Thinking in a macroeconomic way

As noted last week, I am now using 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. 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 1.2 – Thinking in a macroeconomic way

Macroeconomics is a controversy-ridden area of study. In part, this is because the topic of study is seen as being of great significance to our nation and our daily lives even though the variables that are discussed are mostly difficult for us to understand.

The popular press and media is flooded with macroeconomics – the nightly news bulletin invariably has some commentator on speaking about macroeconomics issues – such as, as the real GDP growth rate, the inflation rate or the unemployment rate. The trend to the population being more exposed to macroeconomic terminology has increased over the last two or so decades and the advent of social media has made anyone who wants to be a macroeconomic commentator.

The so-called blogosphere is replete with self-styled macroeconomic experts who wax lyrical about all and sundry, often relying on intuitional logic to make their cases. The problem is that common sense is a dangerous guide to reality and not all opinion should be given equal privilege in public discourse. Our propensity to generalise from personal experience, as if the experience constitutes general knowledge, dominates the public debate – and the area of macroeconomics is a major arena for this sort of false reasoning.

A typical statement that is made in the public arena is that the government might run out of money if it doesn’t curb spending. Conservative politicians who seek to limit the spending ambit of government often attempt to give this statement authority by appealing to our intuition and experience.

They draw an analogy between the household and the sovereign government to assert that the microeconomic constraints that are imposed on individual or household choices apply equally without qualification to the government.

So we are told that governments, like households, have to live within their means. This analogy resonates strongly with voters because it attempts to relate the more amorphous finances of a government with our daily household finances. We know that we cannot run up our household debt forever and that we have to tighten our belts when our credit cards reach our borrowing limit.

We can borrow to enhance current spending, but eventually we have to sacrifice spending to pay the debts back. We intuitively understand that we cannot indefinitely live beyond our means.

Neoliberals draw an analogy between the two – household and government – because they know we will judge government deficits as being reckless, if their budget deficit rises. But the government is not a big household. It can consistently spend more than its revenue because it creates the currency.

Whereas households have to save (spend less than they earn) to spend more in the future, governments can purchase whatever they like whenever there are goods and services for sale in the currency they issue. Budget surpluses (taxation revenue greater than government spending) provide no greater capacity to governments to meet future needs, nor do budget deficits (taxation revenue less than government spending) erode that capacity.

Governments always have the capacity to spend in their own currencies. Why? Because they are the issuers of their own currencies, governments like Britain, the United States, Japan and Australia can never run out of money.

MMT teaches that our individual experience concerning our household budgets has no application to the government budget. We use the currency the government issues. Our individual experience about our own budgets does not generate knowledge about the government budget yet, on a daily basis, we act as if it does.

The “means” that the government has to consider are the real resources available to the economy and how best to deploy them. These are not financial considerations – there are no intrinsic “financial” constraints that are relevant to a currency-issuing government.

A household always has to consider its financial means. Common sense tells us that if we have “too much debt” then we can save and reduce that debt. But, whether public debt is problematic aside, if the government tries to “save” (another inapplicable conceptual transfer from the individual level) then public debt will probably rise.

Indeed, macroeconomics breathed life in the 1930s as a separate discipline of study from microeconomics because the dominant way of thinking at the time was riddled with errors of logic that led to spurious analytical reasoning and poor policy advice.

Microeconomics develops theories about the individual behavioural unit in the economy – the person, household, or firm. For example, it might seek to explain individual firm employment decisions and or the saving decisions of an individual income recipient.

We have learned that macroeconomics studies the aggregate outcomes of all firms and households. The question is how do we go from the individual unit (microeconomic) level to the economy-wide (macroeconomic) level? This is a question that the so-called aggregation problem seeks to address

Prior to the 1930s, there was no separate study called macroeconomics. The dominant school of thought in economics at the time considered macroeconomics to be a simple aggregation of the reasoning conducted at the individual unit or atomistic level.

To make statements about industry or markets or the economy as a whole, they sought to aggregate their atomistic analysis. For reasons that lie beyond this textbook, simple aggregation proved to be impossible using any reasonable basis.

The solution was to fudge the task and introduced the notion of a “representative household” to be the demand side of a goods and services (product) market and the “representative firm” to be the supply side of that market. Together they bought and sold a “composite good”. These aggregates were fictions and assumed away many of the interesting aspects of market interaction.

For example, if we simply sum all the individual demand relationships between price and spending intention we could form a representative household demand function.

