Introduction to Macroeconomics

1 What is Macroeconomics? 32 Macroeconomic Accounts 21

PART I

Introduction toMacroeconomics

Part I of this textbook sets the stage formacroeconomics as a subject. Chapter 1 explains the objectives andmethods of macroeconomics, its history and usefulness, as well as its controversies and open questions. It provides a number of essential definitions and offers a preview of what will follow. Chapter 2 introduces the national incomeaccounts, the language economists use todescribe and communicate the economicactivities of a region or a nation, as well as thebalance of payments, which summarizes itsdealings with the rest of the world.

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What isMacroeconomics?

1.1 Overview 4

1.1.1 Income, Economic Growth, and Business Cycles 4

1.1.2 Unemployment 6

1.1.3 Factors of Production and Income Distribution 7

1.1.4 Inflation 7

1.1.5 Financial Markets and the Real Economy 9

1.1.6 Openness 10

1.2 Macroeconomics as a Discipline 10

1.2.1 The Genesis of Macroeconomics 10

1.2.2 Macroeconomics and Microeconomics 11

1.2.3 Macroeconomics and Economic Policy 13

1.2.4 Demand and Supply 13

1.3 The Methodology of Macroeconomics 14

1.3.1 What is to be Explained? 14

1.3.2 Theory and Realism 14

1.3.3 Positive and Normative Analysis 15

1.3.4 Testing Theories: The Role of Data 15

1.3.5 Macroeconomic Modelling and Forecasting 15

1.4 Preview of the Book 17

1.4.1 Structure 17

1.4.2 Controversies and Consensus 17

1.4.3 Rigour and Intuition 17

1.4.4 Data and Institutions 17

1.4.5 Europe 18

1

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PART I INTRODUCTION TO MACROECONOMICS4

1.1 Overview

Whether we like it or not, economic themes tend to dominate the news. A day seldom passes that we don’t hear about unemployment, inflation, economic growth, stock markets, interest rates, or foreign exchange rates. We hear and read so muchabout these phenomena because, directly or indir-ectly, they a3ect our well-being. It is perhapsmostly for this reason that macroeconomics, thestudy of these economy-wide phenomena, is soexciting. Macroeconomics is more than just head-lines, however; it is a fascinating intellectual adven-ture. The breadth of issues it covers is evidenceenough of its inherent complexity. All the same, wewill see that simple economic reasoning can take us a long way. And it is often surprising how well afew simple ideas fit complex situations.

Macroeconomics can also be useful. The economicwell-being of all consumers, rich or poor, is a3ectedby movements in interest rates, exchange rates,and the rate of inflation. Businesses stand to gain orlose considerable amounts of money when theireconomic environment changes, regardless of howwell they are managed. Being prepared for suchchanges in fortunes can have considerable value;more generally, it makes us all better citizens ableto grasp the complex challenges that our societiesface. Macroeconomics is relevant to voters whowonder what their governments are up to, and canalso help governments avoid the worst economiccrises that have a7icted modern industrial societ-ies in the past century—depressions, when overalleconomic activity is very far below average, andhyperinflations, when prices are increasing atmonthly rates of 50% or more. These extreme situ-ations can tear at a society’s social fabric, yet can be prevented when policy-makers apply sound eco-nomic principles.

1.1.1 Income, Economic Growth, andBusiness CyclesThe most frequently used measure of a nation’s eco-nomic well-being is its output and income, the gross

domestic product (GDP). Figure 1.1(a) displays theevolution of GDP for France, Germany, and the UKsince 1870. A positive long-run general tendency ortrend dominates shorter-run fluctuations. The trendrate of growth has been fairly stable, perhaps withan increase after the Second World War. Anotherway of seeing this is to plot the natural logarithm of

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Fig. 1.1 Gross Domestic Product (GDP),Germany, France, and the UK, 1870–2001National output and income, as captured by the gross

domestic product, exhibits a robust growth trend.

Growth tends to be exponential; that is, annual

percentage increases are reasonably stable in the long

run. This does not preclude significant year-to-year

variations. When the data are displayed on a logarithmic

scale instead (panel b), the slope of the curve measures

the annual rate of growth.

Source: www.eco.rug.nl/~Maddison.

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GDP against time, as in panel (b). With this so-calledlogarithmic scale the slope of the curve is a direct measure of the annual growth rate: a constantgrowth rate would yield a straight line.1 In the longrun, on average, we are not far from the trend.

For the large majority of countries, this trendgrowth in total output coincides with remarkableincreases in living standards. Table 1.1 shows that per capita or average income increased by a factor of more than sixfold in Belgium since 1900, by sevenfold in Sweden, and by almost a factor of 17 in Japan. In contrast, real income per capita rose by only 60% over the same period in Bangladesh.Some countries have faced serious setbacks, such as

wars and famines, while others have grown rapidly.Some, like India, stagnated for many decades beforesuddenly entering a period of rapid increase in living standards.

For this reason, economic growth is one of themost exciting issues in macroeconomics. Chapter 3explores the list of reasons why economies grow.One of them is population increase, since more people can produce more output. Another is theaccumulation of means of production: plant andequipment, roads, communication networks, andother forms of infrastructure make workers more productive. Most important is the development andharnessing of knowledge to economic ends. Thesharp acceleration of scientific discoveries towardsthe end of the eighteenth century is thought tohave triggered the industrial revolution, and somebelieve we are now witnessing the onset of a new

CHAPTER 1 WHAT IS MACROECONOMICS? 5

1 For mathematically inclined readers, if x(t) grows at theconstant rate g ≡ (1/x)dx/dt, then x(t) = A exp(gt) and ln x(t) = ln A + gt, where A is a constant and t stands for time.

