Dan Richards

Article / Updated 12-13-2022

Over the last 50 years, the U.S. economy has grown at an average annual rate of about 2.8 percent. Roughly 1.1 percent has come from population growth: the country typically adds more workers each year. But the majority of it comes from the fact that it gets more productive each year — to the tune of about 1.7 percent annually. If this progress had been steady and even, macroeconomists could just focus on the long-run growth questions. But, like true love, the course of gross domestic product (GDP) seldom runs smoothly. The Great Recession of 2007–09 was a reminder that the economy often wanders far from the long-run trend, with GDP falling and unemployment rising. The GDP that those unemployed workers could have produced — such as more or better health care, more or better transportation services, more or better education, or a lot of other stuff that society values — is lost. To be sure, given how unemployment is measured, some people are unemployed even in the best of times. Basically, you're considered to be unemployed if: a) you don't have a job, and b) you've been looking for one in the last few weeks. Yet over any month or quarter, some people lose or quit their jobs and look for new ones. Others, either new young workers or older ones who had been happy taking time off, enter the labor force and search for employment as well. Because it takes time to match each worker with a specific skill set to a firm looking for just those skills, these workers clearly meet the definition of being unemployed. Because such unemployment reflects the normal frictions in the job matching process, economists refer to it as frictional unemployment. In addition, there are structural features of the labor market that also lead to positive unemployment even in overall good economic times, what economists call structural unemployment. Regulations, for example, that make it difficult to discharge workers once they are employed are also likely to make companies reluctant to hire workers in the first place. State licensing policies and regulations can have a similar effect. It may surprise you to learn that virtually every state imposes a licensing requirement not only for professional occupations like doctors, dentists, and lawyers, but also for those such as manicurists, cosmetologists, HVAC contractors, and massage therapists. Some even impose requirements for being an upholsterer, a locksmith, or an interior designer. Often there is little reciprocity between states. So, in moving from one state to another, a worker frequently must repeat many of the exams and training necessary to regain her license. This expense can be enough to wipe out any gain from moving to a different state. Even if there is a surplus of, say, medical technicians in New Mexico and a shortage in California, those in New Mexico may choose to stay unemployed rather than move to California and incur the cost of regaining a license. Recent estimates suggest that such licensure requirements cost up to nearly 3 million jobs per year. Minimum wage laws can also cause structural unemployment. By mandating a wage higher than the market would, such laws can attract a lot of workers while at that same time making companies less willing to hire. The excess supply will again be considered unemployed — not because there are no jobs but because they cannot get employed by offering to work for a lower wage. The law prevents that. To be sure, this view has been challenged in recent years as economists have found that such effects may be countered by the fact that a higher wage makes it easier to hire and keep workers, thereby paying for itself in lower turnover costs. But part of the reason for this is that, within the U.S., the current federal minimum wage is so low. In inflation-adjusted terms, the current federal minimum wage of $7.25 per hour would have to be about $9 to reach the peak reached in the late 1960s. At such low levels, it is perhaps quite plausible that even significant increases to, say, $12 or $15 an hour might still not create any unemployment. However, at some point, the traditional argument surely holds. Mandating a minimum wage of $30 an hour, for example, would definitely price large numbers of workers out of their jobs. In the case of both frictional and structural unemployment, any solutions lie mainly in policies to improve the functioning of the labor market, that is, in microeconomic policies. These might include improving the information that workers and firms have about each other and reforming licensure practices. By contrast, cyclical unemployment reflects more purely macroeconomic forces. It is, as its name implies, a short-run phenomenon associated with the business cycle. It usually stems from low demand for goods and services that leads firms to cut production and lay off workers. Those workers want jobs and are willing to work — there just aren't enough jobs available to employ them. Cyclical unemployment is very costly because it means not using resources to produce goods that the economy would produce if it were operating normally. The U.S. Congressional Budget Office estimates that in 2009 the U.S. economy lost about $1 trillion (nearly 7 percent) of GDP due to the unemployment associated with the recession. That's a whole lot of healthcare, automobiles, education services, or whatever we wanted to use those unemployed resources to make. This is why understanding the reason that the economy periodically falls into recession is the second great macroeconomics question. The payoff to reducing the costs of cyclical unemployment is potentially very large.

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.

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.

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?

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.

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.

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.

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.

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.

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.