Reading - The Economy as a Whole Definitions and Analyses...

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Unformatted text preview: The. Economy as a Whole: Definitions and Analyses s we have seen, microeconomics is concerned with economic activity at the level of individual markets and generally con— cludes that competitive markets are efficient and work best when not encumbered by government intervention. In rather sharp contrast, macroeconomics is the branch of economics that deals with the relation— ships of large aggregates—all consumption expenditures added up, all exports added up, and so on———in order to analyze the performance of the national economy as a whole. The entire frame of analysis is oriented toward understanding how a central government (in the United States, the federal government) can deliberately manage total effective demand for goods and services through its budget (fiscal policy) and by altering financial conditions (monetary policy). ® CHAPTER 3 Why Macroeconomics? The roots of macroeconomics and the idea that governments need to manage aggregate demand are not difficult to locate. Despite the usual portrayal of the 1920s as a decade of frivolity and good times, it was actu— ally a time of economic instability and difficulty. Some state governments ineffectually attempted to regulate markets, and the federal government in the 1920s did little except to raise tariffs and experiment with a small agricultural price support program. The U.S. stock market crash of 1929 and the onset of the Great Depression drastically altered all of this. The volatility of the international economy, the fragility of domestic financial systems, and the inability to match levels of aggregate demand with output capacity all converged to create the most serious worldwide capitalist crisis ever. Between 1929 and 1934, U.S. production declined by 30 percent and official unemployment rates rose to 25 percent of the workforce. The presidential election of Franklin Delano Roosevelt in 1932 signaled a new era—the New Deal—— of active, interventionist government policies. The short—lived National Industrial Recovery Act (N IRA) of 1933 was an early, ambitious attempt at national industrial planning, and it brought the force of federal law to attempts to stabilize markets. Even though busi— nessmen dominated the councils empowered to make decisions about prices, wages, and output quotas, the NIRA’s failure to bring order into markets soon turned the business community’s initial support into opposi- tion. In any case, the U.S. Supreme Court ruled it unconstitutional in 1935. Two other general policies enjoyed greater successes. The Wagner— Connery Act (1935) established the National Labor Relations Board and legalized protections for union organizing and collective bargaining. The Social Security Act (1935) mandated a national pension system and some limited social insurance, even though it neglected large numbers of poor, minority, and women workers by excluding agriculture and domestic service. Both initiatives were resisted by business interests, and a large 3 :3 El». 3*. THE ECONOMY AS A WHOLE ® part of the entire New Deal endeavor has to be understood as an effort to put the business system back on its feet even if it had to overcome oppo— sition by the business community to do so. Augmenting the three pieces of legislation mentioned above, the New Deal included a myriad of more focused initiatives, ranging from financial market regulation, agricultural price supports, the Civilian Conservation Corps, Works Projects Administration, .and other regula— tory, public works, and relief policies. Nevertheless, the New Deal poli— cies never adequately stimulated aggregate demand, and recovery was slow and uneven. When Hitler’s army invaded the Polish corridor in late 1939, the U.S. unemployment rate was still around 15 percent. World War II, more than any other factor, rescued U.S. capitalism from the Depression. As soon as large federal expenditures for war matériel raised profit prospects and unions agreed to a no—strike pledge, business opposition to federal regulation and control all but evaporated. During the war, the federal government successfully operated a regula— tory regime that went far beyond the NIRA in its comprehensiveness, tight controls, and top—down lines of authority. By—products of the war effort included full employment, new occupational opportunities for women, modest improvements in the distribution of income, and new civil rights possibilities for African Americans. Although most of the direct economic controls were dismantled soon after the war, they and the New Deal had established the foundations for substantial federal economic regulation and intervention (the “mixed economy”). These developments reflected political and economic elites’ general loss of confidence in free markets and their conviction that if left alone, the vicissitudes of unregulated markets could jeopardize the very existence of a capitalist economy. At the same