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  • Macroeconomic issues and measurement

    TEACHER: Hi, Student! Welcome to my "Economics for Business and Management - Macroeconomics" class. Of course, we shall begin by a general definition of Economics. I hope you will enjoy this class and find it useful.

    STUDENT: I hope so too. But tell me something, please. Why should I, as a business person, be interested in economics, or in macroeconomics?

    TEACHER: Well, maybe you shouldn’t. You might not be interested in issues such as inflation, unemployment, recession, competitiveness. As a business person you might not care about how inflation, recession and foreign competition related with exchange rates may affect your profits. Not being the government, you might not care as governments do (or should) to prevent or counteract recessions, control inflation, increase competitiveness and employment. Unless you are working, you might not be anxious at all about unemployment, and not being a pensioner you might not care about the effect of inflation on your savings and pensions.

    STUDENT: OK, sorry. I admit that I shouldn’t have questioned the usefulness of learning economics, but your answer was somewhat too sardonic, wasn’t it? And of course, I do care about all the issues you mentioned.

    TEACHER: OK. I apologize. And having settled the matter of your interest in the subject, let’s begin.

    What Is Economics?

    There are many definitions, and this is the one I consider most comprehensive:

    * Economics is the study of how people and society choose to use scarce production facilities to make different goods and how to distribute them among persons and groups for consumption.

    Economics used to be called Political Economy, and this was a good name, because many of the choices mentioned above are influenced by political conditions.

    STUDENT: But is it a real science?

    TEACHER: Perhaps not an exact science the way physics and mathematics are. Economics, being very dependent on choices made by people, is a behavioral science, overlapping with psychology, sociology and anthropology. But it certainly includes the use of "exact" tools such as statistics and probability analysis.
    But now allow me to explain...

    A Principle And A Concept: Opportunity Cost and the Fallacy of Composition

    Due to the almost universal scarcity of raw materials, labor and capital goods, choosing to produce something means giving up producing something else. This is the foundation of a basic economic principle: the opportunity cost. If it is decided to produce good A instead of good B, the opportunity cost of making A is the benefit we forgo by not producing B.

    A caveat: this is true when practically all people and production facilities are employed. If a substantial portion of labor and capital goods are idle, we could make more goods without forgoing production of others.

    A very important concept in Economics is the fallacy of composition: what is a good solution for a person or a group, is not necessarily a good solution for society. If there is a recession, it may be wise for a person who has a job to spend less and save money to build a reserve for the eventuality of becoming unemployed. But if everyone does the same, the fall in demand would worsen the recession, more people would lose their jobs, and everyone would be worse off.

    STUDENT: I understand. But economies can be organized in different ways, can't they?

    TEACHER: True. So, lets take a quick look at...

    Economic Organization

    A society, even one composed by only two people who interact economically, must be organized. Somehow it must be decided what to produce; who will do what, and how produce should be distributed among members. The basic forms of economic organization are:

    * A fully planned economy (the defunct Soviet Union or communist China years ago). All economic decisions are made by the government.
    * A pure free enterprise economy, where the government does not make any economic decision.
    * A mixed economy. The government makes some decisions and the rest are left to the people.

    Almost all economies today are mixed, with varying degrees of government intervention. The tendency, from China to Germany, is for government to leave more economic decisions to the market forces.

    The question is, in those areas of the economy where the government does not interfere, who makes the decisions of what, how and for whom produce? The answer is no one, unless we accept Adam Smith's concept of the invisible hand. In a competitive system of free markets and prices, decisions are made by millions of people acting as consumers and /or producers.

    STUDENT: I understand. And now, I guess you will begin with the specific subject of this Module, Macroeconomics.

    What is Macroeconomics?

    TEACHER: Right. "Macroeconomics" is the study of how the economy functions in broad outline. Much of the detail macro does not describe is very interesting indeed, but macro (as we will familiarly call Macroeconomics from now on) is concerned basically with what are called "aggregates", meaning roughly "the total sum of". Macro is concerned with total national product, total investment, total exports and imports, total consumer spending, etc.

    STUDENT: Do you mean that macro is only concerned with aggregates?

    TEACHER: Not exactly. Macro is also interested in averages, such as average prices, salaries, etc. Aggregates and averages result from the activities of many different markets, private firms, government agencies, and individual persons acting as consumers or investors.

