Why Macro-economists Are Like Doctors
Just like people, economies can also get sick with things such as recessions, high inflation and high unemployment. Much like a doctor, macroeconomists have to observe the economy and try to work out the underlying cause of these problems. After working out the likely cause, they can think about policies that those in charge can implement to return the economy to health.
For example, an economy is in recession if its gross domestic product (GDP) falls, where GDP is the amount of stuff it produces. Often recessions are caused by insufficient demand in the economy for goods and services. Knowing this, macroeconomists can prescribe some medicine: perhaps temporarily stimulating demand in the economy.
Policy-makers can raise demand in two basic ways:
- Use monetary policy: Basically pumping new money into the economy in the hope that this reduces interest rates throughout the economy and thereby encourages households to consume and firms to invest.
- Use fiscal policy: Increasing government spending — which increases the demand for goods and services directly — or decreasing taxes — which policy-makers hope encourages households to consume and firms to invest.
Economies can also suffer from high levels of inflation. This is often caused by excess demand for goods and services. So, using monetary policy to raise interest rates or fiscal policy to cut government spending or to increase taxes can help here. One other issue here, though, is the role of inflation expectations. For instance, if workers expect high inflation, they may demand high wage increases that cause inflationary price increases. In this case, policy-makers also need to convince the public that they are committed to fighting inflation in the future.