Lecture Audio: http://delong.typepad.com/files/20100830_econ_1_ls.aac
1.1. Introduction to Macroeconomics
Half of the first-year economics college curriculum is microeconomics--the study of individual workers, investors, firms, markets, and industries in our economy. Half of the first-year economics curriculum is macroeconomics--the study of issues that cannot be analyzed properly without considering the economy as a whole. It is conventional to start with the micro half. We are going to start with the macro half--given the big recession outside and the high level of unemployment in this country and the world, I think I have a better chance of grabbing and keeping your attention if I start this course with macro rather than with micro.
The cost will be a certain amount of construction of an intellectual edifice in midair--but we will fill in the foundations later on.
Much of the time economics presumes that the market system as a whole is functioning reasonably well. In its background it presumes that almost all sellers find willing buyers, and vice versa. It presumes that, as a rule, contracts made will be fulfilled. It presumes that, as a rule, promises—whether made by governments, financiers, employers, workers, buyers, or sellers—will be kept.
But what if this overriding assumption is wrong? What if the web of connected markets does not work smoothly? And when does the web of connected markets not work smoothly? And why might the web of connected markets not work smoothly?
That is what macroeconomics is for. And that is where we are going to start.
1.1.1 The Parts of Macroeconomics
The domain of macroeconomics itself has four topics. Each of them deals with one of four major ways in which the web of markets can fail to work well. We are going to survey all four of those parts in the first half of this course.
The first part--and the one of most interest right now, given what is going on outside--is depression economics. It examines what happens when sellers cannot, generally and on average, find willing buyers at more-or-less the normal prices. The answer is not pretty. It is called recession or depression. This topic should grab you. We entered the deepest economic recession since the Great Depression back in 2007.
In December 2006 63.4% of American adults of working age had jobs. By December 2009 only 58.2% had jobs. Over those three years the unemployment rate jumped from 4.4% to 10.0%. Total production in the economy had stood at a level of $13.06 trillion per year at the end of 2006 (measured in the prices as they stood in 2005). It had then been growing at an average rate of a hair above 3% per year. Thus total production should have stood at $14.3 trillion per year at the end of 2009. It did not: it was $13.1 trillion per year instead—fully 8.5% lower than what three years before we had all expected the level of production to be. More than 8% of the useful goods and services that we ought to have been making at the end of 2009 were simply not there. They had vanished completely.
This is what happens when the expectation of sellers that they can, generally and on average, find willing buyers at more-or-less the prices that they had expected, goes wrong. It is what happens when, in general and economy-wide, there is excess supply. And it is what happens when—as invariably happens in conditions of macroeconomic excess supply— the assumption that private financiers and entrepreneurs will generally fulfill their contracts and keep their promises goes wrong as well.
The second part is inflation economics: what happens when buyers cannot find willing sellers at the prices they expected. The answer is that you get situations of moderate inflation. The economy sees full or near-full employment as firms find that they can sell as much as they can produce at prices higher than they expect. But it also sees unsettling and disturbing upward wage-price spirals as workers and managers and consumers change their expectations in order to expect faster general price rises—more inflation—than they had expected before.
And then they find that prices are rising even faster than their new expectations had led them to believe. And the process accelerates and spirals upward.
If the only consequence of a situation of inflation economics were that, year after year, purchasers going to market found that prices were two, three, four, or five percent or so higher than they had been last year, few would complain. An economy in which it is easy for workers to find or change jobs and it is easy for managers to sell what their factories have produced is a comfortable place to be.
The problem arises when managers, workers, and consumers begin to reflect on the process of moderate inflation. If prices have been rising at five percent per year for several years, shouldn’t you expect that to continue, and build that into your expectations? And so buyers pay even more, and prices rise by more than they had been expecting them to. And the entire mechanism breaks down, as prices rise more than people had been expecting even though people had been expecting them to rise. The situation can end in a reversal of course as the situation is brought to a close via a dose of depression economics. Or the situation can end in a breakdown of trust in the government and the monetary system.
The consequences of such breakdowns are the third part of the domain of macroeconomics, which deals with the case in which the macroeconomic market failure is one of promise-keeping on the part of the government. As the late Milton Friedman put it, for the government to spend is for the government to tax. Whenever the government spends, it is also promising explicitly or implicitly to tax somebody, either in the present or the future, either directly or indirectly, to pay for that purchase.