1900 1913 1929 1950 1987 1992 1999 2002 Av. growth rate

Austria 2,155 2,592 2,766 2,772 11,458 12,932 14,631 15,428 1.9

Belgium 2,087 3,156 3,780 4,085 11,624 13,231 14,947 15,694 2.0

Denmark 2,256 2,926 3,796 5,193 13,480 14,089 16,765 17,126 2.0

Finland 1,248 1,579 2,032 3,181 11,505 11,309 14,289 15,164 2.5

France 2,151 2,606 3,523 3,943 12,380 13,710 15,033 15,875 2.0

Germany 2,232 2,729 3,030 2,903 11,744 12,601 13,520 14,028 1.8

Italy 1,335 1,917 2,314 2,619 11,179 12,444 13,660 14,312 2.4

Netherlands 2,561 3,028 4,255 4,485 11,770 13,274 15,701 16,238 1.8

Norway 1,449 1,870 2,597 4,086 13,615 14,555 17,907 19,135 2.6

Sweden 1,915 2,316 2,894 5,041 12,702 12,728 14,678 15,983 2.1

Switzerland 2,867 3,191 4,736 6,779 14,801 15,548 16,036 16,737 1.7

United Kingdom 3,360 3,680 4,116 5,190 11,513 12,033 14,428 15,308 1.5

Japan 882 1,037 1,515 1,437 12,155 14,532 15,431 15,490 2.8

Canada 2,177 3,326 3,789 5,454 13,723 13,613 16,043 17,415 2.1

USA 3,060 3,965 5,160 7,151 16,296 17,329 20,490 21,692 1.9

India 448 503 544 463 841 1,003 1,377 1,421a 1.1

Argentina 2,061 2,840 3,266 3,730 5,459 5,607 6,515 6,058a 1.1

Bangladesh 488 519 521 463 517 576 712 782 0.5

a 2001 data.

Source: www.eco.rug.nl/~Maddison

Table 1.1 Real Income per Capita (GDP in euros, 1990 prices)

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wave of advances related to information and tele-communications technology.

While output and income have increased by stag-gering amounts over many decades, this growth is by no means constant or even steady. A secondimportant message that we can take from Figure 1.1is that real output tends to fluctuate around itstrend. This is even more apparent in Figure 1.2,which focuses on the quarter-by-quarter evolution of GDP in the United Kingdom and magnifies therelative importance of short-run fluctuations. Thesesustained periods of ups and downs are called busi-

ness cycles. One important challenge of macro-economics is to explain such deviations of GDP fromits underlying trend: why they occur and persistover anywhere from one to five years, and what canbe done, if anything, to avoid the disruptions that are associated with them. This is the commontheme of Parts III, IV, and V of this book.

1.1.2 UnemploymentOne important phenomenon associated with cyclicalfluctuations is unemployment, the fact that peopleseeking work cannot find it, even when the economy

is growing rapidly. The unemployment rate is theratio of the number of unemployed workers to thesize of the labour force. The labour force consists ofthose who are either working or are actively lookingfor a job. In comparison with the total population, it leaves out young people who are not yet working,the old who are retired, and those who do not wishto work—or have given up hope of working.

There are many reasons why we are concernedabout unemployment. It is natural to associate idle workers with a loss of output and income to the economy. We need to ask, at the same time,whether unemployed are receiving o3ers of work,whether they are turning down job o3ers, if so, forwhat reason. Are the jobs that workers are searchingfor available at all, or are their aspirations unrea-sonable? The answers to these questions will help usbetter understand this complex phenomenon.

Unemployment is generally not a pleasant a3air.Even with well-developed and e5cient unemploy-ment assistance programmes, long-term joblessworkers can experience emotional stress and their skills may deteriorate. Even if they are notmeasurable, the social and psychological costs of


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Q 1/1962 Q 1/1967 Q 1/1972 Q 1/1977 Q 1/1982 Q 1/1987 Q 1/1992 Q 1/1997 Q 1/2002

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Fig. 1.2 Quarterly Gross Domestic Product, UK, 1962: 1–2002: 4With quarterly data, fluctuations of economic activity around trend become more apparent.

Sources: IMF; OECD.

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unemployment are high for the a3ected individualsand for society as a whole. By that criterion, Europehas not done well over the last decades, as Figure 1.3shows. The average rate of unemployment hasgrown inexorably to reach double-digit numbers. In the USA, in contrast, unemployment has closelyfollowed the business cycle, rising in periods ofslowdown, declining when growth returned. At thesame time, not all European countries have sharedthis misery, as the case of Switzerland shows.Chapter 4 and later, Chapter 17, present explana-tions for these varying experiences.

