Principles of Macroeconomics - College or AP Level

6.1 Measuring the Size of the Economy: Gross Domestic Product

Economists generally express the size of a nation's economy as its gross domestic product (GDP), which measures the value of the output of all goods and services produced within the country in a year. Economists measure GDP by multiplying the quantities of all goods and services produced by their prices and summing the total. Since GDP measures what is bought and sold in the economy, we can measure it by the sum of what is purchased or produced.

We can divide demand into consumption, investment, government, exports, and imports. We can divide what is produced in the economy into durable goods, nondurable goods, services, structures, and inventories. To avoid double counting, GDP counts only the final output of goods and services, not the production of intermediate goods or the labor value in the production chain.

6.2 Adjusting Nominal Values to Real Values

The nominal value of an economic statistic is the commonly announced value. The real value is the value after adjusting for changes in inflation. To convert nominal economic data from several different years into accurate, inflation-adjusted data, the starting point is to choose a base year arbitrarily and then use a price index to convert the measurements so that economists measure them in the money prevailing in the base year.

6.3 Tracking Real GDP over Time

Over the long term, U.S. real GDP has increased dramatically. At the same time, GDP has not increased the same amount each year. The speeding up and slowing down of GDP growth represents the business cycle. When GDP declines significantly, a recession occurs. A longer and more profound decline is depression. Recessions begin at the business cycle's peak and end at the trough.

6.4 Comparing GDP among Countries

Since we measure GDP in a country's currency, we need to convert it to a common currency in different countries' GDPs; we need to do that with the exchange rate, which is the price of one country's currency in terms of another. Once we express GDPs in a common currency, we can compare each country's GDP per capita by dividing GDP by population. Countries with large populations often have large GDPs, but GDP alone can be a misleading indicator of a nation's wealth. A better measure is GDP per capita.

6.5 How Well GDP Measures the Well-Being of Society

GDP is an indicator of a society's standard of living, but it is only a rough indicator. GDP does not directly take into account leisure, environmental quality, levels of health and education, activities conducted outside the market, changes in inequality of income, increases in variety, increases in technology, or the (positive or negative) value that society may place on certain types of output.

7.1 The Relatively Recent Arrival of Economic Growth

Since the early nineteenth century, there has been a spectacular process of long-run economic growth during which the world’s leading economies—primarily those in Western Europe and North America—expanded GDP per capita at an average rate of about 2% per year. In the last half-century, countries like Japan, South Korea, and China have shown the potential to catch up. The Industrial Revolution facilitated the extensive economic growth process, which economists often call modern economic growth. This increased worker productivity, trade, and the development of governance and market institutions.

7.2 Labor Productivity and Economic Growth

We can measure productivity, the value of what is produced per worker or hour worked, as the GDP per worker or hour. The United States experienced a productivity slowdown between 1973 and 1989. Since then, U.S. productivity has rebounded for the most part, but annual growth in productivity in the nonfarm business sector has been less than one percent each year between 2011 and 2016. It is not clear what productivity growth will be in the coming years. The rate of productivity growth is the primary determinant of an economy’s long-term economic growth rate and higher wages. Over decades and generations, seemingly minor differences of a few percentage points in the annual economic growth rate make an enormous difference in GDP per capita. An aggregate production function specifies how specific economic inputs, like human capital, physical capital, and technology, lead to the output measured as GDP per capita.

Compound interest and compound growth rates behave the same way as productivity rates. Seemingly small percentage point changes can significantly impact income over time.

7.3 Components of Economic Growth

Over decades and generations, seemingly minor differences of a few percentage points in the annual economic growth rate make an enormous difference in GDP per capita. Capital deepening refers to an increase in capital per worker, either human capital per worker in the form of higher education or skills or physical capital per worker. Technology, in its economic meaning, refers broadly to all new production methods, including major scientific inventions but also small inventions and even better forms of management or other types of institutions. A healthy climate for growth in GDP per capita consists of improvements in human capital, physical capital, and technology in a market-oriented environment with supportive public policies and institutions.

7.4 Economic Convergence

When countries with lower GDP levels per capita catch up to countries with higher GDP per capita, we call the process convergence. Convergence can occur even when both high- and low-income countries increase investment in physical and human capital to grow GDP. This is because the impact of new investment in physical and human capital on a low-income country may result in huge gains as new skills or equipment combine with the labor force. In higher-income countries, however, a level of investment equal to that of the low-income country is not likely to have as significant an impact because the more developed country most likely already has high levels of capital investment. Therefore, the marginal gain from this additional investment tends to be successively less and less. Higher-income countries are more likely to have diminishing investment returns and must continually invent new technologies. This allows lower-income economies to have a chance for convergent growth. However, many high-income economies have developed economic and political institutions that provide a healthy economic climate for an ongoing stream of technological innovations. Continuous technological innovation can counterbalance diminishing returns to human and physical capital investments.

