Chapter 1: An overview of the macroeconomy

Last Modified 06 November 2012
    The content of macroeconomics

and microeconomics are the two main branches of economics. It is probably obvious,
but still worth stating, that macro examines the "big" issues and micro looks
at the "small" issues. In terms of the economy, this means that macro is concerned
with the overall economy and its major components, while micro focuses on individual
units, such as firms and consumers. Neither branch is more important than the
other, although individual macroeconomists and microeconomists might disagree
about this.

The core of macroeconomics
can be reduced to a few very simple themes. Generally, these themes revolve
around the topics of income and economic growth, jobs, and prices:

  • What determines
    the level and rate of growth of income?
  • Are there
    enough jobs?
  • Are prices

These three questions
span the vast majority of macroeconomic analysis. Most of the research done
by macroeconomists is related to one of these questions, although it may not
be evident from the research itself.

Note that in
posing these questions we have already introduced some macroeconomic terms,
either directly (income) or indirectly
(unemployment, inflation).
Macroeconomics uses a large number of specialized terms and it is important
to become familiar with their basic definitions. Therefore, before we turn
to quantitative macroeconomic analysis, it is useful to go over some of the
basic economic concepts and definitions that are used to measure the economy.

    Economic systems and their main components

Economic systems
are ones "in which goods and services are produced with the ultimate object
of satisfying human wants (Stone, 1984)." Production, as Stone points out, is
divided into intermediate
goods and services
, and final
goods and services
Intermediate goods and services are absorbed back
into the production process, while final goods and services, are divided into
consumption and accumulation
When goods are accumulated, or invested, they are saved and
used to make more goods and services in the future.

Figure 1
is a crude schematic of a complete system of production; several points need
to be made before it is a serviceable set of concepts.

Figure 1

First, it is
helpful if we specify the actors in our economic system. For most purposes,
it is sufficient to include four kinds of economic actors. These are households,
businesses, government, and the foreign
. As we move through an exploration of the macroeconomy, we
will also mention financial
(banks, insurance companies, financial consultants, stock
brokers, and so forth) but in fact, these are a special type of business firm.
Each of the four has a special role in the macroeconomy.

Second, we must
note that some of our production is supplemented by foreign production (
), and conversely, some of our
output is sent abroad ( exports).
Exports are goods that we produce but do not consume or invest. Similarly,
imports are goods we do not produce, but that are available for consumption
or investment. Clearly, we have to take into account imports and exports.

Third, it is
helpful to clarify the meaning of the term "production." Specifically, we
must have a definition that is concrete enough to allow for measurement. This
is not as simple as it may seem since production takes place in a very wide
variety of circumstances. I am not referring here to the differences between
firms, but to the differences between production in households, governments,
and firms. All three of these domestic economic actors produce goods and services,
but with some significant differences. In the case of firms, goods and services
are produced with the intention of selling them in a formal market. There
are records of the quantity produced, and since the production is sold, it
has a known value. Therefore, the output of firms is included in the definition
of production, and it is valued at its market price.

Households also
engage in production. They produce meals, laundry services, housecleaning
services, childcare services, and so on. Unlike firms, these are rarely produced
with the intention of selling them in a formal market. I cook for my wife
and kids but our dining room is not a restaurant. There is no record of the
production that goes on in most households, and since the consumers are the
same as the producers, the output never passes through a formal market where
it would have a price. By convention, household production for consumption
inside the household is not included in the formal measurement of production.
This is solely for convenience (i.e., ease of measurement) and by historical
convention; in theory, production inside a household is no different from
production in a firm. A loaf of bread tastes the same no matter whose oven
it is baked in.

Governments pose
another set of questions about production. Governments in most countries do
not engage directly in production for the market, but they do produce large
quantities of goods and services. For example, governments usually provide
highways and roads, education services, national defense, clean water, irrigation
systems, criminal justice services, fire protection, and sewage treatment,
to name just a few. The problem is how to value production when it does not
pass through a market where a price is set. Taking national defense as an
example, how do we measure its value? There is no market price, yet we all
value our security. Production by governments is included in measurements
of production and, by convention, we value their output at its cost of production
since there is no measure equivalent to a market price.