time, the New Deal and World War II controls seemed to show that active government policies of regulation and demand management could stabilize capitalist economies. These two lessons from experience encouraged a newfound faith in the efficacy of discretionary stabilization policies by public authorities. @ CHAPTER 3 The work of the Englishman Iohn Maynard Keynes, in his The General Theory of Employment, Interest, and Money (1936), plausibly justi- fied and systematically mapped interventionist strategies that did not upset the basic principles of a capitalist social order. The book established the theoretical bases of modern macroeconomic analysis, often referred to as “Keynesian economics.”1 The Keynesian approach emphasizes the need for sustaining levels of total (or “aggregate.”) demand adequate for the full employment of productive capacity. The policy tools of demand management are used to promote economic growth, reduce inflation and unemployment, and generally maintain a smoothly functioning economy with satisfactory levels of material prosperity. Advocates of such policies argue that the macroeconomic stability and buoyancy from prudent pub- lic policy are necessary for markets to work efficiently by satisfying some of the conditions, such as full employment and stable prices, that are assumed in microeconomics. Two legislative acts immediately after the war are important to know about. The Employment Act of 1946 formally obligated the fed- eral government to ensure “full employment” and illustrated these new sensibilities. This was followed closely by the Taft-Hartley Act of 1947, which constrained the freedoms that the Wagner-Connery Act had accorded organized labor, strengthened conservative union leaders’ control over rank—and-file members, and mandated purging unions of left—wing influences. In addition to the Cold War, the Taft—Hartley Act was a direct response to the wave of post—World War II strikes often instigated by the rank—and-file membership against the wishes of union leaders. Moreover, employers feared that the Employment Act would weaken the threat of unemployment and strengthen labor’s bargaining position. It is important to understand, then, that the experiences of the Great Depression of the 19305 and World War II led political and economic leaders to have powerful doubts about the stability of free markets. Corresponding to these doubts were their convictions about the need for .33. .r-v-u HI". .' ghg.._';_.;_4.‘.,_‘ 5.39..»— _4I.. THE ECONOMY AS A WHOLE ® active economic guidance by central political authorities, thus leading to the rise of modern macroeconomic policy. How Gross Is the Gross Domestic Product? It is obligatory to begin with some formal definitions, simply sq that we have a decent idea of what we’re talking about. We’ll start with the National Income and Product Accounts’ most aggregate of the economic aggregates: gross domestic product (GDP), which is the total value of all ' goods and services produced in the nation in a year.2 In the early years of the twenty—first century, the GDP of the United States was over $10,000,000,000,000—that’s right, over ten trillion dollars (thirteen zeros), or 10 million millions. One of the key concepts underlying the National Income and Product Accounts and all of macroeconomics is that a buyer’s expendi- tures represent some seller’s receipts. Wages are costs to firms but receipts (income) for workers. Food that workers buy at the supermarket is a cost of living for them but receipts for the supermarket. An exception to this circular interdependence at the national level is that while the purchase of an imported good is a cost to the buyer, it is a receipt for a foreign seller and lies outside the domestic circular flow. The sale of an export is the mirror image: the receipt from the sale enters the national circular flow from the outside. Table 3.1A presents the flow relationships within the nation and lists the GDP’s components. Table 3.1B lists an alternative organization of the same data but by a different system of main headings (“aggregates”). These frequently used aggregates are important, but for now, let’s con- centrate on table 3.1A. The left column of the table shows the expenditures for all final goods and services produced in that year. That is, the list includes the sale value of all goods and services except for those used for further produc- tion (e.g., steel, plastic, and glass for automobiles). The right column Nd .mé in. A Bow =55 £2.55 Eth .o .556 62:3 Egbsfis *0 088.... x2$t£ «Eco... o_nmmo%_o “£03.... mmxfi. Orr—DUE Eran—un— m::=>_ 333...... .3 Eva. uses .32. wEouE .385... Egg m_m:v_>_u:_ o. 35:53 .322. 98%.... BE 2256ch $3 Eu 9.5.62.1 2.9.8 8.. ,8: 35.2.33 m_m:u_>=.:_ 8 35:3 .328. .55.:qu SE 3322...: B 35:58 9.2.3:. 9.385 Eco... 8552 .25 $53 £05 39598 25:2 AcouuatEQ E95... 8 33:955.. .8 82.58. 3.6.603 o. 55:.qu 38% 2:85 _m_._o_«mz Egan mmocfian 8 £233 SE 8.8.. mmwcfiam 52%5 3:5 63.0... .2932 32 Egg coumnwawv 2.55. 62.0... ficouuz 3.20 .633... 3.3m v3.5 05 :_ 35:53:: :2: E2». 