Economics – Theory Through Applications Chapter 3 Macroeconomics in Action

Chapter in Action Four Examples of LEARNING OBJECTIVES URL books 33 After you have read this section , you should be able to answer the following questions . How might you encounter ?

What are the main indicators of the ?

What are the primary policy tools of the government ?

Figure an mam ox uni cup I let ' Consumer Price Index Nova Product . Fin ! Quarter 2011 ( second ) mum domestic product the . output of good and services , and , I he ( Price Index for All States ' at an Urban ( annual me the fun in March on nI . is I a seasonally adjusted basis , the in ( Bum , of Lab . Il , Over the 12 ed by the Bureau of . In the fourth . Na ) percent . months . the all items index increased ( before ud . 100081 tax ( all ) Dale . 3008 ! lhe Open Make ! Committee decided Io lone , as large ! lot role 75 basis in ! The four screens in Figure are diverse illustrations of as you might encounter it An evening news show presents a story about whether the economy is in a recession . You wonder why prices seem to be higher now than they were a few years ago . You sit down to out your tax return . You make payments on a car loan or a student loan . URL books ( 34

By the time you have this book , you will see these examples very differently from the way you do right now . You may not know it , but your everyday life is with in action . Economic Activity in the United States The top left screen in Figure is tuned to the Bureau of Economic Analysis ( BEA , which is a part of the US government . A newspaper article or blog that reports such news from the BEA is telling us about the state of the . The report from the BEA tells you how the economy has been doing over the previous three months . More , it describes what has happened to something called real gross domestic product ( real ) As you will soon learn , real is a measure of the overall level of economic activity within an economy . We won worry for the moment about exactly what means or how it is measured . Looking at the BEA announcement ( national 2011 ) you can see that in the first quarter of 2011 , real increased by percent , whereas in the fourth quarter of 2010 , it increased by percent . Because real increased in both quarters , we know that the economy is growing . However , it grew much more slowly in the quarter of 2011 than in the quarter of 2010 . You might wonder why you would bother to listen to this report . Perhaps it looks rather dry and boring . Yet the performance of the economy has a direct impact on how easy it is to a job if you are looking for one , how likely you are to lose your job if you are already employed , how much you will earn , and what you can buy with the income you receive from working . Overall economic activity is directly linked to the of everyone in the economy , including yourself . Should you be worried when you see that real is growing much more slowly than before ?

After you have read this book , we hope you will know the answer . Because real is such a general measure of economic activity , it can also be used to compare how economies throughout the world are performing . If you have traveled to other countries , you may have URL books as

observed big differences in people standards of living . If you go to Canada , France , or Japan , you will generally see relatively prosperous people who can afford decent food , clothing , and shelter . If you go to , or , you will see people living in severe poverty . To understand these differences , we need to understand what determines real in an economy . Inflation in the United States The top right screen in Figure reports on another economic variable that comes up all the time in the news the rate of . You have probably never visited the Bureau of Labor Statistics ( website from which we took this quotation . But you have certainly heard a news story , perhaps on television or your car radio , telling you about the rate . After the releases a report such as this one ( news programs will note that the rate reported in March 2011 was percent . This means that , on average , prices in the economy are percent greater than they were a year ago . If you bought a jacket for 100 last year , you should expect the same jacket to cost about right now . Not every single good and service increases by exactly this amount , of course . But , on average , prices are now percent higher . A news report like this tells us that the things we buy have become more expensive . This matters to all of us . If your income has not increased over the last year , this report tells you that you are worse off now than you were last year because you can no longer buy as much with your income . Most of the time , you will hear news reports about only for the country in which you are living . Occasionally , you might also hear a news report about somewhere else . In early 2008 , you might well have heard a news report that the rate in Zimbabwe was over percent . You would probably find it difficult to imagine living in a country where prices increase so quickly , and you might reasonably wonder how two different countries in the world could have such different rates of . When you have this book , you will know the answer to this question . Fiscal Policy in Action URL books 36