But what if the spending intentions of each household or a segment of them were interdependent rather than independent. What if one household changed their demand once they found out what the spending intentions of the next-door neighbour was (for example, the notion of keeping up with the Jones!)? Then a simple summation is impossible to achieve.

But these issues were abstracted from and the representative firm and household were just bigger versions of the atomistic unit and the underlying principles that sought to explain the behaviour of the representative firm or household were simply those that were used to explain behaviour at the individual level.

The economy was seen as being just like a household or single firm. Accordingly, changes in behaviour or circumstances that might benefit the individual or the firm are automatically claimed to be of benefit to the economy as a whole.

In the Great Depression, this erroneous logic guided policy in the early 1930s and the crisis deepened. At that time, John Maynard Keynes and others sought to expose the logical error that the dominant orthodoxy had made in their approach to aggregation. In that debate, which we consider in Chapter 7, the logic was identified as a compositional fallacy – which led to the development of macroeconomics as a separate discipline from microeconomics. Karl Marx had appreciated this fallacy in the mid-1800s.

Compositional fallacies are errors in logic that arise when we infer that something, which is true at the individual level, is also true at the aggregate level. The fallacy of composition arises when actions that are logical, correct and/or rational at the individual or micro level have no logic (and may be wrongful and/or irrational) at the aggregate or macro level.

Keynes led the attack on the mainstream thinking at the time – mid-1930s – by exposing several fallacies of composition. Lets consider two famous fallacies of composition in mainstream macroeconomics: (a) the paradox of thrift; and (b) the wage cutting solution to unemployment.

You will be familiar with these examples but perhaps not the reason why they are fallacious. We will consider the first fallacy here as an example, and the wage cutting fallacy in a later chapter.

The paradox of thrift refers to a case where individual virtue can be public vice. If an individual attempts to increase the proportion that he/she saves out of their disposable income (income after tax) – the so-called saving ratio – then if they approached the task in a disciplined manner they would probably succeed.

There is an old saying – look after the pennies and the pounds will look after themselves.

So by reducing their individual consumption spending a person can increase the proportion they save and enjoy higher future consumption possibilities as a consequence. The loss of spending to the overall economy of this individual’s adjustment would be small and so there would be no detrimental impacts on overall economic activity, which is crucially driven by aggregate spending.

But imagine if all individuals (consumers) sought the same goal and started to withdraw their spending en masse? Then total spending would fall significantly and, as you will learn from Chapter 5, national income falls (as production levels react to the lower spending) and unemployment rises. The impact of lost consumption on aggregate demand (spending) would be such that the economy would plunge into a recession and everyone would suffer.

Moreover, as a result of the income losses it is highly likely that total saving would actually fall along with consumption spending so the economy as a whole would be saving less.

The paradox of thrift tells us that what applies at a micro level (ability to increase saving if one is disciplined enough) does not apply at the macro level (if everyone attempts to increase saving, overall incomes fall and individuals would be thwarted in their attempts to increase their savings in total).

Why does the paradox of thrift arise? In other words, what is the source of this compositional fallacy?

The explanation lies in the fact that a basic rule of macroeconomics, which you will learn once you start thinking in a macroeconomic way, is that spending creates income and output. This economic activity, in turn, explains how employment is generated. Adjustments in spending drive adjustments in total production (output) in the economy.

So if all individuals reduce their spending (by attempting to save) the level of income falls rather than stays constant, as would be the case if just one person reduced their spending.

As total saving (the sum of all household saving) is a residual after all households have made their consumption spending choices from the available disposable income then national income shifts, in turn, feedback on total saving. When national income falls, consumption falls and total saving will also usually decline in absolute terms.

Keynes and others considered fallacies of composition such as the paradox of thrift to provide a prima facie case for considering the study of macroeconomics as a separate discipline. This development explicitly acknowledged that it is dangerous to engage in specific-to-general reasoning.

By assuming that we could simply add up the microeconomic relations to get the representative firm or household and the mainstream at the time were assuming that the aggregate unit faced the same constraints as the individual sub-units. So the individual saver might reasonably assume that changing his/her consumption choices would not impact on his/her income.

But we know that if all consumers act en masse then not only does their spending change but the income constraint also shifts and the logic that applied at the individual level will be spurious or fallacious at the aggregate level.

There are other fallacies of composition that we will examine in the course of this textbook.

For example, a current example relates to the insistence by the conservative policy makers on fiscal austerity.

During the Global Financial Crisis, the conservative reaction to the increasing government deficits has been to propose fiscal austerity and to encourage nations to cut domestic costs in order to stimulate their export sectors via increased competitiveness.

