What is Macroeconomics

Macroeconomics focuses on trying to understand events that affect the whole economy. In the fall of 2000 and continuing through the fall of 2001 there was the U.S. experienced a decline in sales, production, and employment that affected most firms and industries.

A few industries, notably housing construction, continued to do well. This kind of widespread decline in economic activity, when it lasts for more than six months, is called a recession.

Since recessions are felt throughout the economy, it seems unlikely that the explanation for a recession will be found in the microeconomics of individual markets. The causes of recession must involve forces that have widespread influence on economic activity. Nor are these events confined to just one economy; recent U.S. recessions have put a damper on economic activity around the globe – a symptom of globalization.

What causes recessions? Should the government do something about it? If so, what can it do? What forces bring a recession to an end, allowing resumption of normal levels of sales, employment and production?

Here is another example of a problem in macroeconomics. In the late 1970s the price of practically every good and service in the US economy rose very rapidly, at a rate of about 15% per year. A pervasive and persistent rise in prices is called inflation.

Since inflation reflects price changes that are widespread across many different industries it seems clear that the explanation for inflation must lie with factors affecting the entire economy. In recent years inflation has not been a major problem in the U.S. economy, but 2006 saw a modest revival that has some economists concerned. Why did inflation get out of control in the late 1970s, and what should be done if it speeds up again?

Recession and inflation are central problems in macroeconomics.

The division of economics between microeconomics and macroeconomics is not a precise one, and the analytic tools of each are important in understanding the other. For example, the computer industry is of growing importance to the economy, but the study of the economics of that industry belongs in the domain of microeconomics.

On the other hand, although banking is also an industry, its influence on the economy is so pervasive that the study of banking is usually considered part of macroeconomics. Nevertheless, the macroeconomist studying banking will make use of the analytical tools of microeconomics, and the microeconomist studying the computer industry will be concerned with the impact on the industry of macroeconomic events such as recession and inflation.

The topics which economists usually group under the heading of macroeconomics include the following:

• The Measurement of National Income
• The Relationship Between Savings and Investment
• The Cost of Living and Inflation
• Interest Rates and What Influences Them
• Recession, Unemployment, and Economic Growth
• Money and Banks
• The Federal Reserve System and Monetary Policy
• Government Taxation, Spending, and Fiscal Policy
• International Trade and Exchange Rates

Macroeconomic issues are the subject of major news coverage by the media because they affect all of us. They are usually the most hotly debated issues of Presidential campaigns. Candidate Bill Clinton’s mantra was: "It's the economy, stupid!" Here are some of the major macroeconomic issues that are receiving a lot of attention:

The Financial Crisis of 2008 and Recession Now.

Bank failures, collapse of old and storied Wall Street investment firms, astronomical losses in hedge funds, falling house prices, rapidly rising lay-offs, and unsold goods of all kinds – that is the economic reality of 2008! At this writing it is clear that we have entered one of the most severe recessions since the Great Depression of the 1930s, and the future looks shaky indeed. The change of administrations and a Congress that seems unable to act decisively add to the feeling of unease.

How could major banks, household name brands that were solid and expanding only a year ago, suddenly experience unsustainable depositor withdrawals? Why has the price of houses fallen around 20% in one year, after decades of almost relentless increase? How could the stock market lose about 40% of its value in only several months? These are among the troubling and far from resolved questions we will try to grapple with!

The Twin Deficits: International Trade and the Federal Budget.

When the amount we earn from exports falls short of the amount we spend on imports then there is a trade deficit. In 1980 the value of goods exported by the US was $25 billion less than the value of the goods we imported. By 1990 the US trade deficit had swollen to $80 billion. And currently it is around $400 billion! That is about one billion dollars every day. This seemingly relentless widening of the trade deficit to an astonishing level is a source of concern to many, and yet its causes and consequences may be far different from what most imagine.

The amount by which federal spending exceeds tax revenues is called the federal budget deficit. In 1980 the federal government spent $74 billion more than it collected in taxes. By 1990 the federal deficit had widened to $220 billion. The prospect of continuing budget deficits motivated a major tax increase by the Clinton administration in 1993.

