Macroeconomics For Dummies book cover

Macroeconomics For Dummies

By: Dan Richards and Manzur Rashid Published: 08-01-2016

The fast and easy way to make macroeconomics manageable

Macroeconomics is kind of a big deal. Without it, we wouldn't have the ability to study the economy as a whole—which is something that affects almost every aspect of your life, whether you realize it or not. From your employment status to how much you earn and pay in taxes, macroeconomics really matters. Breaking down this complicated and fascinating topic into manageable pieces, Macroeconomics For Dummies gives you fast and easy access to a subject that has a tendency to stump the masses.

With the help of this plain-English guide, you'll quickly find out how to gather data about economies to inform hypotheses on everything from the impact of cutting government spending to the underlying causes of recessions and high inflation.

  • Analyze business cycles for overall economic health
  • Study economic indicators such as unemployment
  • Understand financial trends on the international market
  • Score higher in your macroeconomics class

Filled with step-by-step instruction and enlightening real-world examples, this is the only book you need to slay the beast and make macroeconomics your minion!

Articles From Macroeconomics For Dummies

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20 results
What Everyone Wants: Aggregate Demand

Article / Updated 04-11-2017

Economies run on people, firms, and governments requiring and buying things. A need exists (demand) that firms fulfill (supply). Students of microeconomics spend time learning about the behavior of supply and demand in individual markets. Students of macroeconomics are interested in the economy as a whole, so the emphasis is on aggregate (that is, total) demand for goods and services and aggregate (total) supply. More specifically, aggregate demand comprises the total demand for goods and services produced in the economy. Aggregate demand is important because (along with aggregate supply) it determines a country's GDP and price level (and therefore its inflation rate). Changes in aggregate demand also impact the level of unemployment. Without understanding aggregate demand, policy-makers wouldn't stand much of a chance of being able to control the economy. Indeed the main tools that policy-makers have at their disposal (monetary and fiscal policy) work by influencing aggregate demand.

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Equating Real Returns Across Countries

Article / Updated 10-31-2016

In case you didn't know, the profit motive is powerful. Think about it. Hundreds of millions of people have invested trillions of dollars in pension funds, IRAs, and other assets to provide for their retirement or their children's education or for other reasons. The large banks, mutual funds, and other investment advisors compete for this business by trying to offer their investors a better return than their rivals. In turn, this means that all these funds put tremendous pressure on the firms that they invest in to earn as much profit as they can. So, every member of a business management team knows that its survival depends on earning as much profit as possible. If a manager comes along who can earn more profit, she'll get the job. If another firm comes along that can give investors a higher return, it will get the capital funds. The only way to be sure you keep your job or that your company continues to attract the funds it needs to survive is to push profits to their highest possible level — to maximize them. Profit maximization has a lot of implications. One of these is that firms should invest scarce capital in factories and equipment where the return is highest. If a new factory in Brazil is projected to earn an 18 percent annual return while one in the U.S. is expected to earn 12 percent, build it in Brazil. If it's an even higher 22 percent return in Poland, build it there. Of course, if everyone starts building factories in Poland, capital will become abundant there and its real return will start to fall. Once it falls to 18 percent, investors will start to build new plants in Brazil. Meanwhile, capital will be flowing out of the U.S. So, the returns will be rising there. In a full, long-run equilibrium, then, allowing for capital mobility would imply that real returns and hence the real interest rate r would be equalized across the world. This would change our earlier analysis that said a country's real interest rate would depend on its savings rate s. Instead, the real rate would be the same everywhere, and that worldwide real rate would depend on the world supply of savings. It turns out, however, that capital is not perfectly mobile. So, real returns are not totally equalized across countries. As a result, the savings rate s still plays a critical role in determining the marginal product MPK and hence the real return on capital r within a country. But the importance of international capital mobility also has to be recognized. To the extent national capital markets are linked, the real return in any one country will very much be influenced by the returns available in others.

