1.4 Economy-Wide Interactions

As mentioned earlier, the economy as a whole has its ups and downs. For example, business in America’s shopping malls was depressed in 2008, because the economy was in a recession. While the economy had begun to recover in 2009, the effects of the downturn were still being felt—not until May 2014 did the number of Americans employed recover to its pre-recession level.

To understand recessions and recoveries, we need to understand economy-wide interactions, and understanding the big picture of the economy requires understanding three more economic principles, which are summarized in Table 1-3.

Table : TABLE 1-3 The Principles of Economy-Wide Interactions

10. One person’s spending is another person’s income.

11. Overall spending sometimes gets out of line with the economy’s productive capacity.

12. Government policies can change spending.

Principle #10: One Person’s Spending Is Another Person’s Income

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Between 2005 and 2011, home construction in America plunged more than 60% because builders found it increasingly hard to make sales. At first the damage was mainly limited to the construction industry. But over time the slump spread into just about every part of the economy, with consumer spending falling across the board.

But why should a fall in home construction mean empty stores in the shopping malls? After all, malls are places where families, not builders, do their shopping.

The answer is that lower spending on construction led to lower incomes throughout the economy; people who had been employed either directly in construction, producing goods and services builders need (like drywall), or in producing goods and services new homeowners need (like new furniture), either lost their jobs or were forced to take pay cuts. And as incomes fell, so did spending by consumers. This example illustrates our tenth principle:

One person’s spending is another person’s income.

In a market economy, people make a living selling things—including their labor—to other people. If some group in the economy decides, for whatever reason, to spend more, the income of other groups will rise. If some group decides to spend less, the income of other groups will fall.

Because one person’s spending is another person’s income, a chain reaction of changes in spending behavior tends to have repercussions that spread through the economy. For example, a cut in business investment spending, like the one that happened in 2008, leads to reduced family incomes; families respond by reducing consumer spending; this leads to another round of income cuts; and so on. These repercussions play an important role in our understanding of recessions and recoveries.

Principle #11: Overall Spending Sometimes Gets Out of Line with the Economy’s Productive Capacity

Macroeconomics emerged as a separate branch of economics in the 1930s, when a collapse of consumer and business spending, a crisis in the banking industry, and other factors led to a plunge in overall spending. This plunge in spending, in turn, led to a period of very high unemployment known as the Great Depression.

The lesson economists learned from the troubles of the 1930s is that overall spending—the amount of goods and services that consumers and businesses want to buy—sometimes doesn’t match the amount of goods and services the economy is capable of producing. In the 1930s, spending fell far short of what was needed to keep American workers employed, and the result was a severe economic slump. In fact, shortfalls in spending are responsible for most, though not all, recessions.

It’s also possible for overall spending to be too high. In that case, the economy experiences inflation, a rise in prices throughout the economy. This rise in prices occurs because when the amount that people want to buy outstrips the supply, producers can raise their prices and still find willing customers. Taking account of both shortfalls in spending and excesses in spending brings us to our eleventh principle:

Overall spending sometimes gets out of line with the economy’s productive capacity.

Principle #12: Government Policies Can Change Spending

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Overall spending sometimes gets out of line with the economy’s productive capacity. But can anything be done about that? Yes—which leads to our twelfth and last principle:

Government policies can change spending.

In fact, government policies can dramatically affect spending.

For one thing, the government itself does a lot of spending on everything from military equipment to education—and it can choose to do more or less. The government can also vary how much it collects from the public in taxes, which in turn affects how much income consumers and businesses have left to spend. And the government’s control of the quantity of money in circulation, it turns out, gives it another powerful tool with which to affect total spending. Government spending, taxes, and control of money are the tools of macroeconomic policy.

Modern governments deploy these macroeconomic policy tools in an effort to manage overall spending in the economy, trying to steer it between the perils of recession and inflation. These efforts aren’t always successful—recessions still happen, and so do periods of inflation. But it’s widely believed that aggressive efforts to sustain spending in 2008 and 2009 helped prevent the financial crisis of 2008 from turning into a full-blown depression.

ECONOMICS in Action

Adventures in Babysitting

image | interactive activity

The website myarmyonesource.com, which offers advice to army families, suggests that parents join a babysitting cooperative—an arrangement that is common in many walks of life. In a babysitting cooperative, a number of parents exchange babysitting services rather than hire someone to babysit. But how do these organizations make sure that all members do their fair share of the work?

As myarmyonesource.com explained, “Instead of money, most co-ops exchange tickets or points. When you need a sitter, you call a friend on the list, and you pay them with tickets. You earn tickets by babysitting other children within the co-op.” In other words, a babysitting co-op is a miniature economy in which people buy and sell babysitting services. And it happens to be a type of economy that can have macroeconomic problems.

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As participants in a babysitting co-op soon discovered, fewer nights out made everyone worse off.
iStockphoto

A famous article titled “Monetary Theory and the Great Capitol Hill Babysitting Co-Op Crisis” described the troubles of a babysitting co-op that issued too few tickets. Bear in mind that, on average, people in a babysitting co-op want to have a reserve of tickets stashed away in case they need to go out several times before they can replenish their stash by doing some more babysitting.

In this case, because there weren’t that many tickets out there to begin with, most parents were anxious to add to their reserves by babysitting but reluctant to run them down by going out. But one parent’s decision to go out was another’s chance to babysit, so it became difficult to earn tickets. Knowing this, parents became even more reluctant to use their reserves except on special occasions.

In short, the co-op had fallen into a recession. Recessions in the larger, nonbabysitting economy are a bit more complicated than this, but the troubles of the Capitol Hill babysitting co-op demonstrate two of our three principles of economy-wide interactions. One person’s spending is another person’s income: opportunities to babysit arose only to the extent that other people went out. An economy can also suffer from too little spending: when not enough people were willing to go out, everyone was frustrated at the lack of babysitting opportunities.

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And what about government policies to change spending? Actually, the Capitol Hill co-op did that, too. Eventually, it solved its problem by handing out more tickets, and with increased reserves, people were willing to go out more.

Quick Review

  • In a market economy, one person’s spending is another person’s income. As a result, changes in spending behavior have repercussions that spread through the economy.

  • Overall spending sometimes gets out of line with the economy’s capacity to produce goods and services. When spending is too low, the result is a recession. When spending is too high, it causes inflation.

  • Modern governments use macroeconomic policy tools to affect the overall level of spending in an effort to steer the economy between recession and inflation.

Check Your Understanding 1-4

Question 1.6

1. Explain how each of the following examples illustrates one of the three principles of economy-wide interactions.

  1. The White House urged Congress to pass a package of temporary spending increases and tax cuts in early 2009, a time when employment was plunging and unemployment soaring.

    This illustrates the principle that government policies can change spending. The tax cut increased people’s after-tax incomes, leading to higher consumer spending.

  2. Oil companies are investing heavily in projects that will extract oil from the “oil sands” of Canada. In Edmonton, Alberta, near the projects, restaurants and other consumer businesses are booming.

    This illustrates the principle that one person’s spending is another person’s income. As oil companies increase their spending on labor by hiring more workers, or pay existing workers higher wages, those workers’ incomes rise. In turn, these workers increase their consumer spending, which becomes income to restaurants and other consumer businesses.

  3. In the mid-2000s, Spain, which was experiencing a big housing boom, also had the highest inflation rate in Europe.

    This illustrates the principle that overall spending sometimes gets out of line with the economy’s productive capacity. In this case, spending on housing was too high relative to the economy’s capacity to create new housing. This first led to a rise in house prices, and then—as a result—to a rise in overall prices, or inflation.

Solutions appear at back of book.