That, combined with a long and vigorous economic expansion eliminated the budget deficit at the end of the 1990s, and President George W. Bush successfully lobbied congress for a tax cut. But the budget is again falling into deficit, $400+ billion for 2008!

Could there be a connection between these “twin” deficits? Both emerged alarmingly in the 1980s. Is the similarity in their timing and size coincidental? Are they harmful to the economy? What caused them, and are their causes related? What should we do about them, if anything?

The Challenge of Globalization

After World War II, US business faced little competition from abroad. Germany and Japan were struggling to rebuild and Great Britain was in the process of losing its empire. The only imported car of note in the 1950s was the VW beetle, admired for its simplicity and eccentricity, but no real threat to US competitors. General Motors was the largest industrial corporation in the world and it could claim with some authority that its CadillacTM brand was “The Standard of the World.” How things have changed!

By the late 1980s US industry faced strong competition from Europe and Japan in many fields. Japan particularly had become an economic powerhouse. In 1989 the biggest selling car in America was for the first time not made by an American company. It was the Honda Accord.

Nippon Telephone and Telegraph was larger (in market value) than all US corporations except Exxon. The seven largest banks in the world were all Japanese! The five largest securities firms (dealing in stocks and bonds) were also all Japanese. In 1987 Japan became the world's richest nation with assets worth $44 trillion. The US was spending about $50 billion more on imports from Japan each year than it earned from sales to Japan. Japan invested these trade surplus dollars in the U.S., much in the form of direct investment in the U.S. based subsidiaries of Japanese corporations. Japanese investors also became major owners of real estate and stocks and bonds in the U.S.

Then in the 1990s, Japan’s stock market took a severe tumble and its economy entered a decade of stagnation. Meanwhile, U.S. economic growth was strong, and American firms emerged as the leaders in the new technologies of personal computers and telecommunications. In part because of technological advance, competition is now on a global scale.

Nokia, the Finnish maker of mobile phones came out of nowhere to become a leader in its field and among the 30 most valuable corporations in the world. Nor is competition limited to manufacturing. Of the ten largest banks in the world, only one is American. The largest is Deutsche Bank (with assets equivalent to $700 billion) followed by a Swiss and a Japanese bank in the next two positions. All of these banks have global reach, offer a full range of financial services, and make use of the latest telecommunications to knit their world-wide operations together.

In this new century China has emerged as the new player in the international economy, with rapidly rising exports of manufactured products, selling far more to the U.S. than it buys. Thus, China has billions of dollars to invest in the U.S. and it has become a major purchaser of bonds issued by the U.S. Treasury to finance the federal budget deficit.

The influx of low cost goods from China has been a factor in holding down inflation in the U.S. and allowing Americans to consume more. While we no longer make as many toasters, small appliances are typically produced now in China, that country is a rich market for high value products we do make such as airliners.

Meanwhile, India is undergoing a somewhat similar transformation and even exports services to the U.S. in the form of telephone help lines that make use of Indians’ command of the English language and high level of technical training.

What should be our response to globalization? Do we have any choice but to participate? Or should we try to limit our exposure to international competition and foreign ownership in the U.S.? Public sentiment was once strong for Congress to take action to protect U.S. industry from Japanese competition, but that competition proved to be the stimulus for a new era of change. Now our officials scold Japan that it is doing too little to encourage growth! Concern has now shifted to China and India.

Some observers worry about the impact of globalization on third-world countries where economic development is happening at a dizzying pace, and on the labor market in the U.S. which now is thrown open to world competition. In this debate, economists are almost always a voice for free trade and open world markets. The issues are complex and will play an important role in debate on public policy in the decades ahead.

Social Security and Medicare; Will They Impoverish the Young?

Benefits for the aged account for 27% of federal spending but the elderly constitute only 12% of the population. The Social Security trust fund is now in surplus because the “baby-boomers,” those born between 1945 and 1965) are in their peak earning years and they are a very large age cohort. But this favorable balance will be reversed as the boomer retire over the next couple of decades.

Medicare benefits for the elderly have proved to be about ten times as costly as was projected when the program started in 1965; the actual expenditure now is over $200 billion per year. The taxes that fund Social Security and Medicare are now the greatest tax burden on many lower income young families.