The government can tax now to pay for spending later—and so run a budget surplus. The government can spend now and promise to tax later—and so run a budget deficit and increase the national debt. But what happens when the government runs up too great a debt and the political system tries to get the government to break its promise to tax? How to guard against such attempted promise-breaking by the government, and what happens when the government attempts such promise-breaking occurs is deficit economics. And once again it is not pretty: capital flight, disinvestment, stagflation, currency collapse, and hyperinflation.
The fourth part does not quite fit easily with the other three. It is growth economics, the study of how economies grow--or don't grow--in the longer run: how material living standards and labor productivity levels advance or fail to do so.
Growth economics fits uneasily with the other components of macroeconomics for three reasons: First of all, it is concerned with long-run trends across decades or generations. The other three are short run. They are concerned with whether the government is paying its debts or (implicitly or explicitly) defaulting on them, whether workers expecting to find jobs can do so or are disappointed, whether purchasers expecting to buy goods at yesterday's prices can do so or are disappointed, and whether any or all of these are happening right now/ Second, growth economics is concerned with situations in which expectations are generally satisfied while the others are concerned with situations in which expectations are disappointed. Third, growth economics is concerned with situations in which the economy has recently (where "recently" means something like "the past 200 years") done relatively well, while the other three are concerned with situations in which things are or are near the point of going badly.
Nevertheless, growth economics is similar to the other three in one important respect. It does not look at an individual market or firm or household or industry. Rather, it loos at the economy as a whole. And it looks at a set of circumstances in which market failures are everywhere, and of great importance.
For this reason Greg Mankiw added it to the "macroeconomics" half of the syllabus in the late 1980s, and it has stuck here ever since.
1.1.2. Focusing the Economy as a Whole
Microeconomics analyzes what goes right and wrong at the level of the individual firm, the individual household, the individual industry, or the individual market, macroeconomics shifts the focus to the economy as a whole and analyzes what goes right and wrong in the aggregate--from a macro perspective, one might say. Hence its name.
The difference in perspective from micro to macro has four sets of consequences that you should note. First, it has consequences for what things are held constant in the analysis. Second, it has consequences for how shifts in the economy can feedback upon and amplify each other. Third, it is far, far easier in macro to wind up in situations in which there are a number of possible ways in which supply could equal demand—and in which the principle that the economy comes to rest where supply equals demand is not of much help. Fourth and last, the expectations of the people living in the economy are much more important pieces of analysis in macro than in micro.
1.1.3. The Importance of Expectations in Macroeconomics
The last of these is worth a little more explanation. In microeconomic each little market equilibrium was self-contained: there were suppliers and demanders, they had goods to sell and needs to buy, and so all the relevant information for what would happen in the market was right there in front of us. In macroeconomics people are making decisions and plans which depend on what the future is going to be like—and what the future will be like depends on what decisions and plans are made today, and what their consequences are. Thus the questions of how people form their expectations of the future, and how changes in what happens today affect expectations of the future, are absolutely crucial: different ways of forming expectations lead to very different market outcomes, as we will see.
1.2. The Four Parts of Macroeconomics
1.2.1. Depression Economics
In December 2006 63.4% of American adults of working age had jobs. By December 2009 only 58.2% had jobs. Over those same three years the unemployment rate--which looks at a narrower group, not all American adults but only those who say that they are actively looking for work and would take a job if offered one--jumped from 4.4% to 10.0%. Total production in the economy stood at a level of $13.06 trillion per each year at the end of 2006 (measured in the prices as they stood in 2005). It was then growing at an average rate of a hair above 3% per year. But as of the end of 2009 productino stood not at $14.3 trillion per year but at $13.1 trillion per year. It was fully 8.5% lower than what three years before we had all expected the level of production to be. 8% of the flow of production of useful goods and services that we ought to have been producing and could have been producing at the end of 2009 was gone: vanished completely into thin air.
Why this shift, this "Great Recession" in the pace of the flow of production and demand and and the level of employment?