2339.2 3 wESE mass. v85... flcucfigfi .m.: E0: 32mg. wESE SE finmmd : Unto... uwmeon $.20 35:01 me 2.2.5.: was; 0E8... .225: t. 5E9. 2:. .a —.m mime... $238.... .w... .m... .n-.. E .98” is magmam§§u .o xuaam .858 Aug—on S 9.256 Ami—on .6 2.555 «E85 ufiwEoo $20 mmmda Gavan. ufiwEoo $.20 £32. 0.8 — £32. 51 2.2.5.: use... _muo_ “Em 28m wmzwwovcoz count...an 3.5on 8.8... mmoEmsm 62%... ed E...ku «cum . 885.3“. EuEEw>ou «$.35 md mwtoucgfi E mmcmzu mmEEmm .8533. N... mEmso: fincuEmum mvcwvfio 9m. EwEn—Evu .25 E2; 8me muck. . E2...ng 9.2.2098 fan $3.5m mmmtemwazm Eeasucia «.8 £30» «32352 amok. Nd £30» 25959 9%...3 9.5.5.5 mwtmfim .25 3mm; 93 :owaEsmcou 3E8... non—Eon can 325 .2...— ..$ 3.3.153 tau .9 35:85.. as 835 .3222... 82 6:12.. 3.8.5... 395 a... .o $55.58 .< w CHAPTER 3 shows how the receipts from the production and sale of those goods and services were distributed among recipients. The left side may be thought of as being the sales of all final goods and services, and the right side as the costs of producing and selling those goods and services. Even though there is no direct correspondence between individual entries, the sum of the two sides is equal—sales equal receipts; production equals income. This equality does not reflect the balance of an equilibrium condition; it simply expresses accounting definitions. Table 3.1A suggests two ways to calculate the GDP. Look at the left side of the table, which represents one way to calculate the GDP—count up the total sales of only final goods and services. Since the only goods counted here are those that end up with the final users, we avoid the problem of double counting by not counting all the intermediate goods utilized in further pro— duction. For example, the value of the wheat sold to the miller, the value of the flour sold to the baker, the value of bread sold to the supermarket chain, and the value of the bread sold to consumers/shoppers cannot be added up into a meaningful total. One way to avoid double counting is to count only the value of the final product—the bread—which includes the value of the intermediate products used in its production. Table A.1 in the appendix to this book shows the magnitude of intermediate sales, which in several eco— nomic sectors was more than final sales. This demonstrates the need to pre— vent them from being included in the calculation of final product. This is a fairly clear. principle, right? Well, let’s gum it up a bit by not— ing that investment goods constitute a major exception. When a firm buys a metal lathe from another firm, it is considered to be a final pur— chase, because even though the lathe is used for future production, its contribution to future production will occur over a period of years. For accounting convenience, such investment goods are classed as final pur— chases. The left side of table 3.1A represents the final-purchase/end—use strategy of calculating the GDP. An alternative method to calculate the GDP is to add up the value of the wheat (assuming no intermediate products), the value of the flour THE ECONOMY AS A WHOLE 0 minus that of the wheat, the value of the bread minus that of the flour, and the value of the bread sold by the supermarket minus the value of the bread from the baker. That is, each stage of production adds a certain amount of value to the final value, and this value—added approach is what we find in the right column of table 3.1A. After all, the value added at each stage of production is the value of its sales minus the value of the intermediate goods and services used up at that stage of production. Therefore, value added is what was received in wages and salaries, interest, rent, taxes, deprecia— tion (wear and tear on plant and equipment), and profit (positive or negative—it’s a residual) at each stage of production. The two approaches to the calculation of the GDP ought to add up to the same totals, but given the complexity of the calculations, perfect balance always requires adding some sort of statistical adjustment to one side of the account. Now for some observations about what does not go into the GDP or any of the other aggregates. First of all, there is the resale of any good pro— duced in a previous period (a used car, a thirty—year—old house). Although the commissions earned by the used car salesperson and the realtor are current services and thus counted toward this year’s GDP, the sale prices of the car and house are not. Goods produced last year and kept in inven— tories and sold this year are counted at their current value, but that value is offset somewhat by the reduction in inventories, a component of the investment category. Second, goods and services that do not pass through a market, even though currently produced, are generally not counted. One exception is an estimate of the value of food produced and consumed on farms (it used to be much larger), but food grown in your urban backyard and eaten by you at home is not. If your friend drops some books off at the library for you as a favor, that