Should Social Security taxes be cut now to reduce the tax burden on young wage earners, or should the surplus be allowed to accumulate to cover the anticipated deficit ahead? Is the Social Security system, as it is now designed, fair to both young and old? Should Medicare benefits be broadened? Should they be subject to a minimum income requirement?

These and other vexing questions will figure in public debate for coming decades.

Will We Have Inflation, Recession, or Both?

Two things that are we do not want to see in our economy are inflation and recession. Inflation seems nice at first, people see their incomes rise, their houses become more valuable, but after a while they

realize that prices of things they buy have risen too. And inflation makes it hard for us to use prices to judge the value of goods and services because the ‘yardstick’ we are using is constantly shrinking. Recession is bad because it means few jobs, loss of income for many, and slow growth for almost all. Sometimes we are unlucky enough to have both, as in the 1970’s when soaring oil prices and the cost of just about everything was accompanied by slow growth and then the ‘double dip’ recessions of the early 1980s. How is the U.S. economy doing in the new century?

The 1990s turned out to be a decade of sustained growth and low inflation, to say nothing of a soaring stock market powered by the ‘dot-com’ boom. Concern lingered that inflation would rebound rapidly if the economy continued to expand. But the Federal Reserve, known affectionately as "the Fed," was able to perform a delicate balancing act between inflation and recession and keep the economy on track through the end of the decade. One of the objectives of this book is to understand how they did that.

The boom of the late 1990’s gave way in 2000 to a “bear” stock market and a mild recession, compounded by the shock of 9-11. Two of the microeconomic underpinnings of the boom, dot-com and telecom, experienced the slump that has followed revolutionary innovations of the past. New technology stimulates a frenetic pace of capital investment in new equipment and infrastructure. Stocks of companies in the new industries soar.

After a while it becomes clear that the capacity that has been built is more than adequate – witness the glut of optical fiber – and the ensuing slump in investment spending leads to recession. Similar episodes were the railroad boom following the Civil War and the auto boom of the 1920’s. As in the past, recession gave way to renewed economic growth, with help from the Fed in the shape of extremely low interest rates (how they control interest rates if one of the themes of this book) engineered by its legendary Chairman, Alan Greenspan.

Many hoped that recession and inflation had been banished from our world in the new millennium. The “New Economy” was a popular slogan on Wall Street and in Washington D.C. in the late 1990’s. The productivity of labor was growing at an unprecedented rate, it was said, so the old rules just didn’t apply any more. The Fed was would protect us from the uncertainties of economic life, so the story went.

But as we look ahead to 2007 and beyond it is clear that many uncertainties remain, and the threats of recession and inflation are far from banished from the land. Greenspan has retired, replaced by Ben Bernanke, a brilliant economist and Princeton professor who is nevertheless a rookie in Washington politics. War in Iraq is raising the federal budget deficit again and fears of more to come. Oil prices have soared, reviving a ghost of the 1970s. Economics growth has cooled down and inflation has perked up. Stagflation, a lack of economic growth combined with inflation, is a 1970s buzzword again being bandied about.

As you can see, there is no lack of macroeconomic issues to concern us! They occupy the news media every day, and provide a never-ending drama featuring all the emotions of a good soap opera: hope, fear, greed, success and failure (OK, maybe one or two emotions are missing).

People are interested in macroeconomic issues precisely because they touch the lives of every one of us. Politicians understand that their chances for election hinge on peoples' perception of the health of the macroeconomy.

As citizens we all need to understand as much as we can about its workings, and that understanding may well be the key factor to coping with the uncertainties and opportunities that the economy presents to each of us.

Exercises 1.4

A. Indicate whether each of the following topics falls under the umbrella of microeconomics or macroeconomics.

1) the effect of protecting the spotted owl on the price of lumber

2) causes of the decline in inflation during the 1990's,

3) the persistent deficit in our trade with Japan,

4) effect of a proposed increase in the gas tax on demand,

5) the impact of a change in the exchange rate between the German Mark and the US dollar on employment in the US and Germany,

6) a cost-benefit analysis of federal exhaust emission standards.

B. Give brief and perhaps tentative responses to some of the macroeconomic issues discussed in this section. What are some other issues that feature prominently in the news currently? Which of these issues is of greatest importance to you? Briefly, why?