Introduction to Macroeconomics
Economics is the study of how a society allocates scarce resources to produce the products and services most desired by that society. Economics can be subdivided into microeconomics and macroeconomics. Microeconomics is the study of individual households and firms: how they spend their money, how they set prices, and how they invest. Individuals maximize their utility, while firms maximize their profit. Macroeconomics is the study of the cumulative effect of these households and firms acting in aggregate, and, in turn, how these cumulative effects affect individual households and firms. The major components of macroeconomics include the gross domestic product (GDP), economic output, employment, and inflation.
Macroeconomics is both descriptive and proscriptive. It seeks to explain macroeconomic effects, such as inflation or unemployment, while also offering better guidance in how the economy can be managed to improve the state of the economy, to improve the welfare of its people. Macroeconomics provides insight into the causes of depressions and recessions and how to prevent or mitigate them. It can determine what factors are important for economic wealth and how to maximize employment and economic output, creating greater wealth for society.
Of course, there are still recessions and depressions: long stretches of increased unemployment, when economic output is often considerably less than the maximum possible. Partly why is because macroeconomics is complex and its inputs cannot easily be controlled, but, more often than not, the economy is mismanaged by politicians, who either do not understand economics or do not care, because they need to satisfy their political donors. They do not care, because, being wealthy, they do not usually suffer the economic consequences of their decisions. Certainly, economists agree that mismanagement by politicians was the major cause for the Great Depression during the 1930s, which caused misery for millions of people worldwide. That another Great Depression has not occurred since then is due to the increased amount of macroeconomic knowledge. For instance, John Maynard Keynes, one of the most prominent economists of the 20th century, strongly advocated for increased government spending as a means of spurring the economy out of the depression.
Although economics is considered a science, it is not a science where one can conduct experiments to test hypotheses. Because macroeconomics deals with the economy overall, the individual variables of that economy cannot be set to a given value since they are the result of the actions of many people and of many factors affecting the economy. Instead, economists use mathematical models and logical reasoning to determine what variables are important for the state of the economy and how those variables relate to each other. The success of an economic model depends on how well it can predict the economy in the future: better predictions indicate a more accurate economic model.
Because the economy depends on the aggregate of its individual households and firms, statistics is the main branch of mathematics used to quantify these models. Statistics is also necessary to provide the information on which to base these models. Governments or their agencies provide most economic statistics, since these statistics are important barometers of the economy.
To reduce quantitative complexity, economic models are simplified, based on the most important variables judged to be most influential in determining the result being studied. So some variables will invariably be excluded that may have some effect on the model's predictions. Hence, any economic model has some uncertainty, since specific outcomes have a probability rather than a certainty, even if all the variables influential in the outcome were accounted for.
Economic models force economists to make tacit assumptions explicit and to think about how those variables interact. Variables can be changed to determine what the resulting output would be. Comparing the result of a change in a variable with the result if the variable is not changed is sometimes called comparative statics.
Macroeconomics models were often based on aggregate behavior rather than on individual people or individual firms. These models were periodically adjusted to improve their predictions. However, most economists felt that these adjustments were ad hoc, not based on microeconomics and, therefore, not based on the representative agents of microeconomics, namely people and firms. Hence, economists began to view a good macroeconomic model as being based on microeconomics, what could be called microfoundations.
Monetary and Fiscal Policy
Macroeconomics often concerns itself with policies, since these are the vehicles by which changes are made to the economy through political efforts. These policies are broadly classified as monetary and fiscal policies. Monetary policies are implemented through changes in the money supply or interest rates. In most modern economies, monetary policy is conducted by the central bank, which in the United States, is the Federal Reserve. The major tools for implementing monetary policy include changing the interest rate charged by the central bank, which influences market interest rates, changing the legal reserve requirements, which is the minimum of money that must be held by banks, and by changing the supply of money, which only the central banks can do.
Decreasing the interest rate or increasing the money supply both tend to stimulate the economy, whereas increasing the interest rate or decreasing the money supply tends to depress the economy. Monetary policy is delegated to the central bank to prevent manipulation by politicians, who often call for changes that may improve the economy in the short run, but will have devastating effects in the long run, since their major concern is their next re-election. Additionally, delegating monetary policy to the central bank allows for faster responses to a changing economy.
By contrast, fiscal policy is determined by the legislatures, so it takes much longer to implement changes and the changes usually conform to policy objectives of the controlling political party, who often seeks to satisfy the wants of special interests rather than the needs of the people who voted them into office. The 2 major tools of fiscal policy are government spending and taxation. Increasing government spending or decreasing taxes, or both, stimulate the economy, while decreased spending or increased taxes tend to depress the economy.
A policy can be expansionary or contractionary. Expansionary policy, as the name suggests, expands economic output by stimulating the economy. An expansionary monetary policy is achieved by lowering interest rates or increasing the money supply. An expansionary fiscal policy increases government spending or reduces taxes.
A contractionary policy is implemented to prevent the economy from overheating, which can cause inflation and other problems. A contractionary monetary policy is achieved by raising interest rates or by decreasing the supply of money. A contractionary fiscal policy results from raising taxes or reducing government spending.
To maintain economic stability, the economy should be managed for the long-term rather than short-term. However, fiscal policies are often managed to solve short-run problems because politicians are concerned about their re-election. Another problem with politicians making decisions is their deficient knowledge of economics offers no counterbalance to the desires of big political donors. On the other hand, central banks tend to take a longer view, implementing policies for the long run, even if they hurt in the short run. Paul Volcker of the Federal Reserve, for instance, increased interest rates during the early 1980s to end the stagflation — a combination of economic stagnation and inflation — that haunted the United States in the 1970s, even though the much higher interest rates significantly contracted the economy. In 1981, the federal funds rate reached 20% and the prime rate rose to 21.5%, resulting in a recession from 1980 to 1982. Many people protested the higher interest rates, especially those who were most affected, including farmers and construction workers. Nonetheless, Paul Volcker persisted, finally taming inflation, lowering it from a high of 14.8% in March 1980 to 3% in 1982. Few politicians would have been able to withstand the immense political pressure to adopt expansive policies regardless of the higher inflation rates.
Macroeconomic Agents: Consumers, Firms, Policymakers
The primary consumers of an economy are the households, consisting of individuals living at a particular residence. Most of these households consists of families, although many households consist of only one individual. To simplify macroeconomic models, the consumers within households are assumed to be rational in their choices, in that they will choose the options that will maximize their own utility, which is to say that they will choose the option that they most prefer. Behavioral economics is a newer branch of economics that does not assume that all choices are rational, but instead, that when the choices are not rational, the choice will still be based on the psychology of individuals, which can be studied just as rationality can be studied.
Firms are entities, usually businesses, that convert scarce resources into desirable outputs in the form of products and services. Firms are the primary agents for investment. The primary goal for firms is to maximize profits, according to most economic models. Although a firm may have other objectives, earning a profit is the main reason for forming a business. In economics, a firm may also be an individual who produces a product or provides a service.
Government policymakers create the law under which an economy operates. The law can have a very large effect on the economy, which is why the government is considered a major macroeconomic agent. Macroeconomic models tend to assume that government policymakers are socially benevolent, that they will seek to pass those policies that would best benefit society. Often, policies are rent-seeking, designed to benefit politicians and their major donors. Relatedly, policies can also be strategic, passed to help the politicians win re-election.