors get U.S. assets, in exchange for which U.S. consumers obtain more foreign goods and services.

In summary, the foreign component of output (Exports minus Imports) is affected by the real exchange rate. When the real exchange rate is strong, we run a surplus. When it is weak, we run a deficit. When it is "just right," we have trade balance.

The Real Interest Rate, Tobin's q, and Investment

If the real exchange rate measures the relative cost of goods across countries. then the real interest rate measures the relative cost of goods across time. Durable goods, such as houses, factories, and business equipment, are a mechanism through which people trade present consumption for future consumption. When the real interest rate is high, you can obtain a lot of future goods by giving up present goods. In other words, when the real interest rate is high, you get a high return on saving.

If you will be paid $10 interest a year from now on $100 savings today, is that a high interest rate? We cannot know the answer to that unless we know what to expect in terms of inflation. If the prices of goods and services rise by 10 percent over the next year, then in terms of purchasing power $110 next year is worth the same as $100 today. In that case, the real interest rate is zero, which is low. You subtract expected inflation from the nominal interest rate to get the real interest rate. If the nominal interest rate is 10 percent ($10 in interest for a $100 deposit) and inflation is 10 percent, then the real interest rate is zero.

Purchasing durable goods is called Investment. The higher the real interest rate, the less attractive it is to invest in durable goods. With a high real interest rate, you can obtain future purchasing power cheaply by lending money to a bank, so you do not need to take the risk of investing in a durable good. Another way to see the effect of interest rates is to note that many people and businesses borrow to finance the purchase of durable goods. The higher the real interest rate, the higher the cost of borrowing. Either way you look at it, investment costs more when the real interest rate is high.

When the real interest rate is too high, we will have an excess of Savings relative to Investment. When the real interest rate is too low, we will have an excess of Investment relative to Savings. At the "right" real interest rate, they will balance.

It may help to think of a bank as being in the middle of the balancing process. A bank pays interest to depositors and charges interest to borrowers. When the interest rate is too low, there will be many borrowers and few depositors. When the interest rate is too high, there will be many depositors and few borrowers. At the right interest rate, borrowing and lending will balance.

The late James Tobin, a Nobel Prize winner, pointed out that companies would be likely to invest in new capital equipment (durable goods) whenever the market value of new capital was higher than the cost of purchasing that capital. The ratio of market value to replacement cost was what he called "q." A high real interest rate tends to reduce q, because it lowers the market value of durable goods.

For companies traded on the stock market, q can be measured as the ratio of the value of the company on the stock market to the replacement cost of its capital equipment. Thus, Tobin's theory is able to connect investment with the stock market. This is an important linkage in the economy--when the stock market is high, investment will tend to be high.

We have said that the real interest rate is the price that helps to balance saving and investment. Alternatively, we can think of q, which varies inversely with the real interest rate, as the balancing price. Often, I prefer to use q, because it can encompass additional factors, such as investor expectations and financial market efficiency.

In general, financial markets and financial intermediaries play an important role in determining q. When financial markets function well, q is high. When many banks fail, or where banking is primitive, this lowers q and drives down the rate of investment. The miserable experience of Japan in the past decade reflects a financial collapse, low q, and low investment.

Japan also represents another potential problem--a liquidity trap. When investment is low, a country needs a lower real interest rate in order to increase investment. However, this may be impossible if inflation is close to or below zero, as it is in Japan. The nominal interest rate cannot fall below zero, because people always can just hold money and earn zero interest. Therefore, when the inflation rate is negative, the real interest rate must be positive.

Economists Brad DeLong and Lawrence Summers have argued that it takes an inflation rate of at least four percent to ensure that a country will not fall into a liquidity trap. That is, if investment is low relative to savings at a time when inflation is less than four percent, the interest rate could fall to zero and still not restore the balance between savings and investment.

Sectoral Imbalances and Aggregate Demand

Suppose that the government budget is balanced, but the real interest rate is high (alternatively, "q" is low) and the real exchange rate is strong. This suggests that saving will exceed investment and imports will exceed exports. However, that cannot happen, according to the definitions. What gives?

A "classical" view is that the real interest rate must fall and the real exchange rate must weaken until the imbalance is relieved. A purely Keynesian view is that aggregate demand will decrease, which will decrease income and saving as well as imports. The lower saving and lower imports will eliminate the excess, but at a lower level of income and output. Thus, the sectoral imbalances will be alleviated at the cost of a recession.

The standard macroeconomic view is a combination of the "classical" and the Keynesian--more Keynesian in the short run and more classical in the long run. In the standard view, everything starts to happen at once: the exchange rate weakens a bit, the real interest rate falls a bit, and output falls. In the long run, the exchange rate and interest rate move to their "right" values, and output returns to "normal."

