Lectures in Economics 8

Lectures following Rüdiger Dornbusch’ works (8)



It seems clear that the government, by its actions, has the potential to affect major macroeconomic variables such as unemployment and inflation. For instance, if the government increases its demand for goods, it adds to the total demand for goods and services and probably increases output and unemployment. But at the same time it pxobably increases the price level. Or if the government increases taxes, leaving people with less to spend, that probably reduces demand, output, and the price level.
Economic pollcy consists of government actions to affect the economy. The variables the government adjusts in carrying out economic policy; such as tax rates and government spending, are called policy variables; or policy instruments.
Partly because it is closely related to policy – to questions of what the government can do-macroeooţomics is an area where there are disagreements among economists. Frequently, this disagreements result from differences in value judgments. As always, we should be on guard for these in reading any economist’s advice about macroeconomic policy. But sometimes there are disagreements on positive economics, for instance, on what happens to total production and inflation when the government cuts taxes. Here‚ we have to make up our minds on the basis of theory and data.

In presenting macroeconomic theory and evidence, we do not go out of our itinery to focus on controversies. Where there are differences of opinion on issues that matter; we mention and explain them. But most of the macroeconomics section develops the widely agreed-on solid core of the subject.


The economy is made up of many independent units: millions of households and millions of firms (and federal, state, and local governments, which we leave out of he picture for a while). Households decide how much to buy and how much to work. Correspondingly, firms decide how much to produce and sell and how many people to hire. Together, these decisions by all households add up to the economy’s total spending, and the decisions by all firms add up to the economy’s total level of production. We now develop this interdependence between individual decisions and the total, or economywide, levels of spending and production.

Table 4-2 classifies the different transactions between firms and households in the economy. Households own the firms, which in turn own machines, buildings and equipment, and raw materials and other goods used for production.
Goods and services useful in production are called factors of production. They include, in particular, labor, machines, office and factory buildings, and land. Ultimately, all factors of production are owned by households, either indirectly through firms or directly as in the case of labor.
Table 4-2 provides a simplified picture of the transactions in the economy. Here are some of the simplifications. First, we have omitted the government, which is neither a household nor a firm but does play a role in the economy.
(… omitted)

Second,we show firms selling goods to other firms, flow of services of factors of production. For instance-,IBM sells computers to other firms matched by income not only to households. Third,we have not specified whether we are talking about the firms or households paying from their incomes.

All these points matter,but fortunately they are easily accounted for once we have the simple straight ideas about flows of goods and incomes. In Table 4-2 the top two entries describe the fact that households ultimately own all factors of production and that firms use those factors to produce goods and services. The middle entries show that in exchange for providing factors of production for use by the firms, the households receive incomes,primarily as wages and profits. The households in turn use their incomes to buy the goods produced by the firms,which therefore can pay for the factors of production they use. Figure 4-1 shows the interactions between households and firrns.First we draw attention to the flow of the services of factors of production from households to firms, from which the households receive incomes in exchange. … (10 lines omitted)

Figure 4-1 is called a circular flow diagram, because in each loop there is a circular flow starting at any point and coming back to it. …The top half shows how the economy willing to work cannot find services of factors of production to produce goods and services. If the firms cannot find buyers then the shelves are filled with unsold goods.

The firms are unable to continue production as before and hire fewer people. People lose their jobs and become unemployed.
What happens next? The economy has to find some way to put people back to work. There is a problem here because the people who have lost their jobs will have less income to spend, as we see fţom Figure 4-1. Thus firms will be able to sell even less, and that seems to make the unemployment problem worse.

Here we face a basic question of macroeconomics. If people become unemployed because firrns cannot sell all the goods they are producing, what gets the economy back on track? How do we avoid a continuing fall in production and employment? We shall see that there are mechanisms ‘that get the economy back on track; including changes in wages and prices, and govemment policies, but that these mnechanisms may work quite slowly..

