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Duration: 12:25

Level: Beginner

Macroeconomic theory is concerned with the size and output of a national economy. Economists measure the gross domestic product (GDP) of the economy, comprising inputs from individual macro pieces. Employment, consumer and government spending are a couple of the important pieces of the pie that drive growth in GDP.

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Study Notes:

Macroeconomic studies look at the performance of the economy as a whole. Economists want to dig into the performance, structure and behavior of businesses and consumers to examine decision-making driving the relative speed at which the economy is growing. There are certain growth regulators that can accommodate or restrict growth according to whether the economy needs to be cooled, if growth is too fast, or given a boost if it’s running below par. These include interest rates, taxation and government spending.

In the United States, monetary policy is under the control of the Federal Reserve. Its policy members control the price of money or the rate of interest to affect growth. In turn, they observe a whole host of macroeconomic datapoints to help understand growth, money supply and inflationary pressures. The Fed has a dual mandate of creating maximum employment and stable prices. If policy is loose or too restrictive, while that might spur economic activity, employment and spending, it might also spark unwanted increases in the price level. The Fed therefore might need to increase the cost of borrowing to cool economic growth.

US Congress controls levels of taxation, whether that is income tax or a levy on profits earned by corporations. In general, government can spur economic growth by targeting spending on areas that result in increased economic activity. This should increase employment and workers can spend more money, and the level of overall output increases. Government could reduce its spending levels when the economy is growing strongly.

In conjunction with spending the government has the power to tax.

The rate at which businesses and individuals are taxed can have an important impact on economic growth.

On the one hand, lower taxes on individuals might spur spending as people have more money left from their paycheck. But on the other, that would mean that the government is raising less revenue from economic activity, and thus has less to spend. There is also significant debate over the appropriate level of tax on corporations’ profits. The more companies are taxed, the less they have to invest. If companies are taxed at a lower rate, they argue that they will hire more people for the government to levy income tax upon. These are finally balanced arguments yet have become politicized over many years.

The combination of government spending and taxation is known as fiscal policy. While monetary policy is controlled by appointed officials at the Federal Reserve, policy is typically devoid of political process.

In other words, the policy-making committee at the central bank is not trying to win votes of the US population. The same cannot be said of US politicians who might adopt a populist policy of lowering taxes or spending more in order to boost the economy without regard for the impact on inflation. The Federal Reserve may be forced to counteract fiscal policy by tightening monetary policy to head off inflationary pressures.

Two schools of thought have dominated twentieth century economic philosophy. Keynesian economics and monetary economics. After the 1929 Wall Street Crash and ensuing Great Depression, English economist John Maynard Keynes published The General Theory of Employment, Interest and Money.

Prior to this, classical economists stumbled over explaining how goods were left unsold and workers were left jobless. Classical theory relied upon prices for goods and jobs falling until all goods were sold.

Keynes’s new theory reflected upon the depression and considered that, when times got tough, economic agents would hold on to their money – that is, they preferred liquidity rather than to either spend or invest.

Keynes also introduced two critical concepts of the multiplier effect and so-called animal spirits.

A change in investment or consumption could cause change throughout the economy. And so, when a shocking decline in stock prices and spending starting in 1929 rippled through the economy, its effects were magnified.

Shrinking consumption caused lower demand, which in turn created job losses, and further reductions in consumption. The result was a stagnant economy that created mass unemployment and a huge challenge for government policy.

Animal spirits were described as the natural self-interest and instincts that form the backbone of human behavior, leading to growing confidence to produce, buy and invest. Keynes noted the significant role that those animal spirits played in driving the economy.

Milton Friedman tried to explain the great Depression through the lens of the quantity of money in circulation, demand for money, its price and velocity. That means how fast money circulates through the economy. According to monetarist theories, controlling the growth in money supply along with the price of money were more effective than fiscal policies.   Stable growth in the money supply would be sufficient to grow the economy instead of constantly intervening with bouts of spending and changes to tax policy.

Basic Concepts – There are three concepts central to the study of macroeconomics.

  • Output and income
  • Unemployment
  • Inflation and deflation or the level of prices.