It is not because of any large negative shock to our knowledge about technologies and organizations. It is not because we have forgotten how to make things or organize ourselves. It is not because of any sudden shortage or exhaustion of natural resources. It is not because of any sudden destruction of national capital stock--of the assembly of produced means of production, of machines and structures that assist and amplify our powers to make and do things.
It is not because American workers have lost their taste for labor. It is not that workers today prefer to take a great vacation right now. Those who have lost their jobs and have not found new ones in this "Great Recession" are for the most part not happy people right now.
And it is not because a sudden wave of government regulation or sudden increases in tax rates have disrupted the market economy's productive division of labor--although you can find people who will claim each of these things is true, and do so with straight faces.
All of these factors that might under some conditions explain some of a fall in the pace of production and sales, in the level of employment, and in the fraction of the productive capacity of factories that is being used. But not this time.
Instead, the "Great Recession" of the late 2000s was yet another occurrence of a disease that has periodically but irregularly struck industrial market economies since at least 1825: the demand-driven industrial business cycle. Extraordinarily large numbers of people are unemployed in 2009-2010 because aggregate demand is low. There is no demand for the things they might or that they used to make and do. The expectation of sellers that they can, generally and on average, find willing buyers at more-or-less the prices that they had expected, has gone wrong. Thus there is, in general and economy-wide, excess supply of pretty much everything. And because there is macroeconomic excess supply, the assumption that private financiers and entrepreneurs will generally fulfill their contracts and keep their promises has gone wrong as well.
In a recession--we generally do not use the word "depression" for anything after World War II, largely because the word sounds too scary--sellers all across the economy find that buyers do not show up in the numbers they had been expecting, and so inventories of unsold goods pile up on the shelves. This wave of extra unexpected inventories works it's way back through the production chain, and producers respond as they usually do to deficient demand. They lay off workers, cut back production, and cut prices.
Normally when there is deficient demand for some commodity, and hence a glut of it on the market, there is excess demand for and hence a shortage of another one. Hence one firm or industry will be hiring workers, increasing production, and raising prices when another is firing, cutting, and lowering.
Not this time.
A recession is a general glut: a shortage of aggregate demand and not of demand for only one or only a few commodities. And in a recession the things that producers do to handle a single-commodity glut--firing, cutting back, and lowering--do not help repair the situation but instead work to make matters worse.
One (partial) reason there is low aggregate demand is that so many people are unemployed--and so have reduced incomes, and so can spend less. The feedback loop from lessened aggregate demand to reduced employment to reduced incomes to even further reduced aggregate demand is a vicious circle that makes recessions and depressions worse than they would otherwise be.
But where does the initial deficiency of aggregate demand--the one that caused the first piling-up of inventories unsold on store shelves--come from? You cannot have a downward vicious spiral without an initial push. The answer is that the initial push can come from a number of places, and take a number of forms, but that once the recession begins the process by which deficient aggregate demand is generated and propagates itself is very similar. Investigating that process or propagation and classifying the shocks that produce economic downturns is the subject matter of depression economics.
1.2.2. Inflation Economics
The second part, the subject following depression economics, is inflation economics. Inflation economics deals with times when the economy suffers from the reverse of the problems of depression economics: when there is not a shortage but instead a surplus of overall aggregate demand. It studies what happens when it is not true that buyers generally find willing sellers at the prices that they expected. The answer is that you get situations of inflation. Such are characterized by full or near-full employment, as firms find that they can sell as much as they can produce at prices higher than they expect. And they are times of climbing wage-price spirals, as workers and managers and consumers change their expectations in order to expect faster general price rises—more inflation—than they had expected before.
And then they find that prices are rising even faster than their new expectations had led them to believe.
If the only consequence of a small excess of aggregate demand over aggregate supply were that, year after year, purchasers going to market found that prices were two, three, four, or five percent or so higher than they had been last year, few would complain. An economy in which it is easy for workers to find or change jobs and it is easy for managers to sell what their factories have produced is a very comfortable place to be.
The big problem arises when managers, workers, and consumers begin to reflect on the process of moderate inflation—of ever rising prices. If prices have been rising at five percent per year for several years, shouldn’t you expect that to continue, and build that into your expectations? And then, when people go to market, they find that as long as their is excess aggregate demand their aren’t enough goods on the shelves to satisfy demand at expected prices, which are (say) five percent or whatever above what they were last year.