8.1 How Economists Define and Compute Unemployment Rate

Unemployment imposes high costs. Unemployed individuals experience loss of income and stress. An economy with high unemployment suffers an opportunity cost of unused resources. We can divide the adult population into those in and out of the labor force. In turn, we divide those in the labor force into employed and unemployed. A person without a job must be willing and able to work and actively looking for work to be counted as unemployed; otherwise, a person without a job is counted as out of the labor force. Economists define the unemployment rate as the number of unemployed persons divided by the number of persons in the labor force (not the overall adult population). The Current Population Survey (CPS) conducted by the United States Census Bureau measures the percentage of the unemployed labor force. The establishment payroll survey by the Bureau of Labor Statistics measures the net change in jobs created for the month.

8.2 Patterns of Unemployment

The U.S. unemployment rate rises during periods of recession and depression but falls back to 4% to 6% when the economy is strong. The unemployment rate never falls to zero. Despite enormous growth in the size of the U.S. population and labor force in the twentieth century, along with other significant trends like globalization and new technology, the unemployment rate shows no long-term rising trend.

Unemployment rates differ by group: higher for African-Americans and Hispanics than White people; higher for less educated than more educated; higher for the young than the middle-aged. Women’s unemployment rates used to be higher than men’s, but in recent years men’s and women’s unemployment rates have been very similar. In recent years, unemployment rates in the United States have been compared favorably with those in most other high-income economies.

8.3 What Causes Changes in Unemployment over the Short Run

Cyclical unemployment rises and falls with the business cycle. In a labor market with flexible wages, wages will adjust in such a market so that the quantity demanded of labor always equals the quantity supplied of labor at the equilibrium wage. Economists have proposed many theories for why wages might not be flexible. Instead, they may adjust only in a “sticky” way, especially regarding downward adjustments: implicit contracts, efficiency wage theory, adverse selection of wage cuts, insider-outsider model, and relative wage coordination.

8.4 What Causes Changes in Unemployment over the Long Run

The natural rate of unemployment is the rate of unemployment that the economic, social, and political forces in the economy would cause even when the economy is not in a recession. These factors include frictional unemployment when people either choose to change jobs or are put out of work for a time by the shifts of a dynamic and changing economy. They also include any laws concerning conditions of hiring and firing that have the undesired side effect of discouraging job formation. They also include structural unemployment, which occurs when demand shifts permanently away from a specific job skill.

9.1 Tracking Inflation

Economists measure the price level by using a basket of goods and services and calculating how the total cost of buying that basket of goods will increase over time. Economists often express the price level in terms of index numbers, which transform the cost of buying the basket of goods and services into a series of numbers in the same proportion to each other, but with an arbitrary base year of 100. We measure the inflation rate as the percentage change between price levels or index numbers over time.

9.2 How to Measure Changes in the Cost of Living

Measuring price levels with a fixed basket of goods will always have two problems: the substitution bias, by which a fixed basket of goods does not allow for buying more of what becomes relatively less expensive and less of what becomes relatively more expensive, and the quality/new goods bias, by which a fixed basket cannot account for improvements in quality and the advent of new goods. These problems can be reduced in degree—for example, by allowing the basket of goods to evolve—but we cannot eliminate them. The most commonly cited measure of inflation is the Consumer Price Index (CPI), which is based on a basket of goods representing what the typical consumer buys. The Core Inflation Index further breaks down the CPI by excluding volatile economic commodities. Several price indices are not based on baskets of consumer goods. The GDP deflator is based on all GDP components. The Producer Price Index is based on the prices of supplies and inputs bought by producers of goods and services. An Employment Cost Index measures wage inflation in the labor market. An International Price Index is based on the prices of exported or imported merchandise.

9.3 How the U.S. and Other Countries Experience Inflation

The annual inflation rate in the last two decades has typically been around 2% to 4% in the U.S. economy. The periods of highest inflation in the United States in the twentieth century occurred during the years after World Wars I and II and in the 1970s. The period of lowest inflation—actually, with deflation—was the 1930s Great Depression.

9.4 The Confusion Over Inflation

Unexpected inflation will tend to hurt those whose money received, in terms of wages and interest payments, does not rise with inflation. In contrast, inflation can help those who owe money that they can pay in less valuable, inflated dollars. Low rates of inflation have relatively little economic impact over the short term. Over the medium and the long term, even low inflation rates can complicate future planning. High inflation rates can muddle price signals in the short term, prevent market forces from operating efficiently, and can vastly complicate long-term savings and investment decisions.

9.5 Indexing and Its Limitations

A payment is indexed if it is automatically adjusted for inflation. Examples of indexing in the private sector include wage contracts with cost-of-living adjustments (COLAs) and loan agreements like adjustable-rate mortgages (ARMs). Examples of indexing in the public sector include tax brackets and Social Security payments.

10.1 Measuring Trade Balances

The trade balance measures the gap between a country’s exports and imports. In most high-income economies, goods comprise less than half of a country’s total production, while services comprise more than half. The last two decades have seen a surge in international trade in services; however, most global trade still takes the form of goods rather than services. The current account balance includes the trade in goods, services, and money flowing into and out of a country from investments and unilateral transfers.

