Capstone: Macroeconomics in Practice

This is Unit Eighteen of Principles of Macroeconomics, part two of three. Part one reduced the course to seven models and gave you the rule for choosing among them. This part is about the distinctions that run through all seven, and the technique for working whatever the question actually puts in front of you. Carry one idea through. A handful of distinctions decide more questions than the models do, and the errors they catch are procedural rather than conceptual: comparing two money figures from different years, shifting a curve that should have been moved along, and inverting the one arithmetic operation this course inverts most often. None of those is a failure to understand economics. Each is a failure to do a step. By the end you will deflate a series and compute a growth rate that means something, decide whether an event moves along a curve or shifts it in any market, convert between total and per capita growth, diagnose which goal an economy is failing, and recognise which relationship a numerical question is using.

Three entries on the distinction under every measurement in the course, and on doing the adjustment it requires.

The first distinction.

MAC 1718 Real Against Nominal

A nominal figure is measured in the prices of its own year. A real figure is adjusted so that quantities from different years can be compared. Every macroeconomic series comes in both forms. Unit six applied it to interest rates, unit three to output, unit fourteen to budgets. Comparing two nominal figures from different years measures prices and quantities at once.

Doing the adjustment.

MAC 1719 Deflating a Series

Convert a nominal figure to real terms, then compute a growth rate that means something. Divide the nominal figure by the price index for its year and multiply by a hundred. Do it for both years before comparing them, and never compare a real figure with a nominal one. An economy produces twenty thousand in year one, when the price index is a hundred, and twenty-six thousand in year two, when the index is a hundred and twenty-five. Year one's real output is twenty thousand. Year two's real output is twenty-six thousand divided by a hundred and twenty-five, times a hundred, which is twenty thousand eight hundred. So nominal output rose thirty percent while real output rose four percent, and the remaining twenty-six percentage points were prices rather than goods. The gap between thirty and four is the whole reason the distinction exists. A question reporting that output rose thirty percent while prices rose twenty-five percent is not describing a boom; it is describing an economy that grew about four percent.

A pair that behaves the same way.

MAC 1720 Stock Against Flow

A flow is measured over a period; a stock is measured at a moment. Income, output, saving and the deficit are flows. Wealth, money, capital and the debt are stocks. The deficit is one year's gap; the debt is the accumulation of all of them. A falling flow still adds to the stock, which is why a smaller deficit raises the debt.

Two entries on the distinction that decides more exam questions than any other in the course.

The one test.

MAC 1721 Movement Along Against a Shift

A change in the variable on the axis moves you along a curve. A change in anything else moves the curve. This one distinction decides more exam questions than any other in the course, and it applies to every curve in every model the course built. A curve's own price never shifts it, in any market.

Across every market.

MAC 1722 Along or Shift, Across Six Markets

Decide whether an event moves along a curve or shifts it, in whichever market the question names. The test is always the same: if the axis variable changed, it is a movement along; if anything else changed, the curve moved. What varies between markets is only which variable sits on the axis. The price of coffee falls and people buy more: along the demand curve, because price is the axis. Incomes rise and people buy more coffee at every price: the demand curve shifts. The price level falls and more output is demanded: along aggregate demand. Consumer confidence rises: aggregate demand shifts. The interest rate falls and people hold more money: along money demand. Real GDP rises so more money is needed for transactions: money demand shifts. An exchange rate falls and more of the currency is demanded: along. Foreign interest rates rise: the curve shifts. Notice that the same underlying event can be either, depending on which market you are in. A falling price level is a movement along aggregate demand and a shift of the consumption function. Neither is wrong; they are statements about different diagrams, and the question tells you which diagram you are on.

Four entries on three more pairs, each one pointing back to the unit that built it.

Two horizons.

MAC 1723 Short Run Against Long Run

In the short run wages and prices are sticky, so demand can move output. In the long run they are flexible, so output returns to potential and demand moves only the price level. Units nine and ten are the same economy told over two horizons. A question naming a horizon is telling you which curve is doing the work.

Two kinds of rate.

