Chapter 10 Macroeconomic Variables
What is macroeconomics?
- the study of the economy as a whole, and the variables that control the macro-economy.
- the study of government policy meant to control and stabilize the economy over time, that is,
to reduce fluctuations in the economy.
- the study of monetary policy, fiscal policy, and supply-side economics.
Is macroeconomics the same for all countries?
- the major variables describing the macro-economy are the same.
- the three major policy approaches are the same
- but the quality to which these policies are applied differ from one country to another; this
because the political process from which these policies emerge are unique to each country.
What three main differences separate micro- and macroeconomics?
- First, microeconomics studies individual components, whereas macroeconomics studies the
economy as a whole.
- microeconomics treats the economy as so many separate components, whereas
macroeconomics treats the components of the economy as one unit, as one aggregate, that is
looks for relationships between the various components.
- Second, controversy aside, government involvement in microeconomics is relatively small,
and relegated to public goods, regulation, and welfare.
- But, controversy notwithstanding, government involvement in macroeconomics is rather
substantial, nearly total; it is only government that makes and enforces monetary and fiscal
- Third, whereas microeconomics has been around since the mid eighteenth century,
macroeconomics began only as a reaction to the Great Depression of the 1930s.
Who introduced macroeconomics, and what was its major objective?
- John Maynard Keynes, an English economist, hence macroeconomics is also referred to as
- Keynes argued that by itself the market is unable to generate enough savings (capital) to
sustain investment at full employment levels; and that this could be achieved only with the
periodic sharp increase in government spending.
Why is macroeconomics said to be a typical public good?
- a typical public good has the unique characteristic of nondivisibility and nonexclusive.
- a product is said to be nondivisible if a unit consumption of such a product does not diminish
the quality nor quantity available for other consumers, e.g, air, defense, and stabilizing the
- a product is said to be nonexclusive if its lawful owner cannot enjoy
it unless he or she allows
equal quality and quantity consumption to non-contributors; e.g., a light house, a private rose
garden, information from a US weather satellite, the air purifying effects of the Amazon
- Public goods and services (bads) do not ascribe to the laws of market exchange, their
consumption is indivisible, so their consumers don't feel the responsibility to pay for them,
and their lawful owners lack the necessary control to charge for and profit from trading them.
- similarly, stabilizing the economy is a typical public good that yields lots of positive
externalities including these two:
- First, gathering, analyzing, and distributing information that goes into the making of
macroeconomic policy is very expensive, requiring the hiring of thousands of workers,
including some of the nations' top macroeconomists and statisticians, a task no single
individual however rich can perform, leaving it to government-a typical collective good.
- Second, the effects of a stable economy are enjoyed by all, producers: to plan production,
consumers: to know when to buy, when to demand wage increases, and this regardless
whether or not the support the reigning government, pay their taxes, or like to live under
What are economic indicators of macro-economic variables; and why is knowledge about them
- Macroeconomic variables are indicators or main signposts signaling the current trends in the
- Like all experts, the government, in order to do a good job of macro-managing the economy,
must study, analyze, and understand the major variables that determine the current behavior
of the macro-economy.
- So government must understand the forces of economic growth, why and when recession or
inflation occur, and anticipate these trends, as well as what mixture of policy will be most
suitable for curing whatever ills the economy.
- Of the many economic indicators listed on page 120-21 of your book, you will be tested on
knowledge about these twelve: average prime rate, consumer price index, Dow Jones
Average, foreign balance of payments, inflation rate, money supply, NASDAQ, producer
price index, trade balance, unemployment insurance, unemployment rate, and US Treasury
What is economic growth?
- Economic growth is a measure of expansion of the economy over time.
How is growth measured?
- It is measured over time relative to the performance of the economy over the exact same
period in the immediate past, such as the economic calender year, that is, Oct. 1st to Sept.
30th, or a quarter, that is, three months.
Why is growth important?