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Compounding Growth: The Rule of 70

Article / Updated 10-31-2016

Recall the Rule of 70. Remember, this rule is an easy way to calculate the time it takes something to double. If real gross domestic product (GDP) for instance grows at x percent per year, you divide x into 70 to find out how many years it will take for real GDP to double. Thus, if real GDP grows at 3 percent per year, it will double in 23 years and 4 months, double again in another 23 years and 4 months, and be 8 times what it was 70 years from the start. In contrast, if growth falls to just 2 percent, GDP will double in 35 years and redouble in another 35 years. In that case, it will be 4 times as large in 70 years as it is today — not bad, but only half as large as if the annual growth rate had been 3 percent. The Rule of 70 is a useful mental calculator. What it really shows is the power of compounding growth. When growth compounds, small changes in the growth rate imply big changes in levels even just a few years out. Of course, that power can work both ways. You don't want to think about what a college degree might cost in 25 years if tuition prices continue to rise at a 3 percent rate or higher. (Well, maybe you do if you're a professor.) Because a small change in annual growth rates has such powerful effects, macroeconomists have tried to understand the process of economic growth for a long time. Why does production grow? What will wage rates and interest rates look like along the growth path? What policies best promote growth?

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Interest Rates — Trading through Time

Article / Updated 10-31-2016

The interest rate is a special kind of price because it reflects exchanges through time. An annual interest rate of 5 percent says that in return for giving up $1,000 today, you can get $1,050 a year from now. Thus, $1,000 is the "price" of "buying" $1,050 in one year. To put it another way, you can get $1 in one year for a "price" of about 95 cents today. Of course, interest rates don't have to be 5 percent. In the early 1960s, a one-year U.S. Treasury bond paid an interest rate of a little over 2.5 percent. Twenty years later, a similar one-year Treasury bond paid over 14 percent. As of this writing, the rate is a very low 0.65 percent. Private commercial interest rates tend to be higher. In 1960, the so-called prime rate was 4.5 percent. In 1980, it was 20.5 percent. At the moment, the prime stands at 3.5 percent. The figure displays three different interest rates since 1980. These are the 1-Year Treasury Bill rate, the prime rate at which banks historically lent to their most creditworthy customers, and the conventional 30-year mortgage rate. Four features of this data are noteworthy. First, there's more than one interest rate at any time — a lot more. There's also the London Interbank Offered Rate (LIBOR), the AAA corporate bond rate, and municipal bond rates. That's just for starters. There are many other interest rates that you could quote. Luckily, financial markets are integrated. So, as the figure shows, these interest rates all move together similarly over time. That's why macroeconomists can talk about "the interest rate" as a proxy for all them. Second, while the different rates do move together, they also move around a lot. A good part of this has to do with inflation, but not all. Fiscal and especially monetary policies can play a major role, particularly in the short run. Third, interest rates are quoted in loan markets where someone — a homeowner, business person, or government — wants to borrow funds. In this important sense, interest rates are best viewed as the price of credit. Finally, interest rates are typically positive, even after correcting for inflation. That is, the real interest rate generally exceeds zero. Why it does is a question asked by economists, philosophers, religious writers, and many others.

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Why Inflation Is Usually Overestimated

Article / Updated 10-31-2016

Many economists think that the measures of inflation tend to overestimate the true increase in the cost of living. That is, if the inflation rate is quoted as being 3 percent, economists think that the true cost of living has actually increased by less than 3 percent. Here are some of the reasons why: The substitution effect: Inflation at 3 percent means that on average prices have increased by 3 percent. But some prices will have increased by more and some prices will have increased by less (or even decreased). In response to these changes, people alter their behavior by buying relatively more of the goods that haven't increased in price by much and relatively less of the goods that have increased in price by a lot: hence the name the substitution effect. This means that inflation overestimates the true increase in the cost of living as people switch to relatively cheaper goods. Unobservable quality improvements: As we mention in the earlier section "Adjusting for quality and size" section, inflation needs to be calculated like-for-like. Although statisticians try to adjust for quality improvements, doing so fully is impossible. Thus, some unobserved quality improvements remain unaccounted for. This means that inflation overestimates the true increase in the cost of living. An example helps make this clear: Suppose you had $100,000 to spend from either the 2015 Amazon website or the really cheap 1963 Sears Catalog your Grannie told you about. Which would you choose? Prices were much lower in 1963, so you could buy lots more stuff, but it would be lots of low-quality stuff you would not want. So, even though the 2015 selection is much more expensive, part of that problem is compensated by the higher quality. Introduction of new goods: As time passes, new goods or services are created that didn't exist in the past. When this happens, consumers are better off because they now have a new option to spend their money on. Although these new goods may eventually be included in the "basket of goods", the value of the new option isn't accounted for in the inflation statistics. This means that inflation overestimates the true increase in the cost of living because it doesn't take into account that consumers are better off due to the introduction of new goods.