A fourth clarification
is the distinction between consumption and accumulation. Originally, the only
goods or services placed into the accumulation category were those that earned
income for someone. This includes the construction of places of work (factories,
office buildings, and other structures that house businesses) and the equipment
and machines that business people use (business computers, copy machines,
assembly lines, business owned vehicles, and so forth). In the United States,
we also add houses to the investment (accumulation) category. This is done
because houses are long lived, unlike most other consumption goods. However,
one might argue that cars and refrigerators bought by households are long
lived as well, and should be included as investments by the same criteria.
This makes logical sense, but in our system of measuring national production,
they are counted as consumption, not investment.

Finally, a fifth
issue: How do we measure all this. No doubt this is an enormous task. (If
you are interested, some of the details can be gleaned from the government's
monthly publication Survey of Current Business which is available for
free over the internet; your library undoubtedly subscribes. The March, 1998,
has a lengthy description of the methodology and data sources.) The key point
is that production is measured by adding up the total expenditure on output.
This raises the issue of production that is not sold--is it counted? The answer
is "Yes." Unsold production shows up as a change in business inventories,
and this is counted as a form of investment. Some of this investment is intentional,
but much of it may be unintentional.

    The circular flow of income and output

Figure 2
puts all of these issues and concepts together in a diagram called the circular
of income and expenditure.

Figure 2

The main actors
in the economic system are enclosed in boxes: Households, businesses, government,
and foreigners. Across the top, the arrows point in the direction of the expenditures
on goods and services. For example, households buy consumption goods, so there
is a C coming out of the household's box. Households also devote some of their
income to savings, which flows into financial institutions (specialized types
of businesses) that in turn make loans to businesses that wish to invest (I).
Investment, or accumulation, is shown as a flow of expenditures by businesses.
The two remaining actors in an economy, government and foreigners, each add
to the flow of expenditures on consumption goods and investment goods, but
rather than breaking up their expenditures into C and I, we treat them as
separate expenditure flows.

One idiosyncrasy
of economic accounting should be apparent by now. Namely, in the economic
view, only businesses invest. This follows from the definition of investment,
or accumulation, as output which is not consumed, but that is set aside to
assist in next period's production. Note that this rules out many types of
activities that are common to households. For example, if you buy a share
of stock, it is savings (the S arrow in Figure 2) but not investment. Again,
economic investment includes only those things that add to the productive
capacity of an economy. What households call investment (savings accounts,
purchases on the stock market, mutual funds, rare antiques or artwork, real
estate, and so forth) economists call personal
, or personal
financial investment
. These things are not included in the definition
of investment when they measure I. The connection of households to investment
flows is through financial institutions, where specialized firms take household
savings and lend it to businesses so they can purchase factories, office buildings,
and new equipment.

The circular
flow also records the flow of income payments across the bottom of Figure

Figure 2 is constructed so that all income flows are generated by production
in businesses, and are paid to households. This follows from the facts that
households supply land, labor, and capital to businesses, in return for which
they receive rent, wages,
and interest payments. In effect,
this is simply a way to say that households own the economy, including all
businesses. Therefore, when businesses make payments for the inputs they buy,
the money ends up in households; when businesses earn profits, again the money
is paid to households ( dividends)
since businesses are owned by households. (You may wonder what happens to
profits earned which are not paid out. You can think of these " retained
" as payments to households which are re-lent to businesses.)

One of the most
important concepts in the national accounts is the equivalence between income
and output. That is, the expenditure on production by households (C), businesses
(I), government (G) and foreigners (X-M) equals the total value of production.
In turn, the activity of production must generate income payments which are
equivalent to the value of the goods produced. Consequently, the top arrows
are equal in value to the arrows across the bottom. In order to see this more
clearly, think of a specific example such as a car. If a household buys a
car for $20,000, the firm selling the car and receiving the $20,000 takes
the money and uses it to pay its workers (wages and salaries), its stockholders
(dividends), its landlord (rents), its banker (interest) and its suppliers
of glass, steel, car parts, and so forth. In turn, those suppliers, pay their
workers, stockholders, and so on. Ultimately, the entire $20,000 is distributed
as income.