    STUDENT: Since macro means "big" and "micro" small, I guess that microeconomics is the part of economics dealing with the activities of individual markets and firms.

    TEACHER. Right. In macro the value of all goods and services produced is added together, be it gasoline, soft drinks, bread, wine, haircuts, restaurant meals, or whatever. The value of all these goods and services is the aggregate national product, the main concern of macro.

    STUDENT: And what about averages?

    TEACHER: The best known average used in macro is the general price level: an average, or index, of the prices of all goods and services produced. This index can be calculated with prices at the consumer level or at intermediate levels such as wholesalers. The index at the consumer level is known as CPI (Consumer Price Index) in the US and RPI (Retail Price Index) in the UK.

    STUDENT: Is there any disadvantage in putting everything together ("aggregate" it) and deal only with these broad figures?

    TEACHER: Of course we miss important information about the composition of the economy, but dealing with aggregates shows the big picture. An increase in the price level immediately shows that there are inflationary pressures in the economy. In fact, probably some individual prices did not increase and could even have decreased; but for most economic agents (firms and persons) prices are increasing and the purchasing power of money is falling.

    STUDENT: I see. For instance, if the interest rate index rises, it means that I probably have to pay more interest for a loan, and possibly get a better return on my bank savings account. And if unemployment rises, my chances of getting fired increase, and my chances of getting a job decrease.

    Should a businessperson be concerned about macroeconomics?

    TEACHER: Yes indeed. As a businessperson, you need to understand macro because if affects your own "micro". You may be an expert in your micro environment: the market segment your firm operates in, your competition, the workings of your own enterprise. Certainly you need this information for your day to day operation and for making plans. But since the macro will affect your business, you can not ignore it. You can make a nice business plan based on your micro only to watch it being upset by a recession, rapid inflation, and variations in the exchange and interest rates.

    And now let me name the

    Main Macroeconomic issues:

    1. The Business Cycle (recession, depression)
    2. General Living standards
    3. Inflation and deflation (movements of the price level)
    4. Unemployment
    5. Fiscal Policy (Government deficits and surpluses)
    6. Monetary Policy (management of average interest rates in the economy)

    Having said that, let me ask you a question, dear Student. Can you detect a difference between these six items?

    STUDENT: I think so. The first four involve ends, or targets, to be reached: avoid depressions and recessions, rise the living standard, prevent inflation and deflation, and keep unemployment as low as possible.

    TEACHER: Very well. And what about numbers five and six?

    STUDENT: Obviously they are means, instruments to reach the desirable ends I mentioned. Government actions like budget deficits or surpluses, or affecting the interest rate, are the basic tools to reach those desirable ends.

    TEACHER: I am impressed. Now let’s describe the six main macroeconomic issues.

    1 -The Business Cycle

    The level of overall activity in an economy moves in "waves", with ups and downs. The downs are called recessions, the ups recoveries. The point of inflexion from the former to the latter is called the bottom, and the point of inflexion from the latter to the former is called the peak.

    Let me show you a graphic illustrating a typical business cycle.

    A prolonged deep level bottom is a depression. The world economy experienced a deep depression in the 1930’s. For 25 years after 1945 there was sustained economic growth. Then rather serious worldwide recessions came (1974/75, 1980/82 and 1990/92), but they were mild compared with the Great Depression of the 1930´s. Sometimes the business cycle is not coincident in different economic areas, which is good since the growing areas can help the depressed to recover. Japan has been in a depression for a long time while the US, other regions of Asia and the EC (European Community) were growing; if all others had been n recession at the same time, Japan would have had an even more serious problem. Economists think that the US has suffered a rather mild depression starting in 2000, while Japan remained in depression and the EC economy, while showing some more resilience, did not perform too well either. This created doubts about a quick recover of the 2000 depression.

    Eventually, thanks to the actions of the Federal Reserve -reducing interest rate substantially- the US economy recovered. So did the EC, and the fast growth of India and China added considerable impulse to the recovering of the world economy.. The financial crisis of the low-quality mortgages of 2007 again signaled a possible reduction of the growth rates worldwide.

    Macroeconomics was invented to help in the developing of actions or tools that could flatten economic fluctuations.

