Introduction to Macroeconomics
(Part A)
by
Charles Lamson
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Macroeconomics is part of our everyday lives. If the macroeconomy is doing well, few people do not have a job who want one, people's incomes are generally rising, and profits of corporations are generally high. In this type of an economy it is relatively easy for new entrants into the labor force, such as students who have just graduated, to find jobs. On the other hand, if the macroeconomy is in a slump, new jobs are hard to find, incomes are not growing well, and profits are low. Given the large effects that the macroeconomy can have on our lives, it is important that we understand how it works.
We begin by discussing the differences between microeconomics and macroeconomics. Microeconomics examines the functioning of individual industries and the behavior of individual decision-making units, typically business firms and households. With a few assumptions about how these units behave [firms maximize profits, households maximize utility (total satisfaction received from consuming a good or service], we can draw useful conclusions about how markets work, how resources are allocated, and so forth. Macroeconomics, instead of focusing on the factors that influence the production of particular products and the behavior of individual industries, focuses on the determinants of total national output. Macroeconomics studies not household income but national income, not individual prices but the overall price level. It does not analyze the demand for labor in the automobile industry but instead total employment in the economy. Both microeconomics and macroeconomics are concerned with the decisions of households and firms. Microeconomics deals with individual decisions; macroeconomics deals with the sum of these individual decisions. Aggregate is used in macroeconomics to refer to sums. When we speak of aggregate behavior, we mean the behavior of all households and firms together. We also speak of aggregate consumption and aggregate investment, which refers to total consumption and total investment in the economy.  Because microeconomists and macroeconomists look at the economy from different perspectives, you might expect they would reach somewhat different conclusions about the way the economy behaves. This is true to some extent. Microeconomists generally conclude that markets work well. They see prices as flexible, adjusting to maintain equality between quantity supplied and quantity demanded. Macroeconomists, however, observe that important prices in the economy---for example, the wage rate (or price of labor)---often seem "sticky." Sticky prices are prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded. Microeconomists do not expect to see the quantity of apples supplied exceeding the quantity of apples demanded, because the price of apples is not sticky. On the other hand, macroeconomists---who analyze aggregate behavior---examine periods of high unemployment, where the quantity of labor supplied appears to exceed the quantity of labor demanded. At such times, it appears that wage rates do not adjust fast enough to equate the quantity of labor supplied and the quantity of labor demanded. Since about 1970, much work in macroeconomics has been concerned with making macroeconomic analysis consistent with microeconomic postulates---that is, with the idea that firms and households make their decisions along the lines as suggested by microeconomic theory. If prices do not appear to equate the quantity supplied and quantity demanded, for example, macroeconomists now look with solid microeconomic reasons why not. One of the aims of this analysis is to explain the microeconomic foundations of macroeconomics. The Roots of Macroeconomics The Great Depression Economic events of the 1930s, the decade of the Great Depression, spurred a great deal of thinking about macroeconomic issues, especially unemployment. The 1920s had been prosperous years for the U.S. economy. Virtually everyone who wanted a job could get one, incomes rose substantially, and prices were stable. Beginning in late 1929, things took a sudden turn for the worse. In 1929, 1.5 million people were unemployed. By 1933, that had increased to 13 million out of the labor force of 51 million. In 1933, the United States produced about 27 percent fewer goods and services than it had in 1929. In October of 1929, when stock prices collapsed on Wall Street, billions of dollars of personal wealth were lost. Unemployment remained above 14 percent of the labor force until 1940 (Case & Fair, 2004). Classical Models Before the Great Depression, economists applied microeconomic models, sometimes referred to as "classical" or "market-clearing" models, to economy-wide problems. For example, classical supply and demand analysis assumed that an excess supply of labor would drive down wages to a new equilibrium level; as a result, unemployment would not persist.  In other words, classical economist believed that that recessions (downturns in the economy) were self-correcting. As output falls and the demand for labor shifts to the left, the argument went, the wage rate will decline, thereby raising the quantity of labor demanded by firms, who will want to hire more workers at the new lower wage rate. However, during the Great Depression unemployment levels remained very high for nearly 10 years. In large measure, the failure of simple classical models to explain the prolonged existence of high unemployment provided the impetus for the development of macroeconomics. It is not surprising that what we now call macroeconomics was born in the 1930s. The Keynzian Revolution One of the most important works in the history of economics, The General Theory of Employment, Interest and Money, by John Maynard Keynes was published in 1936. Building on what was already understood about markets and their behavior, Keynes set out to construct a theory that would explain the confusing economic events of his time. Much of macroeconomics has roots in Keynes's work. According to