The bottom left screen in Figure is something you may have seen before . It is a US tax form . Residents of the United States must this form or one like it every year by April 15 . If you live in another country , you almost certainly have to a similar form . As individuals , we typically see this form as a personal inconvenience , and we don think much about what it means for the economy as a whole . But this is much more than a form . It is a manifestation of decisions made by the government about how much tax you and everyone else should pay . Decisions about how much to tax and how much to spend are known as policy . The policy adopted by a government affects your life in more ways than you can easily imagine . It not only tells you how much gets taken out of your paycheck , but it also affects real and much more . It affects how likely you are to be unemployed in the future and how much money you will receive from the government if you do lose your job . It affects the interest rate you must pay on your car loan or student loan . It affects the tax rates you will pay 20 years from now and your likelihood of receiving social security payments when you retire . Monetary Policy in Action The bottom right screen in Figure draws the attention of individuals and businesses all around the world . Every six weeks a group called the Federal Open Market Committee ( meets in Washington , to make decisions on the course of US monetary policy . Their decisions affect the interest rates we pay on loans , including car loans , student loans , and mortgages . Their decisions also the level of economic activity and the rate . The could , if it chose , create very high by allowing rapid growth in the amount of money in the economy . It could , if it chose , create high rates of unemployment . It is a powerful organization . There are other similar organizations elsewhere in the world every country conducts monetary policy in some form , and most have some equivalent of the . International Channels Figure shows the kind of economic news you might see in the United States . If you are living or traveling in a different country , you would see similar announcements about real , and URL books 37

economic policy . Using the Internet , it is also easy to check news sources in other countries . If you start reading about economics on the Internet , you will come to appreciate the global nature of economics . You can read stories in the United States about monetary policy in China or fiscal policy in Portugal . And you can read news stories in other countries about economic policy in the United States . In the modern globalized world , economic connections across countries are impossible to ignore . Figure Price of Euro in British Pounds , March 2008 presents two stories that show globalization at work . Both share a common theme the effects of a March 20 , 2008 , decision by the to cut the target federal funds rate . The graph at the top of Figure Price of Euro in British Pounds , March shows the market price of the currency used in most of terms of the British pound . When you travel , you typically exchange one currency for another . For example , an American tourist traveling to France would buy euros with dollars to have money to spend in France . If that same tourist then wanted to travel from France to London , she might take some of her euros and buy British pounds . The graph tells the price she would have paid in February and March of 2008 . You can see that , over a little more than a week , the euro became much more valuable relative to the pound . Most notably , there was a big increase in the price of the euro between March and March 19 , and then prices settled down a bit . This was a wild week for the international economy . In the United States , the Federal Reserve announced major financial support for Wall Street on March 16 and then reduced interest rates on March 19 . Around the same time , the European Central Bank ( and the Bank of England in London were also taking actions to try to calm the markets . At least for a period of time , they seemed to succeed in stopping the rapid rise of the euro against the British pound . It is striking that much of the action was taking place in the United States , yet the markets in which Europeans trade currencies were also affected . The story at the bottom of Figure Price of Euro in British Pounds , March 2008 discusses the response of Asian stock markets to the action of the US Federal Reserve . Markets all over the world increased in value after the action of the . The actions of the Fed matter well beyond the borders of the United States . Bankers and businesspeople all over the globe are Fed URL books 38

Figure Price Euro ( Is , 716 . int 25 I I I I I I ' PI Li . a I I ' Source . Asian Stocks Rise after Fed Cut TOKYO ( AP ) stock markets rose Wednesday as investors welcomed a hefty interest rate cut Japan benchmark 225 index climbed percent to close at after rising more than percent earlier . Hong Kong Hang index , which rose as much as percent earlier , closed up percent at . Australia main index jumped percent , and markets in South Korea , China and India also rose . KEY TAKEAWAYS You encounter everyday through the news about the state of the , the price you pay for goods and services , the tax you pay on income , and the effects of policy on interest rates . events and policies in other countries affect you as well . Real , the rate of inflation , and the rate of unemployment are three primary indicators of the state of the . The government influences the through its level of spending , taxes , and control of the money supply . Checking Your Understanding . What do we mean by real when we talk about ?

URL books 39 . How might the state of the in another country , such as China , or in a group of countries , such as the European Union , affect the of the United States ?