And so buyers pay more, and prices rise by more than they had been expecting them to.
And then the entire mechanism breaks down. Prices rise more than people had been expecting, even though people had been expecting them to rise. The situation can end in a reversal of course as excess supply is replaced by excess demand and recession, with a larger previous excess of aggregate demand producing a larger subsequent recession. Or the situation can end in a breakdown of trust in the government and the monetary system.
1.2.3. Deficit Economics
The consequences of such breakdowns in trust--caused by times of high inflation as well as other factors--are the third part of the domain of macroeconomics. It deals with the case in which the macroeconomic market failure is one of promise-keeping on the part of the government. As the late economist Milton Friedman put it, for the government to spend is for the government to tax. Whenever the government spends money to purchase something, it is also promising explicitly or implicitly to tax somebody, either in the present or the future, either directly or indirectly, to pay for that purchase.
The government can tax now to pay for spending later—and so run a budget surplus. The government can spend now and promise to tax later—and so run a budget deficit and increase the national debt. But what happens when the government runs up too great a debt and the political system tries to get the government to break its promise to tax, or even when investors and savers and managers and workers and spenders fear that the government will explicitly or implicitly try to break its promises? How to guard against such attempted promise-breaking by the government and what happens when attempted promise-breaking occurs is deficit economics. And once again it is not pretty: capital flight, disinvestment, stagflation, currency collapse, and hyperinflation.
1.2.4. Growth Economics
The fourth part of the domain does not quite fit easily with the other three. It is growth economics, the study of how economies grow--or don't grow--in the longer run: how material living standards and labor productivity levels advance or fail to do so.
Growth economics fits uneasily with the other components of macroeconomics for three reasons: first of all, it is concerned with long-run trends across decades or generations while they are short run, concerned with whether the government is paying its debts or (implicitly or explicitly) defaulting on them, whether workers expecting to find jobs can do so or are disappointed, whether purchasers expecting to buy goods at yesterday's prices can do so or are disappointed, and whether any or all of these are happening right now; second, it is concerned with situations in which expectations are generally satisfied while the others are concerned with situations in which expectations are disappointed; and, third, it is concerned with situations in which the economy has recently (where "recently" means something like "the past 200 years") done relatively well, while the other three are concerned with situations in which things are or are near the point of going badly.
Nevertheless, growth economics is similar to the other three in that it looks not at an individual market or firm or household or industry but rather at the economy as a whole. For this reason Greg Mankiw added it to the "macroeconomics" half of the syllabus in the late 1980s, and it has stuck here ever since.
1.2.5. The Relative Importance of These Four Parts
At the moment of this writing, with the U.S. unemployment rate at 9.5%, everybody’s focus is on depression economics. The other three parts of macroeconomics—inflation economics, government-debt economics, and long-term growth economics—are definitely in the back of people’s minds. But this will not always be the case. By the time you are reading this textbook, it may well be the case that one of the other three parts has come to the forefront of the news and of the policy debate.
So, at least, the pattern has been for the entire past century. The World War I era focused on inflation, the 1920s focused on growth, and the Great Depression of the 1930s saw the true birth of depression economics. But by the 1940s the pressures of World War II brought inflation to the forefront, followed by a concern about growth in the 1950s and 1960s, about inflation in the 1970s, and about depression economics again in the early 1980s. The late 1980s and early 1990s saw focus on government debt, followed by a late 1990s and early 2000s focused, again, more on economic growth than on any of the other three aspects before the financial crisis of 2007 brought about the latest turn of the wheel.
So take from this section of the course what is most useful to you. Some of it will be immediately useful and enormously relevant. Some of it will appear to be fusty and outdated. Some of it will appear to come from the outfield. But if history teaches us anything, it is that things change—and odds are that at some point in your life you will find each of the four components of macroeconomics very important for the economy in which you will then be living at that moment.
1.3. Measuring the Macroeconomy
But what do we mean by the "macroeconomy," anyway?
1.3.1. The Flow of Production and Sales
The U.S. Department of Commerce's Bureau of Economic Analysis has estimated that in the third quarter of 2007--that is, adding up the months of July, August, and September--the United States economy produced goods and services at a rate of $14,179.9 billion worth a year.