    STUDENT: I can imagine it, but why don’t you tell me yourself how these cycles affect businesses and people?

    TEACHER: Glad to oblige. At the bottom of the cycle there is high unemployment, a low level of aggregate demand, a total production lower than the economy has capacity to produce. Business profits are low or negative, and many firms fail. There is low confidence among consumers and entrepreneurs, and therefore firms delay new investments.

    During a recovery, also called an expansion, employment, income and consumer spending begin to rise. For a time not much new investment is needed because idle labor and equipment can be put to work, but at a certain point firms start investing in new plant and equipment and hiring workers. Sales and profits rise, of course.

    At the peak of the cycle, most existing capacity is in use. Shortages develop and costs and prices tend to rise. Business in general remain profitable.

    A recession, or contraction, is a downturn in the total output of the economy. Demand falls and in consequence employment and production fall too. Personal income and business profits drop. New investment falls to very low levels.

    STUDENT: Naturally even during a recovery or a peak there must be short-time mild variations. Suppose that at a certain point during a peak there is a fall of GDP. When does it become a depression?

    TEACHER. Naturally this is a conventional or common usage definition: in general it is accepted that the economy is in a depression when the GDP falls for two consecutive quarters.

    STUDENT: And as your graphic shows, the terms boom and slump are used to indicate expansions and contractions.

    TEACHER: Correct. Now let’s move to the next macro issue.

    2- Living standards

    The most common measure of overall living standard is the real wage: the quantity of goods and services that can be purchased with the average hourly wage.

    Total output of goods and services has risen for decades in most industrialized regions. So has the per capita output.

    STUDENT: Per capita?

    TEACHER: "By head" in English. If you divide any aggregate amount of a region by the number of inhabitants, you have the per capita figure, be it income per capita, Gross Domestic Product (GDP) per capita, or whatever.

    The fact is that the real wage also grew, but not all the time. In the US, the real hourly wage was roughly the same in 1995 as in 1973.

    STUDENT: Real hourly wage? Is there an imaginary one?

    TEACHER: Gook joke. Real here means adjusted for inflation. We all know that the nominal hourly wage was much higher in 1995 than in 1973; but prices were also higher in practically the same proportion.

    Let me stress that long-term growth is the necessary factor in determining higher living standards for the population as a whole. Of course it is possible to distribute the product of an economy in a more egalitarian way, but there is a limit to this. In the long run, if the pie does not grow and it must be distributed among more people, living standards fall.

    The challenge to macroeconomics is finding procedures that would allow sustained worldwide economic growth with a minimum of fluctuations. Utopia? Possibly, but it is the objective to be pursued.

    3- Inflation

    Inflation is a rise in the price level. We should however distinguish between different scenarios. It is possible to experience a one-time increase in the price level due to a particular situation (i.e., a rise in the price of fuel) followed by price stabilization. But the most dangerous type of inflation is the spiraling inflation; in this case prices rise continuously. This is usually the result of a sustained high demand (the demand-pull factor) combined with the increase in production costs (the cost-push factor). The latter is the result of shortages in the factors of production: inputs (labor and raw materials) and capital (equipment and working capital financing costs). An excessive supply of money is usually present as a result of government deficit spending.

    Governments try to keep inflation as low as possible, in most advanced economies a task given to an autonomous Central Bank. This is theoretically quite easy: a Central Bank (the Fed in the US) can manipulate the interest rate and by increasing it reduce demand. The problem is that this instrument must be carefully used, because adjusting too much may cause a depression. On the other hand the Central Bank can stimulate economic activity by lowering the interest rate; but the risk of overshooting and causing inflation always exists. We shall elaborate on this question a little later.

    4- Unemployment

    Unemployment is a central concern of macroeconomics. There is no consensus about the minimum sustainable unemployment level. If it is too low, many firms do not find workers and wages rise, creating inflation. If the level is too high, it creates a fall in demand and a tendency towards a depression and falling prices. During the later years of the twentieth century it was widely believed that the "new paradigm of the economy" would allow sustainable growth without inflation at very low levels of unemployment. The rationale behind it was that the increase in productivity would be continuous due to the use of computerized procedures. The behavior of the economy during the first years of the twenty-first century considerably discredited this theory.