MAC 1724 Marginal Against Average

A marginal quantity concerns the next unit; an average concerns all units so far. The propensity to consume and the tax rate on the next dollar are both marginal. A household can consume more than its income while its propensity stays below one. A higher tax bracket raises the rate on income above the threshold only.

Growth per person.

MAC 1725 Per Capita and Growth Rates

Convert between total growth, per capita growth and doubling time. Per capita growth is roughly total growth minus population growth. Doubling time is about seventy-two divided by the annual growth rate. Both are approximations and both are exam-usable. An economy's output grows three and a half percent a year while its population grows one point two percent, so income per person grows about two point three percent a year, and at that rate it doubles in about thirty-one years. Now compare a second economy growing output at the same three and a half percent with population growth of three percent: per capita growth is half a percent, and doubling takes about a hundred and forty-four years. The two economies grew their output identically. That comparison is the one to carry. Two economies with the same headline growth rate can deliver completely different experiences to the people in them, and a question quoting total growth without population growth has not told you what happened to living standards.

What a net figure subtracts.

MAC 1726 Gross Against Net

A gross figure counts everything; a net figure subtracts what offsets it. Gross investment includes replacing worn-out capital; net investment is what adds to the capital stock. Net exports subtract imports from exports. About half of gross private investment replaces rather than adds. Comparing a deficit against gross investment understates how much it can displace.

Two entries on the small vocabulary that carries the exam, and on what all of it is aimed at.

The words that recur.

MAC 1727 The Vocabulary That Recurs

A small set of words carries most of the exam: potential output, the natural rate, a gap, a shift, the multiplier, a leakage, crowding out, appreciation and indexing. Every one names a quantity or a direction, never a judgement. If a term seems to carry approval or blame, that is imported, not defined.

What all of it is for.

MAC 1728 The Four Macroeconomic Goals

Macroeconomics is organised around four goals: output growing, unemployment low, the price level stable, and external accounts sustainable. Every policy in the course is aimed at one of them. Unit sixteen framed each as a different kind of coordination failure. The goals conflict, which is why every policy question involves a trade.

Four entries on naming what is failing, matching a policy to it, running both instruments together, and what none of it decides.

Naming what is failing.

MAC 1729 Diagnose the Economy

From a description of an economy, name which goal is failing and which model explains it, asking four questions in order: where is output against potential, is unemployment cyclical or natural-rate, is the price level rising and why, and is the external position sustainable. The diagnosis fixes the instrument. Output is below potential, unemployment rose in the last two years, and inflation is low: a recessionary gap with cyclical unemployment, explained by aggregate demand, and demand policy applies. Output is at potential, unemployment has sat high for two decades, and inflation is stable: a natural-rate problem, explained by labour-market institutions, and demand policy will not move it. Output is falling while prices rise sharply: a supply shock, and no demand policy improves both halves. Prices are rising at forty percent a year while the central bank finances the budget: monetary, with a fiscal cause. The third and fourth cases are the ones that punish a reflex. A supply shock offers no good demand policy, and saying so is the correct answer rather than an evasion. A deficit financed by money creation is not fixed by monetary tightening alone, because the deficit will still be there.

Matching policy to gap.

MAC 1730 Which Policy for Which Gap

A recessionary gap calls for expansion: buy bonds, cut taxes, raise spending. An inflationary gap calls for contraction: sell bonds, raise taxes, cut spending. Both work by shifting aggregate demand. Which instrument to use is a political question, and the model does not answer it. Neither instrument can push output past potential for long.

Both instruments at once.

MAC 1731 The Policy Mix, Both Instruments

Work out what happens when fiscal and monetary policy act together or against each other. Both move aggregate demand, so their combination decides the result, and the central bank's response decides how much crowding out the fiscal action meets. The government expands while the central bank holds rates down: aggregate demand shifts right strongly, crowding out is slight, and output rises with some price pressure. Now the government expands while the central bank leans against inflation and raises rates: the two pull against each other, crowding out is severe, and most of the fiscal action is offset. Now the government contracts while the central bank expands: the contraction's effect on output is cushioned, which is the combination used when a deficit must be reduced without causing a recession. And both contracting at once produces the sharpest fall in demand of any combination. The central bank decides which margin adjusts, not whether one must. Unit fifteen's identity still binds: if the borrowing does not displace investment, it must be met by higher saving or by funds from abroad. A policy mix changes where the adjustment lands and cannot abolish it.