That doesn't mean that in July, August, and September we produced $14 trillion plus worth of stuff: we only produced a quarter of that: $3,545.0 billion. What the Bureau of Economic Analysis said was that, if we were to maintain that quarter of the year's pace of production for an entire year, then in that year we would have made $14 trillion plus.
Confused? Don’t blame yourself. It is confusing.
The BEA’s estimates of the current-dollar value of production—its estimates of nominal Gross Domestic Product—are a flow, not a stock. They are measured in terms of how many dollars worth of stuff are made in a given unit of time. It is like an automobile's speed: if you drive 60 miles an hour for fifteen minutes—a quarter of an hour—you don't go 60 miles but instead 15. If you produce $3,545.0 billion worth of stuff in three months you are making things and providing services at a rate of $14,179.9 billion per year.
Not all but almost all of the value of the stuff made in the fourth quarter of 2007 was sold. Nominal gross final sales of domestic product in that quarter proceeded at a rate of $14,148.8 billion per year. The difference between $14,179.9 and $14,148.8—$31.0 billion—is inventory accumulation: the difference between production and sales piles up as “inventories” of goods that firms own but that they want to sell. The inventories of goods that had been produced but had not been sold were greater at the end of September than they had been at the start of July.
How much greater?
If you say $31.0 billion, you are wrong: inventories were growing--inventory investment was proceeding—in the third quarter at a rate of +$31.0 billion per year. It proceeded at this pace for three months: a quarter of a year. Increasing business inventories at a pace of +31.0 billion per year for a quarter of a year means that at the end of September the Bureau of Economic Analysis's estimate was that inventories were $31.0 billion per year x 1/4 year = $7.8 billion higher than they had been at the start of July.
Confused? You should be...
The smartest people in the world at this get confused—one example is Princeton Professor and former Federal Reserve Vice Chair Alan Blinder in the White House, back when he was a member of President Clinton's Council of Economic Advisers: he divided rather than multiplying by four in his head and thus got an answer that was off by a factor of 16, and none of the young hotshots sitting in the room felt sure enough to try to correct him on the spot.
Thus there are three pieces of advice:
- Don't try to do this stuff in your head—it is just too hard.
- Remember what your high-school physics teacher said: no naked numbers. Every number that you write down has to come with its units attached to it. If you keep units attached to numbers then it is harder to divide when you should multiply.
- Do every problem twice, at least.
Remember: just as rate x time = distance, and just as distance/rate = time and distance/time = rate, so flow x time = change in stock and change in stock/time = flow.
One more wrinkle. Does the $14,148.8 billion per year of nominal gross final sales of domestic product in the third quarter of 2007 mean that Americans and others resident in the United States were then buying stuff at a rate of $14,148.8 billion a year? No.
Total nominal gross final sales to American residents were at a pace of $14,847.2 billion per year in that quarter.
Where does this difference come from? The difference is net imports: we bought more currently-produced goods and services from foreigners than we sold to them. That is our trade deficit. In the fourth quarter of 2007 American businesses sold good and services abroad at a pace of $1,685.2 billion per year, while American residents bought goods and services made outside the United States at a pace of $2,383.6 billion per year. Thus our trade deficit in that quarter was at a pace of $698.4 billion per year, our net exports were -$698.4 billion per year. How did we pay for this deficiency of exports relative to imports? Well, in net we sold some of our property and assets to foreigners, and we also borrowed from foreigners.
How much in assets did we sell of borrow?
$698.4 billion?
Again, no. Our net exports in the third quarter of 2007 were -$698.4 billion per year, which means that net foreign investment in the United States was then growing at a pace of $698.4 billion per year, which means that over three months net foreign investment in the United States grew by $698.4 billion per year x 1/4 year = $174.6 billion.
Anybody not confused? If anybody isn't confused yet, there is more that could follow. But it is best to stop and present a summary table of all the numbers we have talked about for the third quarter, July-September, of 2007:
The measure of the size of the American economy that nearly everybody focuses on and that is referred to the most is the Gross Domestic Product--GDP. The word "product" in this measure is important. It is a measure of how much America's businesses make, not how much they sell--that would be Final Sales of Domestic Product. The difference between the two is, as noted above, the change in inventories: Did businesses as a whole add to or subtract from their stock of goods being made and finished products in transit and waiting on store shelves? Did businesses "invest" in inventories by adding to their stock, or disinvest by reducing it? If this "inventory investment" item is positive then GDP will be greater than final sales; if this item is negative then GDP will be less.
