Ultimately, real things are what count
Economists assume that people care about real things and not about nominal magnitudes. Here are some examples:- Real wage: What really matters about your wage is how much stuff you can buy with it, not its numerical value. So if your boss offers you a 5 percent pay rise when inflation is running at 10 percent, you're getting the same raw deal as if you received no increase with inflation at 5 percent. Either way, your real purchasing power will decrease by 5 percent.
- Real interest rate: Whether you're borrowing or saving, the nominal rate i you're promised is not what matters. Looking forward, it's the real rate re that you expect to get, which corrects for expected inflation.
- Real Gross Domestic Product (GDP): The dollar value of stuff produced in a country rises over time due to inflation, even if the physical amount is unchanged. Macroeconomists focus on real GDP by adjusting the dollar value for inflation. They use real GDP per capita to measure living standards.
Growth compounds
Over time, a nation's real GDP grows along a path that fully employs its labor and capital. Though there will be recessions that knock the economy off that growth path for a while, there will also be recoveries that return it to that path eventually. So, the growth path gives the best prediction of where real GDP and, by inference, real GDP per capita will be in, say, 10 or 20 years.Good economic policies will be ones that promote growth. Maintaining a fairly high savings rate is important, because it's a nation's savings behavior that determines its ability to invest in new capital goods.
Excessive growth in the money supply causes high inflation in the long run
The aggregate price level P is the exchange rate between money and real GDP. At any point in time, it indicates how many dollars it takes to buy some standardized chunk of real output. Inflation tells you how this exchange rate is changing over time, that is, an inflation rate of 4 percent per year means that each December, the set of holiday gifts that cost you $100 a year earlier now costs $104.Given the economy's long-run growth trajectory, what happens to the price level in the long run — whether it's rising at 2 percent or 4 percent or perhaps falling at 1 percent annually — depends on the rate of growth in the money supply. If that's very rapid, money will become abundant relative to the amount of goods available. Money will become cheap, and its exchange value will be falling because it's becoming less scarce. It will take fewer chunks of GDP to get a dollar — and more dollars to get a chunk of GDP. That's the definition of inflation.
In the long run, keeping inflation low means keeping the rate of money growth close to the rate of growth in real GDP.
There's no trade-off between inflation and unemployment in the long run
The Phillips Curve relationship tells economists that in the short run, unemployment and inflation are negatively related. All else equal, when unemployment is above its long-run or natural rate, inflation will be falling. When it's below that natural rate, inflation will be rising. This has two, related implications. First, policy-makers can use expansionary monetary/fiscal policies to reduce unemployment below its natural rate at the cost of creating more inflation. Second, policy-makers that want to bring inflation down by using contractionary monetary/fiscal policies will have to pay the cost of more unemployment.But either a fall in unemployment below the natural rate or rise above it will be limited to the short run. This may be a protracted period of time but eventually, unemployment will return to the natural rate regardless of the inflation rate. That's the rate of unemployment consistent with being on the economy's long-run growth path. It reflects normal amounts of frictional (the time it takes for workers and employers to find each other) and structural (regulations and skill obsolescence) unemployment, but no cyclical unemployment. The U.S. natural unemployment rate is about 5 percent.
Because the economy has to be at the natural rate of unemployment, there is no trade-off in the long run. It can be at the natural rate with inflation equal to zero, 5 percent, or 25 percent over time. Which inflation rate it has in the long run depends primarily on the rate of money growth.
Government has a budget constraint
Every country needs to do some public spending. Sadly, providing national defense, law enforcement, a court system, and social services doesn't come free. Governments need to finance their expenditures either by: a) levying taxes, b) issuing debt, or c) printing money.The government has to borrow whatever expenditures aren't covered by taxes. But using debt is a two-edged sword. It raises funds today, but it implies more revenue is needed in the next period to cover the interest on that debt.
Economists typically divide the budget deficit into two parts: one that's due to interest payments and the other that's due to taxes being less than expenditures on goods and services. This second part is called the primary deficit. Hence, paying any interest means having something left over from the primary deficit. So, in the long run, the primary deficit typically must be negative — a surplus. This is the long-run budget constraint that the government faces. More debt today requires either higher taxes or less public spending in the future.
The burden of the debt is the ratio of the debt to GDP. If the government doesn't live within its budget constraint — if it doesn't run primary surpluses — that burden will rise without bound and ultimately crush the economy.