What none of it decides.

MAC 1732 What the Models Cannot Decide

The models say what follows from what. They do not say whose interests should prevail, how to weigh a job against a price, or what a government should do. Those are questions about values. Both sides of most policy arguments use the same diagram correctly. An exam question asks what the model implies, not what you would choose.

Three entries on working whatever the question actually puts in front of you.

Reading a table.

MAC 1733 Reading a Data Table

Extract what a table actually says before answering, checking three things in order: what units each column is in, whether the figures are real or nominal, and whether they are levels or rates of change. Most table questions test one of those three rather than the economics. A table shows output rising from twenty thousand to twenty-six thousand and a price index rising from a hundred to a hundred and twenty-five, and asks whether the economy grew: real output rose to twenty thousand eight hundred, so it grew about four percent. A second table shows unemployment at five point four, four point one, five point four, six point eight and five point four percent against five different inflation rates, and asks for the natural rate: unemployment returns to five point four at very different inflation rates, so five point four is the natural rate. A third table shows a deficit of a hundred and twenty, then ninety, then forty, and asks what happened to the debt: it rose every year. Each used a different reading skill and none needed a formula. The traps are the same each time — comparing nominal figures across years, averaging when you should look for a recurring value, and confusing a flow with the stock it feeds.

Working a described graph.

MAC 1734 Working a Graph Question

A described graph is a model with labels. Name the axes first, then the curves, then what moved. Only then read the result off the new crossing. Naming the axes decides which model you are in and which events can shift anything. If a question says a curve shifted, do not also move the other one unless it says so.

Working a numerical question.

MAC 1735 Working a Numerical Question

Most numerical questions on this exam use one of a short list of relationships. Recognise which one is in play, then substitute. The list is short enough to hold: the multiplier, the real interest rate, a price index, per capita growth, doubling time, and the debt as accumulated deficits. A question gives a propensity to consume of zero point eight and asks the multiplier: one divided by one minus zero point eight, which is five. A question gives a nominal rate of six percent and inflation of two percent and asks the real rate: four percent. A question gives a basket costing two hundred and fifty in the base year and three hundred now and asks for the index: three hundred divided by two hundred and fifty, times a hundred, which is a hundred and twenty. A question gives growth of six percent and asks doubling time: seventy-two divided by six, which is twelve years. A question gives a gap of two hundred and fifty and a multiplier of two point five and asks the spending needed: two hundred and fifty divided by two point five, which is a hundred. That last one is the most frequently inverted. Closing a gap takes the gap divided by the multiplier, not multiplied by it, because the multiplier is what turns the smaller spending change into the larger output change. If an answer comes out larger than the gap, the operation was backwards.

One entry to close this part, on what it means to check a source.

Arguing with the book.

MAC 1736 Where the Course Departed From Its Anchor

This course was built on one textbook and checked against a second. Where they disagreed, or where the textbook was wrong or out of date, the course said so rather than quietly correcting it. The reserve requirement, the euro's founding members and a trade date were corrected from outside sources. A course that never disagrees with its source is not checking it.

Look at what you can now do. You can deflate a series and compute a growth rate that means something, and say why thirty percent and four percent can describe the same year. You can decide whether an event moves along a curve or shifts it in any market, by asking only what sits on the axis — and say why the same event can be either, depending which diagram you are on. You can convert between total growth, per capita growth and doubling time, and say why two economies with the same headline rate can deliver completely different lives. You can diagnose which goal an economy is failing, and say plainly that a supply shock offers no good demand policy rather than reaching for one anyway. And you can recognise which relationship a numerical question uses, and catch the one operation this course inverts most often. Part three assembles the whole course onto a single diagram, and then says what it has not settled.