And GDP is not what Americans buy for their households to use, for their businesses to build up capacity, and for their government to use in its functioning. That would be final sales to domestic purchasers.
Why does everybody focus on GDP rather than on either of the two final sales measures? Mostly for historical reasons: the National Income and Product accounting system was set up before World War II to focus on the “product” measures, and nobody has felt it important to make that change.
1.3.2. Real and Nominal Magnitudes
The $14,179.9 billion per year number that we have been talking about is what economists call a nominal GDP number: a measure of the value in dollars of the production of marketed goods and services. That number was higher in the third quarter of 2007 was higher than it had been a year or two earlier.
In the third quarter of 2006 the pace of nominal GDP had been $13,452.9 billion per year. In the third quarter of 2005 the pace of GDP had been $12,741.6 billion per year. Nominal GDP was thus 11.3% higher in the third quarter of 2007 than it had been two years earlier--a rate of growth in the pace at which America was producing marketed goods and services of 5.6% per year: an average over those two years waiting a year meant that the pace at which the American economy would have been producing sellable stuff--measured in dollars--would be 5.6% higher.
Why this "measured in dollars"? Because the BEA's nominal GDP estimates do not just grow when we produce stuff at a faster rate. They also grow when prices on average go up. Prices are going up and down all the time: some prices rising, some prices falling. But on average, in normal years, more dollar prices are rising than falling. So the BEA’s estimates of nominal GDP would grow in an average year even if Americans were not producing any more goods and services.
That means that the answer to the question “is nominal GDP growing?” is not the same as the answer to the question “is America making more valuable goods and services?” We would like the answer to the second question, but the estimates of nominal GDP answer only the first.
And so the BEA has another measure: not nominal GDP measured in dollars but real GDP measured in “constant dollars”: real GDP is nominal GDP adjusted for changes over time in the average dollar price of goods and services produced and marketed in the United States.
Ask the BEA what the pace of growth in the rate at which America was producing real marketed goods and services was, and it will tell you that real GDP between the third quarter of 2005 and the third quarter of 2007 grew at a pace of 2.5% per year. The difference between the 2.5% per year rate of growth of real GDP and the 5.6% rate of growth of nominal GDP over the period 2005:III to 2007:III is inflation: the fact that on average the dollar prices that goods and services sold for grew over that interval at a rate of 3.1% per year.
The BEA thus tells us that while nominal GDP was being produced at a pace of $12,741.6 billion per year in the third quarter of 2005, the value of that production at the average prices of 2005 was instead $12,683.6 billion per year--by July-September 2005 prices were a little bit higher than the average price in 2005. And by the third quarter of 2007 the BEA will tell you that while its estimate of nominal GDP is that $14,179.9 billion per year of marketed goods and services were being produced, its estimate of real GDP is that only $13,321.1 billion per year in chained 2005 dollars of marketed goods and services were being produced.
What is this "chained 2005 dollars"?
It is a way of telling us that the BEA is calculating the change in the average of all the prices in the economy in a particular and sophisticated way. It is attempting to separate out those changes in the flow of nominal GDP that are due to increases or decreased in the pace at which valuable goods and services are being produced and hitting the loading dock from those changes in the flow of nominal GDP that are due to increases or decreases in the average level of prices. This is not a straightforward task. If this was a full-year course, at this point it would be time digress into the index-number problem--into why this is not a straightforward task. But this is not a full year course.
1.3.3. The Circular Flow of Economic Activity
Back at the start of the nineteenth century a market economy where almost everybody specialized in one particular kind of job was a new thing. For most of human history most people had spent most of their time working to provide for their own households: growing their own food, weaving and sewing their own clothes, building their own houses, with purchases and sales in the market restricted to a relatively small part of total economic activity. But starting in the eighteenth century economic growth brought us to a place where, in northwestern Europe at least, for the first time most of what was produced was not consumed by the household that had made it, but was then sold in the marketplace and the money earned used to buy things that others had made.
