What is macroeconomics?

Today I am departing from usual practice. I have decided to use Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text by the end of this year. So each Friday I will publish the work I have been doing on it during the previous week in between the other work that I am pursuing. Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it. Anyway, this is what I wrote today.

Chapter 1 Introduction

Basic Outline of Chapter

  • What is macroeconomics?
  • Stylised facts of macroeconomics
  • Hard core hypotheses of the model: macroeconomics must recognize government as by far and away the most important actor in the modern economy.
  • Macro foundations versus micro foundations
  • Stocks and flows
    • Flows: income, consumption, investment, government spending and taxing, imports and exports, saving
    • Stocks: wealth, financial and real, domestic and external, private and public
    • Basics of sectoral accounting, relations to stock and flow concepts
    • Deficits, savings and debts, wealth.
  • Measuring the economy – essential tools
    • GDP and alternative measures of output
    • Measures of inflation
    • Employment indicators: labour force, employment, unemployment
    • Measures of growth

1.1 What is macroeconomics?

In macroeconomics we study the aggregate outcomes of economic behaviour. The word Macro is derived from the Greek word makro, which means large and so we take an economy-wide perspective.

Macroeconomics is not concerned with analysing how each individual person, household or business firm behaves or what they produce or earn – that is the terrain of the other major branch of economic analysis, microeconomics. Macroeconomics focuses on a selected few outcomes at the aggregate level and is rightly considered to be the study of employment, output and inflation in an international context. A coherent macroeconomic theory will provide consistent insights into how each of these aggregates are determined and change.

In this regard, there are some key macroeconomics questions that we seek to explore:

1. What factors determines the flow of total output produced in the economy over a given period and its growth over time?

2. What factors determine total employment and why does mass unemployment occur?

3. What factors determines the evolution of prices in the economy (inflation)?

4. How does the domestic economy interact with the rest of the world and what are the implications of that interaction?

A central idea in economics whether it is microeconomics or macroeconomics is efficiency – getting the best out of what you have available. The concept is extremely loaded and is the focus of many disputes – some more arcane than others. But there is a general consensus among economists that at the macroeconomic level, the “efficiency frontier” (which defines the best outcome achievable from an array of possible outcomes) is normally summarised in terms of full employment. The hot debate that has occupied economist for years is the exact meaning of the term – full employment. We will consider that issue in full in Chapters 10 and 11. But definitional disputes aside; it is a fact that the concept of full employment is a central focus of macroeconomic theory. Using the available macroeconomic resources including labour to the limit is a key goal of macroeconomics. The debate is over what the actual limit is.

The related macroeconomic challenge is how to maintain full employment but at the same time simultaneously achieve price stability. MMT develops a macroeconomic framework that exploits the unique features of the monetary system to achieve these two important goals. Those issues are brought together in Chapter 11 after the earlier chapters have developed the essential understandings of how employment and inflation is generated.

The clear point is that if you achieve that then you will be contributing to the prosperity and welfare of the population by ensuring real output levels are high within an environment of a nominal anchor (inflation control).

What this book seeks to develop is a framework for understanding the key determinants of these aggregate outcomes – the level and growth in output; the rate of unemployment; and the rate of inflation – within the context of what we call a monetary system. All economies use currencies as a way to facilitate transactions. The arrangements that pertain to the way the currency enters the economy and the role that the currency issuer, the national government has in influencing the outcomes at the aggregate level is a crucial part of macroeconomics.

Modern Monetary Theory (MMT) is distinguished from other approaches to macroeconomics because it places these arrangements at the centre of the analysis. Learning macroeconomics from an MMT perspective requires you to understand how money “works” in the modern economy and developing a conceptual structure or analysing the economy as it actually exists.

It is thus essential to understand the notion of a currency regime, which can range through a continuum from fixed exchange rate systems to floating exchange rate systems with varying degrees of exchange rate management in between. Understanding the way the exchange rate is set is important because it allows us to appreciate the various policy options that the currency issuer – the government – has in relation to influencing the objects of our study – employment, output and inflation.

At the heart of macroeconomics is the notion that at the aggregate level, total spending equals total income and total output. In turn, total employment is determined by the total output in the economy. So to understand employment and output determination we need to understand what drives total spending and how that generates income, output and the demand for labour.