1.1.3 Factors of Production and IncomeDistributionThe output of an economy, its GDP, is by and large the result of work e3ort by men and womencombined with equipment—‘machines’, but alsobuildings and other structures. Labour and capital

are the technical names given to the two main factors of production, or inputs.2 The distribution oftotal income between these two factors of productionis often a political issue, with important economicaspects. Understandably, wage-earners wish toenlarge their share of the pie. Figure 1.4 shows theshare of income in manufacturing that goes tolabour, the labour share. It also plots the evolution ofthe stock market index over the same period, whichtracks the value of shares in companies traded on thestock exchange or bourse. An index is a number setto take a simple value (e.g. 1 or 100) on a particulardate for easy comparison, and is primarily designedto show relative changes. In stock markets, shares in companies are traded and valued on the basis of their profitability. The figure shows an inverserelationship between the labour share and thestock price index. When the share of income goingto labour is high, less is available for the firms’ owners, and stock prices are depressed. While itwould be premature to assert that one causes theother, it is valid to conclude that both are driven by common economic phenomena. In Chapter 6 wewill see that depressed stock prices may adverselya3ect the accumulation of productive equipmentand, ultimately, the growth and size of the eco-nomic pie itself.

1.1.4 InflationInflation refers to the rate of change of the averagelevel of prices. For comparability, the inflation rateis usually stated in terms of percentage change peryear, even when it is measured more frequently,such as every quarter or every month. Most of thetime, inflation is low or moderate at rates rangingfrom just above 0% to 4%. In the 1970s many Euro-pean countries experienced double-digit inflation,with rates rising to 10%, 20%, or more. In a numberof countries, for example in Latin America or in thetransition countries of Eastern Europe, inflationrates of several hundred per cent were quite com-mon in the 1980s. When inflation is very high it is usually measured on a monthly basis; the term hyperinflation describes situations when this


2 Land, energy, intellectual property, and many other inputsalso matter, but will be neglected as a first approximation.

0

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Switzerland European Union

United States of America

Fig. 1.3 Unemployment Rates in theEuropean Union, Switzerland, and the USA,1970–2003The unemployment rate, measured as the proportion of

workers who do not have a job but are looking for one,

varies considerably across countries. In the USA, the

unemployment rate fluctuates according to business

cycles. In contrast, the experience of the European

Union has been a marked increase over the last three

decades, signalling a key specificity of the continent.

Not all countries of Europe, however, have suffered

from massive unemployment, as Switzerland shows.

Source: OECD.

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monthly inflation rate exceeds 50%. A sign of excep-tional economic distress, hyperinflation has beenobserved in Central Europe in the early 1920s, inLatin America in the 1980s, and in many countriesborn out of the collapse of the Soviet Union in theearly 1990s.

In normal times, inflation is related to the businesscycle. Figure 1.5 shows how the rate of inflationchanges when the rate of capacity utilization varies.The rate of capacity utilization measures the degreeto which companies use available plant and equip-ment, and it serves as a good indicator of cyclicalconditions. The inflation rate is generally procyclical:it tends to rise in periods of high growth anddeclines in periods of slow growth. In contrast, thebehaviour of unemployment is countercyclical. Thebehaviour of inflation is investigated in Parts IV andV of this book.

1.1.5 Financial Markets and the RealEconomyFinancial markets play a central role in moderneconomies. Literally or with the help of sophistic-

ated communications technologies, they representarenas where buyers and sellers of financial assetssuch as bonds, stocks, currencies, and other financialinstruments meet to trade. Together with banksand other financial institutions, financial marketsgather resources from households in the form ofsavings and lend them out to others who will spendthem. One specific feature of these markets is theextreme day-to-day variability of prices at whichfinancial instruments are traded.

Physical investment, the accumulation of pro-ductive capital, is intimately related to financial con-ditions. It is one channel through which financialmarkets a3ect the real economy. The other channelis consumption. Stocks—shares in corporations—represent one form of private wealth. When shareprices rise, people feel richer and consume more.The real economy is contrasted with the financial ormonetary economy: the former concerns the pro-duction and consumption of goods and services,and the incomes associated with productive activities;the latter deals with trade in assets, i.e. monetaryand financial instruments. Chapter 10 brings the


Change in inflation rate Capacity utilization rate

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Fig. 1.5 Capacity Utilization Rates and Inflation, USA, 1962–2003When measures of the utilization of capacity indicate a high level of activity in factories, the rate of inflation tends to

increase. Conversely, low levels of activity are accompanied by declining rates of inflation.

Sources: IMF; OECD Main Economic Indicators.

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real and the monetary spheres of the economytogether to understand short-run determination ofoutput, interest rates, and exchange rates. Chapter11 explores these short and long-run linkages inmore detail. Chapters 12 and 13 bring together theissues of inflation and exchange rates.

1.1.6 OpennessEvery country engages in trade, exporting and im-porting goods and services to and from other partnercountries. An increasing number of countries—sometimes called emerging market countries—arealso connected through trade in financial assets.One measure of a country’s openness, or exposure tothe influences of the rest of the world, is the ratio ofits exports to its GDP. Table 1.2 shows that opennesshas considerably increased over the past decades, aspart of the process of globalization. Smaller countriestend to be more open than larger countries, andindeed the USA and Japan are fairly closed by inter-national standards. This is also the case of theEuropean Union vis-à-vis the rest of the world, eventhough considerable trade integration has takenplace among its member countries, as the tableclearly shows. On 1 May 2004, the European Unionexpanded by ten nations and 75 million inhabit-ants, an event which will further accentuate theimportance of international trade, financial, andpolicy links between these countries.

As a consequence, no one country is free frominfluences of events that occur elsewhere, some-times far away. A good example is the financial crisis that started in Thailand in June 1997 and

spread to the rest of South-East Asia. It didn’t stopthere, moving on to Russia, a3ecting Hungary andPoland along the way, before hitting Brazil andfinally, with some delay, Argentina. Chapters 19and 20 look at these issues.

