Basic Macroeconomic Concepts

Why Zoom Out? Micro vs Macro

And in terms of basic macroeconomic concepts…from the first calculations of national income in the 1930s to current debates about policy, economists have learned how to study whole economies at the same time.

Why do we 'zoom out'? Economists had supply and demand curves and looked at businesses individually as far back as the 1870s. But when the American economy collapsed in 1930, those tools couldn't explain why everything was failing at once. By 1933, 15 million people were unemployed. All the markets were falling apart at the same time. The tools available at the time could explain why wheat became cheaper after a particularly good harvest. They had nothing to say about why the entire system was freezing up. The difference between those two approaches is why economists created macroeconomics as a separate discipline.

Microeconomics focuses on specifics, like individual markets, businesses, and what people buy. Macroeconomics, on the other hand, steps back to examine a country's total production, the average level of prices, and employment across the whole economy.

To illustrate, a coffee shop doing incredibly well could still fail if a nationwide economic slump means no one has money for five dollar lattes. It's not the owner's fault; the entire economy has changed under them. On the AP exam you'll need to distinguish between macro and micro questions - and this distinction didn't really exist in formal economics until the Great Depression made it necessary.

The Circular Flow Model

The Circular Flow Model started with François Quesnay, Louis XV's doctor (not an economist!) and his 1758 work, the Tableau Économique. It was the first attempt to show how money moves around an economy, and today's circular flow model is simply a more detailed version of his idea.

In its simplest form, households provide companies with work, companies pay wages, and households use those wages to purchase what the companies make. Money goes around and around.

But add the government and the rest of the world and it becomes more complicated. The government takes money from households and businesses in taxes, and then spends it on public services, social security, unemployment benefits, and subsidies. The international sector includes exports (money coming into the country from other nations) and imports (money going out).

In essence, every dollar spent becomes someone else's income. That's how the system works. When people suddenly stop spending, as they did after Lehman Brothers failed in September 2008, businesses' income falls, they have to let people go, and those now unemployed people also spend less. A staggering 3.6 million American jobs disappeared within six months of Lehman's collapse. The cycle grinds to a halt very quickly.

Money is removed from the circular flow by leakages: saving, taxes, and imports. It is added back in by injections: investment, government spending, and exports. When leakages are greater than injections, the economy shrinks. Quesnay had a point 270 years ago. An economy is a network of interconnected flows, and when one of those flows is interrupted, the effects spread everywhere.

Three Macroeconomic Goals

The Employment Act of 1946 officially stated that the US would aim for three economic goals, and these are the same three goals found in nearly all introductory macroeconomics courses.

1. Economic growth. This is measured by how much real GDP (Gross Domestic Product) increases per person. From 1980 to 2010, China's economy grew by about 10% each year, lifting hundreds of millions of people out of poverty in one generation. No other period in economic history has seen growth at such a rate or on such a scale.

2. Low unemployment. Being out of work isn't just a statistic; it causes people to lose skills, breaks up communities, and can easily lead to long-term poverty. In April 2020, unemployment in the US reached 14.7% as COVID-19 lockdowns effectively shut down the economy almost immediately. This was the highest it had been since the Bureau of Labor Statistics started keeping monthly records in 1940.

3. Stable prices. When prices swing wildly up or down, it's impossible to make plans. In November 2008, Zimbabwe's hyperinflation was estimated at 79.6 billion percent per month - prices approximately doubled every 24 hours. Money lost all value and people had to barter. You can't save for the future or start a business when the value of money disappears between breakfast and lunch.

These three goals frequently conflict with each other. Trying to get unemployment very low often causes inflation. And strong measures to control inflation, such as Paul Volcker raising the federal funds rate to over 20% in 1981, can send the economy into a deep recession. This push and pull between stable prices and full employment is the main issue in making macroeconomic policy, and has been since the 1940s.

Business Cycle Phases

The National Bureau of Economic Research (NBER) has officially tracked the ups and downs of the U.S. economy since 1929; economies don't simply grow steadily. Instead, they go through increasing production, past a high point, a decrease, then a recovery, and this pattern repeats itself - it's what's called the business cycle.