- it enables wage and income earners, producers, and even macro-economic planners to take
appropriate rational pre-emptive action that avoids any negative effect of a major change in
the direction of the economy.
In which three ways can growth be defined?
- the final market value of goods and services produced by the property and labor of all but
only of residents of a country.
- a measure of the annual growth and expansion in size of the economy
- a measure of the relative economic strength/power of a country
- GDP was first calculated at the request of President Roosevelt in order to adequately plan
US preparedness for WW II .
- GNP stands for the Gross National Product, a measurement of the annual economic
productivity of the property and labor of all but only citizens of a country regardless where
this activity occurs in the world.
- GDP stands for the Gross Domestic Product, a measurement of the annual productivity of
the property and labor of all citizens and foreign residents within the geographic borders of a
country including its foreign territories such as embassies and purchased military bases
- GDP divided by population is called the per-capita GDP, a measure of the annual
improvement in the standard of living of the average citizen/resident of a country.
Imperfections of the GDP
- First is the problem of double counting which could lead to an exaggeration GDP. Solution:
Whether you measure the GDP by spending, by production, or by income, be sure to count
final market value of goods and services only once.
- Solution: Be sure to exclude: cost of intermediate goods and services, market products that
are meant not for direct consumption but for use in further manufacturing and processing;
transfer payments, purely financial transactions like buying and selling of securities, welfare
payments, and the cost of resold items like used cars.
- Second, GDP exaggerates actual improvement in the standard of living. Take a look at
figure on page 117 of your book.
- Real income is nominal or money or unadjusted income adjusted for inflation.
- Because GDP = sum [Q (quantity) x P (price)]; an increase in GDP can be just the effect of
higher prices-called inflation.
- Solution: deflate the real-GDP which takes out the effect of P, and hence, inflation in the
- To get the Real GDP, divide GDP by the GDP deflator index and multiply by 100
- To get the Price Index, also called the Deflator Index, divide the given year price by the base
- To find the base year, look for the year whose price is equal to 100%. (Practice with Table
10:1, p. 118).
- The base year is the year the economy is assumed to have 0 % inflation; therefore, we choose
for the base year, years in which the economy was most stable, has least amount of inflation.
- Therefore, the real-GDP is no more accurate than as a comparison between two economic
periods; Paul is taller than John, but shorter than James.
- GDP reflects only the dollar worth of the economy, not the economic well-being of citizens.
# does not take account services produced at home.
# adds the income from economic activities that detract from the well being of citizens such as
drug trafficking and use.
•developing country real-GDP excludes all of their rather significant but nonofficial
economic sector because of lack of records.
- Third: even the real-GDP gives an inaccurate reading of actual improvement in economic
well by not taking into account useful productivity such as self-provided household services,
while adding non useful ones like income from accidents and drug activity.
- Four: per-capita-GDP does not reflect in-state distribution of income.
- Five: per-capita-GDP understates the productivity of developing countries: See Table 10:2,
•does not include much of the rural non-pecuniary economic activity that does not pass
through the market such as self-subsistence production, and reciprocal, communitarian, and
- Forecasting intended to reduce the level of uncertainty about the future trend of the economy
is necessary for the rational planning of production, and hence for the overall efficiency of
- Short term economic forecast, up to 8 quarters ahead.
- Medium-term economic forecast, is between 2 to ten years
- Long-term forecast is any prediction more than ten years ahead; special cases call for
prediction of 30 years ahead.
- Forecasting is made a little easier by the recurrent nature of the business cycle, enabling
macro-economists to establish statistical regularities as formula for predicting the economy.
- But statistics not withstanding, economic forecasting is not a precise science and predictions
may often be off target. Yet forecasting still serves the useful purpose of giving us, within
broad limits, a sense of where the economy may be headed, allowing consumers, producers
and government macroeconomic policy planners to plan ahead with some level of rational
The Business Cycle
- No economy however strong ever follows a straight growth path; all economies fluctuate
- Fluctuations in the economy (GDP) over time are referred to as business cycles.