1.2 Macroeconomics as a Discipline

procyclical? For a long time, economists paid little attention to such phenomena. In fact, it wasbelieved that properly functioning markets woulddeliver the best possible outcome, to a good approximation at least, and that there was no point in looking into their aggregate behaviour. This

1.2.1 The Genesis of MacroeconomicsWhy do we observe cyclical fluctuations in the levelof activity, for example the movements of GDParound its trend? Why is unemployment generallycountercyclical, while changes in inflation appear

1960 2001

European Union 6.1 11.8

United States 5.2 11.2

Japan 10.7 10.8

Belgium 38.3 84.4

Denmark 32.7 45.6

Germany 19.0 35.0

Hungary — 60.6

Ireland 30.6 95.4

Netherlands 46.3 65.1

Poland — 19.4

Portugal 16.0 31.6

Russian Federation — 36.3

Spain 8.9 29.9

Sweden 22.7 46.5

Switzerland 27.7 45.5

Ukraine — 55.5

United Kingdom 20.9 27.1

Source: World Bank; Eurostat.

Table 1.2 Openness (ratio ofexports to GDP, %)

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principle was called ‘laissez-faire’. Laissez-faire wasopposed by proponents of interventionism, whoadvocated government support for particular marketsand industries, including subsidies and protectionfrom foreign competition.

This does not mean that business cycles wereignored completely. In fact, cycles of varyinglengths were identified and studied, ranging frominventory cycles of one or two years’ duration tolong-wave cycles lasting half a century. Such cycleswere seen as the cumulative outcomes of disturb-ances such as discoveries, inventions, exception-ally good or bad crops, wrong bets by firms ongoods that customers want to buy, or even changingtastes of consumers at home and abroad. Inflation was seen as the consequence of rapidly growingmoney stocks, first because of gold discoveries in the nineteenth century, afterwards because ofreckless paper money creation by central banks. Aswill be seen in Chapter 14, much of this wisdomremains valid today. Yet the Great Depression of the 1930s, which spread worldwide sending mil-lions into unemployment and misery, seemed toosevere to be simply bad luck. Reflecting upon theGreat Depression in 1936, British economist JohnMaynard Keynes published The General Theory ofEmployment, Interest and Money, a book that is often said to have started the field of macroeconomics.Keynes stressed the role of aggregate demand inmacroeconomic fluctuations. His followers laterpersuaded policy-makers to engage in aggregate

demand management, that is, to manipulate govern-ment demand in order to smooth out fluctuations,mainly to avoid protracted recessions.

An evaluation of the success of demand manage-ment policies—which is the subject of Chapters 15and 16—is not conclusive. There have been bothbenefits and costs. Since the Second World War, the amplitude of the business cycle appears to have diminished considerably, as can be seen inFigure 1.1. While earlier generations assumed thatfavourable periods of growth were inevitably fol-lowed by periods of declining activity, today weworry mostly about slowdowns of growth. At thesame time, economists have also begun to thinkhard about the supply side—meaning the product-ive capacity of an economy—and more e5cient

utilization of labour and capital resources. Thisapplies especially to unemployment, which remainsa big problem in Europe. These topics are the subjectof Chapter 17.

Another remarkable change in the behaviour of the post-war economy concerns the general price

level, or the cost of goods in terms of money. Untilthe Second World War, prices were as likely to riseas they were to fall, as can be seen from Figure 1.6.Apart from war periods, the price level was trendless;over long periods of twenty to fifty years, the cost of living—a measure of the average price level—seemed just as likely to fall as to rise. One interpre-tation of the post-war era—a controversial one, as weshall see—is that macroeconomics has led to morestable growth rates at the cost of inflation. In themid-1980s, concern with high inflation triggered achange of heart. In particular, most central bankshave given up Keynesian policies and refocusedtheir energy on keeping inflation low.

1.2.2 Macroeconomics andMicroeconomicsThe macroeconomy is just the sum of hundreds orthousands of markets, each of which is explainedby microeconomic principles. Microeconomics isdevoted to the study of prices of individual goodsand of the markets where these goods are producedand sold. Why do we need two separate disciplines?To a great extent they are linked. Microeconomics isdedicated to the analysis of market behaviour ofindividuals. Macroeconomics is concerned with collective behaviour, the outcome of individualdecisions taken without full knowledge of whatothers do. Keynes stressed the notion of coordination

failures, which arise in decentralized markets asillustrated in the following example.

A consumer wants to purchase a car, but hisincome is insu5cient for him to do so. A car manu-facturer could actually hire him to build cars, and withhis salary he would then be able to buy one. That onesale, however, would not su5ce to pay his salary, soother buyers would need to be found. In order togenerate su5cient demand for his employment,several other individuals would need to be hired,perhaps in di3erent industries. For this scheme towork, a considerable amount of coordination


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Inflation Rate of France

Inflation Rate of UK

Price Level, France (log scale) 1995 = 100

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Fig. 1.6 Price Levels and Inflation Rates, France and the UK, 1870–2002Until the outbreak of the First World War, the price level was stable, and inflation was close to zero on average. Since the

Second World War, the price level has risen secularly, average inflation has been positive, high in the late 1970s and much

of the 1980s, declining over the 1990s.

Source: Maddison (1991), OECD.