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Why Real GDP Is the Real Deal

Article / Updated 10-31-2016

Remember, you're imagining gross domestic product (GDP) as one single good. If that were really the case — if, say, you only produced oil — you'd have no trouble saying that if you produced 1,800 billion barrels of oil this year and next year, your real production hasn't increased, even if oil prices doubled from $10 to $20. You would just divide the second year values by 2 to make the comparison. That same logic should apply to your fictitious single good called GDP. What economists are really interested in then is the actual amount of stuff — barrels of oil or pounds of sugar or units of GDP — that the economy is producing in a year. As the oil example indicates, to calculate that value, you have to purge your nominal GDP measure of price movement effects. If you don't correct the nominal GDP values, you won't know whether say a 5 percent increase happened because The price level is unchanged and the actual quantity of goods being produced increased by 5 percent; or The price level increased by 5 percent and the actual quantity of goods being produced remained unchanged; or The price level increased by 10 percent and the actual quantity of goods being produced fell by 5 percent; or Some other combination of price level and real GDP changes. From the viewpoint of real production and what people have available to them for consuming (or saving), the preceding scenarios are all very different, even though in all three cases nominal GDP has risen by 5 percent. Real GDP, however, has increased by 5 percent in the first case, remained unchanged in the second case, and fallen by 5 percent in the third case. Economists think that people should care about the amount of goods being produced rather than the nominal value of those goods, and so the changes in real GDP are what really count.

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The Difference Between Real and Nominal GDP

Article / Updated 10-31-2016

The assumption (pretense) that underlies gross domestic product (GDP) — that you can think of the economy as just producing one, very multi-purpose good. Why do macroeconomists make this assumption? The simple answer is that they'd like to talk about "the economy" as parsimoniously as possible. If someone asks about the U.S. production last year, they don't want to have to say that it's $2.2 trillion of manufacturing, $3.6 trillion of financial serves, and so on. And they really don't want to have to say that it's $155 billion of machinery, $100 billion of air transportation, $1.4 trillion of finance and insurance services, and so forth. That's too much and too detailed information for anyone to take-in. By the time the list was completed, it would be out of date in any case. So, they keep it short — just one number that summarizes aggregate production overall. But that requires adding up the sugar, oil, manufacturing, finance services, apples, oranges, and so on, all into one total. And you know from math class that there's only one way to add up apples and oranges and manufacturing goods and finance services — you need to find a common denominator. Dollars (or whatever the domestic currency is) are the common denominator. That's why the U.S. GDP was quoted as $18 trillion. That's the sum of the final dollar sales (or value added) across all goods and services. It's easy to add up these magnitudes because they're all expressed in the same unit of account. No good deed and few good shortcuts go unpunished, though. Using dollar magnitudes allows you to add everything up easily. But it also introduces a new problem. The U.S. produced about $18 trillion worth of GDP in 2015. Suppose in 2016 the economy experienced a lot of inflation — so much so that the price of everything doubled. And imagine that the total quantity of goods and services produced in 2016 were the same as in 2015 — the same number of apples, oranges, tons of steel, barrels of oil, passengers carried on airlines, and so forth. The question is: What's GDP in 2016? Well, because the price of everything doubled and the quantity of goods remained the same, you could argue that GDP is now $36 trillion. And in one sense you'd be right. That is the "value" of everything being produced in 2016. But that doesn't sound quite right, does it? The economy is producing just as much this year as last year and yet GDP appears to have doubled. In such a situation economists say that, although nominal GDP has doubled, real GDP has remained unchanged. Here's the difference: Nominal GDP: Measured using current prices — prices that were current at the time of measurement. 2015 prices in 2015 and 2016 prices in 2016. Real GDP: Measured using constant prices — meaning an arbitrary year is chosen to be the base year, and GDP in all other years is calculated on the basis of prices in the base year.

