What Is Macroeconomics?

What isMacroeconomics?1.1 Overview of Macroeconomics 41.2 Macroeconomic Concepts 51.2.1Income and Output 51.2.2Unemployment 51.2.3Factors of Production and Income Distribution 81.2.4Inflation 81.2.5Financial Markets and the Real Economy 101.2.6Openness 111.3 Macroeconomics in the Long Run : Economic Growth 121.4 Macroeconomics in the Short Run: Business Cycles 131.s Macroeconomics as a Science151.5.1The Genesis of Macroeconom ics 151.5.2Macroeconomics and Microeconomics 181.5.3Demand and Supply 201.6 The Methodology of Macroeconomics 211.6.1What is to be Explained? 211.6.2Theory and Realism 211.6.3Positive and Normative Analysis 221.6.4Testing Theories: The Role of Data 221.6.5Macroeconomic Modelling and Forecasting 221.7 Preview of the Book 241.7.1Structu re 241.7.2Controversies and Consensus 241.7.3Rigour and Intuition 241.7.4Data and Institutions 241.7.5Europe 25

4PART I INTRODUCTION TO MACROECONOMICSThe Theory of Economics does not furnish a body ofsettled conclusions immediately applicable to policy. It isa method rather than a doctrine, an apparatus of themind, a technique of thinking, which helps its possessorto draw correct conclusions.]. M. Keynes1.2.1 InOverview of Macroeconomics-:be mmnomic v.income 'gross donUnemployment, inflation, booms and busts, financial markets, interest rates, and exchange rates areeveryday fare in the news. All these phenomenaaffect our well-being. This why macroeconomics is soexciting. Macroeconomics is more than just headlines, however: it is a fascinating intellectual adventure. The breadth of issues it covers is evidenceenough of its inherent complexity. Yet, a few simple ideas can go a long way seeing through complex situations. Macroeconomics is also enormouslyuseful. People, rich or poor, are affected as jobsappear or vanish and as prices change. Businessescan gain or lose large amounts of money whentheir environment changes, regardless of how wellthey are managed. Citizens want to understandwhat their governments are up to. Dramatic eventslike depressions, when overall economic activity isvery far below average and unemployment soars,or hyperinflations, when prices are increasing atmonthly rates of 50% or more, can tear at a society's social fabric, and yet can be prevented whenpolicy-makers apply sound economic principles.But are 'sound economic principles' valid? Theevents that started in 2007 and led to the GreatRecession and the Eurozone crises have led someobservers to conclude that macroeconomics needsto be overhauled. Yet it is also common to blamemedical doctors for epidemics, and or messengersfor bringing bad news, and that doesn't sound fair.Macroeconomists are in a similar situation today.We will argue that macroeconomics as a field hasproved its mettle. To be sure, our understanding isvery far from perfect. In particular, macroeconomists are not good at making forecasts and the profession has failed to see the crisis coming. Yet, theprinciples underlying our field made it possible tounderstand these dramatic events surprisingly wellas they unfolded. They also contained prescriptionsfor what needed to be done. When governmentsheeded this advice, the economic situation in factimproved. In any case, we did not experience theGreat Depression of the 1930s, and we know why.Besides helping diagnose such situations, the material in this book will teach you humility: Someevents, both economic and political, cannot be predicted. This includes banking and financial crises,which contain strong behavioural elements.A key feature of macroeconomics is that it isgeared to finding solutions. Its principles may lookabstract at first, but they readily lead to policy prescriptions. These prescriptions are directly relatedto the observation of economic events with undesirable consequences, which in turn presumesagreement on what is to be measured and howmeasurements are made. Before the arrival of macroeconomics, concepts such the gross domesticproduct (GDP), the consumer price index, or theunemployment rate simply did not exist. Some ofthese concepts are presented in Section 1.2, manymore will be introduced as we move through thebook. The next step is to formulate a diagnosis. Akey challenge at this stage is to distinguishedbetween business cycles, or short-run fluctuations ofoutput and employment, and long-run trends. Thisdistinction, which is presented in Sections 1.3 and1.4, shapes the structure of the book; both represent the subject of macroeconomics and the objective of macroeconomic policies. Equipped withthese preliminary essentials, we can then examinein what sense macroeconomics is a science(Section 1.5) and how it helps us to reason about theworld around us (Section 1.6). The chapter concludes with a preview of the book's contents(Section 1.7).cus ed i.rJ.ar!!e DWcheir ma2015 amGerman)0.68 trillner. 1 Obiay size.capita,\ che samthould btime bee1 morechange.1this issuconstant 1for this 1course olA quidcries are '· e, bu1uctuaticcycles.'-"andcydtrant obsEannual gfe.rencesin Argere lattei- e pericrae com1A crillio1?A usefuJzeros {leperanm

