Four Macroeconomic Problems

This shift of attention of economists from microeconomics to macroeconomics came about because economists (and other people) had come to see four very important national problems as macroeconomic problems -- that is, as problems that could not be understood or solved without an understanding of the workings of the market economic system as a whole. The four distinctively macroeconomic problems are

  1. Recessions
  2. Unemployment
  3. Inflation
  4. Economic Growth (or Stagnation)

The Great Depression

The event that created modern macroeconomics was called "the Great Depression." The Great Depression was a period of about 10 years, 1929-1940. Here is a diagram that shows something of the decline in production in the Great Depression.

Figure 1 -- Production in the Great Depression

The green line in Figure 1 is Gross National Product in dollars of 1929 purchasing power.

Recession

The general term for decreasing national production, in modern economics, is a recession.

Recession
A recession is defined as a period of two or more successive quarters of decreasing production. Production is measured by a number of variables. Real Gross Domestic Product is one important measure. We will focus mainly on it.
The Great Depression was dominated by two recessions. The first of those recessions was of unparalleled depth, and that was what caused people to refer to it as a depression and as "The Great Depression." There is no general definition of a depression, however, and until recently the decline of 1929-1940 was the only decline refered to as a "depression."

Recessions and Production Growth

The recessions show up a little more clearly in the following diagram, which shows the rate of growth of Real GNP; that is, the change from one year to the next divided by the Gross National Product in the earlier year.

Figure 2 -- Change of Production in the Great Depression

Recession Since the 1950's

In the following diagram, we see the rates of growth and decline of Gross Domestic Product in 1992 dollars, computed on the basis of a chain index of Gross Domestic Product. The source for this information is the Federal Reserve Bank of St. Louis. We can see the recessions of 1960-61, 1969-70, 1973-74, 1980, 1981-82, and 1990-91.

Figure 3 -- Change of Production Since 1960

Unemployment as Excess Supply

This definition reflects the idea that unemployment is an excess supply of labor. This is illustrated by Figure four.

Figure 4 -- Unemployment as Excess Supply

Concepts of Unemployment

DEFINITION:

the labor force
The labor force consists of all those persons who are willing to work at a market equilibrium wage, and who either have jobs or are seeking work.

DEFINITION:

unemployment rate
The unemployment rate is a ratio, obtained by dividing the number of unemployed persons by the number of persons in the labor force.

Biases

Discouraged Workers
Discouraged workers are people who are willing to work at the going wage, but have given up looking actively for work, because they do not expect to find a job. They are not registered for unemployment compensation because they have been unemployed too long to be eligible (under American law). Thus, they really unemployed but are not counted as unemployed.
"Andy Capps"
I have borrowed the term "Andy Capps" from a British newspaper comic strip of that name. An "Andy Capp" is a person who is registered for unemployment compensation but not really willing to work at the going wage. He is only keeping up appearances in order to get the unemployment money. "Andy Capps" would be counted as unemployed although they are not really willing to work.

Kinds of Unemployment

These definitions are the ones used in modern economics, which, of course, has refined the ideas somewhat since Malthus' time. In fact, we shall need to pause and look at them more carefully, because there is some vagueness in the idea of unemployment at its best. Modern economics recognizes several categories of unemployment.

  1. Frictional unemployment.
  2. Cyclical unemployment.
  3. Structural unemployment.

Cyclical Unemployment

Figure 5 -- Unemployment in the Great Depression

Cyclical Unemployment

Figure 6 -- Unemployment after World War II

Recession

Unemployment as a Macroeconomic Problem

The two major views on unemployment are:

The "Keynesian" view of Unemployment:
Unemployment is an excess supply of labor resulting from a failure of coordination in the market economy.
The "Classical" view of Unemployment:
Unemployment is job search -- people engaged in the productive work of looking for a better match between worker and employer.

Inflation

Inflation is defined as an increase in the average price level in the economy. But a simple average won't do. Instead we use a "price index."

Two important price indices:

the Consumer Price ("cost of living") Index.
The abbreviation CPI is often used for the Consumer Price Index.
the GDP deflator.

Inflation is measured as a percentage change in the price index. Thus 5% inflation this year means that a price index is 1.05 times as large as last year.