10.2 Trade Balances in Historical and International Context

The United States developed large trade surpluses in the early 1980s, swung back to a tiny trade surplus in 1991, and had even more significant trade deficits in the late 1990s and early 2000s. As we will see below, a trade deficit necessarily means a net inflow of financial capital from abroad. In contrast, a trade surplus means a net outflow of financial capital from an economy to other countries.

10.3 Trade Balances and Flows of Financial Capital

International flows of goods and services are closely connected to the international flows of financial capital. A current account deficit means that, after taking all the payments from goods, services, and income together, the country is a net borrower from the rest of the world. A current account surplus is the opposite, meaning the country is a net lender to the rest of the world.

10.4 The National Savings and Investment Identity

The national saving and investment identity is based on the relationship that the total quantity of financial capital supplied from all sources must equal the total quantity demanded from all sources. If S is private savings, T is taxes, G is government spending, M is imports, X is exports, and I is investment, then for an economy with a current account deficit and a budget deficit:

Supply of financial capitalS + (M – X) = =Demand for financial capitalI + (G – T) Supply of financial capital = Demand for financial capitalS + (M – X)=I + (G – T)

A recession tends to increase the trade balance (meaning a higher trade surplus or lower trade deficit). In comparison, an economic boom will tend to decrease the trade balance (meaning a lower trade surplus or a larger trade deficit).

10.5 The Pros and Cons of Trade Deficits and Surpluses

Trade surpluses do not guarantee economic health, and trade deficits do not guarantee economic weakness. Either trade deficits or trade surpluses can work out well or poorly, depending on whether a government wisely invests the corresponding flows of financial capital.

10.6 The Difference between the Level of Trade and the Trade Balance

There is a difference between the level of a country’s trade and the balance of trade. The government measures its level of trade by the percentage of exports out of GDP or the size of the economy. Small economies with nearby trading partners and a history of international trade will tend to have higher levels of trade. Larger economies with few nearby trading partners and a limited history of international trade will tend to have lower levels of trade. The level of trade is different from the trade balance. The level of trade depends on a country’s history of trade, its geography, and the size of its economy. A country’s balance of trade is the dollar difference between its exports and imports.

Trade deficits and surpluses are not necessarily good or bad—it depends on the circumstances. Even if a country is borrowing, investing that money in productivity-boosting investments can lead to an improvement in long-term economic growth.

11.1 Macroeconomic Perspectives on Demand and Supply

Neoclassical economists emphasize Say's law, which holds that supply creates demand. Keynesian economists emphasize Keynes' law, which states demand creates its supply. Many mainstream economists take a Keynesian perspective, emphasizing the importance of aggregate demand for the short run, and a neoclassical perspective, emphasizing the importance of aggregate supply for the long run.

11.2 Building a Model of Aggregate Demand and Aggregate Supply

The upward-sloping short-run aggregate supply (SRAS) curve shows the positive relationship between the price level and the level of real GDP in the short run. Aggregate supply slopes up because when the price level for outputs increases, while the price level of inputs remains fixed, the opportunity for additional profits encourages more production. The aggregate supply curve is near-horizontal on the left and near-vertical on the right. In the long run, we show the aggregate supply by a vertical line at the level of potential output, which is the maximum level of output the economy can produce with its existing levels of workers, physical capital, technology, and economic institutions.

The downward-sloping aggregate demand (AD) curve shows the relationship between the output price level and the quantity of total spending in the economy. It slopes down because of: (a) the wealth effect, which means that a higher price level leads to lower real wealth, which reduces the level of consumption; (b) the interest rate effect, which holds that a higher price level will mean a greater demand for money, which will tend to drive up interest rates and reduce investment spending; and (c) the foreign price effect, which holds that a rise in the price level will make domestic goods relatively more expensive, discouraging exports and encouraging imports.

11.3 Shifts in Aggregate Supply

The aggregate demand/aggregate supply (AD/AS) diagram shows how AD and AS interact. The intersection of the AD and AS curves show the economy's equilibrium output and price level. Movements of either AS or AD will result in a different equilibrium output and price level. The aggregate supply curve will shift out to the right as productivity increases. It will shift back to the left as the price of critical inputs rises and will shift out to the right if the price of crucial inputs falls. If the AS curve shifts back to the left, the combination of lower output, higher unemployment, and higher inflation, called stagflation, occurs. If AS shifts out to the right, lower inflation, higher output, and lower unemployment are possible.

11.4 Shifts in Aggregate Demand

The AD curve will shift out as the components of aggregate demand—C, I, G, and X–M—rise. It will shift back to the left as these components fall. These factors can change because of different personal choices, like those resulting from consumer or business confidence, or policy choices, like changes in government spending and taxes. If the AD curve shifts to the right, the equilibrium quantity of output and the price level will rise. If the AD curve shifts to the left, the equilibrium quantity of output and the price level will fall. Whether equilibrium output changes relatively more than the price level or the price level changes relatively more than output is determined by where the AD curve intersects with the AS curve.