In isolation, that is, where one nation does this while all other nations are maintaining strong economic growth, this strategy might have a chance of working. But if all nations engage in austerity and cut their growth rates because overall spending declines, then imports will fall across the board, as will exports.

It is the interdependence between all countries via trade that undermines the policy suggestion in this case.

MMT contains a coherent logic that will teach you to resist falling into intuitive traps and compositional fallacies. MMT teaches you to think in a macroeconomics way.

COMING IN THIS INTRODUCTORY CHAPTER – WHAT HAS TO BE EXPLAINED BY A MACROECONOMIC MODEL – STYLISED FACTS.

Annexe 1 – Essential analytical terminology

[Note: This section may appear as Chapter 4 Methods, Tools and Techniques, which will present an array of empirical, mathematical and graphical techniques that help us engage in macroeconomics]

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

The level of mathematics that will be used throughout this book is no more sophisticated than the typical material that a student would encounter in the second-half of their secondary school studies. The most advanced analysis we employ is simultaneous equation technique and some simple calculus. For the most part, the mathematics is confined to algebraic representations of the behavioural theories and/or accounting statements that we advance and some simply solution exercises to determine the unknown aggregates we are interested in.

The practical material accompanying the analytical text will also provide a step-by-step sequence to mastering the techniques required.

We recognise that mathematical techniques are commonly used within the social sciences and that students will gain confidence in dealing with the standard conceptual and empirical literature in economics and more broadly if they develop some formal modelling skills in addition to the deep understanding that we hope to engender.

In Chapter 1, the concept of a model was introduced. It was stated that a macroeconomic model comprises the tools and theoretical connections to advance study of the main aggregates – employment, output and inflation.

A model is a generalisation about the way the system functions or behaves. It could easily be a narrative statement such as – a household will consume a proportion of their income after tax (disposable income). That theoretical statement might then be examined for its empirical relevance but will also stimulate further theoretical work trying to provide an explanation for that conjectured behaviour.

In economics, like other disciplines that use models, the narrative statement might be simplified with some mathematical statement. In this context, the models will be represented by a number of equations (which could be one), which describe relationships between variables of interest. The relationship between the variables is described in terms of some coefficients (or parameters). Usually a variable that we seek to explain is written on the left-hand side of the equals sign (=) and is then expressed in terms of some other variables on the right-hand side of the equals sign, which we consider are influential in explaining the value and movement of the left-hand side variable of interest.

For example, y = 2x is an equation which says that variable y is equal to 2 times variable x. So if x = 1, then we can solve for the value of y = 2 as a result of this equation. The left-side of the equals sign is of the same magnitude as the right-side (that is, an equation has equal left and right sides). You solve an equation by substituting values for the unknowns.

In the above example the number 2 is called a coefficient which is an estimate of the way in which y is related to x. A coefficient can also be called a parameter – which is a given in a model and might be estimated using econometric analysis (regression) or assumed by intuition). In that context, the coefficient’s value is unknown.

For example, we might have written the above equation as y = bx, where b is the unknown coefficient. You will note that we would be unable to “solve” for the value of y in this instance even if we knew the value of x. In the case above where we said x = 1, then all we could say that y = b. We would thus need to know what b was before we could fully solve for y. Further on in the book we will come back to this problem of too many unknowns.

But for now, it is sometimes useful to have models where we cannot solve for numerical values of the unknown variables of interest but we can simplify the equations to show the structure of the model in terms of what is important to understand in relation to our aggregates.

In the context of economic modelling, a variable is some measured economic aggregate (like consumption, output etc), which is denoted by some symbol that makes sense. The correspondence between the shorthand symbol and the variable is not always intuitive but conventions have been established, which we retain in this textbook.

So Y is often used to denote real GDP or National Income (but it can also be used to denote total output). C is usually used to denote final household consumption and I total private investment. X is typically used to denote exports and M imports although in some cases M is used to denote the stock of Money. In this text, M is exclusively used to denote imports.

There are two types of equations that are used in macroeconomic models: (a) identities which are true by definition – that is, as a matter of accounting – they are indisputable; and (b) behavioural equations which depict relations between variables that model behaviour – for example, consumption behaviour.

An example of an identity is the national income equation depicting aggregate demand and output, which we consider in Chapter 5:

Y = C + I + G + X – M

Note that in strict terms we write an equation that is an identity using the identity sign (three parallel horizontal lines) instead of the equals sign (two parallel horizontal lines). That distinguishes it from a behavioural equation which is always expressed using an equals sign (=).