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The Idea of Gross Domestic Product

Article / Updated 10-31-2016

As of late 2015, the U.S. GDP is more than $18 trillion, and projections are that it will grow by 2.7 percent to over $18.5 trillion before 2016 is over. In other words, if you add the value of all final sales recorded in the U.S. in one year it comes to more than $18 trillion. But note the qualifier final: To avoid double counting, economists count only the value of final goods produced, not intermediate goods. So, if a car manufacturer produces a car worth $20,000 but buys component parts worth $8,000 to physically make the car, the total addition to GDP is just the final $20,000. Adding up final expenditures and value added Sometimes you hear people calling GDP the total value added. They do so because you can think of the contribution of a good or service to GDP as the value that is added to it at each stage of production. For example, the car manufacturer we mentioned has added value worth $12,000 (by buying the parts for $8,000 and then selling the car for $12,000 more). The same applies to the parts for which component manufacturers may have had to buy raw materials for $2,000 in order to produce the $8,000 worth of parts. They have then added value worth $6,000. As the table shows, the value of the car (the final good being produced) is $20,000. This is exactly equal to the total value added by the raw materials, the component manufacturer, and the car manufacturer. If a dealer now sells the car for $23,000, it implies further added value of $3,000 in advertising and sales services. Total Value Added Cost of Inputs ($) Value of Output ($) Value Added ($) Raw materials — 2,000 2,000 Component manufacturers 2,000 8,000 6,000 Car manufacturer 8,000 20,000 12,000 Total value added — — 20,000 Determining national income — and not consuming it all at once Someone pays for the value of whatever is produced. So, someone gets paid for the production, too. Those payments are income for whoever receives them. Thus, GDP tells you not just the aggregate production but also everyone's individual income summed in total. And that should be equal to GDP, the aggregate amount of income of the economy. In other words, the total of everyone's income should equal the total of all expenditures made to buy domestic goods, and both should equal GDP. To continue the example from the preceding section, the car manufacturer has managed to turn $8,000 worth of parts into a $20,000 car, leaving it with a surplus of $12,000. Some of this surplus goes to pay the workers in the factory (say $8,000), leaving a profit of $4,000. Ultimately, people own firms, so this profit also provides an income to somebody. Thus, the manufacturer's value added is entirely distributed as income either to its workers or its shareholders. The same is true for the component manufacturer and the owners of the raw materials: The value added must have been paid to someone as income. Because the total value added equals GDP, so too must total income equal GDP. Of course, when you have your part of national income or GDP, you have to decide what to do with it. Here you have a number of options: You can consume it all: Which would mean spending all your income on consumer goods, such as food, entertainment, and similar goods and services. Another way of thinking about this option is that your income gives you a claim to a certain share of national output. By spending it all now, you're choosing to use your entire claim on consumption today. You can consume some of it and save the rest: This would mean you spend only part of your income on consumer goods. By saving some of it, you give up some of your claim to consumption today and trade it for a claim to consumption in the future. The interest rate tells you the terms of this trade. If you save some of your income by putting it in a savings account or perhaps a bond fund that pays 5 percent, it means that by giving up $100 worth of consumer goods today, you will establish a claim to $105 worth of consumer goods one year from now. Thus, economists think of saving as a way of converting consumption today into consumption in the future. You can consume more than your share: How? By borrowing from someone who wants to save part of his share. The catch is that you'll have to pay that person back at some point by giving up some of your own future consumption. This is the same trade as before but in reverse. In this trade, every extra $100 worth of consumer goods you buy today requires a sacrifice of $105 worth of consumer goods in a year. Thus, economists think of borrowing as a way of converting income in the future into consumption today. Watching a nation's GDP flow GDP is the same thing as aggregate annual income and so therefore it must be a flow variable, one that's measured per unit of time — yearly, in this case. It's important to remember then that as a flow variable, GDP "restarts" each year. Roughly $18 trillion worth of goods and service were produced in 2015. On January 1, 2016, the nation started producing all over again and will probably produce $18.6 trillion by the end of 2016. The point is that because GDP is a flow variable, it has a rate of time or per year dimension. Over 2015 and 2016, the U.S. has been producing at an average rate of $18.3 trillion worth of goods and services per year, with some acceleration in this pace over time. Because GDP is a flow, all the component variables such as household consumer spending, private investment spending, and so on, are also flow variables. A new, hopefully bigger pie or flow will be produced next year because we'll have more workers, more capital, and better technology.