The AD/AS diagram superficially resembles the microeconomic supply and demand diagram on the surface, but in reality, what is on the horizontal and vertical axes and the underlying economic reasons for the shapes of the curves are very different. We can illustrate long-term economic growth in the AD/AS framework by gradually shifting the aggregate supply curve to the right. We illustrate a recession when AD and AS intersect substantially below the potential GDP. In contrast, we illustrate an expanding economy when the intersection of AS and AD is near potential GDP.

11.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation

Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below the potential GDP. Cyclical unemployment is small in the AD/AS framework when the equilibrium is near potential GDP. The natural unemployment rate, as determined by the labor market institutions of the economy, is built into what economists mean by potential GDP but does not otherwise appear in an AD/AS diagram. The AD/AS framework shows pressures for inflation to rise or fall when the movement from one equilibrium to another causes the price level to rise or fall. The balance of trade does not appear directly in the AD/AS diagram, but it appears indirectly in several ways. Increases in exports or declines in imports can cause shifts in AD. Changes in the price of key imported inputs to production, like oil, can cause shifts in AS. The AD/AS model is critical in this book to understand macroeconomic issues.

11.6 Keynes' Law and Say's Law in the AD/AS Model

We can divide the SRAS curve into three zones. Keynes' law says demand creates its supply, so changes in aggregate demand cause changes in real GDP and employment. We can show Keynes' law on the horizontal Keynesian zone of the aggregate supply curve. The Keynesian zone occurs at the left of the SRAS curve, where it is relatively flat, so movements in AD will affect the output but have little effect on the price level. Say's law says supply creates demand. Changes in aggregate demand do not affect real GDP and employment, only the price level. We can show Say's law on the vertical neoclassical zone of the aggregate supply curve. The neoclassical zone occurs at the right of the SRAS curve, where it is relatively vertical, so movements in AD will affect the price level but have little impact on output. The intermediate zone in the middle of the SRAS curve is upward-sloping, so a rise in AD will cause higher output and price levels, while a fall in AD will lead to a lower output and price level.

12.1 Aggregate Demand in Keynesian Analysis

Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports. Consumption will change for several reasons, including movements in income, taxes, future income expectations, and wealth levels. The investment will change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of critical inputs, and tax incentives for investment. The investment will also change when interest rates rise or fall. Political considerations determine government spending and taxes. Exports and imports change according to relative growth rates and prices between the two economies.

12.2 The Building Blocks of Keynesian Analysis

Keynesian economics is based on two main ideas: (1) aggregate demand is more likely than aggregate supply to be the primary cause of a short-run economic event like a recession; (2) wages and prices can be sticky, and so, in an economic downturn, unemployment can result. The latter is an example of a macroeconomic externality. While surpluses cause prices to fall at the micro level, they do not necessarily at the macro level. Instead, the adjustment to a decrease in demand occurs only through decreased quantities. One reason prices may be sticky is menu costs, the costs of changing prices. These include internal costs a business faces in changing prices regarding labeling, recordkeeping, and accounting and the costs of communicating the price change to (possibly unhappy) customers. Keynesians also believe in the existence of the expenditure multiplier—the notion that a change in autonomous expenditure causes a more than proportionate change in GDP.

12.3 The Phillips Curve

A Phillips curve shows the tradeoff between unemployment and inflation in an economy. From a Keynesian viewpoint, the Phillips curve should slope down so that higher unemployment means lower inflation and vice versa. However, a downward-sloping Phillips curve is a short-term relationship that may shift after a few years.

Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment or direct increases in government spending that would shift the aggregate demand curve to the right. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left.

12.4 The Keynesian Perspective on Market Forces

The Keynesian prescription for stabilizing the economy implies government intervention at the macroeconomic level—increasing aggregate demand when private demand falls and decreasing aggregate demand when private demand rises. This does not imply that the government should be passing laws or regulations that set prices and quantities in microeconomic markets.

13.1 The Building Blocks of Neoclassical Analysis

The neoclassical perspective argues that, in the long run, the economy will adjust back to its potential GDP output level through flexible price levels. Thus, the neoclassical perspective views the long-run AS curve as vertical. A rational expectations perspective argues that people have excellent information about economic events and how the economy works and that, as a result, price and other economic adjustments will happen very quickly. In adaptive expectations theory, people have limited information about economic information and how the economy works, so price and other economic adjustments can be slow.

13.2 The Policy Implications of the Neoclassical Perspective

Neoclassical economists tend to put relatively more emphasis on long-term growth than on fighting recession because they believe that recessions will fade in a few years and long-term growth will ultimately determine the standard of living. They tend to focus more on reducing the natural rate of unemployment caused by economic institutions and government policies than the cyclical unemployment caused by the recession.