Before households
receive their incomes, however, taxes are taken out. Taxes are, in a sense,
the income of government. That is, they form the revenue that governments
need in order to make transfer payments, and to buy goods and services. Note
the distinction between these two arrows coming out of the government category.
Governments buy things, but they also spend their tax revenues on direct payments
to individuals though social security, unemployment insurance, veteran's pensions,
and income maintenance programs such as welfare. As far as households are
concerned, transfer payments
are another form of income. From the viewpoint of the economy, however, transfer
payments are different because they are not created by production, representing
instead a redistribution of the income that is generated in production. Transfers
are put back into the income flow after taxes are removed and, along with
the remaining after-tax income flow, they make up disposable income. Note
that the taxes in Figure 2 include all types: income, sales, motor vehicle
taxes, and so forth. And finally, note also that government includes all levels,
not solely the federal level.

    Getting the terminology right

Many students are
confused by the jargon of economics and its specialized use of everyday words
such as income and money. Its worth
taking a minute to clarify a few common errors which, unfortunately, if left
un-corrected will cloud our thinking about the economy. For example, if you
ask someone why the economy suffered the terrible depression of the 1930s, many
people ultimately blame it on a "lack of money." Or, during the last economic
slowdown (1990-91) it was common to hear that new car sales were sluggish because
consumers did not have the money to buy cars. We all know what people mean when
they say this, but in fact, these statements confuse money with income. Fewer
cars were sold by the automakers because people's incomes fell, not because
they lacked money. Money is different from income; it is the most easily spendable
( liquid) type of asset in our economy,
while income is a measurement of earnings over some period of time. Money is
the physical amount of currency, coins, checking accounts, and traveler's checks
(M1). In some definitions it also includes household savings accounts and money
market funds (M2).

Another misused
term is wealth. Wealth is the total
of all past savings. Wealth can be stored in many different forms, from stocks
to bank accounts, to money stuffed under your mattress, to rare postage stamps,
or whatever. Recall that savings is the part of household disposable income
that is not consumed. The cumulation of all past savings is a household's

One of the key
differences between wealth and money, on the one hand, and income and savings
on the other, is that the former are stock
while the latter are flow
. Stocks are things that can be measured at a point in time,
while flows are variables that can only be measured over some period of time.
Money and wealth are stocks, savings and income are flows. For example, it
is sensible to state how much money or wealth someone has at any moment of
time. I could add up the money in my wallet, the coins in my pocket and the
value of my checking account to arrive at my total holdings of money. My income,
however, can only be measured over a week, or a month, or a year. Some unit
of time must be attached to it because it is a flow variable and not a stock.
(Stating how much income you have at a moment in time is meaningless in the
same way it is to ask how much water a river holds. If you ask a hydrologist,
they will undoubtedly give you a measure of "gallons per minute"--a variable
with a time dimension.)

    The national income and product accounts (NIPA)

The main components
of any national economy are captured in a set of accounts called the national
income and product accounts (NIPA).
The NIPA are a systematic set of measurements
of a nation's output and income over a period of time, usually one year or one
quarter (3 months). The NIPA presented in the accompanying file are yearly data
for the United States, 1929 to 1996.

The national
income and product accounts date from the 1930s for most industrial economies,
and the 1950s or 1960s for most developing ones. Although the general idea
of trying to measure the entire output and income of a nation dates back to
the works of two 17th century Englishmen, William Petty and Gregory King,
the concepts necessary to construct a fully developed set of national accounts
were developed in the 1930s and the 1940s. Leading contributors to the development
of our modern set of national accounts were Richard Stone and James Meade
in the UK and Simon Kuznets in the US, among others. Each of these three later
earned Nobel Prizes for this and other work.

A brief overview
of the concepts behind the NIPA is a useful starting point. Table1 is a list
of the main components of our economy. Table 1 begins with the most common
measure of overall output, gross
domestic product
. For the United States in 1997, GDP was over
8 trillion dollars ($8,018.0 billion). GDP is defined as the market
value of all final goods and services produced during the year by residents
of a country. Note the following components of the definition:

  • market value
    (i.e., it is measured at market prices, or, for government produced goods
    and services, at the cost of production);
  • final goods
    and services (e.g., we do not count the value of the steel that goes into
    a car, which is an intermediate good, and then count the car, because that
    would double count the steel);
  • during the
    year (i.e., over some time period, usually a year);
  • by residents
    of a country (i.e., regardless who owns the capital or labor used in production,
    if it is inside the US, it is part of the set of inputs used to produce
    within our national borders).