In this context, we will consider the behaviour and interactions of the broad economic sectors – first, the government and non-government dichotomy; and, second, we will broaden the non-government into its component sectors – the private domestic sector (consumption and investment) and the external sector (trade and capital flows). The emphasis on the broad macroeconomic sectors leads directly to a particular approach being taken to the way we view the so-called National Accounts, which we analysis in detail in Chapter 5. This approach is called the sectoral balance approach which is build on the accounting rule that the deficits of one sector must be offset by surpluses of another in the case of the government-non-government dichotomy or that the sum of the balances nets to zero in the case of the government, private domestic, external sector variant.

If one of these spends more than its income, at least one of the others must spend less than its income because for the economy as a whole, total spending must equal total receipts or income. While there is no reason why any one sector has to run a balanced budget, the MMT framework shows that the system as a whole must. Often, though not always, the private domestic sector runs a surplus – spending less than its income. This is how it accumulates net financial wealth. Overall private domestic sector saving (or surplus) is a leakage from the overall expenditure cycle that must be matched by an injection of spending from another sector. The current account deficit (the so-called external sector account) is another leakage that drains domestic demand. That is the domestic economy is spending more overseas than foreigners are spending in the domestic economy. These concepts are developed in full in Chapter 6.

To organise the way of thinking in this regard we use a conceptual structure sometimes referred in the economics literature as a model – in this case a macroeconomic model. A model is just an organising framework and is typically a simplification of the system that is being investigated. In this textbook we will develop a macroeconomic model, which combines narrative and some formal language (mathematics) to advance your understanding of how the real world economy operates. We will necessarily stylise where complexity hinders clarity but always we will focus on the real world rather than an assumed world that has not application to the actual economy.

All disciplines develop their own language as a way of communicating. One might think that this just makes it harder to understand the ideas and we have sympathy for that view. But we also understand that students of a specific discipline – in this case macroeconomics – should be somewhat conversant with the language of the discipline they are studying.

In the Appendix to this Chapter, we present some analytical terminology that is used in the specification of macroeconomic models and which you will find throughout this book.

A macroeconomic model thus comprises the tools and theoretical connections to advance study of the main aggregates. This textbook is designed unique because it specifically develops the MMT macroeconomic model, which will be applicable to the real-world issues including economic policy debates. The application to policy is important because macroeconomics is what might be termed a policy science.

By placing government as the currency issuer at the centre of the monetary system we immediately focus on how it spends and how that spending influences the major macroeconomic aggregates that we seek to explain. The framework will, at first, provide a general analysis of government spending that applies to all currency-exchange rate systems before explaining the constraints (policy options) that apply to governments as we move from a fixed exchange rate to a flexible exchange rate system. We will consider how the design of the monetary system impacts on the domestic policy choices open to government and the outcomes of specific policy choices in terms of employment, output and inflation.
The two main policy choices that seek to influence what is termed the demand or spending side of the economy are monetary and fiscal policy. Fiscal policy is represented by the spending and taxation choices made by the government (the “treasury”) and the net financial accounting outcomes of these decisions are summarised periodically by the by government budget. Fiscal policy is one of the major means that the government seeks to influence overall spending in the economy and achieve its aims.

The textbook shows that a nation will have maximum fiscal space:

  • If it operates with a sovereign currency; that is, a currency that is issued by the sovereign government and that is not pegged to foreign currencies; and
  • If it avoids incurring debt in foreign currencies, and avoids guaranteeing the foreign currency debt of domestic entities (firms, households, or state, province, or city debts).

Under these conditions, the national government can always afford to purchase anything that is available for sale in its own currency. This means that if there are unemployed resources, the government can always mobilise them – putting them to productive use – through the use of fiscal policy. Such a government is not revenue-constrained, which means it does not face the financing constraints that a private household or firm faces in framing their expenditure decision.

To put it as simply as possible – this means that if there are unemployed workers who are willing to work, a sovereign government can afford to hire them to perform useful work in the public interest. From a macroeconomic efficiency argument, a primary aim of public policy is to fully utilise available resources.