Next Asian Stocks Rise after Fed Cut , March 19 , 2008 , accessed June 27 , 2011 , eye on the economy . Behind the Screens LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions . How has real changed over the past 40 years ?

What is inflation and how does it affect the ?

How can we see fiscal and monetary policy in action ?

Let look at Figure again in a bit more detail . The State of the Economy The top two panels in Figure provide information on some key indicators of the state of the economy . The announcement from the Bureau of Economic Analysis ( BEA ) concerns one of the most closely watched indicators of the real gross domestic product ( real ) This is a measure of the goods and services produced by an economy in a year . We discuss real in every application in this book . Figure ( in ) URL books 40

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an . Inn Source Alan , Robert Summers , and , Penn World Table Version , International Comparisons of Production , Income and Prices at the University of Pennsylvania , May 2011 . Figure Real per Person in the United States , shows real per person ( often called real per capita ) from 1960 to 2009 . Pictures like this one show up all the time in newspapers , in magazines , on television , or on the Internet . One of the things you will learn in your study of is how to interpret such economic data . We devote an entire chapter to understanding exactly how real is measured . For now , we draw your attention to some details to help you appreciate what the graph means . The horizontal axis indicates the year . Real per person is shown on the vertical axis . To read this graph , you would look at a particular year on the horizontal axis , such as 2000 , and then use the curve to see that the real per person in 1965 was about . If you look at this picture , the single most notable thing is that real per person has been increasing . It was about times larger in 2009 than in 1960 . This tells us that , on average , the typical individual in the United States was times richer in 2000 compared to 1960 . The increase in is not caused by the fact that there are more people in the economy because the shows per person . The increase in is not because prices are going up the word real in this discussion means that it has been corrected for . Another thing you can see from the picture is that the growth of the economy has not been smooth . Sometimes the economy grows fast sometimes it grows more slowly . Sometimes there are even periods in URL books 41

which the economy shrinks rather than grows . From this , you can see that real per person decreased in the , the , and most notably in 2008 and 2009 . During these times , people were becoming poorer on average , not richer . We keep using the phrase on average . This reminds us that , even though the economy as a whole has been getting richer , the picture doesn tell us anything about how those gains have been shared across the economy . In fact , some people became a lot richer over this period , while many others saw only small gains , and some became poorer . We see this uneven distribution very clearly when the economy shrinks . When that happens , one of the things we also observe is that more people in the economy are is , they are looking for a job but unable to one . The burden of an economic downturn is borne disproportionately by those who lose their jobs . Although this figure displays the history of the US economy over these 50 years , similar figures can be constructed for other countries around the world . They do not all look identical , but the pattern of uneven growth that we observe for the United States is one that we also see for most other countries . However , it is not true everywhere . We will also see examples of countries that have become poorer rather than richer in recent decades . Real is the most frequently watched indicator of economic performance . A second key indicator is the one in the top right screen of Figure the rate . The Bureau of Labor Statistics ( collects information on prices on an ongoing basis each month it releases information on how fast prices are changing . The rate at which prices are changing is the rate . Other countries similarly have government agencies entrusted with gathering information about the rate and other economic indicators . It may seem that the job of the is pretty easy get information on prices and report it . Their task is , in fact , rather complex . In part , it is difficult because there are so many goods and services in the economy . So when we say that prices are increasing , we must decide which goods and services we are talking about . URL books 42

In addition , new goods appear , and obsolete goods disappear the must take this into account . And the quality of goods changes as well . If the price of a computer increases , is this an example of or does it an increase in the quality of the computer ?

What are the implications of an announcement ?

