CHAPTER 1

Introduction

Macroeconomics is the study of the economy as a whole as distinguished from microeconomics, which is the study of individual consumers, workers, firms, industries, and markets. Microeconomics focuses on the individual economic decision maker (or “agent”) without attempting to take into account the full range of interactions that take place between one decision maker and another. Thus, for example, a microeconomic study of an excise tax on the purchase of cigarettes would consider the effect of that tax on the demand for cigarettes but not attempt to account for the effects of that tax on the demand for watermelons and then its feedback effects on the demand for cigarettes.

Macroeconomics is, in essence, a study of feedback effects—of interactions between major economic sectors in response to extraneous events and changes in government policy. It’s just that when we do macroeconomics, we don’t focus on individual products like cigarettes or watermelons. We focus on major economic indicators such as gross domestic product, the capital stock, and the supply of goods and workers.

At the heart of the question of how these indicators behave is the question of how individual economic agents adjust their actions to changes in government policies and other events that influence their behavior. Even though macroeconomics considers the economy broken down into major sectors, it therefore can take—and here we do take—what is called a “microfoundations” approach to its study. Thus, in studying the labor sector, we first ask how the individual worker adjusts the amount of time he spends working to the reward he gets for working and how the individual saver adjusts his saving to the reward he gets for saving. Only after we understand how the individual adjusts his decision to work and save can we understand how the aggregate supply of labor and the aggregate supply of capital adjust to changes in the rewards for work and saving.

The purpose of any economic system is to provide a mechanism through which buyers and sellers can coordinate their activities to their advantage and in such a way as to exploit as many opportunities as possible for mutual gain. For the most part, and throughout the developed world, it is the marketplace that determines the economic activities of buyers and sellers. There is, to be sure, a great deal of direction that comes from government as well. Every country has a government that engages in its own transactions and imposes taxes to finance those transactions. And in some countries with mostly free economies these transactions account for a large fraction of economic activity. But most of the transactions that take place around the world come about as a result of voluntary exchanges between buyers and sellers. The microfoundations of macroeconomics lie in the decisions taken by individual economic actors to work and save and, at the firm level, to hire labor and engage in capital spending.

This book is divided into two volumes. Both volumes incorporate the familiar economic concept of supply and demand. The difference lies in the separation of the tools of supply and demand for the analysis of two, rather distinct, phenomena: (1) decisions by individuals to supply the services of labor and capital and by firms to employ those services in production and (2) the supply and demand for goods and labor, as impacted by government’s monetary and fiscal policy.

Volume I focuses on the first phenomenon: the services of labor and capital as supplied by, and as demanded by, individual economic agents. It provides a framework for understanding the effects of taxes and government spending on individual choices and, through those choices, the aggregate economy. Volume II focuses on the process by which the market system equilibrates the supply and demand for goods and labor and of how government uses monetary and fiscal policy to correct such failures that might occur in that process. It also examines the recent history of U.S. monetary and fiscal policy for their effects on the economy, both during the Great Contraction of 2007 to 2009 and during its aftermath.

The possibility of a major economic downturn such as the Great Contraction has traditionally remained the principal concern of macroeconomists. Indeed, macroeconomics as a field of study came into being from a book called The General Theory of Employment, Interest, and Money, written by John Maynard Keynes in 1936, which was motivated by Keynes’s interest in how the economic system broke down and deteriorated into a worldwide depression (Keynes 1936).

Keynes did not use the term “macroeconomics”; it was coined later.¹ But he did set the stage for a theory of the economy in which wage and price adjustments that normally keep the economy at “full employment” (a term on which we elaborate in the following) fail and, having failed, leave the economy in a state that calls for government intervention in the form of expansive monetary and fiscal policy. Government policies aimed at correcting for the failure of an economic system to achieve full employment are frequently referred to as “stabilization policies,” connoting the idea that it is the job of government to stabilize the economy at a level that brings about full employment without inflation.

Macroeconomics, as presented in most textbooks, is still seen in the spirit of Keynes’s book, primarily focused on whether and how government can use monetary and fiscal policy to keep the unemployment rate below some threshold level, say, 5 percent. If the unemployment rate rises above this level, then, according to standard macroeconomic theory, the government should carry out expansive policies that will increase aggregate demand. The goal of stabilization policy, according to most macroeconomists, is to bring about and maintain “full employment,” while, at the same time, keeping the rate of inflation low (say, around 2 percent). It’s a matter of juggling policy tools to keep aggregate demand at the right level.