Neoclassical economists also see no social benefit to inflation. Inflation can arise with an upward-sloping Keynesian AS curve because an economy is approaching full employment. With a vertical long-run neoclassical AS curve, inflation does not accompany any rise in output. If aggregate supply is vertical, then aggregate demand does not affect the quantity of output. Instead, aggregate demand can only cause inflationary changes in the price level. A vertical aggregate supply curve, where the quantity of output is consistent with many different price levels, also implies a vertical Phillips curve.

13.3 Balancing Keynesian and Neoclassical Models

The Keynesian perspective considers changes to aggregate demand to cause business cycle fluctuations. Keynesians are likely to advocate that policymakers actively attempt to reverse recessionary and inflationary periods because they are not convinced that the self-correcting economy can quickly return to full employment.

The neoclassical perspective places more emphasis on aggregate supply. Neoclassical economists believe that long-term productivity growth determines the potential GDP level and that the economy typically will return to full employment after a change in aggregate demand. Skeptical of the effectiveness and timeliness of Keynesian policy, neoclassical economists are more likely to advocate a hands-off, or relatively limited, role for active stabilization policy.

While Keynesians would tend to advocate an acceptable tradeoff between inflation and unemployment when counteracting a recession, neoclassical economists argue that no such tradeoff exists. Any short-term gains in lower unemployment will eventually vanish, and active policy will only result in inflation.

14.1 Defining Money by Its Functions

People in a society regularly use money when purchasing or selling goods and services. If money were not available, people would need to barter with each other, meaning that each person would need to identify others with whom they have a double coincidence of wants—that is, each party has a specific good or service that the other desires. Money serves several functions: a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. There are two types of money: commodity money, which is an item used as money, but which also has a value from its use as something other than money; and fiat money, which has no intrinsic value but is declared by a government to be the country's legal tender.

14.2 Measuring Money: Currency, M1, and M2

We measure money with several definitions: M1 includes currency and money in checking accounts (demand deposits). Traveler's checks are also a component of M1 but are declining in use. M2 includes all of M1, savings deposits, time deposits like certificates of deposit, and money market funds.

14.3 The Role of Banks

Banks facilitate using money for economic transactions because people and firms can use bank accounts when selling or buying goods and services, when paying a worker or receiving payment, and when saving money or receiving a loan. Banks are financial intermediaries in the financial capital market; that is, they operate between savers who supply financial capital and borrowers who demand loans. A balance sheet (sometimes called a T-account) is an accounting tool that lists assets in one column and liabilities in another. The bank's liabilities are its deposits. The bank's assets include its loans, its ownership of bonds, and its reserves (which it does not loan out). We calculate a bank's net worth by subtracting its liabilities from its assets. Banks run a risk of negative net worth if the value of their assets declines. The value of assets can decline because of an unexpectedly high number of defaults on loans or if interest rates rise and the bank suffers an asset-liability time mismatch in which the bank is receiving a low-interest rate on its long-term loans but must pay the currently higher market interest rate to attract depositors. Banks can protect themselves against these risks by diversifying their loans or holding a greater proportion of their assets in bonds and reserves. Suppose banks hold only a fraction of their deposits as reserves. In that case, the process of banks lending money, re-depositing those loans in banks, and the banks making additional loans will create money in the economy.

14.4 How Banks Create Money

We define the money multiplier as the quantity of money that the banking system can generate from each $1 of bank reserves. The formula for calculating the multiplier is the 1/reserve ratio, where the reserve ratio is the fraction of deposits the bank wishes to hold as reserves. The quantity of money in an economy and the quantity of credit for loans are inextricably intertwined. The network of banks making loans, people making deposits, and banks making more loans creates much of the money in an economy.

Given the macroeconomic dangers of a malfunctioning banking system, Monetary Policy and Bank Regulation will discuss government policies for controlling the money supply and keeping the banking system safe.

15.1 The Federal Reserve Banking System and Central Banks

The most prominent task of a central bank is to conduct monetary policy, which involves changes to interest rates and credit conditions, affecting the amount of borrowing and spending in an economy. Some prominent central banks worldwide include the U.S. Federal Reserve, the European Central Bank, the Bank of Japan, and the Bank of England.

15.2 Bank Regulation

A bank run occurs when there are rumors (possibly true, possibly false) that a bank is at financial risk of having a negative net worth. As a result, depositors rush to the bank to withdraw their money and put it someplace safer. Even false rumors, if they cause a bank run, can force a healthy bank to lose its deposits and be forced to close. Deposit insurance guarantees bank depositors that their deposits will be protected even if the bank has negative net worth. In the United States, the Federal Deposit Insurance Corporation (FDIC) collects deposit insurance premiums from banks and guarantees bank deposits up to $250,000. Bank supervision involves inspecting banks' balance sheets to ensure that they have positive net worth and that their assets are not too risky. In the United States, the Office of the Comptroller of the Currency (OCC) supervises banks and inspects savings and loans. The National Credit Union Administration (NCUA) is responsible for credit unions. The FDIC and the Federal Reserve also play a role in bank supervision.