This market economy disturbed a great many people. “What if it all went wrong?” they asked. “Could we wind up with a situation in which the yoga instructors were offering too many lessons on achieving inner peace that the weavers couldn’t buy, and the weavers had woven too much cloth that the farmers couldn’t buy, and that the farmers had grown too much food that the yoga instructors could not buy—so everyone was unable to satisfy their needs because they could not sell what they had produced, and because they could not sell what they had made they could not afford to buy what others had made.
It was French economist Jean-Baptiste Say who first proposed an answer back in 1803. He claimed that such a “general glut” was almost inconceivable, for every seller was also a purchaser. In a market economy, Say argued, every transaction has two sides, and nobody sells without intending to buy, and so purchasing power flows throughout the economy in a circle. Businesses produce and sell because they then intend to spend the money they earn hiring workers and rent capital: what they pay workers and capitalists in wages, salaries, rent, income, and dividends becomes their household incomes. But workers and capitalists only sell and rent their hours and their resources to businesses because they then intend to spend the money they earn buying goods and services. And those goods and services that they buy—well, those are the goods and services that the businesses make. So businesses sell final products to households and buy factor services from households, and households buy final products from and sell factor services to businesses.
We are going to want to keep finer track of the flow of purchasing power through the economy than just to say that households buy things (goods and services) from businesses and businesses buy things (labor-time and capital services) from households. We are going to want to keep track of what happens with the government, with financial market intermediaries, and with the rest of the world as well.
So let us start with household spending. Households take their incomes and divide them up into three parts: some they spend buying goods and services from businesses, some they use to pay taxes, and some they save and deposit in financial intermediaries—banks, mutual funds, 401(k) account holders, brokerages, et cetera. In the third quarter of 2007, households spent at a rate of $9,865.6 billion/year on consumption goods and services. Households also paid to governments at a rate of $2,467.8 billion/year in net taxes—the difference between tax checks written to governments and income support checks (like Social Security) written from governments to households. And total private savings were $1,851.9 billion/year: the sum of direct savings by households, and indirect savings on behalf of the households that owned them by businesses that took some of their profits and decided not to pay them out as dividends but to save them. That was how households disposed of the $14,185.3 billion/year in net incomes they received in the third quarter of 2007.
The federal, state, and local governments, in that quarter, took their $2,467.8 billion/year in net taxes, added to it $238.4 billion/year in net government borrowing, and spent $2,700.9 billion/year buying goods and services for the government. “Wait a minute,” you say: “2467.8 + 238.4 = 2706.2, not 2700.9.” Yep. The difference between 2706.2 and 2700.9 is the “statistical discrepancy.” The Commerce Department’s Bureau of Economic Analysis does not track ever single purchase and sale in the economy. Rather, it makes estimates. And these estimates are not quite consistent with each other. As long as the statistical discrepancy is small, we are not unhappy.
In the third quarter of 2007, financial intermediaries and businesses received $1,851.9 billion in private savings plus the $698.4 billion/year in net investment in the United States by foreigners. Of this $2,550.2 billion/year total, $238.4 billion/year was loaned to the government, and $2,311.9 billion/year was spent by businesses in gross private investment.
Add up the $9,865.6 billion/year in consumption spending, the $2,700.9 billion/year in government purchases, and the $2,311.9 billion/year in business investment spending, and then subtract off the -$698.4 billion/year in net exports, and we are back to our total of $14,179.8 billion/year for GDP in the third quarter of 2007.
What did the foreigners do with the extra $698.4 billion/year more that they sold us in imports than they bought in exports? Dollar bills are not of much use outside the United States, after all. The answer is that they took them and invested them in the United States: that’s the $698.4 billion/year in loans from abroad and purchases of property and assets in the United States that we saw flowing into financial intermediaries above.
Thus we see the kernel of truth in Jean-Baptiste Say’s idea: every transaction does have two sides, for every buyer there is a seller, and purchasing power does proceed throughout the economy, greasing a flow of production, sales, income, and purchases that in the U.S. economy now amounts to more than $14 trillion worth of commodities every year. In 1803 Jean-Baptiste Say was confident that nothing would interrupt or disturb this flow to render large numbers of workers without work or large piles of goods without buyers.
By 1829—after watching the depression of 1825-6 in England—he had a different view.
But that is for the next class: our first full class on depression economics.
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