Welcome to module two of macroeconomics. The real trick of macroeconomics is to get economy-wide measures that are meaningful

Welcome to module two of macroeconomics. The real trick of macroeconomics is to get economy-wide measures that are meaningful; that tell us something important about how much production is taking place, or what workers are earning, or how many people are employed, or how fast the economy is growing year to year to expand its productive output. The macroeconomics that we'll look at in this module is about how these macroeconomic variables-the gross domestic product, the wage level, the interest rate, the employment level-are determined. What is it that leads an economy to have a gross domestic product of 20 trillion dollars, or maybe the next year 19 trillion or 21 trillion dollars, depending on whether the economy is contracting in a business cycle or whether it is growing as part of a long term trend. Many of the issues we'll be talking about are heatedly debated, where there's no settled consensus among the economists that study these questions. I want to look at the benchmark of a full employment economy. What does that mean? A full employment economy means that all the people in the economy that would like to work are at work. They can find jobs, they're earning their income, the output of the economy in total the gross domestic product is based on all of that work effort of the people in the economy that are at their jobs and doing their work. A lot of macroeconomics studies the problem of what happens when people can't find work. When you're happy at work but suddenly your business says we have to let go a third of our workers because we're not able to sell our products. So a lot of macroeconomics and the whole tradition of this field came from the study of economies that were not at full employment. Economies that were only partial employment; only some of the people that want to work are able to find jobs. But a good benchmark for us is the full employment economy. And the essence of understanding that full employment economy is that we'll then be able to also understand other crucial aspects of the economy. How much do workers earn? How does the economy grow over time? How much of the total output of the economy is consumed in a given period, and how much is saved for the future? So these are some of the questions that we'll ask. We also need to take different time horizons, because macroeconomics actually has three very different time horizons of study. I like them all, I think they're all very, very interesting. One is the short term at the timescale of maybe a year or even part of the year, a quarter of the economy- three months-and the short-term study is involved with the question, principally, of business cycles, of the ups and downs of the macroeconomy from one year to the next. A second time horizon could be called the medium-term, and that might be a time horizon of one to ten years, looking at the basic question, not of the ups and downs, season to season, or year to year, but of the longer-term changes of the economy as an economy goes from being poor to middle income, or from middle income to high income, and as technology changes gradually over time. The third time dimension is really a time dimension of generations, maybe a twenty year interval or even up to a century or more, and this is the long-term macroeconomic perspective, really focusing it turns out on what is most important technological change, which makes our society move from an industrial society to an information society, for example, or in which countries today in poorer parts of the world are in a long-term technological transformation from rural agricultural economies to industrial and information economies. So three time horizons. We'll focus on the short-term in this module primarily and look at longer-term issues later on. Now if we think about the very short run, why is it that one year things are booming and the headlines are saying firms are hiring and everybody's excited, profits are high, the stock market is good, and then it could be six months or a year later, layoffs, crash, stock market falling, people trying to find work but can't find work, unemployment queues rising. This is the business cycle. The ups and downs of an economy over a few months to a couple of years, and our market economies-my own country, the United States, but any country in the world almost these days-has its ups and downs at the business cycle scale and it's rather odd that in one year everyone that wants work is able to find it and businesses have "help wanted" signs out and they're advertising and they just can't find the workers that they need, and then in another year, maybe even following that one, suddenly you can't find work, nobody's hiring, the businesses are laying off, output is down. And when you think about it, it's pretty surprising that this happens, in some sense. It's not, we believe, that suddenly people don't want jobs; in fact, they're usually clamoring for jobs. I's not that they've changed their tastes-we just want to go home and hang out-it's not that businesses have forgotten what they do, that they don't know how to produce anymore, that the technology suddenly went bad, and so the business cycle tends to be rather mysterious in some sense often, that you go from good times to bad times and it's a little bit hard to fathom; what was the underlying set of factors that led to the boom or to the bust that follows? And macroeconomics has been very much engaged in the study of those short-run fluctuations. Sometimes these short-term changes are due to causes that are readily identifiable. Shocks to the economy in the form of real shocks, like hurricanes or earthquakes or an epidemic disease, or on the positive side, a discovery of new mineral wealth that could open up new mining sites and new income. These are sometimes called supply-side shocks because they affect the capacity of the economy to supply goods and services. And those shocks are obviously part of our world- sometimes devastating parts of our world- and they have macroeconomic consequences. But a lot of the year to year changes, where people are at work one year and not at work the next year, don't have such identifiable causes of storms or natural disasters or new resource discoveries; they seem to be evolving within the economic system itself. Credit may be available one year and then very tight the next year, not for reasons in any way obviously related to these kinds of outside shocks. And we'll