MMT provides a broad theoretical macroeconomic framework based on the recognition that fiat currency systems are in fact public monopolies per se, and introduce imperfect competition to the monetary system itself, and that the imposition of taxes coupled with insufficient government spending generates unemployment in the private sector.

An understanding of this point will be developed to allow the student to appreciate the role that government can play in maintaining its near universal dual mandates of price stability and full employment. The student will learn that there are two broad approaches to control inflation available to government in designing its fiscal policy choices. The concept of buffer stocks are involved in each and the textbook will examine the differences between the use of:

  • Unemployment buffer stocks: The mainstream approach, which describes the current policy orthodoxy), seeks to control inflation through the use of higher interest rates (tighter monetary) and supportive fiscal policy (austerity), which leads to a buffer stock of unemployment. In Chapters 10 and 11, students will learn that this approach is very costly and provides an unreliable target for policy makers to pursue as a means for inflation proofing; and
  • Employment buffer stocks: Under this approach the government exploits its fiscal capacity, inherent in its currency issuing status to create an employment buffer stock approach. In MTT, this is called the Job Guarantee (JG) approach to full employment and price stability and the model, which is central to MMT is explained in full in Chapter 10.

The MMT macroeconomic framework shows that a superior use of the labour slack necessary to generate price stability is to implement an employment program for the otherwise unemployed as an activity floor in the real output sector, which both anchors the general price level to the price of employed labour of this (currently unemployed) buffer and can produce useful output with positive supply side effects.

As a further addition to the framework, you will learn the difference between a stock and a flow and relate that to the accumulation of financial assets in the non-government sector. We explain stocks and flows in more detail in Chapters 4 and 6, but for now we note that spending is always a flow of currency per period (for example, households might spend $100 billion dollars in the first three months of 2012).

We will develop the sectoral balances framework to show that a sectoral deficit accumulates, as a matter of accounting to financial debt while sectoral surpluses accumulate to financial assets. MMT is thus based on what is known as a stock-flow consistent approach to macroeconomics where all flows and resulting stocks are accounted for in an exhaustive fashion. The failure to adhere to a stock-flow consistent approach can lead to erroneous analytical conclusions and poor policy design.

From the perspective of fiscal policy choices, an important aspect of the stock-flow consistent approach that will be explained in Chapter 6, is that one sector’s spending flow must equal its income flow plus changes to its financial balance (stock of assets). This implies that a particular sector can spend more than its income, but this implies a deduction from its net financial assets. Likewise, the deficit spending of one sector implies that at least one other sector must be spending less than its income, accumulating net financial assets.

The textbook will show that a country can only run a current account deficit if the rest of the world wishes to accumulate financial claims on the nation. For the most part, these claims are in the form of government debt, which is issued as the government runs deficits. The MMT framework shows that for most governments, there is no default risk on government debt, and therefore such a situation is “sustainable” and should not be interpreted to be necessarily undesirable. Any assessment of the fiscal position of a nation must be taken in the light of the usefulness of the government’s spending program in achieving its national socio-economic goals. This is what Abba Lerner (1943) called the “functional finance” approach: rather than adopting some desired budgetary outcome, government ought to spend and tax with a view to achieving “functionally” defined outcomes.

The consequences of a budget surplus – the government spending less than they are taking out of the economy by way of taxation – when a nation runs an external deficit will also be outlined. In summary, budget surpluses force the non-government sector into deficit and the domestic private sector is forced to accumulate ever-increasing levels of indebtedness to maintain expenditure. The textbook will explain why this is an unsustainable growth strategy and how eventually the private domestic sector is forced to reduce its risky debt levels by saving more and the resulting drop in aggregate spending will reinforce the deflationary impact of the budget surplus.

The central bank in the economy is responsible for the conduct of monetary policy, which typically involves the setting of a short-term policy target interest rate. In the recent global economic crisis the ambit of monetary policy has broadened considerably and these developments will be considered in Chapter 14. MMT considers the treasury and central bank functions to be part of what is termed the consolidated government sector. In many textbooks, students are told that the central bank is independent from government. The MMT macroeconomic model will demonstrate how it is impossible for the two parts of government to work independently if the monetary system is to operate smoothly.