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among producers and consumers would berequired. The laissez-faire principle is that pricesand markets automatically and perfectly performthis coordinating role. Keynes’s view was that some-times they fail to do so. Then, there may be many con-sumers wishing to buy goods and willing to work toproduce them, and many firms that would benefitfrom hiring them if only they could be persuaded thattheir sales would increase. But this potential maynot be realized and we have both recession (fewersales) and unemployment (fewer jobs). Even if marketforces tend to correct this imbalance (which theyeventually do), the period of time necessary may belong enough to involve significant social costs.

Macroeconomics started with the idea that pricesand markets do not continuously resolve all thecoordination requirements of a modern economy. Asmicroeconomics has moved in this direction too,the sharp distinction between the two fields hasfaded. Modern macroeconomics starts from soundmicroeconomic principles, and we follow thisapproach in the early chapters. We then focus onmarket failures to study business cycles and whatcan be done about them.

1.2.3 Macroeconomics and Economic PolicyEarly macroeconomists argued that governmentshave the means and the duty to correct market fail-ures. The experiences of the past decades haveshown that governments too may fail. Indeed, onemajor dividing line among macroeconomists isbetween those who primarily fear market failures onthe one side, and those who primarily fear govern-ment failures on the other. Yet, in nearly everycountry, governments are held responsible for thegood health of the economy. At election timesincumbent governments are judged, first amongmany other issues, on their economic performance.This is largely a consequence of the Keynesian

revolution. It explains why the study of macroeco-nomics is so intertwined with policy and politics.Part V is devoted to these issues.

1.2.4 Demand and SupplyIn its most concentrated form, macroeconomicsboils down to separating events into two categories:those that a3ect the demand for goods and services,and those that a3ect the supply of those goods andservices. The demand side relates to spending deci-sions by economic agents—households, firms, andgovernment agencies—both at home and abroad.The principle of aggregate demand managementpolicies is that the government can take actions too3set or smooth out those of private agents—firmsand households—in order to dampen or eliminatefluctuations in total spending. The idea is to takethe edge o3 recessions as well as booms. Two tradi-tional demand management instruments are fiscaland monetary policy. Fiscal policy manipulates gov-ernment expenditures or taxes in an attempt toa3ect the volume of national spending. This subjectis studied in detail in Chapter 15. Monetary policy isdirected at influencing interest and exchange rates,and more generally conditions in financial markets;this in turn a3ects spending on goods and services.Chapters 8 and 9 provide an in-depth analysis ofmoney and monetary policy.

The supply side relates to the productive potentialof the economy. The choice of hours worked byhouseholds, the productivity of their labour, and in general the e5ciency with which resources are allocated in generating a nation’s output, allinfluence an economy’s aggregate supply. Accord-ingly, supply-side policies represent the governmen-t’s e3ort to increase an economy’s long-run capacityas well as its overall e5ciency. Frequently, thise3ort is about reducing or eliminating government-induced ine5ciencies, which were introducedbefore the importance of the supply side was under-stood, or as the result of successful lobbying byinterest groups. It is also about bringing idle orunderutilized resources into productive uses.Unemployment policy—designed to fight thescourge of market economies—occupies a key rolein the supply side. Chapter 17 explores these issuesand shows how the government can improve orworsen the economic climate.


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1.3 The Methodology of Macroeconomics

(foreign levels of activity and interest rates), theprice of oil, and sometimes even domestic socialconditions such as business optimism or tradeunion militancy.

The distinction between endogenous and exogen-ous variables is necessarily arbitrary. Many exogen-ous variables are not strictly independent of theendogenous variables. Because the analysis occursin steps, many variables first considered exogenousor given at the outset are later made endogenous, orendogenized. For example, fiscal and monetary pol-icy decisions are often responses to the course ofinflation or unemployment. While it is convenientto take policy variables as exogenous, it is some-times illuminating to endogenize them. Chapter 16takes some steps in this direction.

1.3.2 Theory and RealismMacroeconomics proceeds by making simplifyingassumptions. We never literally believe in ourassumptions, but we need them in order to seethrough the vast complexity of an economy. This is why the distinction between endogenous andexogenous variables is artificial. Truly exogenousvariables are rare: two examples are climatic condi-tions (and even these may be a3ected by economicevents, such as the greenhouse e3ect) and scientificdiscoveries and inventions (which also may resultfrom economic decisions). The task of systemati-cally linking the behaviour of endogenous variablesto changes in exogenous variables is accomplishedby specifying relationships between all the variablesof interest.

All these relationships, when brought together,constitute a theory. Almost by definition, theorydeparts from realism. If the real world could beunderstood without simplifying assumptions, theor-ies would be unnecessary. The problem is not witheconomics, but rather with the world’s inherentcomplexity. Progress is made by weeding out thoseassumptions and theories that lead us to false con-clusions. As time passes, some theories prove to be

1.3.1 What is to be Explained?Macroeconomics is concerned with aggregate activ-ity, the level of unemployment, interest rates,inflation, wages, the exchange rate, and the balanceof payments with other countries. As a scientificundertaking, macroeconomics deals with phenom-ena which have highly complex channels of causa-tion. Consider a relatively simple example: in thisbook you will learn that inflation a3ects the deter-mination of the rate at which foreign money istraded for domestic money, the exchange rate. Youwill also learn that the inflation rate is also a3ectedby the exchange rate. Before beginning to thinkabout these questions, it is essential to be clearabout what we want to explain and what we take asgiven, or outside the realm of analysis. The vari-ables to be explained using economic principles arecalled endogenous variables. The other variables—those we do not try to explain—are called exogen-

ous variables. This distinction is represented inFigure 1.7. Examples of variables considered exoge-nous are policy instruments (the tools of fiscal andmonetary policies), economic conditions abroad

Exogenous variables Economic model

Endogenous variables

Fig. 1.7 Endogenous and ExogenousVariablesEndogenous variables are the object of analysis in an

economic model. Exogenous variables are determined

outside the economic model. The weather, political

decisions, and the onset of time are examples of

variables usually considered exogenous.