The purpose of this book is to show that this view of the macroeconomic problem is dangerously (for the economy) oversimplified. The economic problem, if there is one, can lie on the supply side of the economy, as well as on the demand side. One “supply-side” problem can arise from distortions in the markets for labor and capital that pull down the level of potential, full-employment output. “Supply-side” economics, as traditionally defined, is about removing these distortions with the aim of increasing output. But another supply-side problem can arise as well. This problem arises from maladjustments in prices and wages that keep aggregate supply below aggregate demand. Economists refer to this much-neglected phenomenon as “suppressed inflation”—the failure of prices and wages to rise in tandem with a rise in aggregate demand and for firms and workers, as a result, to withhold their products and services from the marketplace.

There are therefore two supply-side problems that can lead to suboptimal performance by the economy: one that arises from distortions in the individual markets for labor and capital and another that arises because of a misalignment between aggregate supply and demand. This requires the economist to compartmentalize his analysis of the macroeconomy. This book attempts to do just that by focusing on distortions (for example, taxes) that negatively affect the flow of labor and capital services into production in Volume I and by focusing on distortions between aggregate supply and demand in Volume II.

One way to simplify matters is to identify a single macroeconomic indicator whose behavior is taken to represent the performance of the overall economy. Here that indicator is “real” (that is, inflation adjusted) gross domestic product (GDP). Real GDP is a measure of the goods and services produced within a geographic unit (here, the United States) in a year’s time. This book focuses on the conditions that determine the level of real GDP and on how government measures—or the absence of appropriate government measures—can negatively affect real GDP.

One important concept based on this measure is “potential” or “full-employment” real GDP, which refers to real GDP when aggregate supply is aligned with aggregate demand. We think of this also as GDP when there is full employment, or, more precisely, when the unemployment rate is low enough so that, for all practical purposes, everyone who wants a job has a job.

There are, to be sure, other measures of economic performance. Another, probably superior but less utilized, measure is real GDP per person. Another is real consumption per person. We will consider these alternative measures in due course as we work through the analysis. But we can make our lives easier by thinking of the macroeconomic problem as one of maintaining a high rate of growth of real GDP, given that the quality of economic life is not just about production (and consumption) but also about smelling the roses or, as we will view it, the ability of economic agents to enjoy leisure.

Another simplifying technique is to separate macroeconomics into a short-run and long-run problem. The underlying idea is that, in the long run, the economy gravitates toward full employment, whereas, in the short run it may not. Keynes criticized what he called “classical” economics for not allowing for this difference. As Keynes saw it, an imbalance between aggregate supply and demand might be self-correcting, as classical economics argued, but sometimes it will not (as witnessed in the severity and length of the Great Depression).

When defenders of the classical tradition claimed that imbalances between aggregate supply and demand would be self-correcting, at least in the long run, Keynes famously answered that “in the long run we are all dead.” Keynes saw himself as the originator of a new school of economic thought that would force the profession (and politicians) to understand that the “short run” could become very long indeed.

This book sees a distinction between self-correcting and protracted imbalances between aggregate supply and demand. Self-correcting imbalances do not require government intervention through monetary and fiscal policy to bring aggregate supply and demand back into line with each other. Protracted imbalances do.

For some three decades after its publication, Keynes’s General Theory remained the bedrock of macroeconomics. The working assumption was that policy makers should keep a steady eye on economic indicators like real GDP and the unemployment rate and stand ready to deploy the weapons available to them at any moment to prevent production and employment from falling, while at the same time, keeping an eye on the inflation rate.

Beginning in the late 1960s, however, a counterrevolution was launched that challenged Keynes’s ideas. This counterrevolution spawned a “new classical” economics, which argued that Keynes’s remedies for a failing economy were likely to be ineffectual and unnecessary. Imbalances would correct themselves, and Keynes’s policy tools were likely to be ineffective anyway. This school of thought succeeded in stripping Keynes of much of his intellectual authority, at least until the downturn that began in December 2007. It is safe to say that, until that downturn, the exponents of the new classical economics and their allies from various sub-branches of that line of thinking were carrying the day.

