Macroeconomic Terms and Variables
Understanding macroeconomics requires understanding its terms. Additionally, macroeconomics is the study of the economy as a whole. Because macroeconomic systems are complex, economists build models to represent the interactions of the important components of the economy. These models depend on key macroeconomic variables that have the greatest influence on the economy.
Macroeconomics uses many terms that are common words, but have more specific meanings in macroeconomics, such as investment and capital. Macroeconomics is also studied through econometric models, which depend on key macroeconomic variables.
Producing goods and services requires capital, and economic growth depends on the investment of capital. When a business owner talks about requiring capital, she usually means money. But economists define capital as the real estate and equipment, such as a factory and everything that it contains, required to produce products and services. The amount of such capital within an economy is referred to as the capital stock. Capital stock increases with investment, but decreases with time, in the form of depreciation, since most capital must be replaced eventually. The change of capital stock is represented by the following equation:
Kt+1= (1 – δ) Kt + It
- Kt+1= capital stock for the next period
- δ = depreciation rate
- Kt = capital stock for this period
- It = new investment for this period
The term investment is also used differently in economics. Most people use the term as the investment of money, such as buying stocks or bonds. However, buying financial instruments is not considered an investment in the economic sense, since it does not buy capital. When a firm receives an investment of money, it may use that money to buy new capital, but the initial purchase of the financial instrument is not considered to be an investment, since that money could also be used to buy used equipment, for instance.
In economics, the term investment means buying new capital to produce goods and services. Note the term new. Buying used capital, such as a used car or factory equipment, is not an economic investment, since the capital stock of the economy has not increased because of the investment. A firm may consider itself to be investing when buying used equipment, since such equipment can often be purchased at a much lower price than new equipment, but since it does not increase the overall capital stock of the economy, it is not considered an economic investment.
There are 5 common terms in macroeconomics that are considered in aggregate: output, gross domestic product (GDP), production, income, and expenditures. Economic output is considered to be the aggregate output of goods and services by an economy, which is also how GDP and production are defined. If a country has no foreign trade, then it's aggregate income, which is the total income received by all of its people, must equal total aggregate expenditures, which is the total amount spent on goods and services. This is true because one's expense is another's income. Because all countries have some foreign trade, the aggregate income will differ by the aggregate expenditure, and both will differ from GDP. If aggregate income is greater, then the economy is running a trading surplus; if aggregate expenditure is greater, then the economy is running a trading deficit.
Economics also distinguishes between flow variable and a stock variable. A flow variable is specified as a quantity per unit of time; a stock variable is a specific quantity at a specified time. Some examples:
- Income is a flow variable, since it represents the amount of money received for a duration. Wealth is a stock variable, representing the amount of wealth that one has at some point in time.
- Annual debt payments is considered a flow variable, while the total debt is a stock variable.
- Changes in the unemployment rate is a flow variable, while total unemployment is a stock variable.
Economists also distinguish between nominal variables and real variables. Nominal variables are quoted in terms of money, but because inflation changes the value of money every year, a nominal variable cannot easily be compared from year to year unless the inflation is accounted for.
A real variable is a quantity, so it is not measured by its monetary value. For instance, the number of unemployed people is a real variable, so it can easily be compared with previous years.
However, economists will often want to know what the real growth rate was, compared to the nominal growth rate, because the real growth rate measures only economic growth, while the nominal growth rate includes a significant component of inflation, which is unrelated to economic growth. A classic example is the distinction between nominal GDP and real GDP. Nominal GDP is simply the Gross Domestic Product in terms of the current value of the domestic currency. Because the GDP is only measured in monetary terms, measuring real GDP depends on selecting a base year where the GDP for other years will be expressed in the value of the currency in the base year. Because inflation is usually positive, real GDP is less than the nominal GDP after the base year, but higher before the base year; in the base year, the nominal GDP will equal the real GDP, by definition.
The description and forecasting of macroeconomics require statistics on macroeconomic variables. The most prominent of these variables is the GDP, inflation, interest rates, and unemployment, but there are many others. The Gross Domestic Product (GDP) is the total value of all goods and services produced in one year within the country. GDP also measures total income, since the payments for the total production must go to someone, usually to the producers of those goods and services. For 2015, the GDP for the United States was slightly more than $18 trillion.
Because the measure of GDP depends on payment for the product or service, only those products and services are measured. Activities where legal payments were not made were not reported, so they are not part of the GDP. This includes the domestic services by a stay-at-home spouse and illegal activities by criminals. It also does not include labor paid for under the table.
In major economies, most of these unreported items are only a small fraction of the total GDP, but in many poor countries, unreported payments can constitute a major share of the economy.
Another key macroeconomic variable related to GDP is a GDP per capita, which is the amount of GDP per person, found by dividing total GDP by the number of people in the country. This provides a rough estimation of the average income per person, which is useful for comparing living standards. The average global GDP per capita is slightly more than $10,000. In 2015, the GDP per capita ranges from a low of $277.10 USD for Burundi to more than 99,717.70 USD for Luxembourg. The world averages about $10,000 USD. The GDP per capita for the United States was $56,115.70.
Employment and unemployment rates are also significant macroeconomic variables, especially since they can have a major impact on political elections. Unemployment rises when businesses reduce their production, usually when the economy entered a recession. The unemployment rate falls when the economy is growing. If the economy grows too fast, shortages may increase, leading to higher prices.
Another key macroeconomic variable is inflation, which can result when the supply of money exceeds the demand for money, which occurs when the supply of money increases faster than the economy. People and businesses are negatively impacted by short-run inflation, but over the long term, the economy adapts to the greater supply of money, causing higher wages and prices.
The main beneficiary of inflation is the government, since the government can create more money before it has an impact on prices. Often, crooked governments will print massive amounts of money to enrich government employees and policymakers and to pay government bills. For instance, the annual inflation rate in Zimbabwe exceeded 231,000,000% in 2008, when it was reported that some people were using Zimbabwean dollars as toilet paper. In fact, Zimbabwe issued a $100 trillion bill, which is the highest denomination ever issued for any currency.
This type of hyperinflation causes people to trade the hyperinflated currency for more stable currency of other countries, such as the American dollar. The currency exchanges are made as quickly as possible, before the currency falls even further in value, which can happen in hours. If the currency cannot be exchanged, then purchases are made as soon as possible, since the maximum real value can be received by immediately exchanging the hyperinflated currency for something else, whether it be other currencies or for goods and services.
Another important variable is interest rates, which is the cost of credit, the cost of borrowing money. Although there are many types of interest rates, the interest rate that a sound business can borrow at is usually the prime rate, which is often published in the newspapers. Central banks have significant control over the interest rate, since they can set interest rates for other banks and they can also control the money supply. A greater supply of money leads to lower interest rates, while a contraction of the money supply has the opposite effect. When the interest rate set by the central bank is already near 0 or even 0, then the central bank may turn to what is called quantitative easing, where money is created and placed within the economy by buying government debt from primary dealers of the central bank.
Interest rates affect not only how much consumers will borrow, but it will also affect how much businesses will borrow, especially since businesses will only borrow if they can invest the money for a higher expected return than the interest rate on the borrowed funds.
So, if a business project is expected return 10%, a business will borrow if the interest rate on the loan is 6% but not if it is 12%, since the business can earn a net 4% in the 1st case, but lose 2% in the 2nd.
Businesses will keep borrowing if they have projects where they can earn a greater expected return than the interest rate on the loan, but at some point, additional projects will yield a diminishing marginal return, where the expected value of additional invested capital will fall to equal the interest rate, reaching what macroeconomists call a capital stock equilibrium.