Price Indices

Let us take the "cost of living" or consumer price index as an example. The Consumer price Index for May, 1996 would tell us the cost, in 1996 prices, of buying the basket of goods an average city wage-earner bought in 1982-84. Thus, if the CPI for May, 1996 is 157, it means that the same goods that an average wage-earner bought in 1982-4 for $1 would now cost $1.57 -- or in other words, there has been 57% inflation of the price level between 1983 and 1996.

Computing a Price Index

Table 1

1995 1996
price quantity expenditure price quantity expenditure
chicken 2 5000 10000 2.75 4131 11360.25
beans 0.75 10000 7500 0.8 12987.19 10389.75
total 17500 21750

Computing a Price Index

Laspeyres Price Index
The Laspeyres Price Index is the cost of buying what people bought in the base year at the prices they pay in the current year, divided by the cost of the same goods and services at the prices actually paid in the base year, times 100.

Computing a Price Index

Table Two

1996 prices 1995 Quantities expenditure
chicken 2.75 5000 13750
beans 0.8 10000 8000
total 21750
1995 spending 17500
Price Index 124
Rate of increase 0.24

Criticisms of the CPI

The four forms of bias were:

Inflation Over 135 Years

In Figure seven we see the increase in the price level from 1860 to 1995, based on three separate price indices.

Figure 7 -- Inflation from 1860 to 1995

Rates of Inflation

We often speak of the "rate of inflation." The "rate of inflation" is the rate of change of the price level expressed as a percent of the base price level. For example, in January of 1917, the consumer price index was 40.2, meaning that a basket of goods that would cost $1 in the base year, 1958, cost only 40 and 2/10 cents in January of 1917. In January of 1918, the consumer price index was 47.70. The difference is 7.5 cents, and the rate of inflation for 1917 was 7.5/40.2=18.66%, a quite high rate by American standards reflecting a wartime inflation.

Rates of Inflation Over 135 Years

Figure 8 shows the rate of change the price level, that is, the rate of inflation, based on the same three price indices.

Figure 8 -- Rate of Inflation from 1860 to 1995

Causes of Inflation

Thinking in terms of supply and demand, price inflation could be caused in one or both of two ways. Prices in general would only rise if, on the average, demand increases or supply decreases. In the first case, when demand increases and this results in inflation, we describe it as demand pull inflation. On the other hand, when cost increases and this causes supply to decrease in turn, and this results in inflation, we describe it as cost push inflation. But these two different causes of inflation are not independent, of course. A demand-pull inflation may itself lead to cost increases, which then give rise to a further cost-push inflation. This sort of vicious circle could account for the persistence of inflation in the latter half of the twentieth century, and many economists believe that it does.

Inflation Problems

A rising price level -- inflation -- has the following disadvantages:

Hyperinflation

The term "hyperinflation" refers to a very rapid, very large increase in the price level. Germany between January 1922 and November 1923 (less than two years!) the average price level increased by a factor of about 20 billion." Some representative examples of hyperinflation include

"Hyperinflation

Stagnation

Stagnation
A stagnation is a period of many years of slow growth of gross domestic product, in which the growth is, on the average, slower than the potential growth in the economy.
Some economists believe that the U. S. A. has suffered from a stagnation in recent decades. One reason for their thinking is expressed in the following table:

Growth of Real GDP by Decades, U.S.A.

decade rate of
growth
1960's 4.46%
1970's 3.24%
1980's 2.84%
1990's 1.81%

Inflation and Economic Growth

We know that recession and inflation often are related. The rate of economic growth is the black line and the rate of inflation is the red line.

Figure 9

We see that there are periods (like the recessions of 1981-83 and 1991) when recession corresponds to a slowdown of the rate of inflation. But there are also periods (like the recession of 1975) when the recession corresponds to the peak of the inflation and still other periods (like the prosperities of 1961-66 and1996-99) when inflation is low although growth is relatively high.

Remember!

A Model

Two relationships:

"Aggregate Supply" or Friedman Curve
Relates the price level to the amount sellers want to sell. (Red)
"Aggregate Demand" or Pigou Curve
Relates the price level to the amount consumers want to buy. (Green)

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