1.4 Macroeconomics and Policy

© 1999-2020, Douglas A.Ruby (06-02-2020)

Macroeconomics is the study of economic behavior in the aggregate. The approach is to understand the activities of households and business as a group in addition to the behavior and role of local and national governments. The study of macroeconomics must begin with a solid understanding of the individual behavior of these households, business firms,and government entities such that there is consistency with behavior in the aggregate. Macroeconomic understanding and explanation must rest on solid microeconomic foundations.

The primary characteristics to be analyzed in the field of macroeconomics include:

These topics are all in support of determining the best way to improve living standards for each person, country, and region around the planet.

1.4.1 Economic Growth

It must be assumed that populations will grow. The world population is growing at a rate of 1.5 - 2% per year. At this rate, world population will double in the next 35 to 50 years. In order to maintain current living standards, the production of food, clothing, shelter, health care, and educational services must also grow by, at least, an equivalent rate. Improvement in living standards require that growth in output exceed the rate of population growth.

Potential GDP and Real GDP

The gray trend line indicates an approximate 3% rate of growth.

Some might argue that the best way to improve the standard of living in a given nation is to reduce the rate of population growth. But this is to ignore demographic considerations. It is true that the rate of population growth can be excessive such that a human beings tend to live at the edge of subsistence and their basic needs are seldom met. The result is greater infant mortality, a less productive population, and shorter life expectancy. Life at the edge of subsistence requires that most resources be used for the production of food, shelter, and clothing such that few resources are available for the creation of capital.

The Standard of Living: output per person available in a given economy. This measure is often calculated as the ratio of Gross National Product and Population.

However, it is also true that population growth rates below replacement levels create structural difficulties for the demographics of a nation. Lower birth rates and lack of in-migration imply fewer young people to support the labor requirements of a nation and inability to support a growing cohort of elderly and retired citizens

Economic growth is typically measured by growth in the production of final goods and services in addition to the accumulation of capital. This latter concept represents the addition to a nation's wealth -- wealth that will be used to produce future output. Nations that often experience high rates of economic growth find that this growth is due to the creation of capital goods: office buildings, apartments, and houses; factories and machinery; transportation equipment and networks; and other types of public and private infrastructure. Resources are often devoted to the creation of capital goods in the expectation of future need and demand.

Economic Growth: the percentage change in aggregate output over some period of time -- usually a calendar year.

However, between the time resources are committed and the project is completed economic or market conditions may have changed such that the need for the project no longer exists. It may be the case that managerial or technical expertise is lacking such that productive use of these capital goods is not possible. A completed capital project for which no market demand exists can not be considered an addition to the wealth of a nation. Resources were committed and wasted. Economic growth based on the over-accumulation of capital is not sustainable.

Sustainable economic growth should be that rate that at a minimum exceeds the rate of growth in population, supports growth in living standards but is not excessive such that poor choices are made with respect to the development of the capital stock. Determination of this rate of growth is a primary consideration for any nation.

1.4.2 Employment of Resources

An economy should use its resources to attain the maximum output possible with the inputs available and, as a related goal, employment of people to allow them to privately earn an income that allows for satisfying basic needs. In addition, this income can provide the incentives for individuals to produce in excess of their physical needs and human wants.

These resources should be used in an efficient and effective manner. Under-utilization of factor inputs results in an economy producing at a level below its potential. The opportunity to produce goods and services that are needed or desired is forever lost. Unemployment

Lost output is not the only problem with under-utilization of resources. There is the real effect on human beings who cannot find work and earn a sufficient income necessary for their survival. Unemployment in labor markets takes its toll on individual workers and households. Lack of work results in lack of income to purchase needed goods and services in addition to the lack of an opportunity to contribute to the production these goods and services.

Unemployment: Factors of production available to factor markets but not being hired or employed in the production process. In market-based economies, this results in inefficiency in resource allocation and lost output. Overemployment

Over-utilization may also be a problem in that machinery is not properly maintained and thus wears-out sooner or labor markets become so tight that wages and thus production costs increase at an undesirable rate.

The proper balance in the employment of resources is dependent on an efficient functioning of labor, capital, and natural resource markets. Inefficiencies are introduced due to the information and transactions costs inherent in the functioning of these markets. These information costs include the costs of disseminating information about employment opportunities and labor needs of business firms in addition to information about worker availability, ability, and productivity. Transaction costs include those costs related to the maintenance of the legal and political framework required to ensure the enforcement of contracts, the provision of insurance, and the avoidance of discrimination.

1.4.3 Price Stability

In a market economy, relative prices act as signals about surpluses and shortages that may exist in individual markets. Where a surplus or shortage is present, a reallocation of resources may be necessary. Inflation and Resource Allocation

Understanding this notion of relative prices helps us understand how inflation can cause problems for a market economy. In an inflationary environment, all prices are rising although often at different rates. It may be that the price of housing is increasing by 5% per year and the price of food is increasing by 8% per year. The overall rate of inflation would be some average of these two values combined with price changes of other consumer goods. For individual producers and consumers, it becomes difficult to distinguish between a change in relative prices (such that one good is more valuable relative to other goods) and a change in all prices due to the inflation. In an inflationary environment, individual producers may often confuse a change in the price of her/his particular good as a relative change with the reaction that s/he allocates more resources towards production of that good. A reallocation of resources mistakenly takes place. Thus, inflation can cause inefficiencies in the marketplace in that it distorts the signals necessary for the proper allocation of resources. Borrowing and Lending

Price stability is also important for the proper functioning of financial market in that savers seek to protect the purchasing power of their wealth invested for different periods of time.