When a central bank acts as a lender of last resort, it makes short-term loans available in severe financial panic or stress. The failure of a single bank can be treated like any other business failure. Yet, if many banks fail, it can reduce aggregate demand in a way that can bring on or deepen a recession. The combination of deposit insurance, bank supervision, and lender-of-last-resort policies helps to prevent weaknesses in the banking system from causing recessions.

15.3 How a Central Bank Executes Monetary Policy

A central bank has three traditional tools to conduct monetary policy: open market operations, which involve buying and selling government bonds with banks; reserve requirements, which determine what level of reserves a bank is legally required to hold; and discount rates, which are the interest rate charged by the central bank on the loans that it gives to other commercial banks. The most commonly used tool is open market operations.

15.4 Monetary Policy and Economic Outcomes

An expansionary (or loose) monetary policy raises the quantity of money and credit above what it otherwise would have been. It reduces interest rates, boosting aggregate demand and thus countering recession. A contractionary monetary policy, also called a tight monetary policy, reduces the quantity of money and credit below what it otherwise would have been. It raises interest rates, seeking to hold down inflation. During the 2008–2009 recession, central banks worldwide also used quantitative easing to expand the credit supply.

15.5 Pitfalls for Monetary Policy

Monetary policy is inevitably imprecise for several reasons: (a) the effects occur only after long and variable lags; (b) if banks decide to hold excess reserves, monetary policy cannot force them to lend; and (c) velocity may shift in unpredictable ways. The fundamental quantity equation of money is MV = PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q is the actual economy's real output. Some central banks, like the European Central Bank, practice inflation targeting, which means that the only goal of the central bank is to keep inflation within a low target range. Other central banks, such as the U.S. Federal Reserve, are free to focus on reducing inflation or stimulating an economy in recession, whichever goal seems most important at the time.

16.1 How the Foreign Exchange Market Works

People and firms exchange one currency to purchase another in the foreign exchange market. The demand for dollars comes from those U.S. export firms seeking to convert their earnings into foreign currency back into U.S. dollars, foreign tourists converting their earnings in foreign currency back into U.S. dollars, and foreign investors seeking to make financial investments in the U.S. economy. On the supply side of the foreign exchange market for the trading of U.S. dollars are foreign firms that have sold imports in the U.S. economy and are seeking to convert their earnings back to their home currency, U.S. tourists abroad, and U.S. investors seeking to make financial investments in foreign economies. When currency A can buy more of currency B, currency A has strengthened or appreciated relative to B. When currency A can buy less of currency B, currency A has weakened or depreciated relative to B. If currency A strengthens or appreciates relative to currency B, then currency B must necessarily weaken or depreciate about currency A. A stronger currency benefits those who are buying with that currency and injures those who are selling. A weaker currency injures those, like importers, who are buying with that currency and benefits those who are selling with it, like exporters.

16.2 Demand and Supply Shifts in Foreign Exchange Markets

In the extreme short run, ranging from a few minutes to a few weeks, speculators are trying to invest in currencies that will grow stronger and sell currencies that will grow weaker, influencing exchange rates. Such speculation can create a self-fulfilling prophecy, at least for a time, where an expected appreciation leads to a stronger currency and vice versa. In the relatively short run, differences in rates of return influence exchange rate markets. Countries with relatively high accuracy rates of return (for example, high-interest rates) will tend to experience stronger currencies as they attract money from abroad. In contrast, countries with relatively low rates of return tend to experience weaker exchange rates as investors convert to other currencies.

Inflation rates influence exchange rate markets in the medium run of a few months or years. Countries with relatively high inflation will tend to experience less demand for their currency than countries with lower inflation, and thus currency depreciation. Over long periods of many years, exchange rates tend to adjust toward the purchasing power parity (PPP) rate, which is the exchange rate such that the prices of internationally tradable goods in different countries, when converted at the PPP exchange rate to a common currency, are similar in all economies.

16.3 Macroeconomic Effects of Exchange Rates

A central bank will be concerned about the exchange rate for several reasons. Exchange rates will affect imports and exports and thus affect aggregate demand in the economy. Fluctuations in exchange rates may cause difficulties for many firms, especially banks. The exchange rate may accompany unsustainable flows of international financial capital.

16.4 Exchange Rate Policies

In a floating exchange rate policy, a government determines its country's exchange rate in the foreign exchange market. In a soft peg exchange rate policy, the foreign exchange market usually determines a country's exchange rate, but the government sometimes intervenes to strengthen or weaken it. The government chooses an exchange rate in a hard peg exchange rate policy. A central bank can intervene in exchange markets in two ways. It can raise or lower interest rates to make the currency stronger or weaker. It also can directly purchase or sell its currency in foreign exchange markets. All exchange rate policies face tradeoffs. A complex peg exchange rate policy will reduce exchange rate fluctuations. However, a country must focus its monetary policy on the exchange rate, not fighting recession or controlling inflation. When a nation merges its currency with another nation, it disregards nationally oriented monetary policy altogether.