distinguish the supply shocks from what in the field of macroeconomics came to be called demand shocks, which are associated with changes in the desire of businesses or government or households to buy goods and services. And those changes in the desire to make purchases can also ripple through the economy, and we'll see that if businesses decide, well, maybe we don't want to invest so much this year, and for some reason, in the aggregate, businesses make a decision to cut back on investments that can have a rippling effect in the short term, such that enterprises can't sell all that they want and then they decide they're not going to keep all of their workforce on the payroll because they're producing more than they can actually get out the door and building inventory, so they start firing people that can have a cumulative effect because the people who are out of work suddenly say, we better cut back our spending, as well, because our incomes are at risk. The great economists that pioneered this demand-side interpretation of business cycles was John Maynard Keynes, perhaps the greatest political economist of the 20^th century,and the person who did more than anyone else to help understand the Great Depression, which is one of these calamitous changes that occurred in the 1930s when up to a quarter of all those who wanted to find jobs could not find work and businesses collapsed, went bankrupt, couldn't sell their output. And Keynes was there to help explain this and he gave rise to what became known as Keynesian macroeconomics, meaning macroeconomics in the footsteps of John Maynard Keynes. So we'll be looking at that, as well. But before we get to these short-term big changes whether they're supply shocks or demand shocks, let's start with the simple benchmark and that is a fully employed economy. Suppose that everybody that wants a job is able to find a job and that businesses hire workers according to their decisions on how best to make profits and they sell output and all that they produce is sold in the economy, some of those sales are used for current consumption purposes for our entertainment or our daily lives, some is set aside in the form of investment for the future, building new factories or new roads or new energy transmission systems, and so on; that's the fully-employed economy. And we want to understand as a starting point, so how big is that economy? What is the fully employed economy in the United States, for example? How would we even think about understanding US gross domestic product at full employment? Well a good way that economists have thought about this over the years is to start with the concept of a production function, a kind of engineering relationship that relates the inputs into production-the factories, the machinery, the power and so forth that goes into production-together with the the workforce, the employment and what the workers contribute to output. And with that production function, one makes a relationship between the main inputs into production and the amount of output that one gets. And if macroeconomists do this, they don't study a particular industry, they study the gross domestic product and macroeconomists have found it very helpful to think about a kind of engineering abstraction called the Aggregate Production Function, which links all of the inputs into production in an economy with that total output measured by the gross domestic product. There are two main inputs to production; there's what the workers contribute in their jobs and there's the capital stock that we work with in order to produce. What do we mean by the capital stock? We mean the buildings like the one that I'm in right now; we mean the power grid and the roads that help get me to the office today; we mean the machinery that we work with, whether it's the computers on our desk or some part of an assembly line to produce automobiles, and so forth. So we distinguish the labor input and the capital input, and here it's very important for our consideration to realize that the capital input-the machines, the buildings, the infrastructure-that stock of capital in the economy changes very gradually and at any given moment, any given year, we have what we've been able to invest in the past-that's what we have to work with-and the question of short-term changes of inputs mainly relate to the amount of workers at work, not the amount of capital in the enterprises of the economy. So in the short-term analysis, we tend to think of the capital stock as relatively fixed, stable, and available for the short-term, whereas it's the number of workers at jobs that fluctuates year to year. So in a fully- employed economy, we want to relate the aggregate output of the economy, the gross domestic product, to the aggregate input of work effort in the economy, the amount of workers employed, and taking is given for the short-run analysis, the amount of capital available to the workers in the economy. And if we relate the amount of employment to the level of output, we get a positive relationship: more workers, more output. And that relationship is sometimes drawn, as in the curve that you're looking at, where on the horizontal axis is the number of workers at work or the labor input, and on the vertical axis is the gross domestic product. And it's a positive relationship: more work, more output. It's also a bow-shaped relationship; we'll see later on that this makes a difference, but right now, we have a kind of curve that relates output in the form of gross domestic products to inputs in the form of workers. And when we talk about a fully-employed economy, what we can do is say, if all who want to work in the economy are at work, we can identify that level of employment-look up the curve to where that level of employment meets the aggregate production function-go across and determine the level of the gross domestic product consistent with full employment. To give you some round numbers: there are about 150 million people in the US right now that would like to work-that's roughly speaking what we call the labor force- and if all of them are at work, or nearly all of them are at work, the amount of output that all of those workers plus the capital stock of the US would produce is about 18 trillion dollars. That is our first determination of the macroeconomic variables, the level of employment at full employment, and the level of gross domestic product when the economy is fully employed. But how do we find how many people really want to work? Well that's the subject of the next chapter.