Real Unit Labor Cost and Unemployment

In microeconomics, we learn that as long as prices are free to move, there can be no persistent excess demand or supply. In theory, this means that there can be no persistent unemployment, since high unemployment appears to be an excess supply of labor.

The price that should clear the labor market is the real unit labor cost. The real unit labor cost is the real wage rate divided by output per worker. The real wage rate is the wage rate divided by the price of output. Output per worker is the same as productivity. When wages are high relative to prices and productivity, real unit labor cost is high, and vice-versa.

When real unit labor cost is high, firms are not profitable. Unless they can increase sales, they have to cut back on output and on the demand for labor. This should put downward pressure on wages, which should fall until the excess supply of labor is eliminated.

In the real world, wages do not seem to fall to eliminate excess supply in the labor market. The reasons for this are much debated. It is one of the great puzzles of macroeconomics.

One characteristic of labor markets is that they are very dynamic. New matches between firms and employees are constantly being made, and old matches constantly are being broken. Unemployment is the difference between the two phenomena.

For example, suppose that at the beginning of April you leave your job, and you find a new job at the beginning of May. Then you are unemployed for one month. If this happens to people on the average of once every two years, then the average unemployment rate is 1/24, or a little over 4 percent. That is considered a relatively low unemployment rate.

Next, consider what happens if it takes the average person 1-1/2 months to find a job, rather than just one month. Assuming that people leave their jobs once every two years, on average they will be unemployed just over 6 percent of the time. That is, the unemployment rate will be over 6 percent.

Here is another way to think about the delicate nature of the labor market. If 3 percent of the labor force separates from their jobs in a given month, and 2.8 percent of the labor force takes a new job, then the unemployment rate rises by .2 percent, say, from 5.2 percent to 5.4 percent. This is considered a large one-month increase in unemployment--it will be reported by the press as a "jump" in unemployment.

From these exercises, it is clear that relatively small changes in the state of the labor market can lead to large aggregate changes in the unemployment rate. For an individual, having a job search extend to six weeks rather than four weeks may not suggest a need to lower his or her wage demands. Perhaps that explains why wages tend to be "sticky" even when aggregate unemployment is high.

If wages are sticky, then it is reasonable to expect that fluctuations in aggregate demand will cause fluctuations in the unemployment rate. As output falls, firms will cut back on employment. This in turn will reduce income, and this will reduce output further. This is a version of what Keynes called the "multiplier." Upturns and downturns can start to feed on themselves.

Fragile Equilibrium

If macroeconomic equilibrium were robust, then the real exchange rate usually would be close to the level needed to balance trade, the real interest rate usually would be close to the level needed to balance saving and investment, and real unit labor cost usually would be close to the level needed to keep the unemployment rate at a normal level. However, macroeconomic equilibrium is fragile, rather than robust.

Investment is affected by Tobin's q, which in turn is affected by investors' expectations for the future. Suppose that investors are optimistic (Keynes coined the term "animal spirits") and capital flows freely, as happened in the United States during the Dotcom Bubble of 1999 and the Telecom Bubble of 2000. In that case, q is high, and investment is high. On the other hand, when investors are pessimistic and capital is frozen, as in Japan in recent years, investment is low.

The trade balance also is affected by investor expectations. When investors are optimistic about the prospects for a country, as they have been for the United States, that country will have a strong real exchange rate. This in turn will lead that country to run a trade deficit.

Through much of the 1990's the world's investors were optimistic about Argentina. Then, suddenly, they became pessimistic, and a country that was habitually running trade deficits and issuing debt denominated in foreign currency suffered an economic collapse and a sharp drop in its living standards.

Sectoral imbalances can cause changes in aggregate demand and output, because the real interest rate and the real exchange rate are unable to adjust sufficiently to restore balance. In particular, when investors are pessimistic, aggregate demand can plummet.

Finally, changes in aggregate demand tend to translate into changes in employment. History shows that there can be large, sustained increases in average unemployment without a drop in wages sufficient to restore real unit labor costs to a level that brings labor supply and demand back into balance. Instead, when aggregate demand falls, employment falls, which in turn leads to "multiplier" effects that lower demand still further.

Keynes believed that when aggregate demand falls, an increase in the government deficit can help restore full employment. There are circumstances when this is true. However, there are examples where the latitude that governments have to run deficits is too limited. Neither Argentina nor Japan is in a position to borrow in large quantities, because the world's investors are not convinced that those countries can carry additional debt and reliably pay it back. In Japan's case, financing some of the deficit with money creation is an option, but in Argentina's case, it is not--hyperinflation already is a problem there.

In the fragile world of macroeconomics, financial institutions have to function well and investors have to be fairly confident. If, as in Japan, there is a collapse in investor confidence and financial institution performance, there may not be much that fiscal and monetary policy can do to alleviate the collapse in aggregate demand.