1.1 Module 9: Introduction to Macroeconomics

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Today many people enjoy walking through New York’s beautiful Central Park. But in 1932 there were many people living there in squalor in one of the many “Hoovervilles”—the shantytowns that had sprung up across America as a result of a catastrophic economic slump that started in 1929. Millions of people were out of work and unable to feed, clothe, and house themselves and their families. Beginning in 1933, the U.S. economy would stage a partial recovery. But joblessness stayed high throughout the 1930s—a period that came to be known as the Great Depression.

These shantytowns were named after Herbert Hoover, who had been elected president in 1928. When the Depression struck, people blamed Hoover who, along with his economic advisers, didn’t seem to understand the crisis and had no idea what to do about it.

At the time of the Great Depression, microeconomics, which is concerned with the consumption and production decisions of individual consumers and producers and with the allocation of scarce resources among industries, was already a well-developed branch of economics. Macroeconomics, which focuses on the behavior of the economy as a whole, was still in its infancy.

But macroeconomics came into its own during the Depression. Economists realized that they needed to understand the nature of the catastrophe that had overtaken the United States and much of the rest of the world in order to learn how to avoid such events in the future. To this day, the effort to understand economic slumps and find ways to prevent them is at the core of macroeconomics.

In this module we will begin to explore the key features of macroeconomic analysis. We will look at some of the field’s major concerns, including

• Business cycles
• Economic growth
• Price stability
• Trade imbalances

The Business Cycle

Figure 9-1 shows a stylized representation of the way the economy evolves over time. The vertical axis shows either employment or an indicator of how much the economy is producing, such as real gross domestic product (real GDP), a measure of the economy’s overall output that we’ll learn about in the next module

This is a stylized picture of the business cycle. The vertical axis measures either employment or total output in the economy. Periods when these two variables turn down are recessions; periods when they turn up are expansions. The point at which the economy turns down is a business-cycle peak; the point at which it turns up again is a business-cycle trough.

A broad-based downturn, in which output and employment fall in many industries, is called a recession (sometimes referred to as a contraction). Recessions, as officially declared by the National Bureau of Economic Research, or NBER, are indicated by the shaded areas in Figure 9-1. When the economy isn’t in a recession, when most economic numbers are following their normal upward trend, the economy is said to be in an expansion (sometimes referred to as a recovery). The alternation between recessions and expansions is known as the business cycle. The point in time at which the economy shifts from expansion to recession is known as a business-cycle peak; the point at which the economy shifts from recession to expansion is known as a business-cycle trough.

The business cycle is an enduring feature of the economy. Table 9-1 shows the official list of business-cycle peaks and troughs. As you can see, there have been recessions and expansions for at least the past 155 years. Whenever there is a prolonged expansion, as there was in the 1960s and again in the 1990s, books and articles come out proclaiming the end of the business cycle. Such proclamations have always proved wrong: the cycle always comes back. But why does it matter?

The Pain of Recession

Not many people complain about the business cycle when the economy is expanding. Recessions, however, create a great deal of pain.

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The most important effect of a recession is its impact on the ability of workers to find and hold jobs. The most widely used indicator of conditions in the labor market is the unemployment rate. We’ll explain how that rate is calculated in the next section, but for now it’s enough to say that a high unemployment rate tells us that jobs are scarce and a low unemployment rate tells us that jobs are easy to find. Figure 9-2 shows the unemployment rate from 1988 to 2013. As you can see, the U.S. unemployment rate surged during and after each recession but eventually fell during periods of expansion. The rising unemployment rate in 2008 was a sign that a new recession might be under way, which was later confirmed by the NBER to have begun in December 2007.

The unemployment rate, a measure of joblessness, rises sharply during recessions and usually falls during expansions. The shaded areas indicate periods of recession.

Source: Bureau of Labor Statistics.

Because recessions cause many people to lose their jobs and also make it hard to find new ones, recessions hurt the standard of living of many families. Recessions are usually associated with a rise in the number of people living below the poverty line, an increase in the number of people who lose their houses because they can’t afford the mortgage payments, and a fall in the percentage of Americans with health insurance coverage.

You should not think, however, that workers are the only group that suffers during a recession. Recessions are also bad for firms: like employment and wages, profits suffer during recessions, with many small businesses failing.

All in all, then, recessions are bad for almost everyone. Can anything be done to reduce their frequency and severity?

Taming the Business Cycle

Modern macroeconomics came into being as a response to the Great Depression of 1929–1933.

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Modern macroeconomics largely came into being as a response to the worst recession in history—the 43-month downturn that began in 1929 and continued into 1933, ushering in the Great Depression. The havoc wreaked by the 1929–1933 recession spurred economists to search both for understanding and for solutions: they wanted to know how such things could happen and how to prevent them.