All else being the same , higher prices mean that we are unable to afford goods and services we were able to buy when prices were lower . But all else is not the same . Generally when prices increase , wages also increase . This means that the overall effects of on our ability to buy goods and services are not . Another implication of is the policy response it elicits . The monetary authorities in the United States and many other countries are focused on ensuring that does not get out of control . A report of might therefore lead to a response by a monetary authority . affects us directly through the prices we pay and the wages we receive and indirectly through the policy response it induces . Though not included in our screens , another significant variable also indicates the state of the the rate of unemployment . The ( reports the unemployment rate on a monthly basis . It measures the fraction of people in the labor force who do not have a job . When real is relatively high , then the unemployment rate tends to be lower than average , but when real decreases , more people find themselves out of a job . The Making of Fiscal and Monetary Policy The top screens in Figure provide information that to the in an economy . These carefully watch the state of the economy and then , if appropriate , take actions . The bottom screens in Figure show policy in action . Fiscal Policy For individuals and firms paying taxes in the United States , April 15 is an important day because tax forms are due for the previous calendar year . Each year US citizens fill out their tax forms and either make tax payments or receive from the government . URL books 43

The tax day differs across countries , but the experience is much the same everywhere individuals and must pay taxes to the government . This is one of the key ways in which citizens interact with their governments . A more complete version of the form for 2010 is shown in Figure Form . Figure Form ?

man an nu . a . um ' I I From the perspective of an individual out this form , the task is to get the data correct and determine exactly what go where on the form . This is no small challenge . From the perspective of economists working for the government , the tax form is an instrument of policy . Embedded in the tax form are various tax rates that must be paid on the different types of income you earn . Where do these tax revenues go ?

The government collects taxes to its purchases of goods and services in the as roads , schools , and national also to make transfers to households , such as unemployment insurance . URL books . 44 The tax forms we fill out change each year , sometimes quite . The tax rates households and confront are changed by governmental decisions . The government alters tax rates to affect the level of economic activity in the economy . It uses these tools when , in its judgment , the level of economic activity ( as measured by real , the unemployment rate , and other variables we will learn about ) is insufficient . This is a delicate assessment that requires an understanding of the meaning and measurement of satisfactory economic performance and a deep understanding of how the economy works . For example , consider the winter of 2008 . working in the White House and on Capitol Hill kept careful track of the state of the economy , looking as we just did at announcements from the BEA and the on output and . Eventually , they concluded that economic activity was not at a high enough level . They took actions to increase output by reducing taxes through the American Recovery and Reinvestment Act of 2009 ( newsroom article ) The idea is as follows when people pay less in taxes , they have more income available to spend , so they will purchase more goods and services . The link between the legislation and you as an individual is through tax forms like the one shown Form . Monetary Policy The bottom right screen in Figure shows a decision of the Federal Open Market Committee ( to reduce a key interest rate by of a percentage point to percent . As we shall see in our study of monetary policy , a reduction in interest rates is a tool to increase economic activity . Lower interest rates make it cheaper for households and to borrow , so they spend more on goods and services . The action was taken on account of weak economic conditions in the United States , but its consequences were felt worldwide . Other monetary authorities likewise look at the state of their economies and adjust their monetary policy . The following is part of a statement from the European Central Bank ( the monetary policy authority for the European Union . It was part of a press conference held in April 2005 in which URL books 45

, president of the , and Lucas , vice president of the , provided a statement about economic outlook for Europe and the stance of monetary policy . All in all , we have not changed our assessment of risks to price stability over the medium term . So far , we have seen no significant evidence of underlying domestic pressures building up in the euro area . Accordingly , we have left the key interest rates unchanged . Both nominal and real rates are at exceptionally low levels , lending ongoing support to economic activity . However , upside risks to price stability over the medium term remain and continued vigilance is therefore of the essence . I shall now explain our assessment in more detail , turning first to the economic analysis . Recent data and survey indicators on economic activity have been mixed . In general they point to ongoing economic growth at a moderate pace over the short term , with no clear signs as yet of a strengthening in underlying dynamics . Looking further ahead , the conditions remain in place for moderate economic growth to continue . Global growth remains solid , providing a favourable environment for euro area exports . On the domestic side , investment is expected to continue to be supported by very favourable financing conditions , improved and greater business efficiency . Consumption growth should develop in line with real disposable income growth . However , at the same time , persistently high oil prices in particular pose downside risks to growth . Statements such as this are reported in the business press and widely read . Businesspeople all over the world closely follow the actions of central banks . That is , the people interested in this statement by the were not only European citizens but also individuals in the United States and other countries . Likewise , when the Fed takes action , the news shows up on televisions and computer screens across the world . The quotation mentions several key economic variables , real interest rates , nominal interest rates , economic activity , investment , exports , consumption growth , and real disposable income URL books 45

