A primer from Prof. Jarrell on this important subject
Macroeconomics is the study of aggregate supply and demand, and looks both internally to the workings of the economy and externally to how a domestic economy interacts with others worldwide.
Macro builds on the principles of microeconomics, which is the study of prices and quantities of individual goods and the markets where these goods are produced and sold.
In macro, “price” refers to some index of the prices of domestic goods and services, and “quantity” refers to some measure of the value of domestic production or “output.” One common measure of output is gross domestic product (“a measure of the productive activity of a country computed on the basis of the ownership of the factors of production”). A country’s standard of living is usually directly correlated with its real output, or the value of total output corrected for inflation.
Unlike microeconomics, macroeconomics started with the idea that prices and markets do not continuously resolve all of the coordination requirements of a modern economy. Such “failures of coordination” (Keynes) seem likely when one views the economy as the collective sum of thousands of microeconomic markets.
For example, although most economies around the world have experienced generally positive trends in their gross domestic product, short run positive and negative deviations (recessions and, in more dramatic examples of the failure of coordination, depressions) around the trend line, or “business cycles,” are common.
Inflation is the rate of change of the average level of prices, where the price level is usually measured as a price index. Inflation rates are typically quoted in annualized percentages. In normal times, the inflation rate is procyclical: it rises in periods of high growth and declines in periods of slow growth. Unemployment, by contrast, is usually countercyclical. The U. S. inflation rate was as likely to be negative as it was positive before World War II; since then, price levels have risen fairly consistently.
Financial markets play a key role in macroeconomics. It is here that resources are collected from savers and lent to producers for investment in the real economy. The real economy stands in contrast to the nominal (or financial or monetary) economy. The real economy is concerned with the production and consumption of goods and services; the nominal economy deals with the trade in assets, such as monetary and financial instruments. Physical investment, which is the acquisition of the physical means of production by firms, provides one channel by which financial markets affect the real economy.
Two fundamental approaches to macroeconomic policy have arisen, both of which are concerned with how to manage the inevitable failures of coordination between the micro units in the economy.
- Demand side: the use of government demand to smooth out fluctuations in the economy, mainly to avoid protracted recessions.
- Supply side: improving the efficient utilization of labor and capital resources to enhance the productive capacity of an economy.
One can also usefully separate the approaches to macroeconomic policy into laissez-faire and interventionism. Keynesians are frequently characterized by the view that markets are imperfect and that government holds an information advantage and should engage in active policy interventions in the economic activity of the markets.
Monetarists, one the other hand, see politics and bureaucracies as barriers to government attempts to deal successfully with market failures, which they see as just one step toward a self-correcting market mechanism.
Monetarists tend to reject activist policies because of uncertainties, policy lags, and government incompetence.
Which of these two approaches are currently in favor depends on the state of our knowledge of the causes and effects in macroeconomics and also, perhaps largely, on politics.
The close link between the state of the economy and politics is summed up by the “misery index,” which has no scientific basis but so closely predicts the political fortunes of incumbent governments that most believe it does contain substantive information about the electorates’ views on how well the government has managed the economy.
The misery index is the sum of the inflation rate and the rate of unemployment, two measures of national performance that are easily understood and monitored by the voting public. Incumbents tend to be thrown out when the misery index is rising. Economies are alike in that they hold their governments responsible for the health of the economy. Where they differ is in how hands-on the government should be (a “normative,” as opposed to a “positive,” statement) in making things better!