I will state upfront that I subscribe to this new classical school, insofar as I think that it has much to say about improving economic performance, especially through tax and welfare reform. Thus, Volume I of this book is focused on explicating the “new classical” world, in which the economy is performing normally (which is to say, it hasn’t broken down owing to imbalances between aggregate supply and aggregate demand) and will respond positively to policy reforms that incentivize people to work and save. Volume II considers policies that are appropriate for correcting protracted periods of low employment and reviews the policies adopted over the span of the recent Great Contraction.

Keynes’s core idea was that a sudden, unanticipated fall in the demand for goods could create a state of affairs in which the economy would sink into a long-lasting slump. This fall in demand could come from various sources. The fact that the U.S. money supply shrank by nearly one-third during the Great Depression no doubt helps explain its depth and length. If a downturn occurs because of a fall in aggregate demand, a housing crisis or a related financial crisis, or any other such cause or combination of causes, then the obvious remedy is for government to increase demand through expansive monetary and fiscal policy.

This line of thinking, though presumably invalidated by the new classical economics, sprang phoenix-like from the ashes when the Great Contraction got under way in late 2007. In reality, Keynesian thinking had remained—and remains today—alive and well in the deliberations of the Federal Reserve Open Market Committee, where Federal Reserve officials preside over monetary policy. The architects of the new classical economics—economists such as Robert Barro, Robert Lucas, and Thomas Sargent—had won all the battles but never quite won the war against what they saw as Keynesian dogma.

The new classical economists argued that expansive monetary and fiscal policies will fail in their purpose, since, once those policies are known to have been implemented, individual economic agents will adjust their behavior in such a way as to defeat the purpose for which the policies were implemented. A collateral proposition is that the government should focus its attention not on the demand side but on the supply side of the economy, where, by reducing distortions in economic activity, particularly in the form of taxes, it can improve the performance of the economy. From this point of view sprang the practice of “supply-side economics.”

The recognized way of putting the distinction between Keynesian and new classical thinking is to recognize two states in which the economy can find itself. In one state—the classical state—markets clear through appropriate price and wage adjustments, and government can improve economic performance only through the elimination of distortions in individual markets for goods and for labor and capital. (In Volume I, I give a lot of attention to that state.) The other state—the Keynesian state—represents a state in which price and wage rigidities prevent markets from clearing and cause the economy to contract in response to a fall in the demand for goods and labor. The trick is to recognize which state the economy is in and to apply the appropriate remedies. For some economists, it is a matter of distinguishing the short run from the long run.

In an article entitled, “The Economy Needs More Spending Now,” economist Alan S. Blinder offered his own characterization of the short-run/long-run distinction (Blinder 2013). “Poor economic policy,” he argued, stems, among other things, from “the failure to distinguish between the short-run and the long-run effects of particular policies.”

“In the short-run,” said Blinder,

The long run, however, is different. “In the long run,…a larger accumulated public debt probably spells higher interest rates, which deter some private investment spending. Economies that invest less grow less” (Blinder 2013).

The problem is that Blinder fails to recognize that interest rates can rise in both a short-run and a long-run scenario involving increased government spending. In the short run, deficits brought about by increased spending can increase interest rates because of the increase in output that they bring about and because of the resulting increase in the demand for money. (We recognize this line of thought in Chapter 3 of Volume II of this book.) In the long run, it is a temporary rise in government spending, which may or may not take place in tandem with a rise in the deficit, that can cause interest rates to rise. (We address this possibility in Chapter 2 of Volume II.)

Blinder’s short-run problem arises when the supply of goods and labor exceeds demand: The quantity of labor services demanded by firms is less than the quantity workers want to provide, and the quantity of goods demanded by consumers is less than the quantity firms want to provide.

What Blinder ignores is an equally plausible short-run problem that arises when demand exceeds supply. The economy can suffer a downturn in production and employment because workers offer fewer labor services than firms want to hire and because firms offer fewer goods than consumers want to buy. Chapter 3 of Volume II will show how both scenarios— generalized excess supply and generalized excess demand—are consistent with short-run economic contraction.