Output and income – During any given year, an economy produces a volume of output. Once again, these are goods and services.

When everything produced is sold, it generates an equal amount of income. Gross domestic product or GDP measures that total output.

Economists then divide the value of GDP by the population to arrive at GDP per capita or per person.

You could then compare the relative wealth of two competing nations.

Economists consider output and income equivalent, and so it doesn’t matter which method is used to measure the economy: Both will arrive at an economy of the same size since output changes into income. Output measures the total value of final goods and services, or the sum of all value added to the economy.

Economic output tends to increase over time. That is because of advances in technology, more efficient and better machinery, improvements in education leading to a smarter labor force and productivity gains over time. However, often for unforeseen circumstances, the economy is subject to the business cycle in which case output fluctuates.

When output declines, the economy may temporarily slip into recession. A mix of fiscal and monetary policy measures can be used to address the temporary lull in activity in order to lead the economy back into an upswing. The imperfect view ahead by policy makers can make this a tough challenge. They may not foresee or realize the impact of a drop in consumption or an increase in price levels or misjudge its impact.

And of course, things don’t always follow a plan.

Crude oil prices, which are at the heart of most manufacturing processes and have a significant impact on consumer spending, are subject to controlled supply and can have significant impact on economic activity.

Unemployment – Any economy is comprised of people, some of whom are young and in education. Some are retired, but most are willing and able to work. When an economy is growing strongly employment is high making it difficult for companies to fill additional positions. When the economy is in recession, a lower level of overall demand forces companies to furlough or fire workers and jobs become harder to get. The proportion of people unable to find but are willing to work is represented by the unemployment rate. The rate of unemployment is politically sensitive. Few returning presidents have been able to win reelection when the rate of unemployment has been high, which is why economic policy seeks to create jobs, boost economic growth and spending and push down the unemployment rate.

There are different types of unemployment that create challenges for policy makers. A woman looking for work in Philadelphia may be uninterested in applying for a role in Los Angeles. Cheap imports of steel from another country might make it economically unviable to produce steel in the US. There have been many cases where entire industries have folded leaving pockets of high unemployment when a specific industry dominates towns or areas. Employers may turn away applications from workers as they get older, favoring younger and easier to train cheaper labor. Unemployment among workers of specific education, class and age can pose policy challenges.

Inflation and deflation or the level of prices. Economists look to the general level of prices to examine the stability of an economy and to understand the way in which policies are working. A common method of monitoring the price level is to construct a price index. This takes the form of a basket of prices for popular or at least commonly used goods and services. The stability of the basket is paramount. Rising prices are defined as inflation and erode the value of incomes. If embedded within an economy, such price increases can spiral and undermine the economic system forcing remedial monetary policy action. Rising interest rates intended to combat price increases by raising the cost of borrowing can cause the economy to fall into recession.

Falling prices are likely to reduce the level of national output and potentially lead to deflation. Falling prices can be more difficult to remedy than rising prices.

The Central Bank: A country’s central bank is generally accountable for monitoring macroeconomic variables and setting monetary policy accordingly. Raising interest rates can have the effect of reducing the money supply and preventing inflation. Conversely, by lowering the cost of borrowing, the central bank can stimulate activity and increase money supply and ultimately economic activity.

Macroeconomic policy. Governments usually set macroeconomic objectives to maintain a stable economy with steady growth. Policymakers tend to use both monetary and fiscal policy measures to achieve stable growth. One objective is to mitigate the effect of the business cycle in order to achieve growth within a specific range, in addition to keeping prices stable and achieving full employment. One of the major challenges of mitigating the business cycle is the dynamic nature of changing relationships.

For example, consumer spending is a function of not just income and employment, but also household wealth. In turn wealth is a function of equity amassed in both the housing market and the stock market. Attempting to apply the same monetary and fiscal policy remedies across time when household wealth might be high and even higher can present persistent challenges to policymakers. On the flip side, policymakers may decide not to tighten monetary policy following a deep and sudden decline in stock market prices for fear of causing further damage to those same animal spirits that shaped Keynesian thinking following the Great Depression.


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