- The Great Depression forced neoclassical economists to accept for the first time that
business cycles and the extent of fluctuations in the economy are both significant.
- For a number of theoretic and historical reasons, both classical (1776-1871) as well as
neoclassical economists had prior to the Great Depression, believed business cycles would
be weak and insignificant for the overall production.
- the first two decades of this century were expansionist and pro-growth years.
- World War I, the cause of the first serious disturbance in the U.S. economy, was seen as
externally induced, and not the fault of the U.S. economy.
- the roaring 1920s suggested the economy as a whole was so strong it could not fail even if
some industries fail.
- The Great Depression, therefore, caught economists completely off guard as for nearly
twelve years 1929-1941, the economies of the US and Western Europe plummeted, resulting
in 32% drop in the GDP with unemployment rates reaching a high of 28% in 1932.
- Since then, the US economy has been pro-growth with five notable recessions, none of
which lasted long, suggesting the overall economy remains healthy, reaching its historical
high in the current 1993 to 2000 period.
Nature of a Typical Business Cycle.
- The typical GDP growth path goes from trough to recovery to peak to decline and back to
trough (Figure 10.4), with six known broad characteristics.
- First, though they follow typical patterns, no two business cycles are ever the same.
- Second, with increased economic interdependence and interconnectedness among countries,
especially among the Western industrial countries, business cycle changes in one country
quickly draw the other economies into similar behavior.
- Third, the business cycle is an inherent part of all money-using economies, so nothing to
worry about when the economy goes down south, provided it is healthy enough to recover.
- A change in the flow of the economy (GDP) occurs whenever there is a significant change in
the money supply, a change which could be caused by any of the following:
- introduction of new technologies like the computer, the Internet.
- shift in consumer demand and not a change in demand cause by change in income.
- sharp increase in government spending.
- change in consumption of imports.
- major change in the capital stock (capital available for investment).
- Four, forces at work in a typical business cycle are cumulative, each phase generating its
own momentum and counteractive forces that beget the next phase.
- Five, Government policy intended to control one side of the business cycle might wind up
inducing the other. E.g., generating unemployment to fight inflation may end up throwing
the economy into a recession. (More on this later).
- Six and finally, fluctuations in the GDP over time are not even across industry.
So What Is a Healthy Economy?
The economy is healthy, that is, stable and steady over the long term if:
•fluctuates but not widely out of control;
•is able "to stay between the lines" meaning the actual growth path stays close to the
projected growth path;
•able to avoid long-drawn recessions;
•able either by itself or with a little help from policy, to pull out of recession and inflation;
•does not have any major structural constraints so that it can respond to policy.
Are the concepts of a healthy and an efficient economy the same things?
- No, they are not the same. An efficient economy is one performing at 100% of its potential,
called its productive potential.
- A healthy economy can exist at any level below this superlative but has the potential of
achieving its productive potential.
- A high rate of resource and labor utilization gives indication the economy is on an upward
swing nearing its peak, whereas a low resources utilization gives the opposite indication of
an economy significantly underperforming its capability, and therefore, not healthy.
- Fine-tuning the economy is the calculated alternating between anti-inflationary and
anti-recessionary policy measures in other to keep the economy stable in the happy middle
between inflation and recession and to minimize the impact on consumers of GDP
What is a Full-employment Economy?
- An efficient economy is one that has the two pre-requisites for solving the scarcity problem
in an optimal manner.
- First, it means the economy is in full employment, meaning all available resource, including
human skills, are being engaged in production.
- Full employment economy is said to exist whenever the unemployment rate falls below
5.5%, which represents the level of voluntary unemployment not caused by the non
availability of jobs.
- Full employment unemployment is said to be voluntary because economists believe that at
full employment, all it will take to fine jobs is a change in attitude on the part of the
- Those likely to choose voluntary unemployment when the economy is at full employment
will include those between jobs-the frictional unemployment-, social drop-outs, workers who
leave their jobs to raise children.