Unemployment is, of course, a problem for the people who cannot get jobs. But it is also a problem for society, because it means society is wasting its scarce labor. Figure 4-2 showed the production possibility frontier that was introduced in Chapter l. When there is unemployment, society is not on the production possibility frontier but rather is operating at an inefficient point; such as G, inside the frontier. One of the basic questioms in macroeconomics is why society sometimes has very high unemployment and thus wastes resources.

Although the term “unemploymerit” is usually reserved for labor, other factors of production such as machinery and factories are sometimes not used even though they are available for production. They too can be described as unemployed. The basic macroeconomic question of why society sometimes has high unemployment of labor extends also to the question of why society sometimes (usually at the same times that labor is uriemployed) wastes resources

FIGURE 4-2 UNEMPLOYMENT AND THE PRODUCTION POSSIBILITY FRONTIER. The frontier shows combinations of output at which the economy is fully employing its labor. When there is unemployment, the economy is producing at some point such as G and wasting resources. One of the basic questions in macroeconomics is why the unemployed are not put very quickly back to work producing goods and services that people would like to consume.

Suppose that the firms in the economy are producing a given amount of goods and that everyone is working. The economy is producing on the production possibility frontier. Now consumers decide that they would like to spend more than they used to. They demand more goods from the firms. Firms cannot produce more goods because all resources in the economy are fully employed.

Something has to give. To start with, firms may put “sold-out” signs in the windows or put customers on waiting lists. But they will also raise prices, trying to reconcile the scarcity of goods with the households’ increased demand for goods. Inflation here results as firms raise prices in response to households’ demands for more goods than can be produced.
The decisions of firms and households, affecting one another through their interactions are described in Figure 4-1. The essential difference between macroeconomics and microeconomics consists in the interactions described in Figure 4-1. The fact that firm and household decisions are made independently is not unique to macroeconomics. Going back to the supply-demand analysis of the fish market in Chapter 3, we see that the decisions about how much to supply and how much to demand are made independently by suppliers and demanders. But macroeconomics is different in that firms’ decisions about how much to produce determine the incomes of households and therefore their spending. Those interactions, or feedbacks, which are unimportant in microeconomics, are the essence of macroeconomics; they are illustrated by the circular flow diagram in Figure 4-1.

We follow up this overview of macroeconomics problems with a look at the facts. The following sections present definitions and a discussion of recent experience with inflation, growth, and unemployment.


In Chapter 2 we introduced price indices as measures of the oost of buying a specified basket of commodities. In particular, the CPI represents the price of a basket of 224 goods and services, each of which receives a weight that was determined by studying the spending behavior of more than 20;000 families. Weights for broad categories of goods were given in Table 2-7. Table 4-3 shows the CPI, with base 1967 =100, for selected years.

In 1981, for example, the value of the CP,I -was 272.4. With the base year 1967 =100, this means the cost of buying the basket of goods and services in the CPI…
was 2.724 times as high in 1981 as in 1967. Prices had, on average, nearly tripled. Similar comparisons can be made with earlier years. For instance, looking back to 1929, which is not shown in the table, we find the CPI equal to 51.3. With the CPI at 100 in 1967 and 51.3 in 1929, the costs of goods bought by the typical consumer about doubled from 1929 to 1967. Thus we see that prices of goods in general have risen threefold since 1967 and sixfold since 1929.

In Chapter 2 we also discussed the inflation rate.
The inflation rate is the percentage rate per period that prices are increasing. Normally we talk about annual inflation, but we can also look at inflation rates between months, quarters, or decades. Table 4-3 reports the annual inflation rates of the prices of the goods represented by the CPI.
We briefly recall how ţhe inflation rate is calculated. Suppose we want to figure out the inflation rate, or the growth rate of prices, between 1979 and 1980. This inflation rate is reported in the table as the entry for 1980. Inflation for 1980 is the percentage change in prices, or the growth rate of prices, from 1979 to 1980. It is calculated as in equation (1)
The 1929 index does not measure the cost of exactly the same basket of goods as the current index, but the costs of goods bought by consumers can still be approximately compared from CPI values at different dates.


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