growth . These variables are also important indicators of the state of the economy , as we can tell from the fact that they play such a prominent role in the assessment . The economists at the need to know the current state of the economy when deciding on what policies to pursue . But there are compelling reasons for others to care about these variables as well . Suppose , for example , that you are an investor contemplating an investment in Spain . Your interest is in making from producing a good in Spain and selling it in that country and others . The of the investment in Spain depends on the overall state of the Spanish economy and its neighbors in the European Union who are the target group for your sales . For you as an investor , the statement contains vital information about the state of the European economy . It also contains information on the likely conduct of monetary and policy in Europe . These factors matter for you simply because they impact the profitability of your investment . Thus you want to understand the statements from the , starting with the of key variables . By now , you may well have a number of questions . What exactly are these monetary authorities in Europe and the United States ?

Where do they come from and what are their powers ?

How exactly do their actions have so much on our lives ?

Answering these questions is one of our tasks in this book . We devote two full chapters to the determination and the of monetary policy in the economy . KEY TAKEAWAYS Real has grown on average over the past 50 years , but the growth is not always constant sometimes the economy grows quickly and sometimes real grows slowly ( or not at all ) The inflation rate measures the percent change in prices . If prices are increasing , then a unit of currency , such as a dollar , buys fewer goods and services . During a period of inflation , the monetary authority may take action to reduce the inflation rate . URL books 47

Each year , the income taxes we pay to the government reflect its choice of fiscal policy . The policy meetings of the in the United States , the of the European Monetary Union , and other central banks around the world are examples of monetary policy . Checking Your Understanding . Which of the variables discussed would a authority pay attention to ?

Do the and the always make the same policy decision ?

Is a change in the tax code an example of fiscal or monetary policy ?

Next In the bottom right of the picture , you can see the phrase Data in 1996 dollars . This means that the numbers in the table are based on how much a dollar would have bought in 1996 . Do not worry if you do not understand exactly what this phrase means right 18 The State of the Economy will provide much more detail . Statement with A , European Central Bank , April , 2005 , accessed June 27 , 2011 , Between News and Policy The Framework of LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions . What is the methodology of ?

What is the role of models in the making of policy ?

We have seen the news and policy in action . But there is a vital piece missing given the economic news , how do know what to do ?

The answer to this question is at the heart of this book . The basic methodology of is displayed in Figure Methodology . involves the interplay of theory , data , and policy . We have already URL books 48 seen two of these components in Figure . Two screens highlighted data we have on the , and two screens highlighted policy actions . Figure Muc ' Economists use data to test theory Observations theory ! Fiscal and monetary policy The answer to the question how do know what to do ?

is on the top left of Figure Methodology theory . typically begin by observing the world and then try to develop a theoretical framework to explain what they have seen . An old joke says that the of an economist is someone who sees something happen in practice and wonders whether on earth it is possible in ) Usually , a theory developed by economists has a mathematical by either equations or diagrams . There is even a bit of art here the theoretical framework must be simple enough to work with yet realistic enough to be useful . We hinted at these theories in our earlier discussion when we explained that both monetary policy and policy affect the economy by changing the willingness of households and firms to purchase goods and services . In our applications chapters , we develop these ideas and explain the that use when deciding on their policies . URL books 49

Our models , as they are often tested by their ability to match existing data and provide accurate predictions about new data . Models are constantly refined so that they can do a better job of matching facts . After many rounds of interaction between theory and data , a useful framework emerges . This then becomes the basis for . How do know about the theories devised by economists ?