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Where Macroeconomics Meets Microeconomics

Article / Updated 10-31-2016

Economics is often split into microeconomics and macroeconomics. Microeconomics is the study of individual and firm behavior, and macroeconomics is the study of the economy as a whole. Decades ago they were very different fields with different ways of doing things: Microeconomics stressed the importance of modeling individuals and firms as optimizing agents. This means that when people and companies make choices, they consider all possible options and then choose the one they prefer most. Economists say that individuals maximize their utility and firms maximize their profits. Macroeconomics often uses models that are less rooted in strict optimizing behavior. The reason, in part, is that the outcome of an aggregate variable such as aggregate consumer spending across all households or aggregate investment spending across all firms is not the outcome of one optimizing consumer or business person, but many. Unless all households and businesses are the same — what macroeconomists call a representative agent — the aggregate behavior may be hard to derive as the result of a strict optimization exercise. So, macroeconomists have often used models that seemed reasonable if not formally optimal and that seemed to capture the basic features of the economy. This modeling approach, though, runs the danger that one will just adjust the model in a “reasonable” way every time the model mispredicts. As a result, this approach can seem a bit ad hoc. Not happy with this situation, many economists felt that because the economy is made up of millions of interactions between individuals and firms, macroeconomic models should have as their building blocks microeconomic foundations — so macroeconomic models (explicitly or implicitly) should have optimizing agents within them. In short, most economists now feel that good macroeconomics should be based on sound so-called microfoundations.

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5 Important Macroeconomics Terms

Article / Updated 10-31-2016

Like all practices, economics has its own terminology. Following are explanations of five essential terms that economists use all the time. When calculated for the economy as a whole, all these measures are equal: Gross Domestic Product (GDP): Value of final goods and services an economy produces in one year (a final good or service is one directly provided to the end user). Specifying that it's only the value of final goods and services is important to avoid double counting. So, if you own a coffee shop, every time you sell a coffee for $3, that adds exactly $3 to GDP. The cost of coffee beans and milk and so on is already included in that $3, so it can't be added again to GDP. Output: Aggregate output of an economy is also a measure of the value of the goods and services produced by an economy in a year. So, output is really just GDP by another name. Production: The aggregate production of an economy is just the total value of everything produced by firms and the government in one year. Pretty clearly, this means that production is really just GDP or output by another name. Perhaps you're wondering why we say it's the production by firms that yields private goods and services. What if you set up a market stall and sell handbags or do some babysitting for a neighbor? Economists bypass these questions by just calling anyone or anything that provides a good or a service traded in the market place a firm. Goods produced at home, such as meals and laundry, or produced for the underground economy, are not part of GDP. Income: Aggregate income is the sum of everyone's income in an economy. And where does income come from? Well, it comes from selling the output/production/GDP of the economy. No surprise, then, that income must also be equal to those things; equal to production. Expenditure: Aggregate expenditure is just the sum of everyone's expenditure, that is, their spending on goods and services. This can be different from aggregate income, and the difference is the trade balance. If aggregate income exceeds aggregate expenditure, the economy is running a surplus in its international accounts. If expenditure exceeds income, it's running a deficit.

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