Keynesians emphasize the scenario in which supply exceeds demand. That is why Blinder characterizes short-run unemployment as a “demand-side” problem: If the economy is suffering from low employment and production, it must be because aggregate demand is “too low” relative to aggregate supply, requiring a cure in the form of government policies, for example, deficits that will boost aggregate demand.

An alternative view that emerged in the 1950s and then gathered steam in the 1970s observed that it is equally likely that aggregate demand could exceed aggregate supply, so that the appropriate policy response would be to reduce aggregate demand through, for example, government surpluses (Barro and Grossman 1974). This is often referred to as a case of “suppressed inflation,” a name that comes from wartime experiences with price controls. As we go forward, we will see that the same phenomenon can result, not from price controls, but from a failure of the economy to generate wage and price increases needed to keep aggregate supply in line with aggregate demand.

Volume II shows how a suppressed inflation scenario could develop because of failure on the part of employers to raise wages in line with rising prices and from other factors that prevent wages from rising in tandem with prices as aggregate demand rises.

Once we admit the possibility of suppressed inflation, we have to consider the fact that a protracted downturn could be the result of too much, rather than too little, aggregate demand. There can be subnormal production and employment if either aggregate supply exceeds aggregate demand (as in the Keynesian scenario) or if aggregate demand exceeds aggregate supply (as in the suppressed inflation scenario).

A Revised View of the Long Run

This book focuses on macroeconomic policy and therefore gives attention both to policies that are effective in long-run “normal” times and to policies that are needed in short-run “abnormal” times. From the foregoing discussion it is clear that in order to conduct this inquiry, it will be necessary to distinguish between two very different “supply-side” problems. One stems from policies that prevent firms from using “inputs more efficiently” and the other from a supply shortfall brought about by the maladjustment of prices and wages.

When there is a failure of prices and wages to adjust and therefore a protracted downturn in the economy, there is a case for “nonclassical” solutions in the form of expansive or contractive monetary and fiscal policy, whichever may be called for. Then the need will be for a correct diagnosis of the problem (too little demand or too little supply) and the application of the appropriate remedies.

By looking at the problem in this manner, we undertake a radical departure from conventional books on macroeconomics. Macroeconomists traditionally take the approach adopted by Blinder in his 2003 Wall Street Journal article. In that approach there is only one diagnosis to perform, which is to answer the question whether the moment is right for a short-run or long-run remedies.

This book approaches the problem differently. We first (in Volume I) examine the economy under new classical assumptions (which is to say, in the long run) and consider the policies that cause distortions in the markets for labor and capital. We next (in Volume II) consider the possibility of a protracted downturn and whether nonclassical remedies in the form of expansive or contractive monetary and fiscal policy are called for.

In order to avoid terminological confusion, the book will recognize a distinction between two kinds of economic subperformance: (1) short-run (though, possibly protracted) subperformance brought about by imbalances between aggregate supply and demand and (2) long-run subperformance brought about distortions in the markets for labor and capital. In discussing the first kind of subperformance, we will distinguish between imbalances attributable to excess aggregate supply (the Keynesian scenario) and imbalances attributable to excess aggregate demand (the suppressed inflation scenario).

The Great Contraction of 2007 to 2009 appears to have resulted from a Keynesian-type reduction in aggregate demand. In Volume II, Chapter 5, we see evidence that the weakness of the ensuing recovery may be attributable to a failure on the part of government to adopt a sufficiently expansive policy response. Yet, the evidence is not unambiguous. Given the distortions in the price system created by safety-net measures that were implemented concurrently with the downturn, it is likely that the eagerness of government to cushion the effects of the downturn contributed to its severity. These competing explanations exemplify the difficulty policy makers encounter in their efforts to hit upon the correct response to an economic downturn.

The Purpose of This Book

In two opinion columns in the Wall Street Journal, published over the period December 2017 to January 2018, Alan Blinder unwittingly provided an example of why current-day macroeconomics does not provide a cogent guide to macroeconomic policy. President Trump had signed the Tax Cuts and Jobs Act on December 20, 2017. The Act provided for steep reductions in business taxes, along with some, more modest, reductions in individual taxes. It also, according to government forecasts, could be expected to add $1.7 trillion to the federal deficit over the next 10 years (Hall 2017).