The work of the British economist John Maynard Keynes, published during the Great Depression, suggested that a depressed economy results from inadequate spending, and that using monetary policy (changing the quantity of money to alter interest rates, which in turn affect overall spending) and fiscal policy (changing taxes and government spending to affect overall spending) can mitigate the effect of recessions. To this day, governments turn to these policies, known as Keynesian Economics, when recession strikes. Later work, notably that of another great macroeconomist, Milton Friedman, led to a consensus that it’s important to rein in booms as well as to fight slumps.

So modern policy makers try to “smooth out” the business cycle. They haven’t been completely successful, as a look at Table 9-1 makes clear. It’s widely believed, however, that policy guided by macroeconomic analysis has helped make the economy more stable.

Although the business cycle is one of the main concerns of macroeconomics and historically played a crucial role in fostering the development of the field, macroeconomists are also concerned with other issues, such as the question of long-run growth.

COMPARING RECESSIONS

The alternation of recessions and expansions seems to be an enduring feature of economic life. However, not all business cycles are created equal. In particular, some recessions have been much worse than others.

Let’s compare the two most recent recessions: the 2001 recession and the Great Recession of 2007–2009. These recessions differed in duration: the first lasted only eight months, the second more than twice as long. Even more important, however, they differed greatly in depth.

In Figure 9-3 we compare the depth of the recessions by looking at what happened to industrial production over the months after the recession began. In each case, production is measured as a percentage of its level at the recession’s start. Thus the line for the 2007–2009 recession shows that industrial production eventually fell to about 85% of its initial level.

Source: Federal Reserve Bank of St. Louis.

Clearly, the 2007–2009 recession hit the economy vastly harder than the 2001 recession. Indeed, by comparison to many recessions, the 2001 slump was very mild.

Of course, this was no consolation to the millions of American workers who lost their jobs, even in that mild recession.

Long-Run Economic Growth

In 1955, Americans were delighted with the nation’s prosperity. The economy was expanding, consumer goods that had been rationed during World War II were available for everyone to buy, and most Americans believed, rightly, that they were better off than the citizens of any other nation, past or present.

Yet by today’s standards, Americans were quite poor in 1955. Figure 9-4 shows the percentage of American homes equipped with a variety of appliances in 1905, 1955, and 2005: in 1955 only 37% of American homes contained washing machines and hardly anyone had air conditioning. And if we turn the clock back another half-century, to 1905, we find that life for many Americans was startlingly primitive by today’s standards.

Americans have become able to afford many more material goods over time thanks to long-run economic growth.

Source: W. Michael Cox and Richard Alm, “How Are We Doing?” The American (July/August 2008). http://www.american.com/archive/2008/july-august-magazine-contents/how-are-we-doing

Why are the vast majority of Americans today able to afford conveniences that many Americans lacked in 1955? The answer is long-run economic growth, the sustained rise in the quantity of goods and services the economy produces. Figure 9-5 shows the growth since 1900 in real GDP per capita, a measure of total output per person in the economy. The severe recession of 1929–1933 stands out, but business cycles between World War II and 2007 are almost invisible, dwarfed by the strong upward trend.

Over the long run, growth in real GDP per capita has dwarfed the ups and downs of the business cycle. Except for the recession that began the Great Depression, recessions are almost invisible until 2007.

Sources: Angus Maddison, Statistics on World Population, GDP, and Per Capita GDP, 1–2008AD, http://www.ggdc.net/MADDISON/oriindex.htm; Bureau of Economic Analysis.

Part of the long-run increase in output is accounted for by the fact that we have a growing population and workforce. But the economy’s overall production has increased by much more than the population. On average, in 2013 the U.S. economy produced about $43,000 worth of goods and services per person, about twice as much as in 1971, about three times as much as in 1951, and almost eight times as much as in 1900.

Long-run growth is the key to higher living standards in the poorer, less developed countries of the world.

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Long-run economic growth is fundamental to many of the most pressing economic questions today. Responses to key policy questions, like the country’s ability to bear the future costs of government programs such as Social Security and Medicare, depend in part on how fast the U.S. economy grows over the next few decades. More broadly, the public’s sense that the country is making progress depends crucially on success in achieving long-run growth.

When growth slows, as it did in the 1970s, it can help feed a national mood of pessimism. In particular, long-run growth per capita—a sustained upward trend in output per person—is the key to higher wages and a rising standard of living. A major concern of macroeconomics is trying to understand the forces behind long-run growth.

Long-run growth is an even more urgent concern in poorer, less developed countries which would like to achieve a higher standard of living. In these cases, the central concern of economic policy is how to accelerate long-run growth.