    5- Fiscal Policy

    After the Great Depression it became popular to believe that government deficit spending was a panacea for fighting depressions. If the government spends more than it collects in taxes, obviously it is stimulating demand. On the other hand if the governments "saves" by spending less than it collects and runs a budget surplus, it is reducing demand and so this practice can be used to bring inflation under control. These two elements constitute what is called "Fiscal Policy".

    STUDENT: Where does the difference in tax collections and spending come when there is deficit spending?

    TEACHER: The "difference" can come from "printing money" (expanding the money supply). This may work as long as a substantial part of production capacity remains idle, but this practice has to be stopped in a timely manner in order to avoid inflationary pressure.

    The government can cover the gap by borrowing. If it borrows locally it competes with firms in need of credit and interest rates tend to go up, which works against the objective of deficit spending. If the government borrows from a foreign financial market this influences the exchange rate, the tendency being to increase the value of the local currency. This is also a negative factor if the objective is to stimulate the economy. In either case the "national debt" increases, interest has to be paid, meaning more deficit spending or higher taxes.

    STUDENT: No simple solution, right?

    TEACHER: Unfortunately not. In an economy, everything is related to everything else, and any action taken may cause undesired results. But let’s advance to the second of the two "tools":

    6- Interest and exchange rates

    In addition to fiscal policy, governments or the Central Bank can use "monetary policy" to influence economic activity, Monetary policy is basically the manipulation of interest rates. It is not difficult to understand why lower interest rates stimulate demand and vice-versa; the lower interest rates are, the more eager people and firms will be to borrow and spend and invest. And the reverse is also true, of course.

    To a certain degree governments may also manipulate the exchange rate, lowering or increasing the value of their currencies relative to others. These actions change the relative prices of foreign and local goods. A fall in the exchange rate of the local currency stimulates exports and tends to reduce imports, thus stimulating the local economy.

    STUDENT: So this is a fool-proof solution, isn't it?

    TEACHER: Not quite. After a devaluation of the local currency, firms get better prices by exporting; naturally they will increase the prices of the exportable goods in the local market too. Dearer imports, be it industrial inputs or consumer products increase costs and thus prices. The result is that local prices tend to rise to the same point of real relative prices before devaluation; inflation has chased devaluation and nullified its effect. Now a new devaluation becomes necessary, and so on and on.

    GDP and the concept of Added Value

    GDP stands for Gross Domestic Product and is the aggregate money value of all goods and services produced in an economy during a period.
    Let me add that we are only talking about added value.
    Some firms produce outputs that are used as inputs for other firms, and so on. This means that to calculate the GDP by adding the output of all economic factors in a country would not be realistic. If I sell you paper for $500 and you use it to make photocopies you sell for $ 800, you have not added $800 to the aggregate GDP. What you have contributed is the "added value", the difference between the cost of your inputs ($500 in paper plus other costs). Assuming your total cost was $600, you have added $200 to the GDP.

    GDP is calculated by adding up the value added of all economic factors in a region.

    The circular flow of income and expenditure

    Over a period of time, every product and service (GDP) is sold to someone. The "money" from these sales must go to someone, either as salaries or profits. Thus, the Total Value of the Output (GDP) equals Total Income (TI).

    This income in turn is either spent, saved or paid in taxes ("Expenditure"). So, GDP=TI=Total Expenditure (purchases + taxes + savings).

    We may refine the equation a little more by discriminating the different types of incomes and expenditures: Thus

    * GDP = Total Income = Total Expenditure
    * GDP = Personal Consumption + Business Investment + Government Spending + (Exports minus Imports)

    GDP is normally calculated at "market prices". When comparing GDP figures over time, changes in the general level of prices must be considered. One way is to apply a "deflator index" to neutralize the effect of price inflation.

    GDP, GNP, NDP and National Income

    National Income accounting is the name given to the calculation of GDP and other indicators such as GNP, Gross National Product.

    STUDENT: Like many other people, I get confused by the way the media use GDP (Gross Domestic Product) and GNP (Gross National Product). Are they the same?

    TEACHER: Not exactly. Total output produced in the economy measured by GDP should be equal to total net income received. This would be true in a completely closed economy but is not a fact in real life open economies. This is because residents in a country receive income from assets they hold abroad and pay out money to foreign residents for assets own locally by the latter.