The value of commitment
The government needs to be clearly committed to long-run targets of low inflation and fiscal stability. Policy rules are a part of this process. Of course, the problem with any hard-and-fast rule is that it limits flexibility. For example, the Friedman Rule, which calls for the Federal Reserve to fix the rate of money growth once and for all, would take away the Fed's ability to respond to any short-run shocks that might throw the economy into a recession.Other rules with some built-in flexibility are possible as well. Whatever the rule, some such commitment is needed to remove the doubt and uncertainty that people will otherwise have about macroeconomic policy.
Cyclical unemployment is costly
Current estimates of the natural rate of unemployment run between 4.5 and 5.5 percent with somewhere around 5 percent being a reasonably good guess. By any measure, though, unemployment above 6 percent represents some amount of excess unemployment, likely due to a recession — a business cycle dip.Such unemployment is costly. Okun's Law implies that every 1 point rise in the unemployment rate above the natural rate lowers real GDP by 2 percentage points. That's a lot.
The cost can rise further if there is hysteresis in the natural rate, which means that long-run rate is affected by the short-run history. This can happen in the labor market because being unemployed for a significant length of time leads you to lose skills or good work habits and so makes you less employable. Hence, a recession that lengthens the typical spell of unemployment will increase skill obsolescence for many and so raise the amount of structural unemployment. It will therefore raise the natural rate of unemployment and lower potential GDP permanently.
Monetary and fiscal policy can be stabilizing
Aggregate demand shocks, whether due to financial crises or to other factors, hit the economy frequently. Since World War II, the U.S. economy has suffered 11 recessions. Some have been reasonably mild, but some have been whoppers. The most recent one falls in this last category. It's taken seven years or more to get real GDP back to potential (or at least near it).These recessions are costly. The cumulative loss of GDP from the Great Recession's start to the present exceeds $19 trillion. Some estimates are higher owing to the fact that a number of economists think that the recession lowered the economy's future potential GDP.
Since Keynes's time, macroeconomists have widely recognized that when such shocks occur, policy-makers have two choices. They can wait for the automatic, market-based adjustments to wages and prices that will eventually restore the economy to full employment and potential GDP. Or they can use expansionary monetary and fiscal policies to shift the aggregate demand curve back and restore full employment more quickly. The danger of the first is that it seems to take a very long time. The danger of the second is that it's not always easy to get the magnitude and timing right. And raising money growth or government expenditures (or cutting taxes) in the short run can weaken the commitment to restraining inflation and controlling the deficit in the long run.
Yet there is some evidence that such efforts can be stabilizing. In general, the heavy costs of cyclical unemployment make it too expensive to always just wait for prosperity to show up automatically around the next corner.
Financial markets are important . . . and fragile
Financial markets are deeply connected to the macro economy. No kidding, you say! Yes, but the connections are more extensive and go deeper than you may have thought. Government debt is bought and sold in the financial markets. And the financial markets are where the Fed operates to control the nation's money supply.Unfortunately, the financial markets are fragile, especially the fractional-reserve banking system. The importance and fragility of the financial sector imply that a healthy degree of oversight is needed.
Efficient markets should be surprised
Asset prices are forward-looking. The price you (or anyone else) is willing to spend for a house or for a share of GM stock is primarily determined by the price it's expected to be in the future. Of course, the future is unknown. So, in setting today's asset prices, the market has to guess at what they'll be in the future.People in financial markets know what information to look for and where to look for it to make their future price forecasts. Because current asset prices result from the buying and selling behavior of literally millions of traders and analysts, there are a lot of people getting a lot of information. So it's hard to imagine that anything really important will be left out from the trades that set today's price.
That's the Efficient Market Hypothesis (EMH) in a nutshell. It says that the financial markets are very efficient in terms of setting prices that reflect the most and the best information possible.
The EMH has two implications. One, it's hard to find obvious profit opportunities in the market. If you think a share is under- or overpriced, you have to believe that you know something that the millions of other analysts don't.
Equally if not more important, the EMH says that any difference between the price that investors forecast and the price that actually occurs has to come as a surprise. It can only happen because new information came along that investors could not have known about earlier. Otherwise, they weren't using that earlier information very efficiently.
In short, when asset markets are efficient, asset price movements are surprisingly unpredictable.