- Second, an efficient economy must also have full production, utilization of resources where
they are most appropriate and so likely to be most productive. An efficient economy must
not have significant underemployment nor underutilization of resources.
- Which suggests that an economy can only be efficient and operate at its productive potential
if it trains its youth properly before they enter the work force; if has the most appropriate
technology, if it has plentiful investment capital, and if it invests sufficiently in R&D
(research and development).
- But an efficient economy is by itself not synonymous with development. A country is said to
be developed if it has all the elements of an efficient and healthy economy operating within a
socially civilized environment including the practice of the rule of law, democracy, and
justice, especially for its less politically powerful social and economic groups.
- Unemployment, the % of the workforce (in the US people between ages 18-65) out of work
because of unavailability of jobs, is made to sound as a crisis because it is (a) personal, and
in a money economy, (b) total, that is, short of the 26-week unemployment compensation,
and (c) and one of the changes in the market place that is quickly turned into political
opposition to government--the unemployed is an angry uncertain voter.
- Thus unemployment frightens politicians, while macro-economists and political economists
are mainly worried about inflation
- Seasonal unemployment is tired to seasonal occupations, and not a major concern for the
economy except for those seasonal workers whose pay is too little to save up against the
expected unemployment season.
- Cyclical unemployment is part and parcel of a money economy, and is brought on by
speculation of profits and bursts in business.
- Frictional unemployment is another name for labor turnover, when new workers enter the
workforce as old ones retire or die and when workers change jobs.
- Economists look favorably on a high rate of frictional unemployment as indication the
economy is strong enough to give workers confidence to seek to match their skills to higher
paying jobs, an indication of a healthy economy.
- Structural unemployment caused by a lag between change in production and change in
labor (skills and mobility), meaning the economy becomes rigid, unable to respond to both
market as well as policy incentives to change course-the lost of fine tuning ability.
- Structural unemployment tends to be regional, and industry and racially-specific, not across
the board, as a result, aggregate policy measures (policy incentives directed at the economy
as a whole) is not very effective in removing pockets of structural unemployment.
- Recession sets in if the GDP rate is negative for four consecutive quarters. But just two is
enough to set of recessionary alarms and speculative reaction.
- The National Bureau of Statistics defines a recession as any period in which the GDP
dropped for two successive quarters (six months). The obvious difference is a matter of
judgment, the depth of the fall in output, the severity of labor unemployment, and the
Bureau's known sensitivity to the political implications of a decline in economic activity.
- A protracted and severe recession is a depression.
- Speculative recession acts as a self-fulfilling prophesy: Because economic agents suspect
there would be a recession, they adopt reactionary measures that actually trigger one, e.g.,
- U.S. economic has showed generally positive growth since WWII with nine notable
- Recession per se is not bad, provided the economy has no major structural constraints that
might prevent it from responding to market and policy incentives to change course.
- Apart from the four causes of unemployment named above, recession may occur as a result
of mere business speculation and the reaction of rational consumers and producers to shield
themselves from the negative impact of a future trend in the economy.
- Recession accompanied by unemployment is not always bad: At times, it becomes the only
cure against inflation the bigger of the two evils.
- The philip curve theory argues that the economy cannot stay at full employment for a long
time without triggering inflation. This forces policy makers to accept unemployment to fight
inflation. E.g., The Reagan induced recession of 1982-83, reduced inflation by pushed
unemployment into double digits.
- Anytime the economy grows so fast it pushes all prices significantly and for a protracted
time above the actual utility value of goods and services.
- Inflation is particularly bad for the economy because it affects everybody and all segments of
the economy, distorting prices and undermining the clear relationship that must exist
between value and price, the very basis of market exchange.