Inflation and Deflation

In January 1980 the average production worker in the United States was paid $6.57 an hour. By December 2013, the average hourly earnings for such a worker had risen to $19.40 an hour. Three cheers for economic progress!

But wait. American workers were paid much more in 2013, but they also faced a much higher cost of living. In early 1980, a dozen eggs cost only about $0.88; by December 2013, that was up to $2.00. The price of a loaf of white bread went from about $0.50 to $1.39. And the price of a gallon of gasoline rose from just $1.11 to $3.33.

Figure 9-6 compares the percentage increase in hourly earnings between 1980 and 2013 with the increases in the prices of some standard items: the average worker’s paycheck went further in terms of some goods, but less far in terms of others. Overall, the rise in the cost of living wiped out many, if not all, of the wage gains of the typical worker from 1980 to 2013. In other words, once changes in prices are taken into account, the living standard of the typical U.S. worker has stagnated from 1980 to the present.

Between 1980 and 2013, American workers’ hourly earnings rose by 195%. But the prices of just about all the goods bought by workers also rose, some by more, some by less. Overall, the rising cost of living offset much of the rise in the average U.S. worker’s wage.

Source: Bureau of Labor Statistics.

The point is that between 1980 and 2013 the economy experienced substantial inflation: a rise in the overall level of prices. Understanding the causes of inflation and its opposite, deflation—a fall in the overall level of prices—is another main concern of macroeconomics because both inflation and deflation can pose problems for the economy. Here are two examples:

• Inflation discourages people from holding onto cash, because cash loses value over time if the overall price level is rising. That is, the amount of goods and services you can buy with a given amount of cash falls. In extreme cases, people stop holding cash altogether and turn to barter.
• Deflation can cause the reverse problem. If the price level is falling, cash gains value over time. In other words, the amount of goods and services you can buy with a given amount of cash increases. So holding on to it can become more attractive than investing in new factories and other productive assets. This can deepen a recession.

We’ll describe other costs of inflation and deflation in a later section. For now, let’s just note that, in general, economists regard price stability—in which the overall level of prices is changing, if at all, only slowly—as a desirable goal. Price stability is a goal that seemed far out of reach for much of the post–World War II period but was achieved to most macroeconomists’ satisfaction in the 1990s.

International Imbalances

The United States is an open economy that trades goods and services with other countries. There have been times when that trade was more or less balanced—when the United States sold about as much to the rest of the world as it bought. But this isn’t one of those times.

In 2012, the United States ran a big trade deficit—that is, the value of the goods and services U.S. residents bought from the rest of the world was a lot larger than the value of the goods and services American producers sold to customers abroad.

Meanwhile, some other countries were in the opposite position, selling much more to foreigners than they bought. Figure 9-7 shows the exports and imports of goods and services for several important economies in 2012. As you can see, the United States imported much more than it exported, but Germany, China, and Saudi Arabia did the reverse: they each ran a trade surplus.

In 2012, the goods and services the United States bought from other countries were worth considerably more than the goods and services sold abroad. Germany, China, and Saudi Arabia were in the reverse position. Trade deficits and trade surpluses reflect macroeconomic forces, especially differences in savings and investment spending.

Source: World Trade Organization.

A country runs a trade surplus when the value of the goods and services it buys from the rest of the world is smaller than the value of the goods and services it sells abroad. Was America’s trade deficit a sign that something was wrong with our economy—that we weren’t able to make things that people in other countries wanted to buy?

There isn’t an obvious relationship between the success of an economy and whether it runs trade surpluses or deficits.

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No, not really. Trade deficits and their opposite, trade surpluses, are macroeconomic phenomena. They’re the result of situations in which the whole is very different from the sum of its parts. You might think that countries with highly productive workers or widely desired products and services to sell run trade surpluses while countries with unproductive workers or poor-quality products and services run deficits. But the reality is that there’s no simple relationship between the success of an economy and whether it runs trade surpluses or deficits.

Microeconomic analysis tells us why countries trade but not why they run trade surpluses or deficits. Earlier we learned that international trade is the result of comparative advantage: countries export goods they’re relatively good at producing and import goods they’re not as good at producing. That’s why the United States exports wheat and imports coffee. One important question the concept of comparative advantage doesn’t answer, however, is why the value of a country’s imports is sometimes much larger than the value of its exports, or vice versa.

So what does determine whether a country runs a trade surplus or a trade deficit? Later on we’ll learn the surprising answer: the determinants of the overall balance between exports and imports lie in decisions about savings and investment spending—spending on goods like machinery and factories that are in turn used to produce goods and services for consumers. Countries with high investment spending relative to savings run trade deficits; countries with low investment spending relative to savings run trade surpluses.

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