During an Expansion, real GDP (the value of goods and services) increases, unemployment goes down, companies invest more, and people feel good about spending. The longest period of growth in the U.S. lasted from June 2009 to February 2020, nearly 128 months in a row, until the Covid-19 pandemic stopped it.

A Peak is the very top of the cycle. At this point, production and employment are at their highest, but problems are starting to show. For example, the housing market peaked in mid-2006, two years before the financial crisis of September 2008. Often, prices start to rise around the peak because the economy is working at its maximum ability.

A Contraction, or recession, is when real GDP goes down for a significant period. Businesses make fewer things, people lose their jobs, and consumers buy less. Many people say a recession is two three-month periods in a row with a decreasing GDP, although the NBER uses a wider variety of data (like employment numbers, factory output, and real income) to officially say when a recession is happening.

The Trough is the lowest point. Production stops falling, the economy gets more stable, and then the cycle starts up again with the next expansion.

As a quick reminder for the exam: if unemployment is decreasing and GDP is increasing, the economy is expanding. If unemployment is increasing and GDP is decreasing, it's contracting. The NBER has said there have been 34 complete business cycles in the U.S. from 1854 to 2020, so this pattern is a fundamental part of how free markets function.

Economic Systems

Regarding Economic Systems, every society has to figure out what will be made, how it will be made, and who will get what's made. A society's answers to these questions determine its economic system and the 20th century was essentially a huge test of different systems.

In a Market Economy, individuals and businesses make decisions based on prices. When people in the United States wanted more cars in the 1920s, car prices and company profits increased, which encouraged new businesses to start. Chrysler was founded in 1925 to take advantage of the increasing demand. There wasn't any government order involved - the price system coordinated the decisions of millions of people without any central planning.

A Command Economy puts the government in control. Starting in 1928, the Gosplan agency in the Soviet Union decided how much of everything was to be produced, from steel to shoes. This centralized control could quickly get things done and Soviet industry grew very quickly in the 1930s. However, without prices showing planners what people actually wanted, the system made too much of things no one needed and not enough of things people did. By the 1980s, constantly not having enough basic goods was a normal part of life.

The Soviet Union broke apart in 1991, but this didn't mean government shouldn't be involved in an economy. In reality, every country mixes market forces and government involvement in a mixed economy. The U.S. has public schools, Medicare (from 1965), and rules about protecting the environment (the Environmental Protection Agency was created in 1970) along with private companies. China has businesses owned by the government and a very large private sector that creates over 60% of its wealth. The question wasn't really "market or command". It has always been about looking at things together.

Worked Example: Identifying the Business Cycle

Let's look at an example of figuring out where in the business cycle we are. Consider a country's figures over four years:

- Year 1: Real GDP = $800 billion, Unemployment = 5.0%
- Year 2: Real GDP = $860 billion, Unemployment = 4.2%
- Year 3: Real GDP = $870 billion, Unemployment = 4.0%
- Year 4: Real GDP = $830 billion, Unemployment = 6.1%

What phase of the business cycle was happening each year?

From Year 1 to Year 2, GDP went up by 7.5% (from $800 billion to $860 billion) and unemployment went down from 5.0% to 4.2%. This is expansion, with increasing production and a shrinking pool of available workers. It's similar to what the US experienced approximately from 2014 to 2018.

Between Year 2 and Year 3, growth really slowed. GDP only slightly increased from $860 billion to $870 billion (about 1.2%) and unemployment only decreased to 4.0%. The economy was getting to its peak, producing nearly as much as it could, but was losing speed. This is much like the situation in late 2006.

From Year 3 to Year 4, GDP decreased by 4.6% (from $870 billion to $830 billion) and unemployment increased to 6.1%. This is a contraction: production is going down, and companies are laying people off.

The important thing to pay attention to is which direction Real GDP and unemployment are moving, not what the actual numbers are. A high GDP figure doesn't indicate expansion if that figure is decreasing.