Politicians are typically not expert economists . In most countries , a large number of trained economists are employed as advisors to the government . These individuals have studied economic theory and are also familiar with economic statistics , allowing them to provide the link between the economic and the actual implementation of policy . The big challenge for economists is to understand the links from policy to the aggregate economy . When you first learned to drive , you were presumably introduced to all the instruments in the car the steering wheel , the accelerator , the brake , the mirrors , and so forth . At the same time , you were learning the rules of the road . For many , the instruments of the car are easy enough to grasp , and the rules of the road are reasonably intuitive . The difficulty ( and this is why driving schools make money ) is in making the connection between the controls in the car and the outcome you wish to achieve while driving . The same is true of economic modeling policy tools are not very difficult to understand , yet it can take decades of experience to truly understand how to use these tools effectively . Economists and businesspeople hope , for example , that the current chairman of the Federal Reserve , Ben , has this understanding , as discussed in the following news article excerpt . Economic View Models , and Their Limits In terms of intellect , Ben may be to the Federal Reserve what John Roberts is to the Supreme Court . And like Chief Justice Roberts , the nominee to replace Alan at URL books 50

the Fed , has left a paper trail worth studying . What can it tell us about the sort of Fed chairman he would be ?

In general , work has been solidly in the mainstream he has helped since he began publishing papers in major economic journals since 1981 . He has written repeatedly about ways of using mathematical models of a dauntingly complex economy to set monetary policy . When he has strayed from that subject , his conclusions have sometimes raised eyebrows . These topics , however , are not at the core of what would be concerned with at the Fed . There , his opinions about domestic monetary policy would be more important . One tenet of philosophy could not be clearer that the central bank should use a model , not just hunches , to decide about interest rates and the money supply . This is how he put it in 1997 in a paper with Michael , now a professor of political economy at Columbia We conclude that , although forecasts may contain information useful to the central bank , ultimately the monetary authorities must rely on an explicit structural model of the economy to guide their policy KEY TAKEAWAYS The methodology of involves the interplay between data and models . Abstract models provide with a framework to understand what is happening in the and also a way to predict the effects of policy actions . Checking Your Understanding . Why are economic models always being refined ?

If a theory is inconsistent with some but not all observations , could it still be useful for purposes ?

URL books 51 Next Daniel , Economic View Models , and Their Limits , New York Times , October 30 , 2005 , accessed June 27 , Material In Conclusion Our book is built around economic topics , such as the income tax code , the social security system , the determination of monetary policy in Europe , and the contrasting economic health of different countries . Throughout this book , we will emphasize the measurement and interpretation of economic data . Understanding how to read charts and tables of economic data is a critical skill for anyone who wants to be a sophisticated consumer of economic and political news . We also explain both policy tools and their links to economic outcomes . Understanding these links requires a model of the economy . We introduce models as needed , in the context of their applications . Mastering involves both understanding the tools that use and knowing how and when those tools should be applied . In this book , you will learn about these tools by example you will see them in use as we study different questions in economics . At the same time , you will learn about many topics that should interest you as engaged and aware citizens of the world . We hope that , after reading this book , you will both better understand what it is that economists do and be better informed about the world in which we all live . As you proceed through the chapters , you will often see reference to our toolkit . This is a collection of some of the most important tools that we use over and over in different chapters . Each tool is fully introduced somewhere in the book , but you can also use the toolkit as a reference when working through different chapters . In addition , it can serve as a study aid when you are preparing for quizzes and examinations . We try to avoid getting too hung up on the mathematical expression of our theories ( although the math will usually be lurking in the background where you cant quite see it ) In particular , our applications URL books 52

chapters contain very little mathematics . This means that you can read and understand the applications without needing to work through a lot of mathematics . Compared to our applications chapters , our toolkit contains slightly more formal versions of the that we develop . You will refer to the tools over and over again as we progress through the book , for the same tool is often used to shed light on all sorts of different questions . Key Links Bureau of Economic Analysis Bureau of Labor Statistics Board of Governors of the Federal Reserve ( European Central Bank home EXERCISES . Provide updated information for at least one of the four screens in Figure . Use the Internet to find an article ( for example , magazine , newspaper , publication of an economics research group ) that contains a graph of real for a country other than the United States . What purpose does the picture serve in the article ?

Why do you think it was included ?

Find a statement about monetary policy from the monetary authority in the United States , Canada , or Australia . What are some ofthe indicators of the state of the economy that are used in the policy statement ?

The article on model contained the following quote We conclude that , although forecasts may contain information useful to the central bank , ultimately the monetary authorities must rely on an explicit structural model of the economy to guide their policy What do you think is meant by this statement ?

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