Macroeconomics

The study of the aggregate economy

What is Macroeconomics?

Macroeconomics refers to the study of the overall performance of the economy. While microeconomics studies how individual people make decisions, macroeconomics deals with the overall aggregate effect of microeconomics. Macroeconomics is crucial for the government to understand and predict the long-term consequences of their decisions.

 

Macroeconomics

 

Summary

  • Macroeconomics refers to the study of the aggregate economy.
  • The primary goals of macroeconomics are to achieve stable economic growth and maximize the standard of living.
  • Economic indicators are a good source of information to track macroeconomic performance.
  • Monetary policy and fiscal policy are tools used by the government to control economic performance and reach macroeconomic goals.

 

Goals of Macroeconomics

The overarching goals of macroeconomics are to maximize the standard of living and achieve stable economic growth. The goals are supported by objectives such as minimizing unemployment, increasing productivity, controlling inflation, and more. The macroeconomy of a country is affected by many forces, and as such, economic indicators are invaluable to assessing different aspects of performance.

 

Economic Indicators

 

1. Gross Domestic Product (GDP)

Often used as the primary indicator of macroeconomics, absolute GDP represents the economy’s size at a point in time. GDP is usually calculated and released by the government on a quarterly or annual basis.

 

Economic Indicator - Gross Domestic Product (GDP)

 

As a rule of thumb, spending stimulates growth. Individual consumer consumption drives businesses, business investments promote growth, and government spending maintains social welfare. Net exports, as calculated by (exports – imports), measures trade. Positive net exports represent a trade surplus, while negative net exports represent a trade deficit.

Economic growth can be calculated by comparing GDP over time, such as year-over-year increases.

 

2. Inflation

Inflation is the increase of overall price levels and consequently the decrease in purchasing power. It occurs primarily due to increased demand for products and services, which, in turn, raises prices. Inflation, therefore, represents growth.

However, too much inflation is also harmful if purchasing power decreases much more than inflated prices, decreasing overall spending and devaluing the currency. The target inflation rate is usually around 1% to 3%.

 

3. Unemployment

Unemployment accounts for individuals who are jobless and are actively seeking one. Individuals who are retired or disabled are not included as unemployed. Unemployment is a natural occurrence and cannot be completely eliminated. We can distinguish unemployment into different categories:

 

Economic Indicator - Unemployment

 

  • Frictional unemployment occurs when individuals spend time searching for a job.
  • Structural unemployment occurs when jobs are eliminated due to economic structural changes.
  • Cyclical unemployment occurs due to fluctuations in the business cycle.

 

The sum of frictional and structural is called natural unemployment. It arises from everyday events, such as individuals changing jobs or industries shrinking from a decline in demand.

The sum of natural unemployment and cyclical unemployment represents the actual unemployment. Naturally, in recessions, employees are laid off, and in times of prosperity, employment rates skyrocket.

Since employment is directly related to economic output, it is a good indicator of economic conditions. Actual unemployment is useful to gauge the economy’s short-term conditions, while natural unemployment can identify trends in the long term.

 

4. Interest Rates

Interest rates are the return the borrower pays from lending. They are set by the central bank – the Federal Reserve in the U.S. and the Bank of Canada in Canada. Because interest rates influence consumer decisions, it is a very useful tool for influencing economic activity.

When interest rates are high, borrowing becomes more expensive, so consumers are incentivized to reduce spending. Conversely, when interest rates are low, it is cheaper to borrow, so consumers will be incentivized to spend more.

 

How Does the Government Influence the Macroeconomy?

 

Monetary Policy

Implemented by central banks, monetary policy is an action that influences money supply and interest rates. The central bank can set interest rate targets for direct results. Money supply also affects the interest rate, with increased supply usually lowering interest rates (negative correlation). As previously mentioned, interest rates influence consumer consumption and investment. There are two types of monetary policy:

 

1. Expansionary Monetary Policy

In times of economic slump, the government can encourage economic growth by implementing an expansionary monetary policy. They purchase securities from the open market and ease reserve requirements to increase the money supply, and on the other hand, lowering the interest rate target.

 

2. Contractionary Monetary Policy

In economic booms, high inflation rates in the long term can spell trouble by reducing purchasing power. To cool down inflation, the government can decrease the money supply and increase interest rates by selling securities on the open market, tightening reserve requirements, and increasing the interest rate target.

 

Fiscal Policy

The government implements fiscal policy through spending and taxes to guide the macroeconomy. Government spending influences job creation and infrastructure improvements, which, in turn, affects money in circulation. Taxes affect consumer disposable income. Fiscal policy is also segmented into two types:

 

1. Expansionary Fiscal Policy

To increase inflation, governments increase spending to increase money in circulation or cut taxes, so consumers have more money to spend.

 

2. Contractionary Fiscal Policy

To ease inflation, governments decrease spending to reduce money in circulation or increase taxes. As a result, money available for consumers to spend becomes less.

 

More Resources

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Cyclical Unemployment
  • Government Spending
  • Inflation Targeting
  • Disposable Income

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