The main sub-components
of GDP are the same items as in the circular flow of Figure 2. These consist
of personal consumption expenditures (C) of households, private domestic investment
(I) of businesses, government expenditures (G), and net exports (NX) to foreigners.
NX is defined as total exports minus imports and can be (and is) negative.

Table 1

Gross Domestic Product

domestic product (GDP):
  • The
    market value of all final goods and services produced during the
    year by residents of a country.
  • $7,636.0
    billion in 1996
consumption (C):
  • Purchases
    of new goods and services by households.
  • $5,207.6
    billion in 1996
domestic investment (I):
  • Purchases
    of assets that will be used in production for more than one year.
  • Includes
    new residential construction.
  • $1,116.5
    billion in 1996.
  • Purchases
    of final goods and services and investment by all levels of government.
  • $1,406.7
    billion in 1996.
exports (NX):
  • Exports
    of goods and services minus imports of same.
  • $-94.8
    billion in 1996.

Table 2 breaks each
of component of GDP into the sub-component included in the data file. After
each item in Table 2, the variable name from the data set is given in parentheses.

Table 2

The Main Subcomponents of GDP

consumptionexpenditures (C): 

  • Durable
    goods (C1A) 
  • Nondurable
    goods (C1B)
  • Services

  • Gross
    private domestic investment (I):

    • Total
      fixed investment (I1)
      • Nonresidential
        fixed investment (I1A)
        • Nonresidential
          structures investment (I1AA)
        • Nonresidential
          equipment investment (I1AB)
      • Residential
        investment (I1B)
    • Inventory
      investment (I2)

    expenditures (G):

    • Federal
    • State
      and local (G2)

    Exports (NX):

    • Gross
      exports (EX)
    • Imports

    Since output equals
    income, adding up the output of C + I + G + NX should also equal total income.
    Therefore, if we add up everyone's income, we should get the same number as
    C + I + G + NX. Total income is called national
    in the NIPA and Table 3 breaks it up into its five main


    National Income and ItsComponents

    income (NI):

    • The
      sum of all factor incomes.
    • $6,254.5
      billion in 1996.
    salaries, and benefits (NI1):
    • Payments
      to individuals in return for their work.
    • $4,426.9
      billion in 1996.
    profits (NI4A):
    • Net
      income based on current production.
    • $735.9
      billion in 1996
    income (NI2A and NI2B):
    • Net
      income of sole proprietorships and partnerships.
    • $520.3
      billion in 1996
    income (NI3):
    • Income
      from rental property.
    • Includes
      imputed income from owner-occupied dwellings.
    • Includes
      royalties, patents, copyrights.
    • $146.3
      billion in 1996.
    income (NI5):
    • Net
      interest received by businesses.
    • Includes
      interest paid by households on their home loans.
    • $425.1
      billion in 1996.

    People also receive
    transfer payments as a
    part of their income. These are not included because transfer payments are not
    the result of income that is created in production; they are a redistribution
    of existing or newly earned income that is accounted for elsewhere.

    The astute student
    will have noticed that GDP in Table 1 is $7,636.0 billion, while national
    income is "only" $6,254.5. There are three reasons why they are different.
    First, some of what we pay for a good is no one's income, for example sales
    taxes or tariffs on the goods we import. Therefore we must subtract indirect
    business taxes
    from GDP. Second, some of what is produced goes to
    replace the machines that wore out in production. This is called depreciation,
    and it too must be subtracted from GDP since it is output used to replace
    worn out equipment. Third, some of our income is paid to foreigners for the
    use of their capital and labor. An example is a Toyota factory in Ohio that
    earns profit income for its Japanese owners. When we adjust for these items
    the part of GDP that remains is national income. This relationship is summarized
    in Equations 1 and 2.

