Macroeconomics

A study on aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. Macroeconomic variables: aggregate output or income, the unemployment rate, the inflation rate, and the interest rate. OUTPUT/INCOME: An economy's overall economic activity is summarized by a measure of aggregate output. Since the production or output of goods and services generates income, any aggregate output measure is closely associated with an aggregate income measure. The United States uses an aggregate output concept known as the gross domestic product (GDP). The GDP is a measure of all currently produced goods and services valued at market prices. One should notice several features of the GDP measure. First, only currently produced goods (produced during the relevant year) are included. This means that if you buy a 150-year old classic Tudor house, it does not count towards the GDP, but the service rendered by your real estate agent in the process of buying the house does. Secondly, only final goods and services are counted. In order to avoid double counting, intermediate goods used in the production of other goods and services do not enter the GDP. For example, steel used in the production of automobiles is not valued separately. Finally, all goods and services included in the GDP are evaluated at market prices. Thus, these prices reflect the prices consumers pay at the retail level, including indirect taxes such as local sales taxes. A measure similar to GDP is the gross national product (GNP). Until recently, the government used the GNP as the main measure of the nation's economic activity. The difference between GNP and GDP is rather small. The GDP excludes incomes earned abroad by U.S. firms and residents and includes earnings of foreign firms and residents in the United States. Several other measures of output and income are derived from the GNP. These include the net national product (NNP), which subtracts from the GNP an allowance for wear and tear on plants and equipment, known as depreciation; the national income, which mainly subtracts indirect taxes from the NNP; the personal income (measures the income received by persons from all sources, and is arrived at by subtracting from the national income such items as corporate profit tax payments and social security contributions that individuals do not receive, and adding such items as transfer payments that individuals do receive but are not part of the national income); and the personal disposable income (which subtracts personal tax payments such as income taxes from the personal income measure). While all these measures move up and down in a related manner, it is personal disposable income that is intimately tied to consumer demand for goods and services, the most dominant component of aggregate demand.

It should be noted that the aggregate income/output measures discussed above are usually quoted both in current prices (in "nominal" terms) and in constant dollars (in "real" terms). The latter are

adjusted for inflation and are thus most widely used since they are not subject to distortions introduced by changes in prices.

When is the economy considered to be in good shape? Of course, zero growth in the real gross domestic product (a stagnant economy) or negative growth in the real GDP (a shrinking or a recessionary economy) is not a good reflection on the economy. Positive growth is considered desirable. Whether or not a given positive growth rate is good enough, however, depends on whether it can be sustained without generating serious inflationary pressures. Once an economy reaches full employment, a 3 percent rise in the real GDP is considered sustainable on a long-term basishigher rates are considered inflationary. Nevertheless, when an economy is coming out of a recession, a growth rate of more than 3 percent may not generate a serious inflationary pressure due to unemployed resources. Thus, how well an economy is doing in terms of real GDP growth should be judged on the basis of the 3-percent benchmark, with appropriate upward adjustment for slack in the economy. UNEMPLOYMENT.

The level of employment is the next crucial macroeconomic variable. The employment level is often quoted in terms of the unemployment rate, defined as the fraction of labor force not working (but actively seeking employment). Contrary to what one may expect, the labor force does not consist of all able-bodied persons of working age. Instead, it is defined as consisting of those working and those not working but seeking work. Thus, the labor force as defined leaves out people who are not working but also not seeking worktermed by economists as being voluntarily unemployed. For purposes of government macroeconomic policies, only people who are involuntarily unemployed really matter when calculating the unemployment rate.

For various reasons, it is not possible to bring down the unemployment rate to zero in the best of circumstances. Realistically, economists expect a fraction of the labor force to be unemployed at all timesthis fraction for the U.S. labor market has been estimated to be 6 percent. The 6-percent unemployment rate is often referred to as the bench mark unemployment rate. In effect, at 6 percent unemployment, the economy is considered to be at full employment.

Whether or not the economy is doing well in terms of the unemployment rate depends on how far this rate is above the 6-percent benchmark. If the economy has an unemployment rate around 6 percent, it is said to be doing well. Higher unemployment rates reflect worse economic conditions. During the Bush recession, the unemployment rate peaked at 7.7 percent; during the Reagan recession, it peaked at 9.7 percent; and during the Great Depression, it reached more than 25 percent.

INFLATION RATE.

The third key macroeconomic variable is inflation. The inflation rate is defined as the rate of change in the price level. Most economies face positive rates of inflation year after year. The price level, in turn, is measured by a price index, which measures the level of prices of goods and services at a point in time. The number of items included in a price index varies depending on the objective of the index. Government agencies periodically report three kinds of price indexes, each having their particular advantages and uses. The first index is called the consumer price index (CPI); it measures the average retail prices paid by consumers for goods and services bought by them. A couple thousand items, typically bought by average households, are included in this index.

A second price index used to measure the inflation rate is called the producer price index (PPI). It is a much broader measure than the consumer price index. The PPI measures the wholesale prices of approximately 3,000 items. The items included in this index are those that are typically used by producers (manufacturers and businesses) and thus include many raw materials and semifinished goods. The third measure of inflation is the called the implicit GDP price deflator. This index measures the prices of all goods and services included in the calculation of the current GDP. It is the broadest measure of price level.

The three measures of the inflation rate are most likely to move in the same direction, even though not to the same extent. Differences can arise due to the differing number of goods and services included in compiling the three indexes. In general, if one hears about the inflation rate in the popular media, it is most likely to be the one based on the CPI.

Zero percent inflation may appear ideal, but it is neither practical nor desirable. A moderate rate of inflation1-2 percentis considered desirable by a vast majority of economists. An inflation rate of up to 5 percent is tolerable. Double-digit inflation rates, however, are definitely considered undesirable by most economists. THE INTEREST RATE.

The concept of interest rates used by economists is the same as that used widely by other people. The interest rate is invariably quoted in nominal termsthat is, the rate is not adjusted for inflation. Thus, the commonly followed interest rate is actually the nominal interest rate. Nevertheless, there are literally hundreds of nominal interest rates, including: savings account rate, six-month certificate of deposit rate, 15-year mortgage rate, variable mortgage rate, 30-year Treasury bond rate, 10-year General Motors bond rate, and the commercial bank prime-lending rate. One can see from these examples that the nominal interest rate has two key attributesthe duration of lending/borrowing involved and the identity of the borrower.

Fortunately, while the hundreds of interest rates that one encounters may appear baffling, they are closely linked to each other. Two characteristics that account for this linkage are the risk worthiness of the borrower and the maturity of the loan involved. So, for example, the interest rate on a 6month Treasury bill is related to that on a 30-year Treasury bond, as bonds/loans of different maturities command different rates. Also, a 30-year General Motors bond will carry a higher interest rate than a 30-year Treasury bond, as a General Motors bond is riskier than a Treasury bond.

Finally, one should note that the nominal interest rate does not represent the real cost of borrowing or the real return on lending. To understand the real cost or return, one must consider the inflation-adjusted nominal rate, called the real interest rate. Tax and other considerations also influence the real cost/return. But the real interest rate is a very important concept in understanding the main incentives behind borrowing or lending.

The desirable level of the nominal interest rate is linked to the desirable level of the inflation rate. If we consider that an inflation rate of 1-2 percent is desirable, then the short-term nominal interest rate will lie in the 4-5 percent range (assuming a real interest rate of 3 percent).