CONTINUING …

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    21 Responses to What is macroeconomics?

    1. NeilT says:

      I look forward to the textbox (cannot come sooner in my opinon), the intro above reads well and although I understand it’s aimed at undergrads it looks like it’ll be a (very, very) usfeul tome for the rest of us. Presmuably free ones for all the chancellors and finance ministers amongst us?

    2. Hugo Heden says:

      Slight confusion on this:

      > MMT provides a broad theoretical macroeconomic framework based on the recognition that fiat currency systems are in fact public monopolies per se, and introduce imperfect competition to the monetary system itself, and that the imposition of taxes coupled with insufficient government spending generates unemployment in the private sector. <

      Why "per se“? In italics even? Confuses me. Can you remove “per se” without changing the meaning of the sentence? If not, then is there some other way to express the meaning of the sentence?

    3. Hugo Heden says:

      Perhaps it is not really proof-reading of that kind you’re looking for though…

    4. Dear Bill
      It sometimes seems that you have more than 24 hours in a day. You write an extensive blog, give speeches, have a professorship and now write a textbook. I’m certainly going to buy it when it comes out.

      I would like to add that the capital/output ratio is also an important indicator of efficiency. The higher it is, the lower the efficiency. Investments are only a means to consumption, just as exports are only a means to obtain imports. Tractors are only a means to produce food and have no other purpose. Let’s take Ruritania and Slobodia again. They both have a fully employed labor force of 5 million and they both produce 200 billion. However, Ruritania does it wqith a capital stock of 500 billion while Slobodia does it with a capital stock of 700 bilion, then Ruritania is more efficient.

      Regards. James

    5. Steve says:

      Excellent, Bill. I’ll test drive as much of your work on my intro macro course as I think I can get away with…

    6. Jonathan Oates says:

      Dear Prof,
      Looking fwd to seeing more.

      Noticed just a single typo – In MTT, this is called the Job Guarantee (JG) approach to full employment and price stability and the model, which is central to MMT is explained in full in Chapter 10.

      Presume MMT, not MTT.

      For the record, I still feel ambivalent about the MMT moniker as I believe you are propounding ‘economics as if reality mattered’, to bend Schumacher’s title. On the other hand, I suppose it suggests alternatives might be pre-modern?

      Trying to do something in political economy for an MSc in International Public Policy Analysis here at the University of Bath’s Dept for Social & Policy Sciences. Will try to head in MMT direction if pursue a PhD (if play cards right).

      Best wishes from the old country
      Jonathan Oates
      University of Bath

    7. Justin Holt says:

      Bill,

      Looks great, can’t wait to read it all.

      I have few suggestions on the text:

      “Often, though not always, the private domestic sector runs a surplus – spending less than its income. This is how it accumulates net financial wealth. Overall private domestic sector saving (or surplus) is a leakage from the overall expenditure cycle that must be matched by an injection of spending from another sector. The current account deficit (the so-called external sector account) is another leakage that drains domestic demand. That is the domestic economy is spending more overseas than foreigners are spending in the domestic economy.”
      Do you want to mention more explicitly that accumulation in the private sector of net financial wealth requires a public sector deficit, since this is essential to MMT’s theory of full-employment and sector balances?

      “The two main policy choices that seek to influence what is termed the demand or spending side of the economy are monetary and fiscal policy.”
      You then briefly discuss fiscal policy but not monetary policy, perhaps a line on monetary policy?

      “that fiat currency systems are in fact public monopolies per se “
      This would be clearer, for stuents, if you said ‘public monopolies of money per se’

      Best,
      Justin Hol

    8. Jim Luke says:

      Bill,
      It looks good so far. I am curious as to:
      1. Do you have a publisher? What plans on format, costs, etc. exist – or is this too early?
      2. To whom is the text targeted? Is this the Principles course typically taken by freshmen/sophomores? By largely non-majors or people expected to become majors?
      3. Is it macro only? What would you recommend to use as micro?