- Demand-pull inflation occurs whenever there is a sudden and significant jump in consumer
demand which stays way ahead of supply. E.g., post-Viet Nam War boost in demand +
Johnson's Great Society expenditure.
- Cost-push inflation: a major shift in the cost of production which are passed onto consumers
in the form of increased prices. E.g., the 1973-78 ten-fold increase in oil prices as a result of
oil boycott by Arab countries.
- A special form of cost-push inflation is market power inflation, or profit-push inflation, the
result of monopolies' unchallenged ability to set prices above price equilibrium prices and to
force consumers to absorb those prices.
- Wage-price spiral inflation: is cause when a sudden sharp increase in consumer prices leads,
through unionist activity, to increased wages, which in turn leads to a 2nd and 3rd rounds of
still higher prices, and wages.
- Expectation inflation is caused by an inflationary psychosis, a crippling fear of inflation
that so dominates the public it forces consumers and producers into taking actions that
actually trigger inflation as a self-fulfilling prophesy. E.g., the general panic following the
Stock Market crush of 1929 leading to over a decade of Depression.
- Full-employment inflation is caused when demand continues to be strong when the
economy is already at full employment and all available resources, including labor, is already
engaged. Supplying that demand will add to cost and prices because:
producers are forced to use inferior resources and less competent labor
•producers are forced to tap into expensive overtime work
•over-utilization of factory plants results in a higher rate of machine depreciation
•productivity of overstretched workers declines
•producers are forced to increase wages to retain efficient labor
•producers are forced to pay higher than normal wages to attract the frictionally
THE CONSUMER PRICE INDEX
- The CPI is the best barometer of the rate of inflation; it measures the increases in the price of
a typical basket of goods and services the average city dweller would consume.
- To capture the consumption pattern of a typical city dweller, it was necessary to change
some items in the typical basket of goods and services; some food and beverage items and
medical care have been replaced by things that reflect our modern communications age like
telephones, computers, and the cost of education.
- Increases in the CPI is both indication of increased prices as well as consumers confidence to
spend money as opposed to consumers' fear of pending disaster which would cause them to
safe against an uncertain future.
- Increased consumer prices in the face of increased consumer confidence in the economy
amounts to double jeopardy because it means consumers are buying more at a time when the
purchasing power of their dollars has declined.
- A periodic jump of 3% in the CPI is generally accepted as the on-set of inflation.
- Thus the CPI also serves the useful purpose of telling government and other wage payers
how much to increase money wages to bring them to 1000% purchasing power.
- Interest rate is the cost of borrowing money: cash, credit, bonds, stocks, mortgage,
- Interest rates reach a peak just before recession, and fall throughout the recession.
- Rising interest rates signal an expanding economy, and when already high interest rates
begin to rise even further and faster, that is a sure sign of the on set of inflation.
- Fine-tuning interest rates is a key monetary instrument of government:
- To fight recession, lower already low interest rates.
- To fight inflation, raise already sharply rising interest rates to discourage would-be money
borrowers and so reduces the volume of liquidity.
- Often however, using rising interest rates to fight inflation leads the economy directly into a
THE MONEY SUPPLY/THE RATE OF LIQUIDITY
- Liquidity is that part of money that can be accessed for immediate transaction: if you can
cash it, it is part of liquidity.
- Liquidity rate is the % of total GDP that is liquid.
- Monetarists see a link between the liquidity rate and the timing of recession or boom.
- High liquidity, high rate of production.
- Low liquidity, low level of production.
- Money or to be more precise, the current volume of money or the liquidity rate has three
functions that together control the beat of the economy:
- money is the medium of all economic transactions or exchange
- money is the store of value over time, the more reliable the better
- Money is a commodity that can be traded for
its value. Money or the cost of borrowing it is an important macroeconomic tool for stabilizing the
Question: What is the Federal Reserve System’s role in macro-managing the
The Federal Reserve System is the central bank of the United States and the
institution through which government carries out its monetary policy.