A behavioural equation captures the hypotheses we form about how a particular variable is determined. These equations thus represent our conjectures (or theory) about how the economy works and obviously different theories will have different behavioural equations in their system of equations (that is, the economic model).

An example of a behavioural equation is the Consumption function:

C = C₀ + cY_d

which says that final household consumption (C) is equal to some constant (C₀) plus some proportion (c) of final disposable income (Yd). The constant component (C₀) is the consumption that occurs if there is no income and might be construed as dis-saving.

Note that subscripts are often used to add information to a variable. So we append a subscript d to our income symbol Y to qualify it and denote disposable income (total income after taxes).

In macroeconomics, some behavioural coefficients are considered important and are given special attention. So the coefficient c in the Consumption function is called the marginal propensity to consume (MPC) and denotes the extra consumption per dollar of extra disposable income. So if c = 0.8 we know that for every extra dollar of disposable income that the economy produces 80 cents will be consumed.

The MPC is intrinsically related to the marginal propensity to save (MPS) which is the amount of every extra dollar generated that is saved (after households decide on their consumption). So the MPS = 1 – MPC by definition.

The importance of MPC is that is one of the key determinants of the expenditure multiplier (more about which later). We will consider this in Chapter 5 when we discuss the expenditure multiplier.

The other piece of jargon that we encounter is the difference between exogenous (pre-determined or given) variables and endogenous variables (which are determined by the solution to the system of equations).

An exogenous variable is known in advance of “solving” the system of equation. We take its value as given or pre-determined. We might say, by way of simplification, that government spending (G) is equal to $100 billion which means that its value is known and not determined by the values that the other variables take or are solved to.

But in a system of equations, the values of some variables are unknown and are only revealed when we “solve” the model for unknowns.

So if we have these two equations, which comprises a “system”:

(1) y = 2x

(2) x = 4

Then x is a pre-determined variable (with the value 4) and is thus exogenous. You do not know the value of y in advance and you have to solve the equations to reveal its value – so it is endogenous. It is determined by the solution to the system.

To solve this system we substitute the value of x in Equation (2) into Equation (1) so we get:

y = 2 times 4
y = 8

So the solution of a system merely involves substituting all the known values of the coefficients (in this case the 2 on the x) and the exogenous variables (in this case x = 4) into the equations that depict the endogenous variables (which in this case is only Equation (1) but there will typically be multiple endogenous variable equations).

In real modelling it becomes very complicated as to which variables can be considered endogenous and which are truly exogenous. At the extreme, everything might be considered endogenous and then things get mathematically complex and there is a whole body of theory in econometrics relating to the identification problem, which is well beyond this textbook.

We will also express our theories in graphical terms, which are an alternative to mathematical representation. Here are three ways to express the same theoretical idea.

1. Household consumption rises proportionately with disposable income but the proportion is less than one.

2. C = C₀ + cY_d, where 0 < c < 1 and C₀ is a constant (fixed value). The less than sign (<) tells us that the MPC lies between the value of 0 and 1, that is, it is positive but less than 1. 3. Graphical form:

If C₀ = 100, and c = 0.8, and Y_d = 1000 then total consumption would be 900. We could have solved the equation C = C0 + cYd by inserting the known values of the parameters and explanatory variable (in this case disposable income) into the equation and solving it.

Thus:

C = C₀ + cY_d = 100 + 0.8 x 1000 = 900.

You can also see that by tracing a vertical line from where Disposable income equals 1000 up to the graph line and then tracing across the vertical axis we derive the value of Consumption by where that line crosses the vertical axis.

It was stated that the slope of the line is the Marginal Propensity to Consume (c). How do we derive a slope of a line and what does it mean? In Chapter 3 we will deal with applications of the slope of a line when we study the principle of the spending multiplier.

In general terms the following will be useful.

SIMPLE CALCULUS AND GRAPH TO BE INSERTED HERE.

We recognise that different students have different ways in which they learn and accumulate knowledge. Some prefer the mathematical approach while others prefer the graphical approach. Others still learn better through reading the written word, even though that form of communication is prone to interpretative issues. In that regard, all the essential material in the text will be presented in all three ways (sometimes the mathematics will appear in the Annexe of the relevant chapter sometimes within the main body of the text.

Saturday Quiz

The Saturday Quiz will be back tomorrow (from 04:00 Eastern Australian Time). I noted this week some person claimed they have worked out how I think. If they have I would appreciate them telling me so I would know too. But like all idle boasts … it has spurned action. I aim to disabuse that person of his conjecture in this week’s quiz. 🙂

That is enough for today!