Macro Chapter Summaries

Economists’ disagreements about macro built into “the fundamental macro question”

 If left alone by government, do the price mechanisms of market economies adjust quickly to maintain steady growth in living standards, full employment, stable prices?

or

If left alone, do markets quickly self-adjust?

Essential concepts are those students must know to answer that question for themselves — macroeconomics they need to know as citizens.

Part 1 Thinking Like a Macroeconomist

Chapter 1: Are Your Smart Choices Smart for All?: Macroeconomics and Microeconomics

Transitions from micro to macro, asking whether combined smart choices of individuals yield the best outcome for the economy as a whole. Using stories of the Great Recession and Great Depression, we introduce reasons why markets may not yield ideal aggregate results: fallacy of composition, connections between labour and output markets, and impact of money, banks, andexpectations. The fundamental macroeconomic question is introduced: “If left alone by government, do the price mechanisms of market economies adjust quickly to maintain steady growth in living standards, full employment, and stable prices?” The “Yes” answer is tied to Say’s Law, the “No” answer to Keynes.

We connect “Yes” answers to a government hands-off position and the political right; “No” to a government hands-on position and the political left.We sketch macroeconomic performance outcomes—GDP, unemployment, inflation—which affect students’ lives. We introduce macroeconomic players: consumers, businesses, government, the banking system, and the rest of the world (R.O.W.).

Chapter 2: Up Around the Circular Flow: GDP, Economic Growth and Business Cycles

Distinguishes nominal, real, and potential GDP, as well as limitations of GDP as a measure of well-being. In explaining potential GDP, there is an overview ofsources of economic growth, emphasizing creative destruction and howincreases in the quantity and quality of inputs expand the circular flow and improve productivity. We define phases of business cycles and explain output gaps and connections to unemployment and inflation. The choices of all macroeconomic players are combined to create the circular flow diagram—theanalytical core of the book—together with the “mantra” C _ I _ G _ X _ IM _ Y.

Chapter 3: Costs of (Not) Working and Living: Unemployment and Inflation

Details measurements of unemployment and inflation. We begin with unemployment rates, issues of involuntary part-time and discouraged workers, and differentiate “healthy” unemployment (frictional, structural) from “unhealthy” unemployment (cyclical). We define the natural rate, connecting all forms of unemployment to recessionary and inflationary gaps.We explain inflation rates using the Consumer Price Index and identify limitations of inflation measurements.

We differentiate the core inflation rate, nominal, and realized real interest rates and explain inflation problems for fixed income streams, investors, and expectations.We present the quantity theory of money to help explain inflation.

After illustrating the Phillips Curve, the final section connects unemployment to inflation and distinguishes demand-pull from cost-push inflations. Long-run Phillips Curve complications are postponed until Chapter 7.

Chapter 4: Skating to Where the Puck Is Going: Aggregate Supply and Aggregate Demand

Develops a framework for thinking about macroeconomics. We start with macroeconomic players’ choices that determine aggregate supply; we then develop aggregate demand choices to ask if aggregate supply and aggregate demand match. Matches yield steady growth, full employment, and stable prices; mismatches may yield business cycles, unemployment, and inflation.

Without demand and supply curves, we use circular flow diagrams to explain the framework. Paralleling micro distinctions between quantity supplied and supply, aggregate supply choices are divided into supply plans with existing inputs (law of aggregate supply), supply plans to increase inputs (increase in aggregate supply), and supply shocks. The question is: will supply plans create their own demand?

Again using circular flow diagrams, we differentiate the law of aggregate demand, changes in aggregate demand, and demand shocks.We use the fallacy of composition to explain the inverse relation between the price level and aggregate quantity demanded as different from micro explanations, focusing on substitution of foreign for domestic products. Equilibrium matches between aggregate supply and aggregate demand are tied to Say’s Law (“Yes—markets quickly self-adjust, so hands-off ”) both for existing inputs and for growth over time with increasing inputs. We introduce the banking system and loanable funds market to “rescue” Say’s Law when saving is possible. Disequilibrium mismatches between aggregate supply and aggregate demand are tied to Keynes

(“No—markets fail to quickly adjust, so hands-on”) and we explain short-run consequences of positive/negative aggregate supply and demand shocks for output gaps, unemployment, and inflation. The final section differentiates “Yes” and “No” explanations of origins of shocks, role of expectations, price adjustments, and operation of the loanable funds market.

Part 2 The Price of Money

Chapter 5: Money is for Lunatics: Demanders and Suppliers of Money

Emphasizes acceptability as key feature of money, and explains functions of money as medium of exchange, unit of account, and store of value. Motivated by Keynes’s question of why hold assets as money, which pays no interest, we develop the demand for money in the context of the asset choice of holding money (for liquidity) or bonds (for interest). We identify factors changing the demand for money: real GDP and average prices. We differentiate the relative de-emphasis on the store-of-value function of money by the “Yes” camp— when Say’s Law holds and loanable funds markets clear, bonds are a relatively safe investment. For the “No” camp, with Keynes’s business cycles and fundamental uncertainty, money is more appealing as a store of value. The supply of money story begins with four forms of money, the definition of M1, and roles of the Bank of Canada and chartered banks in creating money through fractional reserve banking. We emphasize banking tradeoffs between profits and prudence and explain bank runs.We explain the interest rate as the price of money in terms of connected money and bond markets. The inverse relation between bond prices and interest rates has centre stage in explaining adjustments to equilibrium. The final section explains monetary transmission mechanisms connecting interest rate changes to real GDP through aggregate demand.We differentiate camps in terms of “how much does money change the economy out of equilibrium?” The “Yes” camp answer is “not much” with loanable funds markets facilitating adjustment to equilibrium, while the “No” camp answer is “a lot” with money as a store of value adding new internal demand shocks slowing adjustment to equilibrium.