Keynes, it is not prices and wages that determine the level of employment, as classical models had suggested, but instead the level of aggregate demand for goods and services. Keynes believed governments could intervene in the economy and affect the level of output and employment. The government's role during periods when private demand is low, Keynes argued, is to stimulate aggregate demand and that, by doing so, to lift the economy out of recession. Recent Macroeconomic History After World War II and especially in the 1950s, Keynes's views began to gain increasing influence over both professional economists and government policymakers. Governments came to believe they could intervene in their economies to attain specific employment and output goals. They began to use their powers to tax and spend, as well as their ability to affect interest rates and the money supply, for the explicit purpose of controlling the economy's ups and downs. This view of government policy became firmly established in the United States with the passage of the Employment Act of 1946. This act established the President's Council of Economic Advisers, a group of economists who advise the president on economic issues. It also committed the federal government to intervene in the economy to prevent large declines in output and employment.  Fine Tuning in the 1960s The notion that the government could, and should, act to stabilize the macroeconomy reached the height of its popularity in the 1960s. During these years, Walter Heller, the chairman of the Council of Economic Advisers under both President Kennedy and President Johnson, alluded to fine-tuning as the government's role in regulating inflation and unemployment. During the 1960s, many economists believe that the government could use the tools available to manipulate unemployment and inflation levels fairly precisely. Disillusionment in the 1970s and early 1980s In the 1970s and early 1980s, the U.S. economy had wide fluctuations in employment, output, and inflation. In 1974-1975 and again in 1980-1982, the United States experienced a severe recession. While not as catastrophic as the Great Depression of the 1930s, these two recessions left millions without jobs and resulted in billions of dollars of lost output and income. In 1974-1975 and again in 1979-1981, the United States saw very high rates of inflation. Moreover, in the 1970s stagflation (stagnation + inflation) was born. Stagflation occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation). Until the 1970s, rapidly rising prices had been observed only in periods when the economy was prospering and unemployment was low (or at least declining). The problem of stagflation was vexing, both for macroeconomic theorists and for policymakers concerned with the health of the economy. It was clear by 1975 that the macroeconomy was more difficult to control then either Heller's words or textbook theory had led economists to believe. The events of the 1970s and early 1980s had an important influence on macroeconomic theory. Much of the faith in the simple Keynesian model and "conventional wisdom" of the 1960s was lost.  Good Times in the 1990s and a Pause in 2001 The economy grew well in the 1980s after the recession of 1980-1982. There was a mild recession in 1990-1991, and then the economy grew for the rest of the 1990s. Growth in 1997-1999 was particularly strong, fueled in part by the stock market boom that began in 1995. Remarkably, inflation was not a problem throughout the entire 1990s. The economy then entered into a recession in early 2001, before the terrorist attacks on September 11th, 2001. In spite of the attacks, however, the economy began to pick up at the end of the year. The growth rate in 2002 and 2003 was moderate, but not large enough to prevent the unemployment rate from rising. The unemployment rate rose sharply from about 4 percent in 2000 to about 5.5 percent by the end of 2001. And then rose further to 6.2 percent by the second quarter of 2003. Inflation continued not to be a problem in the early 2000s. The 2008 Financial Crisis and Great Recession Few economists predicted the 2007-2008 financial crisis, and, even afterwards, there was great disagreement on how to address it. Many economists agree that the crisis stemmed from an economic bubble (situation in which asset prices appear to be based on implausable or inconsistent views about the future), but had not paid much attention to finance or a theory of asset bubbles. The failures of macroeconomic theory at the time to explain the crisis spurred macroeconomists to reevaluate their thinking. Commentary ridiculed the mainstream and proposed a major reassessment ["The Other-Worldly Philosophers (2009)]. The COVID-19 Recession February 20, 2020 - Present The COVID-19 recession caused a recession or a depression in many countries. The crisis began due to the COVID-19 lockdowns and other precautions taken during the COVID-19 pandemic. Most economists generally peg good economic growth in the 2 percent to 4 percent range of gross domestic product (GDP), with the historical average around 2.5 percent annually (revenuerocket.com). U.S. GDP increased at an annual rate of 6.4 percent between the fourth quarter of 2020 and the first quarter of 2021 according to the advance estimate by the U.S. Bureau of Economic Analysis (BEA) (thebalance.com). The unemployment rate is 6.1 percent in April, 2021 (bls.gov). The Federal Reserve has not established a formal inflation target, but policymakers generally believe that an acceptable inflation rate is around 2 percent. Right now, the annual inflation rate for the U.S. is 4.2 percent for the 12 months ended April 2021 after rising 2.6 percent previously, according to U.S. Labor Department data published May 12 (usinflationcalculator.com).  The discipline of macroeconomics is still in flux, and many an important issues have yet to be resolved. this makes it hard to teach, but exciting to study. *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 375-378* end |
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