    Equation 1:


      - income paid to foreigners

      + income received from foreigners

      = gross national product (GNP);

    and Equation 2:


      - depreciation

      - indirect business taxes

      = national income

    The labor force and unemployment

    The national
    income and product accounts are measures of production and income; they omit
    measures of jobs and unemployment. We turn now to a consideration of the basic
    concepts and definitions relevant to a discussion of employment and unemployment.

    The first important
    concept is the labor force. The labor force is a measure of the size of the
    available pool of workers. It is comprised of both the employed and the unemployed.
    This may seem straightforward, but the key is in the definitions of employed
    and unemployed. These are not exhaustive categories and many adults are neither.
    In order to be unemployed, a person must be 16 years of age or older, not
    working, and making an effort to find a job. If a person does not want a job,
    or if they want one but are not looking, then they are not counted as unemployed
    but are considered to be out of labor force.

    The definition
    of employment includes any work for pay even if you only worked one hour.
    That means that people who want to work full time but are only working part
    time are counted as employed. In addition, if you work for 15 hours or more
    per week in a family owned business, you are counted as employed even if you
    received no pay.

    The labor force,
    employment, and unemployment are measured by the Bureau of Labor Statistics
    . The BLS conducts a monthly telephone survey of approximately 60,000
    households across the nation. The survey is carefully designed to provide
    proportional representation of every region, ethnicity, family arrangement,
    occupational category, age,education level, and so on. This is to ensure a
    representative sample so that statistical inferences may be extrapolated to
    the whole US population. The telephone interviewers ask the respondents a
    series of questions such as

    • Did you work
      last week?
    • If yes, how
      many hours?
    • If no, did
      you want to work?
    • If you wanted
      to work, did you look for a job?
    • What did
      you do to try to find a job?

    This is not the
    precise wording, but you get the idea: the interviewer has to determine if the
    person is employed, unemployed, or out of the labor force.

    Since a different
    government agency measures unemployment (the Bureau of Labor Statistics in
    the Department of Labor) than the one that measures production and income
    (the Bureau of Economic Analysis in the Department of Commerce), the availability
    of data is not the same. Data for unemployment rates is readily available
    back to 1929 (the same as GDP and its components), but most other measures
    of the labor force begin in the 1940s, 1950s, and even later. In particular,
    the decomposition of data by race, an item of great interest since the 1960s,
    began in 1972. Similar decompositions by gender began in the 1950s.

      Inflation and prices

    Macroeconomics is
    also concerned with the overall level of prices and the rate at which they are
    rising or falling. A general rise in the price level is defined as inflation,
    while a fall in prices is called deflation.
    Inflation and deflation are usually expressed in percentage terms.

    In order to measure
    inflation, economists add up all prices into just one number. If you stop
    and think for a moment, you will realize that it does not make sense to treat
    equally all the prices of things in the economy. For example, we buy a lot
    of bread but only a few tulips, so changes in the price of bread should count
    for more than changes in the price of tulips. Economists handle this problem
    by constructing an index number
    for prices. An index number is an average in which some goods (bread) are
    given relatively more weight than other goods (tulips). The weights that are
    used are equivalent to the relative importance of each good in a typical consumer
    basket of goods and services. In other words, if the typical consumer spends
    0.1% (0.001) of their income on bread, then before the price of bread is added
    to the other prices, it is multiplied by 0.001. (The sum of weights must equal

    Another issue
    concerns the differences between firms and households. The goods and services
    that you and I buy are different from what General Motors buys. They buy steel,
    pumps, generators, electrical wiring harnesses, and other intermediate goods,
    whereas you and I buy oranges, shirts, haircuts, education, pizzas, and other
    final goods. Consequently, it does not make sense to measure the change in
    prices for households in the same way that one would measure the change in
    prices for firms. The way around this problem is to construct two price indexes,
    one for households called the consumer
    price index
    , and one for businesses called the producer
    price index

    The differences
    between these two indexes is in the composition of goods that go into each
    one. The consumer price index is based on the price of a basket of goods and
    services that a typical household buys; the producer price index is based
    on the price of a basket of goods and services that a typical firm buys. In
    both cases, the measurement of prices is a weighted average where the weights
    reflect purchasing patterns of typical households and businesses. Needless
    to say, if you are not typical, it may not be a good measure of prices for
    the things you buy.