Chapter 6: Trading Dollars for Dollars?: Exchange Rates with the Rest of the World

Explains exchange rates as a prerequisite for understanding monetary policy. After explaining the foreign exchange market, we outline derived demands for Canadian dollars to buy Canadian exports, assets, and for speculation. The supply of Canadian dollars is demand for foreign currency derived from Canadians’ demand for imports, for R.O.W. assets, and for speculation. We explain how exchange rates adjust to equilibrium and calculate reciprocal and cross exchange rates. We explain exchange rate fluctuations from interest and inflation rate differentials, GDP, and speculators’ expectations. We trace international transmission mechanisms from exchange rates to net exports, aggregate demand, and to prices, explaining advantages/disadvantages of higher and lower exchange rates. The final section explains overvalued or undervalued currencies using purchasing power parity examples and the Big Mac index.We use the law of one price to motivate purchasing power parity and rate of return parity, and differentiate floating and fixed exchange rates.

Part 3 Macroeconomic Policy for Citizens — Hands-Off or Hands-On?

Chapter 7: Steering Blindly?: Monetary Policy and the Bank of Canada

Portrays challenges of monetary policy using the metaphor of driving down mountain roads with 30-second delays in pressing the accelerator and brake. After explaining origin and objectives of the Bank of Canada, we explain open bond market operations for changing the overnight rate and other short-term interest rates. We then use domestic and international transmission mechanisms from Chapters 5 and 6 to illustrate the impact of monetary policy on aggregate demand, GDP, employment, and inflation, and explain how the balance sheet recession of 2008–2009 highlighted store-of-value functions of money, blocked transmission mechanisms, and was addressed through quantitative easing.We discuss Bank of Canada independence, how the original Phillips Curve relationships broke down with changing expectations, and the importance of inflation rate targeting in anchoring inflationary expectations.

While highlighting the agreement on the need for a central bank, we identify differences between the “Yes” camp’s preference for hands-off monetary policy rules and “No” camp’s preference for hands-on government policy discretion to correct transmission breakdowns and to allow for government-set targets besides inflation.

Chapter 8: Spending Others’ Money: Fiscal Policy, Deficits and National Debt

Begins with use of demand-side fiscal policies to correct output gaps, working through expenditure and tax multipliers based on injections and leakages in the circular flow. We then review supply-side policies to promote growth by stimulating savings and capital investment, encouraging R&D and improving education and training.While both camps largely agree on supply-side policies, differences exist on savings policies. The “Yes” camp emphasizes long-run benefits of growth; “No” camp worries about short-run consequences of decreased aggregate demand. We also explain supply-side incentive effects, reviewing supply-sider arguments politicians make that tax cuts increase tax revenues. For government budgets, we document revenues and expenditures and explain deficits and surpluses, distinguishing cyclical from structural. We trace how automatic stabilizers have moderated business cycles and automatically generate cyclical deficits and surpluses, and the destabilizing risk of forcing always-balanced government budgets. We suggest balancing the budget over the cycle to avoid structural deficits. The section on national debt distinguishes flows (deficits) from stocks (debt) and documents Canada’s national debt as a percentage of GDP. We explore five common arguments about national debt, distinguishing myths and genuine problems: will Canada go bankrupt?; burden for future generations; debt is always bad; interest payments creating self-perpetuating debt; crowding out and crowding in. The final section differentiates economic and political statements about deficits and debt as positive or normative to help students make informed choices as citizens about hands-off and hands-on roles for government fiscal policy.

Chapter 9: Are Sweatshops All Bad?: Globalization and Trade Policy

Begins with a basic choice—producing for yourself or specializing and trading. A simple example—reproduced from microeconomics Chapter 1—uses tables of numbers that are implicit production possibility frontiers, illustrating gains from trade and comparative advantage.We define terms of trade and emphasize the role of creative destruction in creating winners, losers, and opponents to trade. Winners are consumers and export industries; losers are businesses and workers in import-competing industries. We explain protectionism—tariffs, quotas, domestic subsidies—by the unequal distribution of gains and losses producing political pressure to protect those who lose from trade. We review protectionist arguments—saving Canadian jobs; competing with cheap foreign labour; national security and cultural identity—and risks of trade wars. Thesection on economic globalization begins with anti-globalization protests against trade, the World Bank and IMF, and explains the “Yes” camp’s hands-off “free market” conditions on assistance to developing countries during the 1990s. We explain forces driving globalization and present a history of sweatshops and trade.We propose the opportunity-cost question: are workers’ lives better off, or worse off, compared to a situation without globalization, trade, and the factory jobs that follow? We use Stiglitz’s views for hands-on arguments, partially supporting protesters, for a limited role for government to maintain a social safety net for those left behind by trade and markets. We present The Economist’s criticisms of international trade negotiations—problems for developing countries are not caused by trade, but by protectionist policies in developed countries. A power struggle over tariffs and subsidies between rich and poor countries affects terms of trade and how gains are divided.We outline hands-off and hands-on positions on government in global markets, to enable students—as citizens of Canada and the world—to reach an informed position on globalization.