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unfounded, while others gain acceptability. Thisprocess is long and complex, and far from complete.Because macroeconomics is a young discipline, anumber of controversies continue to dominate, andthis aspect is discussed in Section 1.4 below.

1.3.3 Positive and Normative AnalysisMacroeconomic analysis and policy are closelylinked. Because a number of exogenous variablesare under the control of government, it makessense to ask what is good and what is bad policy. At its best, macroeconomics can explain the eco-nomy; for example, it can link particular events toexogenous events or policy decisions. This is posit-

ive economics: it refrains from value judgements.Normative economics takes a further step andpasses judgement or makes policy recommenda-tions. In so doing, it must specify what criteria are used in arriving at particular conclusions. Thisinevitably implies a value judgement. Economistsgenerally like to make policy recommendations. Aslong as they reveal their criteria, this is part of theirprofessional activity. In this textbook, we will gen-erally refrain from normative economic analysis.3

At the same time, we believe and hope that manyreaders will make use of their newly acquiredknowledge to indulge in the normative side ofmacroeconomics: this is what makes it fun.

1.3.4 Testing Theories: The Role of DataThe generally accepted way of evaluating theories is to subject them to scientific testing. In macro-economics, this means looking at the facts, i.e. atdata. This is easier said than done, and there are anumber of unusual di5culties. First, data corres-pond to sometimes elusive concepts, as Chapter 2 will show. Second, constructing aggregate dataimplies enquiring into the behaviour of millions ofindividuals, who sometimes have good or bad reasonsto misrepresent the truth. Third, economics sharesthe predicament common to other social sciences

that experimentation is not really possible—whenobserved, people often change their behaviour. Notonly is it possibly immoral—no macroeconomistwould wish to start a hyperinflation just to test atheory—but more importantly, many importantvariables simply are not observable. This is the caseof expectations, for example. Macroeconomists areforced to conduct empirical tests with the data thatthey have. They develop statistical techniques,often sophisticated ones, to deal with observationand measurement errors. They refine the tech-niques they use to gather and analyse data. Thisallows the elimination of some theories and themodification of others. The surviving theories will be those that withstand the test of time in this scientific process.

1.3.5 Macroeconomic Modelling and ForecastingEconomists are frequently asked to make forecasts.Governments, international organizations, andlarge financial institutions frequently employ largeteams of economists to prepare forecasts. If macroe-conomics were to be judged by the performance of forecasts, the verdict would not be unkind. Therespectable track record of forecasters has howeverbeen sullied by some large historical errors. Box 1.1illustrates this fact by examining the accuracy offorecasts, after the fact, for the year 2002.

There are several reasons why economic forecast-ing is inherently di5cult. First and foremost, even anexcellent understanding of an economy’s structure—how its endogenous variables interact—does notpreclude misjudging changes in exogenous variables.Good examples of this are the oil price increases of1973 and 2000, or the Gulf War of 1991. Second,expectations—which are volatile in nature—wield an important influence over the economy. Govern-ments sometimes react to their own forecasts byimplementing policies designed to prevent thoseforecasts from happening. Political changes occurquickly and can disrupt the economic environment.Finally, it takes time—often several months—toknow what has really happened at any given point, so forecasts are always based on provisionalinformation which becomes more precise onlywith time.


3 Many are motivated by ‘social conscience’ to studyeconomics. Much like medical doctors who want to cure the sick, economists are often eager to provide relief to the disadvantaged and su3ering.

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Most forecasts are generated by computer-basedmodels. These models resemble those that we presentin this book. They are made of hundreds, some-times thousands, of equations. Constructing theseequations is a long and di5cult task. The exogenousvariables must be guessed by forecasters beforethey can ask their computers for an answer. This

introduces many margins of error. The models cannever be fully reliable, and the exogenous variablesmay be di5cult to pinpoint. For these reasons, the forecasters themselves take their results with a grain of salt, and often, when the outcome is not completely satisfactory, ‘drop in’ their ownsubjective factor to the results.


Box 1.1 Forecasting the Year 2002

Economics forecasts can be wrong, and often signific-antly so. Table 1.3 presents forecasts of GDP growth andinflation published every six months by the Organizationfor Economic Cooperation and Development (OECD), an organization of industrialized countries. With theexception of South Korea, both economic growth andinflation in 2002 turned out to be considerably lowerthan first expected from the perspective at year end2000. Several factors contributed to this development.First, a sharp drop in stock prices associated with the col-lapse of the internet boom was followed by sharply lowerinvestment spending by firms around the world. Thiscontributed directly to the slowdown in growth as well asinflation. Second, the terrorist attacks on the UnitedStates in September 2001 reduced investment as well asconsumer spending in most industrial countries. Finally,a rise in oil prices is generally associated with a slowdown

in economic activity. From the perspective of 2000,these were all unforeseen events, with a large negativeimpact on the economy all the same.