A soft peg exchange rate may create additional volatility as exchange rate markets try to anticipate when and how the government will intervene. A flexible exchange rate policy allows monetary policy to focus on inflation and unemployment. It allows the exchange rate to change with inflation and rates of return, but it also raises a risk that exchange rates may sometimes make large and abrupt movements. The spectrum of exchange rate policies includes (a) a floating exchange rate, (b) a pegged exchange rate, soft or hard, and (c) a merged currency. Monetary policy can focus on a variety of goals: (a) inflation; (b) inflation or unemployment, depending on which is the most dangerous obstacle; and (c) a long-term rule-based policy designed to keep the money supply stable and predictable.

17.1 Government Spending

Fiscal policy is the set of policies that relate to federal government spending, taxation, and borrowing. In recent decades, federal government spending and taxes, expressed as a share of GDP, have not changed much, typically fluctuating between 18% to 22%. However, state spending and taxes, as a share of GDP, have risen from about 12–13% to about 20% over the last four decades. The four primary areas of federal spending are national defense, Social Security, healthcare, and interest payments, which account for about 70% of all federal spending. When a government spends more than it collects in taxes, it is said to have a budget deficit. When a government collects more in taxes than it spends, it is said to have a budget surplus. If government spending and taxes are equal, it is said to have a balanced budget. The sum of all past deficits and surpluses makes up the government debt.

17.2 Taxation

The two central federal taxes are individual income taxes and payroll taxes that provide funds for Social Security and Medicare; these taxes account for more than 80% of federal revenues. Other federal taxes include the corporate income tax, excise taxes on alcohol, gasoline, and tobacco, and the estate and gift tax. A progressive tax is one, like the federal income tax, where those with higher incomes pay a higher share of taxes out of their income than those with lower incomes. A proportional tax is one, like the payroll tax for Medicare, where everyone pays the same share of taxes regardless of income level. A regressive tax is one, like the payroll tax (above a certain threshold) that supports Social Security, where those with high incomes pay a lower share of income in taxes than those with lower incomes.

17.3 Federal Deficits and the National Debt

For most of the twentieth century, the U.S. government took on debt during wartime and paid down that debt slowly in peacetime. However, it took on quite substantial debts in peacetime in the 1980s and early 1990s before a brief period of budget surpluses from 1998 to 2001, followed by a return to annual budget deficits since 2002, with huge deficits in the recession of 2008 and 2009. A budget deficit or budget surplus is measured annually. Total government or national debt is the sum of budget deficits and surpluses over time.

17.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation

Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases aggregate demand through cuts in government spending or increases in taxes. Contractionary fiscal policy is most appropriate when an economy produces above its potential GDP.

17.5 Automatic Stabilizers

Fiscal policy is conducted through discretionary fiscal policy, which occurs when the government enacts taxation or spending changes in response to economic events or through automatic stabilizers, taxing, and spending mechanisms that, by their design, shift in response to economic events without further legislation. The standardized employment budget calculates the budget deficit or surplus in a given year if the economy has been producing at its potential GDP. Many economists and politicians criticize the use of fiscal policy for various reasons, including concerns over time lags, the impact on interest rates, and the inherently political nature of fiscal policy. We will cover the critique of fiscal policy in the next module.

17.6 Practical Problems with Discretionary Fiscal Policy

Because fiscal policy affects the quantity of money that the government borrows in financial capital markets, it not only affects aggregate demand—it can also affect interest rates. If an expansionary fiscal policy also causes higher interest rates, firms, and households are discouraged from borrowing and spending, reducing aggregate demand in a crowding-out situation. Given the uncertainties over interest rate effects, time lags (implementation lag, legislative lag, and recognition lag), temporary and permanent policies, and unpredictable political behavior, many economists and knowledgeable policymakers have concluded that discretionary fiscal policy is a blunt instrument better used only in extreme situations.

17.7 The Question of a Balanced Budget

Balanced budget amendments are a popular political idea, but the economic merits behind such proposals are questionable. Most economists accept that fiscal policy needs to be flexible enough to accommodate unforeseen expenditures, such as wars or recessions. While persistent, large budget deficits can be a problem, a balanced budget amendment prevents even small, temporary deficits that might sometimes be necessary.

18.1 How Government Borrowing Affects Investment and the Trade Balance

A change in any part of the national saving and investment identity suggests that if the government budget deficit changes, then private savings, private investment in physical capital, or the trade balance—or some combination of the three—must also change.

18.2 Fiscal Policy and the Trade Balance

The government need not balance its budget every year. However, a sustained pattern of large budget deficits over time risks causing several adverse macroeconomic outcomes: a shift to the right in aggregate demand that causes an inflationary increase in the price level, crowding out private investment in physical capital in a way that slows down economic growth; and creating a dependence on inflows of international portfolio investment which can sometimes turn into outflows of foreign financial investment that can be harmful to a macroeconomy.

