Some Macroeconomic Points.
1. Gross domestic product (GDP) is the measure of the economy’s output of new, final, goods and services over a given time period—typically a year. Gross Domestic product means that this is the output of businesses located within the United States.
2. The output measured by GDP must be new output, not simply a reselling of existing goods. Garage sales, for example, would not be included in GDP even if the government could measure them because they involve almost totally sales of existing goods. The sales of second hand stores are largely not included in GDP, though the “value added” by the second hand store (wages and salaries paid, for example) are included. The electric bill paid by the second hand store is part of GDP, but it’s counted as part of the value added by the electric industry.
3. Output measured by GDP needs to be final goods and services. The output of the tire industry is only, in part, final goods. Much of the output goes to automobile companies who buy tires to put on their new cars and trucks. The value of these tires is captured in the price of the new cars. Were we to count the entire output of the tire industry directly into GDP, we could double count the tires that went on new cars because their value is included in the price of the new cars and trucks. So, we include final goods only to avoid double counting.
4. The actual method of “adding up” GDP avoids the final goods distinction altogether. It does this because, while the idea of “final goods” is intuitively appealing, there are actually no goods that are always final goods. So, in order to avoid the impossible task of determining how much of each industry’s output is “final”, we turn to the concept of value added. Each firm adds value to the raw materials it purchases. This added value is represented by the firm’s activities such as assembly, machining, decorating, marketing and what not. If we subtract the cost of the materials purchased by a firm from the value of the output it produces, we have a measure of the value added by the firm. The difference between sales price and purchases is pretty much wages, salaries and profits. This is not surprising, because the value added represents the efforts of those employed or working in the firm so it’s logical that the rewards to labor, management and owners (wages, salaries and profits) should equal the dollar amount of value added.
5. What we earn reflects what we make, and visa-versa. In other words, all of our incomes derive from our productive activities, and the things we make are precisely equal in value to the sum of all of our incomes.
This suggests that we are able to purchase all we collectively produce, but only if we spend all of our incomes to do so. So, when people argue that we can’t buy all we make, they are fundamentally wrong. We can. One important question is “will we buy all we make?” There are three possibilities:
A. We buy up precisely all what we produce. In this case, everyone’s expectations are met. The various businesses sell all they intended to produce with no excess left over or unmet orders waiting to be filled. Because business’ expectations are met, they do not change their production levels, and output and employment remains stable. Note that output and employment may not be at the level we want while acting stable, but at least they have no immediate tendency to change.
B. We buy less than what we produce. In this instance, business expectations are frustrated. Businesses find that goods are piling up, unwanted and unintended inventories are growing. Businesses will cut back production in response to this shortfall of demand, and output and employment will fall. This is not at stable GDP condition, instead, it portends recession.
C. We buy more than we produce. In this case, sales are running ahead of business expectations. Business will expand output and employment to meet the unanticipated demand. Inventories will shrink without businesses having intended that they should. Incomes and employment will rise. We are experiencing “boom” conditions, and will encounter increased inflation as the physical limit of the current economy to increase production is neared.
6. Classical economists argued that we would always buy up all that was produced. This, they argued, could occur because households have enough income to purchase everything that is produced. One might object that households don’t spend all they earn, and thus (because they must spend all they earn to buy up all that’s produced) something will not be purchased. There will be, in other words, a shortage of consumption due to household savings. The classical economist would reply that it’s a good thing that people don’t spend all they earn, that, in effect, they save part of it. This is because a healthy economy needs to buy other things than consumer goods. We need new investment, new tools that is. Part of the economy’s output must be directed to this end, and in a market economy, it is business that buys and installs the new tools or “capital”. To accomplish this, businesses need to invest. Businesses get investment funds in two ways, either they re-invest profits or they borrow money (I’m ignoring the option of selling shares of stock, just for convenience). The money that business borrows for investment comes from household savings. We’re there to be no household savings there probably would not be enough investment to maintain the capital (tool) stock. If there is too much household savings for investment to borrow up, total spending will not be sufficient to buy up all that businesses intend to produce. The question then is, will there be enough investment to soak up household savings?
The answer, the classical economists said, lies in the effect of the interest rate.
The level of household savings responds positively to (increases with increases in) the interest rate. Investment, on the other hand, responds inversely to (decreases with increases in) the interest rate. If there is too much saving for the current level of investment, there will be an excess of funds to borrow and interest rates will fall (due to the excess supply of savings) and as this happens, a. savings will decrease in response to lower interest rates and, b. investment will rise as a result of reduced borrowing costs (interest). As savings fall and investment rises, we will inevitably come to rest at an interest rate that simply balances the amount businesses wish to invest (borrow) with the amount households wish to save. See if you can explain what happens if there are too few savings to meet investment needs.
7. If, as classical economists suggest, savings and investment are always held equal by the action of the interest rate, then the economy will always be in a situation where everything made is sold. Charming, but what about employment? Could the economy find itself buying all that’s produced with, say, a 25% level of unemployment? The classical economists would say no. Flexible wages and prices will assure that any unemployment is quickly ended. If people find themselves unemployed, they will soon adjust their wage requests to a level such as allows them to be hired. If someone chooses to ask too much in wages to secure employment, that person is voluntarily unemployed, and not part of the labor force. So, peoples’ willingness to price themselves cheap enough to find work will, from the classical perspective, make quick work of unemployment. The economy will tend, always, to be at full employment with all of the output being purchased. An interesting argument, but the existence of depressions makes it an unsatisfying one.
8. Given that we have experience a fairly constant cyclical movement in economic activity (recession, boom, inflation, etc.) we need to understand what elements of the classical argument might be wrong. There are two essential problems. First, the interest rate is probably inadequate to govern savings and investment sufficiently to assure their equality; and second, wages and prices are not particularly flexible. They change, but do so slowly—particularly in the downward direction.
Household savings tend not to be interest rate driven. Rather, people save based on what they feel they can afford to set aside, given all the considerations at hand. The interest rate plays, on average, a fairly small role in this decision. Indeed, if folks are saving for a particular goal (a trip, home down payment, etc.) they may save less at higher interests rates simply because the higher rate allows them to achieve their goal (or target—to use the economists’ phrase) with less actual outlay.
Wages and prices fall only reluctantly, given that they represent people economic hopes, intentions and dreams. Only after serious economic “buffeting” do people drop the price of the goods their selling, the asking price for their home, or the payment to their work—their livelihood. Depressions and unemployment are the means by which prices and wages are driven downward to levels where it is profitable to expand output and production once more. Left alone, an economy moves out of depressions through a fall in price levels and gradual restoration of business and consumer confidence. Prices do not change “quickly” as the classical economists thought, particularly downward. They fall slowly and painfully, and the process accompanying the fall we call a “depression” with all the unemployment it suggests.