    The indexes are
    re-calculated monthly so changes can be compared on a month to month basis.
    When the number are published, they are always presented in reference to a
    base year which serves as a standard of comparison. The level of prices in
    the base year is always set equal to 100. An example will illustrate this
    point. Suppose that in 1992 the researchers for the Bureau of Labor Statistics
    bought their typical consumer basket of goods and services for $2,000. If
    1992 was the base year, they would set the $2,000 equal to 100. If the same
    basket cost $2,100 a year later in 1993, then the price index for 1993 would
    be as follows:

    1993 CPI = 100
    [(2,100)/(2,000)] = 100 (1.05) = 105.

    This implies
    the following:

    Current year
    price index =

    100 [(price of a consumer basket in current year)/(price of a consumer basket
    in base year)].

    The rate of inflation
    can easily be calculated as the percentage change in the price indexes, expressed
    in percents:

    Inflation =
    [(1993 CPI - 1992 CPI)/(1992 CPI)] 100 =

    [(105-100)/100] 100 = 5%.

    Inflation between
    any two years, whether consecutive or not, and whether one is a base year
    or not, can be calculated in exactly the same way: as the percentage change
    in the price index.

    For the CPI in
    the data set, the base year is an average of prices in 1982, 1983, 1984. The
    PPI uses 1982 as its base year.

    There is a third
    price index in the data set, called the GDP
    . It would make more sense to have called this the GDP price
    index, because the word "deflator" is confusing to novice macroeconomists.
    Nevertheless, you should not be confused by this; just remember it is a price
    index for all the goods that enter into the calculation of GDP (see Tables
    1 and 2). The base year for the GDP deflator is 1992.

      Finding your own data

    The accompanying
    data file has the NIPA for the US (annual data, 1929-1996), as well as price
    indexes, labor force measures, productivity measures, federal finances, the
    money supply and interest rates, and comparative stock market and production
    indexes for the US, Japan, UK, and Canada. (See the codebook
    for a complete list.)

    Some adventurous
    types may want to gather their own data. Or, better yet, you may want specific
    measures for a term paper or a research report that are not in the accompanying
    data file. All the data series presented here, and a vast quantity of additional
    historical data are available in (usually) two formats: hardcopy in federal
    government publications and electronically from federal government web servers.

    Two hardcopy
    sources of data are The Survey of Current Business and The Economic
    Report of the President.
    The former is a monthly publication from the
    Department of Commerce, containing the latest releases of GDP and price data
    as well as specialized articles on a variety of topics such as US international
    transactions, and regional indicators of income and production. The Economic
    is an annual series which comes out in February of most years.
    It contains several chapters of text which give the current presidential administration's
    view of the economy and its definition of the main issues. It also has a lengthy
    set of historical tables with macroeconomic data.

    Both the Survey
    of Current Business
    and The Economic Report of the President are
    available on-line from federal government web sites. They require an Adobe
    Acrobat Reader, which you can download for free if you need to. The addresses
    are for
    the Survey, and
    for the Economic Report. The Bureau of Economic Analysis (publishers
    of the Survey) also have a wealth of additional data at

    In addition to
    these sites, the latest-latest macro data can be found on the Whitehouse's
    website in the monthly Economic Indicators report from the Council of Economic Advisors. The address
    for this report at the Whitehouse is

    Another interesting
    site used to develop the accompanying data file is the Department of Commerce.
    There you can find the entire federal budget, as well as a complete set of
    historical measures such as federal expenditure and revenues, going back to
    the founding of the Republic:

    If you cannot
    find what you are looking for at any of these sites, try looking at the main
    gateway to federal statistics, FEDSTATS:


      Bureau of Economic
      Analysis, U.S. Department of Commerce. Survey of Current Business.
      U.S. Government Printing Office, Washington, DC. Monthly.

      Council of
      Economic Advisors. The Economic Report of the President. U.S. Government
      Printing Office, Washington, DC. Annual.

      Stone, Richard.
      1984. "The Accounts of Society," Nobel Memorial Lecture. Reprinted in American
      Economic Review,
      December, 1997, v8, n6.