The savings of a household represent the difference between what was produced by the household, as measured by the income earned, and consumption of goods and services desired by that household measured by spending. This difference represents a release of resources for other uses. These savings are an addition to that household's wealth to be drawn upon to support future spending needs. Other households, business firms or governments may borrow these resources to meet immediate spending needs, acquisition of inventory, creation of capital or other infrastructure projects. The actual process of savings involves the placement (or supply) of funds into the financial sector of an economy.

Borrowing involves the demand for these funds with an expectation to repay the principal borrowed plus a percentage of the income generated with the use of these borrowed funds. Borrowing allows an individual or institution to acquire resources to create income-producing assets -- assets that contribute to the growth and wealth of a nation. Repayment allows the lender to consume in the future in excess of income earned. The accumulation of wealth and the income it produces (through production of desired goods and services) allows for the payment of a percentage in excess of the principal -- the interest rate. Interest payments represent a reward to lenders (savers) for lending to an increasingly productive economy.

Inflation can reduce the purchasing power of these funds to be repaid. The quantity of goods and services that could have been purchased at the time lending took place is greater that the quantity of goods that may be purchased given the higher prices that might prevail when repayment occurs. Lenders attempt to protect the purchasing power of their wealth by attaching an inflation premium to what they think is a proper reward (interest) for lending to a productive economy. This inflation premium is based on expectations of the future rate of actual inflation. Borrowers will agree to this premium if they share the same expectations. However, if these expectations are incorrect either lender or borrower may suffer. If the actual rate of inflation exceeds what is expected, lenders will be repaid with funds that have less than expected purchasing power. The reward for lending may be wiped out. If the actual rate is below expectations, the borrower may find himself in the position of having to pay an interest rate (inflation premium included) that exceeds the rate of return of a given investment project--the debt becomes difficult to service with the income earned. Inflation as a Tax

Finally, inflation can act as a tax--used to transfer resources from the private sector to the public sector. Governments can print money to buy goods that were previously purchased by private individuals. The printing of money does not lead to any new production of goods. But, the competition from the public sector causes a shortage with an attendant increase in prices such that the money incomes in the private sector have less purchasing power--fewer goods and services are purchased by private individuals releasing those goods to the public sector. Deflation

We must also note that deflation also has serious consequences for a market economy. In deflationary times all prices are falling; goods and services, financial assets, and factor incomes. Just as inflation erodes the purchasing power of money lent, deflation increases the burden of debt. If the deflation is not fully anticipated, borrowers will find that they have agreed to debt contracts under the assumption of steady or perhaps growing income and revenue. If these incomes are falling, then the interest payments and repayment of principal will represent a larger fraction of this income. Borrowers often react by defaulting on this debt leading to problems for the financial sector of the economy and consequent liquidation of collateral assets. This liquidation just furthers the price decline of assets -- fueling the deflation. Debt combined with deflation, a debt-deflation, can easily tip an economy already in recession into a full-blown depression.

1.4.4 International Linkages

Over the past generation, the global economy has evolved through the lowering of trade barriers, freer movement of factor inputs (labor & capital), and the development of highly efficient financial markets.

From a policy perspective, international trade and finance can be tricky. There are real, and often perceived, winners and losers. Attempts to realize gains from trade through specialization and exchange may make goods and services cheaper but sometimes at a cost to employment in domestic industries. The benefits of increased purchasing power through these lower prices is widely dispersed and thus often difficult to quantify. But the costs measured in job losses and Structural Unemployment is often concentrated and highly visible.

Trade deficits will be offset with surplus capital inflows or financed by internal holdings of reserve currencies. The deficit might be perceived to be a bad thing but the inflows may help to finance deficits in the public sector or demands of private sector borrowing. The obverse can also be true with capital inflows being a consequence of safe-haven characteristics such as is found in the U.S. but with the consequence of a stronger dollar, less competitive (more expensive) exports and relatively cheaper imports resulting in further trade deficits.

Smaller, less developed, economies find that in the absence of this safe-haven status, they need to protect against volatile capital flows by holding significant stocks of reserve currencies to protect the foreign-exchange value of their domestic currencies. Policy-makers in different nations have come to realize that shocks in world markets can have a profound effect on their economy. Exchange Rates, which facilitate the movement of goods, services, factor inputs and financial assets, are highly sensitive to domestic economic and political conditions.

Policy makers might find that they are hamstrung by considerations of international finance that may run contrary to domestic economic policy needs.

Concepts for Review:

Top of page related: Economics as a Social Science previous: Markets and Equilibrium Macroeconomic Theory
© 1999-2020, Douglas A.Ruby (05-20-2020)