Table 1.3 also shows how being wrong can changeover time. This is frequently the case, as forecasters tendto underestimate large changes, and are usually cau-tious to modify their forecasts unless new evidence iscompelling. Only in the case of the US economy was theOECD quick to expect a major slowdown in 2002, and onlyas of mid-2001—well before 11 September. Theseexpectations were later revised significantly upward, as theUS responded by cutting income taxes sharply andincreasing defence spending, measures which generallyincrease economic growth. These policies could nothave been fully anticipated at mid-2001, since they werelargely a result of the terrorist attacks which occurredlater on.

France Germany Japan Korea UK USA

Economic Growth (annual increase in real GDP, % per annum)

Forecast (December 2000) 2.5 2.5 2.0 5.6 2.3 3.3

Forecast (June 2001) 2.7 2.4 1.1 5.5 2.6 3.1

Forecast (December 2001) 1.6 1.0 –1.0 3.2 1.7 0.7

Actual Outcome 1.2 0.2 0.3 6.3 1.8 2.4

Inflation (rate of change in average prices, % per annum)


Forecast (June 2001) 1.5 1.5 –0.5 3.5 2.2 1.6


Actual Outcome 1.5 1.4 –1.5 3 0.8 1.4

Source: OECD, Economic Outlook.

Table 1.3 Forecasting the Year 2002

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1.4 Preview of the Book

1.4.1 StructureThe book proceeds in steps. Parts I–IV build up an understanding of the measurement and thebehaviour of the underlying economy. Part I is con-cerned mostly with defining terms and construct-ing a macroeconomic vocabulary. Part II elaboratesthe behaviour of the real economy. It focuses on themotivations of consumers and producers, abstractingfrom the influences of money and financial aspectsof the economy. Part III studies money and its cen-tral role in macroeconomics, as well as the financialsystem that creates it. Part IV studies macroeco-nomic equilibrium in the short, medium, and longrun. Part V examines inflation and its evolution,and pins down its determinants over a longer hor-izon. It introduces a framework for thinking aboutinflation and the business cycle. Part VI then uses this framework to explore policy issues facing governments: fiscal policy, demand management,and supply policy. The focus then shifts in Part VIIto more specialized topics, financial markets andforeign exchange rates, as well the world inter-national financial system.

1.4.2 Controversies and ConsensusEconomists often make a bad name for themselvesby quarrelling in public. Visible disagreementsamong economists frequently have to do with finerpoints, if not outright hair-splitting. This discourseis intellectually healthy, but misleading to out-side observers, whose opinions are often based onaccounts in the popular press and more apt to recallsensational talk-show appearances rather thansober analysis of theory and data. It is unfortunate that many disagreements have important policyimplications. Perhaps as a result, politicians oftensee economics as a sort of debating event, witheconomists acting as advocates for one particularideology or another. Getting a stamp of approval fora particular policy means simply finding the righteconomist with the right theory.

In this textbook we do not shy from presentingsome of the most important disagreements amongeconomists along the way, leaving the reader free tojudge. Yet we do not dwell upon these controversieseither, choosing to focus rather on the commonground. Because there is so much that is not con-troversial, it is best first to understand the broadareas of consensus. Box 1.2. provides more details.

1.4.3 Rigour and IntuitionThe only possible scientific approach to the com-plexities of the real world is the rigour of reasoning.However, to be useful, macroeconomics must beversatile and easily put to work when we want tounderstand particular events. This is why a greatdeal of macroeconomics simply amounts to accumu-lating intuition about particular phenomena. Ourobjective is, therefore, to leave readers with an intuitive understanding of how the economy func-tions. We do this by trying to draw robust yet sim-ple conclusions from the various and often intricateprinciples presented. Such intuition is never com-pletely rigorous, but can be useful in practice.Rigour plays its crucial role in reminding us whenintuition is correct, and when it should be usedwith caution.

1.4.4 Data and InstitutionsMacroeconomics is fascinating because it tells us agreat deal about the world in which we live. It is notmerely a set of abstract principles with interestinglogical properties. Many theories will look odd atfirst sight, yet they capture key aspects of the realworld. This is why at each important step we pauseto look at facts. Facts can be data or particularepisodes. Studying them carefully shows how the-ories work and shape our understanding of macro-economic phenomena. It broadens our knowledge of important events that have shaped the lives ofmillions of people.

On the other hand, a graph or a table is no sub-stitute for more rigorous analysis of the data. Merely

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demonstrating that two economic variables moveclosely together is a far cry from proving that onecauses the other. Our motive in using data to illus-trate economic phenomena is to give readers a feelfor economics itself. At the end of each chapter wegive a list of suggested reading—which is by nomeans meant to be exhaustive—for those whowant to learn more about the theory and practice ofmacroeconomics.

Finally, good economic theories must be validunder di3erent conditions. At the same time, theresponse of di3erent countries to exogenous eco-nomic stimuli are often shaped by their particular economic and political institutions. These includetheir form of government, the existence of labourunions and employers’ associations, and regula-

tions. The interplay of macroeconomic principlesand institutions is an essential part of a properunderstanding of the field, and this is why we spenda lot of time reviewing them. The economics ofthese institutions is, however, far beyond the levelof this textbook.

