Macroeconomics is concerned with the study of the economy as a whole. The main goals of macroeconomics are to achieve:
- An improvement in the standard of living of the population;
- A low unemployment rate;
- A low inflation rate.
A low rate of inflation is desirable in itself but also because it may help promote the other two objectives. These three objectives have to be achieved subject to two important financial constraints. The government must maintain a long run balance in the public finances and the balance of payments. There are also real constraints due to the availability of factors of production. Here we will consider these objectives, the associated constraints and the relationship between them.
1.1. A Rising Standard of Living
Economics is above all concerned with the factors that contribute to improving people’s well-being over the long run. In order to track the performance of an economy over time and to compare it with other economies, we have to measure the output of all the goods and services being produced. One measure of this is known as Gross National Product (GNP). Closely related to GNP is the concept of National Income. This is the total amount of income received by residents in the country. The nation’s output is closely linked to the nation’s income; the more a nation produces, the more income is generated. A principal aim of macroeconomic policy is to find ways of increasing GNP and national income. If this is achieved, then the standard of living of the population is raised. Thus we use changes in income as a proxy measure for changes in the standard of living.
Real Growth and Inflation
GNP measures the level of output for a given year, but to measure increases in the standard of living we are interested in how GNP changes from year to year. In this context it is important to distinguish between changes in nominal and real GNP. Nominal GNP is computed using the actual prices; real GNP is computed using prices observed in some predetermined base year . An increase in nominal GNP can result from either higher prices are more output. An increase in real GNP means that a greater volume or quantity has been produced. In terms of improving the country’s standard of living, it is the change in volume or real GNP that matters. If increases in nominal GNP are due to price increases only, people are not becoming better off. Changes in real GNP are closely related with changes in employment and unemployment. The real growth rate measures the percentage change in real GNP from one year to the next. A high and stable rate of economic growth is one of the principal goals of macroeconomic policy.
The Business Cycle
The variability of the real growth rate over time is referred to as the business cycle. A peak describes an upper turning point, and a trough is a lower turning point. A downturn in the business cycle is referred to as a contraction in output, and an increase in the growth rate is referred to as an expansion. In the US, if a contraction lasts for two or more consecutive calendar quarters, the economy is said to be in recession. If a recession is prolonged and deep, it may be called a depression. The macroeconomic goal in terms of the business cycle is to smooth out booms and recessions and maintain a stable level of economic activity.
The business cycle is important as it acts as a barometer of business activity. If a high growth rate is expected, firms will consider new investment projects and hire additional workers. If slow growth is predicted firms will postpone investment plans and reduce the size of their workforce.
Potential GNP is that level of output that could be produced given the state of technology and the size of the labour force, without increasing prices in the economy. It is sometimes referred to full employment GNP. As the size and average educational level of the labour force increases, and new technology is introduced, potential GNP grows over time. These changes allow us to determine the growth rate of potential GNP. In many instances the potential growth is taken to be the long run average growth rate.
When the actual growth rate exceeds the potential growth rate the economy is booming. There is upward pressure on wages and prices. Overheating encourages firms to raise prices. The distance from the actual growth rate to the potential growth rate is referred to as the inflation gap. If the actual growth rate falls below the potential growth rate, unemployment will tend to rise. The economy is operating below capacity and, as stocks build up, firms cut production and lay off workers. The distance from the actual growth rate to the potential growth rate is known as the output (unemployment) gap. Good macroeconomic management avoids increasing prices on the one hand and excessive unemployment on the other, by keeping the actual growth rate as close as possible to the potential growth rate.
The definition of unemployment is fraught with difficulties. Generally a person is regarded as unemployed if he or she is looking for work and willing to accept a job at the going wage rate for the type of work that he or she is qualified to do. The labour force is the sum of the numbers employed and unemployed. The unemployment rate is defined as the number employed as a percentage of the labour force.
The unemployment rate associated with potential GNP is referred to as the natural rate of unemployment. This is the level of unemployment that reflects friction is the labour market and if an economy’s unemployment rate is equal to the natural rate the labour market may be said to be in equilibrium.