18.3 How Government Borrowing Affects Private Saving

The theory of Ricardian equivalence holds that changes in private savings will offset changes in government borrowing or saving. Thus, more fantastic private savings will offset higher budget deficits, while greater private borrowing will offset more significant budget surpluses. If the theory holds, government borrowing or saving changes will not affect private investment in physical capital or the trade balance. However, empirical evidence suggests that the theory holds only partially.

18.4 Fiscal Policy, Investment, and Economic Growth

Economic growth comes from a combination of physical capital, human capital, and technology investment. Government borrowing can crowd out private sector investment in physical capital, but fiscal policy can also increase investment in publicly owned physical capital, human capital (education), and research and development. Possible methods for improving education and society’s investment in human capital include spending more money on teachers and other educational resources and reorganizing the education system to provide more significant incentives for success. Methods for increasing research and development spending to generate new technology include direct government spending on R&D and tax incentives for businesses to conduct additional R&D.

19.1 The Diversity of Countries and Economies across the World

Macroeconomic policy goals for most countries strive toward low unemployment and inflation levels and stable trade balances. Economists analyze countries based on their GDP per person and rank as low-, middle-, and high-income countries. Low-income people earn less than $1,025 (less than 1%) of global income. They currently have 18.5% of the world's population. Middle-income countries have a per capita income of $1,025–$12,475 (31.1% of global income). They have 69.5% of the world's population. High-income countries have a per capita income greater than $12,475 (68.3% of global income). They have 12% of the World’s population. Regional comparisons are inaccurate because even countries within those regions tend to differ.

19.2 Improving Countries’ Standards of Living

Growth fundamentals are the same in every country: improvements in human capital, physical capital, and technology interact in a market-oriented economy. High-income countries tend to focus on developing and using new technology. Middle-income countries focus on increasing human capital and becoming more connected to technology and global markets. They have charted unconventional paths by relying more on state-led support than on markets. Low-income, economically-challenged countries have many health and human development needs, but they are also challenged by the lack of investment and foreign aid to develop infrastructure like roads. There are some bright spots regarding financial development and mobile communications, which suggest that low-income countries can become technology leaders in their own right. Still, it is too early to claim victory. These countries must do more to connect to the rest of the global economy and find the best technologies for them.

19.3 Causes of Unemployment Around the World

We can address cyclical unemployment by expansionary fiscal and monetary policy. The natural unemployment rate can be more brutal because it involves carefully considering the tradeoffs in laws that affect employment and hiring. Unemployment is understood differently in high-income countries compared to low- and middle-income countries. People in these countries are not “unemployed” because we use the term in the United States and Europe, but neither are they employed in a regular wage-paying job. While some may have regular wage-paying jobs, others are part of a barter economy.

19.4 Causes of Inflation in Various Countries and Regions

Most high-income economies have learned that their central banks can control medium- and long-term inflation. In addition, they have learned that inflation has no long-term benefits but potentially substantial long-term costs if it distracts businesses from focusing on real productivity gains. However, smaller economies around the World may face more volatile inflation because international movements of capital and goods can unsettle their smaller economies.

19.5 Balance of Trade Concerns

There are many legitimate concerns over the possible negative consequences of free trade. Perhaps the strongest response to these concerns is that there are good ways to address them without restricting trade and thus losing its benefits. There are two significant issues involving trade imbalances. One is what will happen with the large U.S. trade deficits and whether they will come down gradually or with a rush. The other is whether smaller countries around the World should take some steps to limit flows of international capital in the hope that they will not be quite so susceptible to economic whiplash from international financial capital flowing in and out of their economies.

20.1 Absolute and Comparative Advantage

A country has an absolute advantage in those products in which it has a productivity edge over other countries; it takes fewer resources to produce a product. A country has a comparative advantage when it can produce a good at a lower cost than other goods. Countries that specialize based on comparative advantage gain from trade.

20.2 What Happens When a Country Has an Absolute Advantage in All Goods

Even when a country has high productivity levels in all goods, it can still benefit from trade. Gains from trade come about as a result of comparative advantage. By specializing in a good that gives up the least to produce, a country can produce more and offer that additional output for sale. If other countries specialize in their comparative advantage as well as trade, the highly productive country can benefit from a lower opportunity cost of production in other countries.

20.3 Intra-industry Trade between Similar Economies

A large share of global trade happens between high-income economies that are pretty similar in having well-educated workers and advanced technology. These countries practice intra-industry trade, importing and exporting the same products simultaneously, like cars, machinery, and computers. In the case of intra-industry trade between economies with similar income levels, the gains from trade come from specialized learning in particular tasks and economies of scale. Splitting up the value chain means several stages of producing a good occur in different countries around the world.

20.4 The Benefits of Reducing Barriers to International Trade

Tariffs are placed on imported goods to protect sensitive industries, for humanitarian reasons, and for protection against dumping. Traditionally, tariffs were used as a political tool to protect specific vested economic, social, and cultural interests. The WTO has been and continues to be, a way for nations to meet and negotiate to reduce trade barriers. The gains of international trade are huge, especially for smaller countries, but are beneficial to all.