      I wonder because I teach community college principles courses in U.S.
      jim

    9. Vassilis Serafimakis says:

      Dear James Schipper,
      Bill has confided to a select number of readers that he indeed possesses the secret of time travel. He can spend 24 hours “doing stuff” and then wind his life’s clock back and cram a few more hours into the same day.
      It’s actually very easy if you know what to do.
      Plus, he doesn’t have to bother with daylight saving time.
      Cheers.

    10. MamMoTh says:

      Under these conditions, the national government can always afford to purchase anything that is available for sale in its own currency.

      I hope the textbook will somehow explain why this anything does not include foreign currency, or the point about being indebted in a foreign currency will not make much sense.

    11. Some Guy says:

      What is macroeconomics? IMHO Kenneth Boulding gave the best answer: “There has been a great advance in what used to be called the theory of money, but now is frequently called “macroeconomics” …”
      (Appendix to Economic Analysis, 4th edn.)
      Money is an inherently macroeconomic concept; remembering the older name, “The Theory of Money” imho enlightens. Austrian/Neoclassical/Commodity theory of money attempts to force an intrinsically macro concept into a micro box too small to hold it.

      ***********
      @Mammoth:

      Bill: Under these conditions, the national government can always afford to purchase anything that is available for sale in its own currency.

      Mammoth: I hope the textbook will somehow explain why this anything does not include foreign currency, or the point about being indebted in a foreign currency will not make much sense.

      Of course it includes foreign currency. Central Banks can & do buy foreign currencies with their own currencies. It’s just that beyond some finite point, a large enough sum of foreign currency will not be “available for sale” for any amount, no matter how large, of domestic currency. For instance, Argentina has its own currency, but no matter how much it printed and spent on US dollars, it could not obtain US$10 Trillion that way. If Argentina incurred a large enough $US debt, there might be no way to pay it off. Weimar Germany is another country which was famously in this fix.

    12. Coises says:

      In macroeconomics we study the aggregate outcomes of economic behaviour. The word Macro is derived from the Greek word makro, which means large and so we take an economy-wide perspective.
       
      Macroeconomics is not concerned with analysing how each individual person, household or business firm behaves or what they produce or earn – that is the terrain of the other major branch of economic analysis, microeconomics. Macroeconomics focuses on a selected few outcomes at the aggregate level and is rightly considered to be the study of employment, output and inflation in an international context. A coherent macroeconomic theory will provide consistent insights into how each of these aggregates are determined and change.

       
      This strikes me as missing the central motivation of macroeconomics. (It is possible that I just don’t understand the degree to which macroeconomics intentionally limits itself.) I would think:
       
      Macroeconomics is the study of the economic context in which individual actors operate: it is learning about the forest, while microeconomics investigates the trees. When examining a tree, one needs to know some things about the environment the forest provides, but there is no need to think about the insignificant degree to which that one tree changes the forest. The forest, however, affects its trees and they, in the aggregate, not only affect the forest but in fact are the forest.
       
      The challenge of macroeconomics—not fully met by any methodology yet devised—is to effectively describe and analyze the complex system by which the economic environment constrains and prompts the behavior of individual actors, while the aggregate effects of those behaviors, together with external factors such as natural resources and government policies, generate that same environment.
       
      Frequently macroeconomists concern themselves with specific measures of aggregates such as employment, national product and inflation. These are important ways of reducing complexity to make analysis possible; but it should always be remembered that the real subject at hand is understanding the economic environment that surrounds the individuals, households and businesses of a nation, and what happens as a result.

    13. joebhed says:

      I think the question should be:

      What is monetary economics?

      esp. What is modern monetary economics?

      For the beginning

    14. Dan Kervick says:

      Buying a foreign currency does not commit the buyer to any future payments in that currency, so it’s not the same as becoming indebted in that currency.

    15. Cameron Murray says:

      You say…
      “The current account deficit (the so-called external sector account) is another leakage that drains domestic demand. That is the domestic economy is spending more overseas than foreigners are spending in the domestic economy”

      Well, that is true for goods, but is balanced by the capital account. It means that we buy more goods and services from foreigners, but they buy more assets from us. Not sure if this is the place to mention it, or whether it is covered in more detail later.

    16. Philip Pilkington says:

      There are a good few typos in the above. But I’m sure you’ll iron them out in the next draft.