    To arrive at the GNP starting from GDP it is necessary to add income received by domestic residents and subtract income paid to non-residents.

    STUDENT: And what about NDP, Net Domestic Product?

    TEACHER: The word gross in GDP conveys the meaning that depreciation, or capital consumption, is not taken into account. To arrive at NDP, it is necessary to subtract from the GDP figure the value of the depreciation, the amount to be spent just to replenish the consumed capital, usually plant and equipment.

    STUDENT: A couple more questions. What is Personal Income, and what makes it different from Personal Disposable Income?

    TEACHER: Personal Income is the gross amount paid to individuals for any reason. Disposable Income is what remains from Personal Income after taxes and other compulsory payments individuals must make. In short, DI is the amount left to individuals for either spending or saving.

    Interpreting national income figures

    There is no doubt about the usefulness of national income accounting. However, as is the case of most statistical information, it may be misleading unless carefully interpreted. It is also necessary to choose among the different measures to use the one more appropriate for a specific need.

    Real and nominal figures

    We have already explained above that nominal figures almost always are misleading for comparing different periods. Nominal figures reflect the effect of inflation, since they are computed at market values. We mentioned the deflator index before. The adjustments can be done by different procedures, but the main objective is the same, to allow realistic comparisons over time.

    International comparisons

    Since national income figures are calculated in the local currency in each country, comparisons between countries are affected by exchange rates. And exchange rates often fluctuate significantly over time, or remain fixed while local prices fluctuate. Suppose country A has a per capita GDP of LC (local currency) 20,000 in Year 1. The exchange rate in year 1 is LC 10=1 US$, and so we have a per capita GDP of US$ 2,000. The following year country A reports a per capita GDP of LC 30,000, a 50% increase. Somehow (possibly by government management of the exchange rate), 1 US$ is still worth LC 10. Thus, the per capita GDP in year 2 could be reported as being US$ 3,000. Obviously, this is a misleading figure, because the real GNP per capita could not possible have grown 50% in a year.

    To solve this problem, instead of using the actual market exchange rate, an index called "equilibrium exchange rate" is used. This is a theoretical figure, expressing what the exchange ought to be at a given time. How to arrive at this figure is not easy. The most common system is the PPP, the purchasing power parity. This is the exchange rate that equates the prices of a group of representative products in different countries.

    You will also see national income figures expressed in "constant dollars"; i.e., "1995 dollars". This means that the GDP is calculated for different years adjusting local currency figures and the exchange rate to the values of the chosen year.

    Unreported output

    STUDENT: I still have the feeling that an important part of an economy’s output is not measured by national income accounting.

    TEACHER: Naturally illegal activities are not reported and thus not included in official national income accounts. We do not wish to make any moral or ethical judgment here: what is illegal in one country is often legal in another, as for example, gambling, prostitution and alcoholic beverages. Anyway a part of the output of illegal activities is actually computed indirectly because business people involved in illegal activities report some of their income as coming from legal activities (the famous "money laundering" process).

    Many perfectly legal activities are not included in the accounts simply because they are not reported to avoid paying taxes. This so called "black" economy is very important even in advanced industrial countries such as Canada (estimated at 15% of GDP). In some less developed countries it is much higher, especially because the agencies in charge of collecting taxes and enforcing tax laws are inefficient and/or corrupt.

    STUDENT: I often hear housewives complain about not getting a salary for their very important work. I assume that this activity, as many other "non-marketed" activities, is not included either. But are all these omissions important?

    TEACHER: If one is interested basically in changes of the GDP over time in the same country, and the omitted percentage does not change rapidly, then the omissions are not important. If one is interested in calculating the actual aggregate flow of products and services, the omissions become important. It is of course possible to estimate the amounts omitted, but they will still be only estimates. As for comparisons between countries or regions, the omitted proportion of the GDP can be very different. In rural areas there is a lot more "non-marketed" activity than in urban settings, and this makes comparisons between these two types of economic regions more difficult.

    Which is the best measure?

    STUDENT: Is there a "best" measure of national income?

    TEACHER: Not really, each one has advantages for a specific purpose. Employment will be in general related with changes in the GDP and business profits, while Disposable Income may be more helpful in predicting consumer spending behavior.

    Well, this will be all for this Module. See you in next one!


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