The banking system is a critical part of US political economy, where
government and the private banking system cooperate to ensure the economic
health of the country.
Not all commercial banks are members of the Federal Reserve System, but most
The government can act through the banks because their chief commodity,
money, is nothing but the debt of commercial banks and government. Money is
essentially government IOUs. (More on this shortly).
The Federal Reserve System is designed for maximum independence from other
branches of government, especially, the executive presidency, in order to
suggest the independence of monetary policy from political controls, especially
of the sitting president.
The Federal Reserve Board of Governors: or the Fed, the core of
the Federal Reserve, consists of seven appointees of the president confirmed by
the Senate, and is most directly responsible for setting individual bank reserve
requirements, as well as the final discount rate.
The 12 Presidents of the Federal Reserve District Banks is collectively
responsible for establishing and recommending to the Fed the discount rate. (More
on this later).
The Federal Reserve Open Market Committee, made up of 7 Fed
representatives and 5 Federal Reserve District Bank presidents, has exclusive
responsibility for determining when to sell or buy government bonds and how much
is necessary to fight recession or inflation.
The Federal Reserve Advisory Council, a 12 member advisory council which
together with the Consumer Advisory Council and the Thrift
Institutions Advisory Council advises the fed on its macro-management
The Twelve Federal Reserve District Banks each representing one of the 12
banking districts in the country and responsible for all banking activities
within the districts, including:
(a) the coinage and distribution of the country’s currency;
(b) the operation of a nationwide payments network,
(c) supervising and regulating member banks and financial holding companies;
(d) issuing, servicing, and redeeming Treasury securities or bonds;
(e) conducting nationwide auctions of Treasury securities;
(f) daily monitoring of federal tax receipts;
(g) meeting every two weeks to recommend to the Fed, the discount rate.
25 Federal Reserve Branch Banks created over time to aid in the ever
expanding banking and monetary responsibilities of the Federal Reserve District
Member Banks of the Federal Reserve System are commercial banking
institutions that form the vital link between individual US citizens and
residents and the Federal Reserve System. Members banks are required by law to
subscribe to stock with their Federal Reserve Regional Bank in amount equal to
three percent of their total capital and surplus.
Consumers, the millions of individual persons and institutions brought
into the monetary system as customers of commercial banks, as borrowers of
money, and generally as uses of government commercial debt (also called money).
The effectiveness of Fed monetary policies depends greatly on how
successfully these policy alter consumers’ demand for money habits; and
in turn, on how much confidence consumers have in the fed’s monetary policy as
well as the money it issues.
The Logic of Banking
The Role of Consumers: The banking system is a system built on the trust
and confidence of the public that its hard earned money when deposited with
banks will retain their value over time as well as earn some interest; thus the
decision to consume now or consume in the future will not be a false empty
choice. This trust is based on four considerations:
a rational weighing of personal current versus future consumptive needs
and the projected future trends in prices;
current versus future interest rates; whichever is higher will determine
consumers’ demand for money;
consumers’ confidence in the banking system to deliver on its promises;
consumers’ confidence in the stability of the economy as a whole.
The Role of Commercial Banks: Their primary task and objective is to
retain the confidence of their depositors by being in position to honor their
withdrawal demands at all times.
This they do by maintaining a fraction of their total deposits or liabilities
as reserves with the Federal Reserve District Banks.
The Role of the Federal Reserve System: The Fed determines the amount of
commercial banks’ total deposits they must keep as reserves in order to
maintain the public’s confidence in the banking system.
Commercial banks and other financial depositories submit to the Fed because
their interest of maintaining a steady value of money coincides with, indeed, is
exactly the same as the interest of the Fed, as the monetary branch of
government, to ensure that at anytime the money supply is exactly equal to the
actual total value of goods and services, in order words, to ensure zero
In return, commercial banks and other financial depositories benefit from the
insurance backing of the financial power of government, that is, the entire
economic power of United States. That is powerful insurance.