      I think you should consider getting about ten copies of this when it comes out and sending it to key people in the media. For example, I hear Martin Wolf at the Financial Times is sympathetic to the MMT point-of-view. There’s a few others I can think of. You also want to hit reviewers in papers like the FT, the NYT, the Washington Post, The Economist (last two have already ran MMT articles, so that’s a plus), the LRB, the Guardian and so on. If you do this right and get the books out to all the right people in one go you could cause a bit of a media sensation…

    17. Tom Hickey says:

      Coises wrote: Frequently macroeconomists concern themselves with specific measures of aggregates such as employment, national product and inflation. These are important ways of reducing complexity to make analysis possible; but it should always be remembered that the real subject at hand is understanding the economic environment that surrounds the individuals, households and businesses of a nation, and what happens as a result.

      An ideal macroeconomic explanation would involve a formalized model as a set of equations that accounts for multi-variable inputs (factors) in terms of functions yielding output information that allows prediction of real world events with precision, enabling testing of hypotheses. The economists with whom I am familiar that have a superior understanding of mathematics, having earned degrees in math or physics before entering economics, say to a person that such a model has never been undertaken seriously, and that the math of present econometric models is far too limited for the task. So such models describe assumed worlds that are not representational enough of the real world to be sufficiently predictive to achieve any degree of precision. The result is that the models not only result in predictions that are disconfirmed by events, even a mammoth events like the GFC, which was thought not be possible or of extremely low probability, but also they are used in policy formulation that fails, resulting in real world damage. like the GFC. MMT economists and others (Wynne Godley) did foresee the potential for crisis building early one using SFC sectoral balance modeling and cautioned about it..

      So the question for this idealized concept of macro is who is going to write those complex equations and what might they look like? At this stage this is asking for a level of precision that humans have not yet achieved in the social sciences, which have to deal with reflexivity and other factors resulting in uncertainty, quite unlike hard science that deal only with data that is subject to quantification and observation in terms of changes in space-time/mass-energy, where ergodicity prevails at least at the classical level. Not that we can’t do better, but economics is not likely to approach the precision of physics anytime soon.

      The social sciences, including economics, are non-ergodic. Solutions in this case are limited to describing underlying structures of a system, or probabilistically based on processing a huge amount of data. MMT chooses to investigate the underlying structure of modern economic system from a particular angle that is selected for the reasons Bill summarizes above.

    18. rsj says:

      Hi Bill,

      I am looking forward to this book. Would you consider making a pdf version available at a lower cost than the hardback? It would be useful to many people.

      The social sciences, including economics, are non-ergodic. Solutions in this case are limited to describing underlying structures of a system, or probabilistically based on processing a huge amount of data. MMT chooses to investigate the underlying structure of modern economic system from a particular angle that is selected for the reasons Bill summarizes above.

      I was also wondering whether your approach would include household preferences in its description of the underlying structural relationships, or whether you are sticking to operational relationships of the financial institutions. The PK macro literature can be a little overwhelming and fragmented to someone who doesn’t have a lot of time, so there would be a lot of value in single book that gives a coherent presentation of heterodox views.

    19. RonT says:

      James Schipper says:
      “I would like to add that the capital/output ratio is also an important indicator of efficiency. The higher it is, the lower the efficiency….However, Ruritania does it wqith a capital stock of 500 billion while Slobodia does it with a capital stock of 700 bilion, then Ruritania is more efficient.”

      I disagree: the capital stock can be created cost-free by the government, so it is not a burden in any way. If Slobodia uses more capital, maybe it is because its citizens like to sleep on money, so what? The government can deal with this “problem” with a push of a button and simply provide the capital they so much like. What counts is the real output and real consumption. Fiat currency allows the government to get money out of they way irrespective of saving/hoarding desires of the private sector and ensure full capacity utilization and maximal output.

    20. Richard Gay says:

      Doesn’t the demand price for labor by the government have a downward effect on the subsequent demand price for labor in the private sector once those jobs come available, assuming the government demand price is lower in order to motivate the employed buffer stock to re-enter the private workforce as soon as jobs are available?

    21. simon says:

      How´s the book coming and evolving? As point of enriching the economical debate around – would be glad to get it asap =)

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