1.4.5 EuropeOur textbook bears the subtitle ‘A European Text’.Does this mean that we think that macroeconomicsin Europe is fundamentally di3erent from macro-economics elsewhere, say in the USA, Japan, or LatinAmerica? Most certainly not! On the contrary, wetake the view that macroeconomics is su5cientlyglobal in scope to apply to economies around theworld. This includes the transforming economies ofCentral and Eastern Europe as well as the newlyemerging economies of southern and eastern Asia.On the other hand, we do wish to send a more subtle signal: we believe strongly that Europeaneconomies have important distinguishing featuresthat make them hard to study through the lens of,say, the leading textbooks from North America.


Box 1.2 Macroeconomic Schools of Thought: A Primer

Almost from the beginning, macroeconomics has beendivided into two main schools of thought. Keynesians(and their neo-Keynesian heirs) and monetarists (andneo-monetarists) continue to pursue the old debatebetween laissez-faire and interventionism. Keynesiansare often characterized by the view that markets functionimperfectly and that governments can and should use economic policy actively to combat recessions.Monetarists4 tend to reject this view, seeing politics andthe power of bureaucracies as barriers to governmentefforts to steer the economy away from business cycles and more generally market failures, which they see aseither unavoidable or of lesser importance. Given thesepremises, each school uses theories and data to buildand support its case.

These labels are not exclusive. In the United States,where much of the debate takes place, reference issometimes made to salt-water versus freshwater macro-economists. Salt-water economists come from univer-

sities located on the two US seaboards (Harvard, MIT,Yale, Stanford, Berkeley) and tend to defend theKeynesian legacy. Freshwater economists are more fre-quently associated with Monetarism and laissez-faireand hail from universities located near the Great Lakes,e.g. Chicago, Rochester, or Minnesota. In Europe, sim-ilar controversies characterize national, and increasinglyEuropean debates. National traditions tend to makeBritish and French economists more Keynesian, whileGerman or Swedish economists more Monetarist. Dutch,Italian, and Spanish economists are hard to classify, having as many exceptions as examples for any rule. In recent years, older Keynesian ideas have enjoyed arenaissance among politicians in France and Germany,primarily, who endorse more active fiscal and monetarypolicy. Later on in this book, we will see how this newemphasis on activist policy is a consequence of the common European currency, the Euro, which was intro-duced in 1999.

4 The term ‘monetarist’ derives from the Latin ‘moneta’signalling their original emphasis on excess money growthas the sole cause of inflation. Now the term is more generallyapplied to those who generally advocate unregulatedmarkets and criticize government intervention at both the microeconomic and the macroeconomic level.

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There is much in Europe that warrants such aEuropean emphasis. Rather than a collection ofstates under a federal government, Europe is amosaic of nation-states, each with a sovereignmacroeconomic policy-maker, but also with dis-tinct preferences and endowments. Surely, thecompletion of the Single European Market, the creation of a monetary union, and the recentsignificant enlargement of the European Union willincrease the pressure towards integration, raising

specific new challenges along the way. In addition,to varying degrees, European countries share acommon view of the relationship between marketforces and social justice. The attachment to fairnessand economic solidarity is deeply ingrained inEurope’s traditions and history, which explain whyour labour markets di3er so much from those inthe USA. This observation alone warrants amarkedly di3erent look, even if the underlying theory is the same.


3 Key Concepts

u macroeconomics

u gross domestic product (GDP)

u trend

u economic growth

u business cycle

u unemployment rate

u labour force

u labour

u capital

u factors of production

u labour share

u index, index number

u inflation

u hyperinflation

u capacity utilization

u procyclical and countercyclical

u real economy, monetary economy

u laissez-faire versus interventionism

u aggregate demand management

u price level

u co-ordination failures

u Keynesian revolution

u demand side

u economic agents

u fiscal policy

u monetary policy

u supply side

u exchange rate

u endogenous

u exogenous

u positive and normative economics

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4 Suggested Further Reading

On economics as a science, and the process ofscientific discovery, see:

Friedman, Milton (1953), ‘The Methodology ofPositive Economics’, in his Essays in PositiveEconomics, University of Chicago Press.

Kuhn, Thomas S. (1982), The Structure of ScientificRevolutions, University of Chicago Press.

On the state of macroeconomics and itscontroversies, see:

Dornbusch, Rudi (2000), Keys to Prosperity, MIT Press.

Greenwald, Bruce C., and Stiglitz, Joseph E. (1988), ‘Examining Alternative Macro-economicTheories’, Brookings Papers on Economic Activity, 1: 207–70.

Solow, Robert M. (1980), ‘On Theories ofUnemployment’, American Economic Review, 70: 1–11.

The symposium ‘Forecasts for the Future ofEconomics’, Journal of Economic Perspectives,Winter 2000.

5 Media

Students can greatly benefit from reading daily the economic section of their newspaper. Somepublications with high-quality analyses (but notfree of prejudices) are (in English): the FinancialTimes and The Economist. There is also a wealth ofinformation on the internet. See our website fordirections.

Data are produced by national statistical institutesand central banks. Some international institutions

produce comparable data and are of easy access: theIMF’s International Financial Statistics and its biannualsurvey World Economic Outlook, the OECD’s biannualEconomic Outlook, the World Bank’s World Develop-ment Report and Global Economic Prospects, theEuropean Commission’s European Economy, and the EBRD’s annual Transition Report. All maintainwebsites, more or less generous in allowing access to their publications.

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Introduction to Macroeconomics

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Transcript of Introduction to Macroeconomics