“Dec. 2017,” wrote Blinder in his December 2017 article, “should go down in political history as a day of infamy or absurdity, probably both.” Besides being highly regressive, said Blinder, the tax cuts mandated by the Act, “blow a large hole in the federal budget,” a feature of the Act that should worry “most Americans” (Blinder 2017).

After several readers pointed out the apparent inconsistency between this argument and Blinder’s 2003 article advocating federal deficits, Blinder published another column just a month later, defending his complaints about the Tax Cuts Act. The explanation, he said, lay in the difference between running deficits in a depressed economy (which characterized the U.S. economy during the Obama years) and running deficits in an economy that is at full employment (which characterized the U.S. economy at the end of 2017). Deficits of the former kind, argued Blinder, do good. It is deficits of the latter kind that do harm (Blinder 2018). The problem, as Blinder saw it, was that, whereas the Obama deficits were the intended cure for the recession under way at the time, the deficits resulting from the Tax Cuts Act were the unwanted by-product of the Act.

Blinder’s arguments have a basis in economic theory. In later chapters, we will allow that there is an argument for deficits in times of economic contraction. But Blinder attempts to deceive the reader when he says that 2017 was the “wrong time” to increase the deficit. The purpose of the Act was to expand investment, not increase the deficit. That it also increases the deficit is collateral damage. Arguably, 2017 was the perfect time to increase the deficit if doing so was the price that had to be paid in order to cut taxes on business profits.

In Volume II, Chapter 2, we show that, in the long run, it is temporary increases in government spending, not deficits, that drive up interest rates in the long run. It is true that there is a growing risk of future U.S. deficits becoming unsustainable. A budget deal, put together by Republican and Democratic members of Congress in February 2018, could, according to one estimate, add another $1.7 trillion to the U.S. debt over the next 10 years—that, on top of the $1.7 trillion to be added by the Tax Cuts and Jobs Act. The 2018 addition to the debt was the price that the country had to pay in order to avoid a government shutdown.

The question is how it is possible to forge a coherent macroeconomic policy in the face of such cross-currents in economic policy advice. The country began the first year of the Trump administration with the economy still experiencing abnormally slow growth. Long before Trump took office, there was bipartisan agreement on the need for corporate tax reform. A fiscal commission, established by President Obama, issued a report in 2010 in which it wrote as follows:

The question for Blinder and other critics is just how the 2017 legislation could have been written to satisfy their concerns about deficits but also to provide a needed reduction in corporate taxes. Any cut in tax rates would have resulted in a loss of revenue, meaning that any cut, by Blinder’s logic, should have been made in tandem with cuts in spending. It would be useful to know whether Blinder would have been willing to accept cuts in entitlement spending as a price worth paying to reduce business taxes.

Organization of the Book

First, a word of warning. This book is not going to be useful if the reader is unwilling to wade through some math and graphics. It is intended to be accessible to anyone who can remember his high-school algebra. Such calculus as there is appears in an appendix and in footnotes. Yet, the book is not light reading for train or air travel. Better, perhaps, to enjoy the movie than to tackle this book in a short flight. I hope, of course, that many readers will not be deterred and will wade through to the end.

Why all the math? The reason is that, without the math, the reader will, to be blunt, continue to be vulnerable to the great amount of folklore that continues to misinform just about everyone’s understanding of the topic. The math notwithstanding, the book can serve as a principal or supplementary text for Intermediate and Master’s level courses in macroeconomics.

The book is an update and expansion of the book that came out under the same title in 2015. This edition adds new chapters on government spending and on monetary and fiscal policy. It works through deficit spending in more detail. It traces the economy from the end of the Great Contraction to the present day. There is also new coverage of growth topics such as Robert Gordon’s Rise and Fall of American Growth, Piketty’s Capital in the Twenty-First Century, and Lawrence Summer’s take on secular stagnation. Much of original microfoundations material is unchanged.

