The Global Economy

No component of GDP excites political passions to the degree of net exports – not even government expenditure and its correlative, taxation. In recent years, advocates and opponents of globalization have frequently dominated headlines. “Globalization” generally refers to the increasingly free movement of goods, services, labor, and capital across national borders, increasing international financial integration and the rise of multinational corporations. Globalization has always excited passions.

Monetary and Fiscal Policy

Monetary policy is one of the two main types of macroeconomic policy. In Chapter 13 (section 13.2) we defined the other type, fiscal policy, as comprising those government actions that aim to influence macroeconomic performance through the manipulation of government revenue (taxes) and government spending (both on goods and services and on transfer payments). Monetary policy comprises those government actions that aim to influence macroeconomic performance through the financial system. Although we touched on monetary policy in the discussion of the financial system in Chapter 7 (section 7.6.1), a complete picture needs much more detail. The main discussion of fiscal policy is in Chapter 17. Nonetheless, because monetary and fiscal policies are not independent, we shall consider their relationship in this section.

The Government Budget Constraint

Like all agents in a free-market economy, the government must pay for the goods and services it receives. When tax revenues fall short of expenditure (i.e., it runs a deficit), the government must raise the money some other way. Most often, it does so by selling government bonds, which adds to the stock of government debt held by the private sector (BG ). There is another possibility: instead of borrowing, the government can “print money.” Sometimes, it is literally true that governments finance their spending by printing more currency. More often, this phrase refers to the central bank (in the United States, the Federal Reserve) purchasing some of the government bonds. They pay for these bonds with central-bank reserves – that is, by credits to the accounts of commercial banks with the central bank. As we saw in Chapter 6 (section 6.3.2), the monetary base (MB) equals currency plus central-bank reserves.

The Problems of Macroeconomics

Perhaps the most direct way to understand what macroeconomics is about is to sample the typical problems that it addresses.

Nothing focuses the mind on the economy more readily than an economic crisis. And when most of us think about an economic crisis, it is the macroeconomic aspects of the economy that spring to mind. The U.S. economy entered a recession in December 2007. Between then and the beginning of the recovery in June 2009, gross domestic product (GDP) fell by 3.7 percent – the largest fall during a recession since the Great Depression of the 1930s. To put that in perspective, GDP per head fell by $2,981 – that is, if the GDP had been evenly distributed across every person in the United States, each would have lost nearly $3,000 per year or nearly $4,500 over the eighteen-month recession (i.e., a family of four would have lost $18,000).

The goal of economics is to make sense of the economy. Applied Intermediate Macroeconomics keeps that goal constantly in mind. It teaches macro economics as a tool of factual and interpretive understanding of the economy. It differs from most intermediate macroeconomics textbooks in its focus on applications to real-world data. The object is to prepare students to use economic theory and data to illuminate the information and policy debates that constantly bombard us in newspapers, on television and radio, and online. The strategy of the book is always to illustrate economic theory with data and detailed worked examples and to present the student with problems that involve the analysis and interpretation of actual data.

This strategy presupposes some facility with data manipulation and some familiarity with rudimentary statistics, such as constructing graphs, calculating growth rates, and taking means. The necessary level of statistical prowess is roughly things one can easily do with data using Microsoft's Excel or a similar spreadsheet without any special statistical add-ons. The text assumes a basic competence with Excel or another spreadsheet, and it gives frequent hints about particular applications. Most students will already have the necessary skills. But those who do not need to get quickly up to speed. The website www.appliedmacroeconomics.com, which is a resource for this book, contains some guidance on getting started with Excel.

The Role of Money and Finance

Money and financial assets are not direct sources of economic welfare. We cannot eat them or build houses with them. The Scottish economist/philosopher/historian David Hume (1711–1776) wrote that money “is none of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy.” We do not value a car for its lubrication system; we do not value an economy for its financial system. The financial system is important only because it affects the things that do govern our welfare: whether or not we have a job; how much we can consume now or in the future; how our government is financed; and the part that our country plays in the world. The lubrication system makes the complex parts of the car function smoothly; the financial system simplifies consumption and production. The financial system is essential if complicated economic relationships are to be feasible. An economy without a financial system could hardly be more than a small village. Just as we often drive with no regard to lubrication, we conduct our daily economic transactions giving little thought to the financial system. But too little oil or a broken oil pump can bring the car to a standstill; and financial disorders can push an economy into a slump.

Five Questions about Interest Rates

Look at Figure 7.1, which shows the time series of five rates of interest: a short government rate (the 3-month Treasury-bill rate); a short private-sector rate (the 3-month commercial-paper rate); a long government rate (the 10-year Treasury bond rate); and two long private-sector rates for corporations with different degrees of riskiness (the Moody's Aaa and Baa bond rates). (The time series are a tangled skein, making the figure a little hard to read. But, as we shall see, the tangles themselves reflect an important fact about interest rates.) These five rates are chosen to represent the thousands of interest rates that are reported regularly. These thousands themselves represent the countless rates (one for each loan or debt instrument) recorded in the history of the economy. The figure reveals several consistent patterns in the interrelationships of the different rates and suggests at least five questions.