CHAPT ER 1 WHAT IS MACROECONOMICS?; its possessor1.2 Macroeconomic Concepts1.2.1 Income and Outputrescriptionswernmentstion in facterience theknow why.;, the mateility: Somemot be preicial crises, nts .; that it iss may lookpolicy pre:tly relatedwith undepresumesI and howtl ofmacrodomesticlex, or thet . Some of1.2, manyLrough theiagnosis. Atinguishedruations ofrends. Thisns 1.3 andoth reprethe objec ped with1 examinea scienceabout thetpter concontentsThe most important indicator of a nation's economic well-being is a measure of its output andincome during a given year, which is called thegross domestic product (GDP). The concept will be discussed in greater detail in Chapter 2. GDPs are verylarge numbers, and it is good to develop a feel fortheir magnitudes. In 2015, the GDP of the UK in2015 amounted to about 1.89 trillion pounds; inGermany, 3.02 trillion euros; in the Netherlands0.68 trillion euros; in Denmark 1.981 trillion kroner.1 Obviously, these numbers are related to country size, which is why we often look at GDP percapita, which range from 25,000 to 40,000 euros inthe same year across the countries of Europe. Weshould be careful when comparing these data overtime because GDPs can change for two reasons:(1) more is produced, and (2) prices of those goodschange. We will learn in Chapter 2 how to deal withthis issue using so-called real GDP numbers-atconstant prices, so to speak. Table 1.1, which correctsfor this using prices in the year 2000, displays thecourse of GDP over the past century.A quick look at the table reveals that (1 ) most countries are characterized by steady growth of GDP overtime, but that (2) there are significant and recurringfluctuations of GDP around its trend, called businesscycles. We return to the distinction between trendsand cycles in separate sections later. Another important observation is that small differences in averageannual growth rates cumulate over time to huge differences in levels. A striking example: GDP per capitain Argentina was about 15% larger than that ofSweden in 1900; 110 years later, it had fallen to halfthe latter's value. The reason? While both grew overthe period, Sweden's economy expanded at a 2.1 %rate compared with Argentina's 1.3%.2 Sinlilarly, it is12A trillion (1 000 000 000 000) (US usage) is 1 followe d by 12zeros (10 12 ).A useful rule of thumb is that a country growing at rate g%per annum needs about 70/g years to double in size.striking to note how much poorer the Asian countries were in comparison to Western Europe and theUS in 1900. Some of them caught up Oapan), orstarted to catch up recently (China after the late1970s) while others still have not (Bangladesh).A natural concern is whether GDP, or GDP percapita, is a good indicator of individual well-being.GDP says nothing about the distribution of incomein the economy, which may also matter to its residents. Many researchers are now examining issuesrelated to happiness and quality of life, not justeconomic output. One of the robust findings onresearch in this area is that while GDP is not everything, it is certainly one important determinant ofeconomic and social well-being. Some evidence isprovided in Figure 1.1, which displays on the vertical axis the results of coordinated public opinionpolls. People were asked how satisfied they werewith their lives. The horizontal axis corresponds tothat year's GDP per capita in each country. The figures show that deep unhappiness is only found inpoor countries. Yet, people in some countries seemto be poor and happy (e.g. Bhutan) while theFrench and the Germans seem less happy than theDanes and the Finns, who have similar standardsof living. A number of explanations are currentlybeing explored, but this is an entirely differentsubject!1.2.2 UnemploymentOne important phenomenon associated with cyclical fluctuations is unemployment, the fact that people seeking paid work cannot or do not find it,sometimes even when the economy is growing rapidly. The unemployment rate is the proportion ofunemployed workers in the labour force. The labourforce consists of those who are either working orare actively looking for a job. In comparison withthe total population, the labour force leaves outyoung people who are not yet working, the oldwho are retired, and those who cannot or do notwish to work-or have given up hope of working.5

6PART I INTRODUCTION TO MACROECONOMICS,,Real Income per Capita (GDP in euros, 2000 prices) o/)190019131929195019871992199920022007201 O2015Av. growth rateAustria2.4622,9613, 1603, 16713,08514,93717, 14517,92020,28920,28020,8241.9%Belgium3, 1883,6064,3 194,66713,28015,07817,01017,98720,06920,07120, 1041.6%Den mark2,5783,3434,3375,93315.40116, ,8042,3223,63413.14412,83715,93117, 414, 14415.77417,54918,61 O 19,04018,56218,9041.8%Germany2,5503, 9.4201.8%Italy1,5262, 5,3302.0%Netherlands2,9253,4594,8615, 12413.44715, 455,4107.74516,91217,80018,59019, 179 21, 3013, 15413,78516,65017,8 17 20, 18319, 8958, 1,1461,5681.7192,4022,8473,6391.7%1,0081, 9,6992.6%Source: www.eco.rug.nl/-Maddison/and The Conference Board and Groningen Growth and Development Centre, Total Economy Database, January2011, http}/www.conference-board.org/economics/The Maddison-Project, htm, 2013version. IMF, World Economic Outlook Database April 2016.There are many reasons to be concerned aboutunemployment. A first reaction to the image ofidle workers is one oflost production and income.At the same time, we need to ask whether theunemployed are able to find offers of work,whether they are turning down job offers, and ifso, for what reason. Are the jobs that workers aresearching at all, or are workers really unavailablefor jobs on offer, perhaps because their expectations are unreasonable? Or are they simply frustrated not to find a job and have given uplooking?Unemployment is generally not a pleasant affair.Even with well-developed and efficient unemployment assistance programmes, long-term joblessworkers can experience emotional stress and theirskills may deteriorate. Even if they are not measurable, the social and psychological costs of unemployment are high for the affected individuals andfor society as a whole. By that criterion, Europe hasnot done well over the last decades , as Figure 1.2shows. The average rate of unemployment hasgrown inexorably to reach double-digit numbers.In the USA, in contrast, unemployment has closelyco