Volume I is mostly about microfoundations, which is to say the individual choice calculus from which macroeconomic activity emerges. That volume first works through the principal accounting relations that describe the macroeconomy (Chapter 2). It then takes on three topic areas: individual choices to work and save (Chapters 3 to 4), the supply and demand for labor and capital (Chapter 5), and economic growth (Chapter 6). It concludes by describing how taxes and government spending affect individual choices to work, save, and invest (Chapters 7 and 8).

Chapters 3 and 4 of Volume I lay out what might be considered the book’s core theory. Chapter 3 lays out a two-period model in which the individual must solve two problems: how to divide his current time between leisure and work and how to divide his current income between consumption and saving. Chapter 4 elaborates on the second problem by generalizing the individual’s choice calculus to incorporate a planning horizon of any length. Chapter 5 extends the analysis of Chapters 3 and 4 to model the supply and demand for labor and capital as the aggregation of individuals’ choices. There we work out the conditions under which the suppliers of capital (savers) are coordinated with investors to bring about an equilibrium capital stock. Likewise, we work out the conditions under which workers are coordinated with employers to bring about an equilibrium level of employment.

Volume II is more along the lines of traditional macroeconomics. It starts out by delineating the two principal policy instruments available to the federal government for correcting sustained contractions of the macroeconomy: monetary policy (Chapter 1) and fiscal policy (Chapter 2). It then proceeds to identify the conditions under which the government can apply these two policy instruments in order to restore the economy to full employment (Chapters 3 and 4).

Chapter 3 shows how the failure of wages and prices to adjust to changing economic conditions can lead to either a brief or a protracted spell of low employment. It first examines the conditions under which the classical assumptions of Volume I apply, which is to say, conditions necessary for there to be equality between aggregate supply and demand. It then divides the analysis of inequality between aggregate supply and demand into two possibilities: self-correcting inequalities and inequalities that will be long lasting in the absence of corrective government policies. In addressing self-correcting inequalities, it considers instances in which an inequality stems from myopia on the part of workers, who temporarily misinterpret changes in aggregate demand as changes in localized demand. We then consider instances in which employers suffer from their own kind of myopia, which causes them, similarly, to misinterpret changes in aggregate demand as changes in localized demand.

In Chapter 3 we next consider the possibility of protracted spells of low employment brought about by maladjustments in wages and prices in response to changes in aggregate demand. We ask how government can apply monetary and fiscal policy to the correction of the resulting contraction in economic activity.

Chapter 4 extends the analysis to consider the problem government faces in diagnosing a fall in employment for its root cause. We consider the consequences of a misdiagnosis of a spell in which real GDP falls below potential real GDP.

Chapter 5 takes up the Great Contraction of 2007 to 2009. It shows how the policy response to that recession was arguably misguided.

Chapter 6 ties both volumes together to show what I have tried to explain about the drivers of the macroeconomy and about the government policies that can alleviate an economic downturn. I find much to criticize in the Federal Reserve’s policy of targeting interest rates in carrying an expansionary policy regimen.

It is hoped that the reader of this book will come away from it with a solid understanding of the foundations of macroeconomic analysis and, from that understanding, acquire a more sophisticated appreciation of the role of monetary and fiscal policy in macroeconomic policy analysis. It is also hoped that he or she will gain an understanding of how economic systems can slump into a protracted downturn and how, in forging the appropriate policy response to that downturn, it is important to diagnose the cause correctly.

The book offers, as the title suggests, an integrative approach to its subject. Ever since Keynes, there has been tension between Keynesian and the pre-Keynesian classical elements of macroeconomic theory. The goal here is to integrate these elements into a more internally consistent approach to the subject matter. More specifically, the goal is to integrate the short-run and the long-run elements of macroeconomic activity and policy, so as to avoid the approach common to other books, which is to take the reader through a series of alternative, disjointed models that leave the reader puzzled about which model works best.

This is not at all to say that I have been able to create a window to the world through which all macroeconomic reality can be seen clearly. On the contrary, I close with the warning that the evidence may point to many, equally plausible explanations of economic activity and as many plausible government policy options. I can only hope that, with this book, I have provided a path toward a better understanding of those options.

¹ According to macroeconomist Kevin Hoover, the first person to use the term “macroeconomics” was Ragnar Frisch, the Norwegian economist (and future Nobel laureate), in a lecture given in 1931 (Hoover 2008a, p. 332).