is not counted in GDP, but if you pay him $5.00 for the service, then it should be counted. Third, the value of leisure is not included in the GDP. If economic growth is possible by everyone working 60—80 hours a week, there is no way in the National Income and Product Accounts to acknowledge the ® CHAPTER 3 costs from the loss of downtime. It simply is not measured as economic value in the National Income and Product Accounts. This takes us to one of the more contentious areas: the value of house— work and child rearing is not counted in the GDP unless it is done under commercial auspices, by house cleaning, food, and child care service providers. When I began teaching economics oh so many years ago, many textbooks used the following example to illustrate this: if a man marries his (paid) housekeeper, he reduces the GDP. This once—common exam— ple seems to have become extinct. Then there are genuine market activities that are not counted in the GDP because they are deliberately hidden. Evading taxes is definitely an incentive to under—report income and the value of production even if the economic activity is perfectly legal. Self-employed people are in the best position to evade taxes in this manner, whether they are self-employed professionals, house painters, bodyguards, or whatever. Tips are another income source that often is not reported. Finally, there are illegal economic activities, where the incentive to keep under cover goes beyond chiseling on taxes. Maybe the product is not naughty but the manner of its production is frowned upon (e.g., employ— ing illegal immigrants to make clothes or using unsafe chemicals to bleach paper). Completely illegal activities—the production and trade in amphet— amines and other controlled substances, gambling, prostitution, contract killing, and other thoroughly criminalized economic production—are yet another subset of economic activity that is not noticed in the GDP. Usually lumped together in the category of the underground econ- omy (not the realm of the Hobbits), these market activities respond to the forces of demand and supply, even though the risks, costs, and returns of their illegality significantly condition their demand and supply curves. The very nature of the underground economy makes estimates of its size very tricky, and estimates range from 5 to 25 percent of GDP. Although the actual magnitude of these economic activities is uncertain, there is a suspicion that they are growing. One indication is the increasing amount THE ECONOMY AS A WHOLE w of cash, especially $100 bills, in circulation compared to what people are holding in checking accounts. Returning to the aboveground economy, government services that are not sold on the market (e.g., public education, fire and police protec- tion, tax collection, standing army, most roads) are valued at the cost of public employees’ wages and salaries. What governments buy from pri- vate firms (e.g., macadam, rockets, fire hoses, paper and pencils, surveil- lance equipment) are not considered to be intermediate products but rather final products purchased by the government. Finally, some costs of production are generally not counted or else are severely undervalued in the GDP. Pollution and other sorts of resource degradation from production are the most obvious examples. Once we have some idea of what GDP is, the next step is to figure out how to compare it over a period of time in order to discern growth or recession. This can present a problem, because prices change in different amounts and directions over time. The GDP is the price of each final good and service multiplied by the quantity of the corresponding good and ser- vice. Therefore, when comparing the GDP of 2000 with, say, the GDP of 1996, there is no easy way to know how much of the difference between the two figures is due to price changes and how much to “real” (quantity) changes. For this reason, it is necessary to use GDP at constant prices to compare GDPs over time. The idea is quite simple: use the prices of one period, say that of 1996, to calculate the GDP of 2000; then you can com— pare the two GDPs having avoided the distortions of price changes and isolated the changes in quantities—changes in real GDP. You can see this in table 3.2. The first row is GDP in current prices, and the second row is GDP of each year using 1996 prices. The year-to— year changes of the GDP in the second row are changes only in quanti— ties produced and sold, not of price changes because the same (1996) prices have been used to calculate each GDP. Thus the GDPs in the sec— ond row are known as real GDP. If you want to construct an index num- ber of real GDP in order to be able to read proportional changes more ® CHAPTER 3 an» in Current 'an'rl "constant bulimia-Id Index Numb-in" 1996 I991 1999 1999 2000 GDP in billions of current dollars 7.81 8.32 8.79 9.30 9.96 GDP in billions of 1996 dollars 7.81 8.16 8.52 8.87 9.32 Index of real GDP 100.0 104.5 109.1 1 13.6...
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