Economic growth is not an end in itself, but a means towards improving the well-being of the population. A high unemployment rate combined with rapid growth of GNP would not be a very satisfactory situation. However, a growing GNP tends to reduce unemployment. The American economist Arthur Okun estimated that in the United States for every 4 percent increase in real GNP, unemployment fell by one percentage point. This relationship became known as Okun’s Law. Thus the macroeconomic objectives of growth and unemployment are closely associated.
The costs of unemployment to individuals and society are very serious. When unemployed people feel a low level of self-esteem, which can lead to personal stress and suffering. The unemployed suffer a loss of income. In many countries this is shared between the employed and unemployed through transfer payments. High unemployment has serious budgetary implication, through increased social welfare expenditure and reduced tax revenue. The economy loses the output and income that would be produced if the unemployed could find work.
It is customary to talk about different types of unemployment, even though it is never possible to identify who falls into each category. Frictional unemployment arises because of changes in particular markets that result in people losing their jobs, switching between one job and another, and entering and leaving the labour force. Seasonal unemployment reflects friction in tourism and agriculture. Cyclical unemployment arises during the contractionary phase of the business cycle and many of these workers should be hired back during the recovery phase. Structural unemployment arises when there is a permanent decline in the industries located in a particular region or country. Cyclical unemployment can turn in structural unemployment if the recession is prolonged or the recovery weak.
Inflation is measured using a price index, which is a weighted average of the individual prices included in it. The annual inflation rate is equal to the percentage change in the price index over a year. Low inflation is a goal of macroeconomic policy because of the costs of high inflation. Also, a low rate of inflation is considered desirable because it implies certainty and stability and facilitates economic growth.
Inflation lowers the purchasing power of money and people living on fixed incomes suffer a decline in their living standards. Inflation reduces the ability of domestic firms to compete with their international rivals resulting in reduced output and increased unemployment. Price increases impose costs on firms and retailers who have to reprint price lists. Consumers have to go to additional trouble to find out about price changes in order to keep up to date. These are the ‘menu’ costs of inflation. People with savings are penalised by inflation, which reduces the purchasing power of their savings if inflation exceeds the rate of interest while borrowers benefit by going into debt and repaying a loan with money whose value has declined.
1.4. Constraints in Macroeconomic Policy
Policy makers would like to raise incomes and achieve more rapid growth, but they are constrained in how effective they can be in this area. The constraints they face are two fold, real and financial.
A nation’s income depends on what its population can produce and sell. The key factors of production are labour and capital. The labour force works with the country’s capital stock. The greater the ability and skills of the labour force, the more capital equipment available to each worker, and the more technically advanced this capital, the high the value of what is produced. The rate of growth of the economy’s GNP depends on the rate at which these inputs are growing.
The key financial constraints are the fiscal deficit and the balance of payments. These act as constraints on the government’s ability in trying to achieve growth and employment objectives.
The fiscal deficit is the balance between government revenue and government expenditure. Cumulative borrowings to finance the fiscal deficit lead to an increase in the national debt. The problem with the national debt is that it has to be serviced. Interest must be paid on outstanding balances. If the national debt grows significantly a government may end up introducing policies to cut the fiscal deficit, regardless of the consequences for growth and unemployment. In a sense, a policy instrument (government expenditure) becomes a policy objective, which ends up taking priority over the growth, unemployment, and inflation objectives.
The balance of payments is a record of a country’s transactions with the rest of the world. The outcome on the balance of payments can affect the exchange rate. A deficit may lead to an exchange rate depreciation and a surplus may leas to an appreciation of the exchange rate. The exchange rate has major implications for the economy and in particular the inflation rate. For example, a policy that increases the real growth rate could result in a rapid increase in exports and a balance of payments deficit. An associated depreciation of the exchange rate could increase inflation and undermine the growth rate.
What, then are the policy instruments open to governments anxious to achieve an increased standard of living for their population. Clearly, not very much can be achieved simply by the government spending money – this will have to be financed through increased taxes or increased borrowings. Either approach will have negative long run effects on the economy.
Some economists are of the opinion that the best results will be achieved if the economy is left to itself. Market economies have proved remarkable capable of raising living standards and reducing poverty throughout the world. Centrally planned or socialist economies have failed dismally to deliver remotely comparable results.
Policies that lead to an improvement in the efficiency of the labour force or higher rates of investment in capital can promote faster growth. These polices affect the real sources of economic growth, which are the quality of the labour force and the amount of capital available to work with.