Principles of Economics

331 Pages·5.437 MB·English

by  McDowell Moore et al.

PRINCIPLES OF ECONOMICS (SELECTED CHAPTERS)
MCGRAW-HILL PUBLISHERS
3RD EUROPEAN EDITION
Principles of Economics
It is a fact of common knowledge that first-year students
inevitably face a book crisis while in their first year. This
problem is even more aggravated by bookish and set-in-their-
ways instructors who bring their students to grips with quizzes-
to-be as well as the harsh reality of textbook supply.
Therefore, considering the scarcity of this textbook (many
tutors use it, but none of them actually wonders how students
can winkle it out), this e-book provides a full account of the
original, covering chapters as far as macroeconomics is
concerned. Please note that the initial pagination has been
preserved.
Good read!
PART 5

Macroeconomics: Issues and Data

Physical scientists study the world on many different scales, ranging from the inner workings of the
atom to the vast dimensions of the cosmos. Although the laws of physics are thought to apply at all
scales, scientists find that some phenomena are best understood ‘in the small’ and some ‘in the
large’. Although the range of scales they must deal with is much more modest than in physics,
economists also find it useful to analyse economic behaviour at both the small-scale, or ‘micro’ level,
and the large-scale, or ‘macro’ level. This section of the book introduces you tomacroeconomics, the
study of the performance of national economies. Unlike microeconomics, which focuses on the
behaviour of individual households, firms and markets, macroeconomics takes a bird's-eye view of
the economy. So, while a microeconomist might study the determinants of consumer spending on
personal computers, macroeconomists analyse the factors that determine aggregate, or total,
consumer spending. Experience has shown that, for many issues, the macroeconomic perspective is
the more useful.
Chapter 16 begins our discussion of macroeconomics by introducing you to some of the key
macroeconomic issues and questions. These include the search for the factors that cause
economies to grow, productivity to improve and living standards to rise over long periods of time.
Macroeconomists also study shorter-term fluctuations in the economy
(called recessions andexpansions), unemployment, inflation, and the economic interdependence
among nations, among other topics. Macroeconomic policies – government actions to improve the
performance of the economy – are of particular concern to macroeconomists, as the quality of
macroeconomic policy making is a major determinant of a nation's economic health.
p. 420
To study phenomena such as economic growth scientifically, economists must have accurate
measurements. Chapter 17, 18 and 19 continue the introduction to macroeconomics by discussing
how some key macroeconomic concepts are measured and interpreted. Chapter 17discusses an
important measure of the level of economic activity known as gross domestic product (GDP).
Besides describing how GDP is constructed in practice, this chapter also discusses the issue of how
it is related to the economic well-being of the typical person. Chapter 18 concerns the measurement
of the price level and inflation and includes a discussion of the costs that inflation imposes on the
economy, while Chapter 19 explains how unemployment is measured, and discusses several
important labour market trends.
p. 421
Economics is a subject that does not greatly respect one's wishes. Nikita Khrushchev

Learning Objectives

After reading this chapter, you should be able to:
1. Understand the subject matter of macroeconomics and how it is distinguished from that
of microeconomics;
2. Survey the major issues which concern macroeconomists;
3. Distinguish between different types of macroeconomic policies;
4. Distinguish between positive and normative economic analysis;
5. Understand how the concept of aggregation helps economists to analyse economic data
at the economy-wide level.

Over the years 2008 and 2009 the economies of large industrial countries such as the United
Kingdom, France, Germany and the United States slowed dramatically. In the United Kingdom total
output as measured by real gross domestic product (GDP) declined by 0.1 per cent in 2008 and by 5
per cent in 2009 – the largest fall in any single year since the Second World War. Also in 2009 real
GDP fell by almost 3 per cent in the United States and by 4 per cent in the euro area. Faced with
declining demand, firms cut their output, resulting in job losses and rising unemployment. In the
United Kingdom unemployment increased from just over 5 per cent of the labour force in 2007 to
almost 8 per cent in 2009 and in the United States from 5 to 10 per cent over the same period. In
some other countries conditions were even worse. In Ireland real GDP had increased at an annual
average rate of 6 per cent over 2000–07 (the highest growth rate in Western Europe) but declined by
3.6 per cent in 2008 and by an alarming 7.6 per cent in 2009 with unemployment increasing from 4.6
per cent in 2007 to almost 12 per cent in 2009.
Most economists are in broad agreement that the decline in economic activity over 2008–09 was
closely related to a series of banking failures, most notably the collapse of Lehman Brothers in the
US and the failure and subsequent nationalisation of Northern Rock in the UK. Bank failures in turn
lead to a severe ‘credit crunch’ with households and firms finding it difficult, and in many cases
impossible, to obtain loans to finance consumption and investment plans. As a consequence,
spending and the demand for goods and services fell dramatically, leading to a decline in output and
a rise in unemployment. For example, in the 2009 United Kingdom real, private, consumption
expenditure (mainly spending on goods and services by households) fell by 3.3 per cent, while real,
private, non-residential investment by firms declined by 19 per cent and residential investment (or
investment in housing, etc.) by 27 per cent.
p. 422
The 2008–09 downturn is not the only recession in recent history. The United Kingdom and other
industrial countries also experienced significant downturns in 1974–75, 1980–81 and 1990–91.
Going further back, the most severe collapse in economic activity occurred during the Great
Depression of 1929 to 1932, when the British unemployment rate rose to 22 per cent of the labour
force. In Germany, which had never fully recovered from its defeat in the First World War, the
economy's output declined by 16 per cent and nearly a third of all workers were without jobs. One of
the few benefits of the Great Depression was that it forced economists and policy makers of the
1930s to recognise that there were major gaps in their understanding of how the economy worked.
This recognition led to the development of a new sub-field within economics, calledmacroeconomics.
Recall from Chapter 1 that macroeconomics is the study of the performance of national economies
and the policies governments use to try to improve that performance.
This chapter will introduce the subject matter and some of the tools of macroeconomics. Although
understanding episodes such the onset of recession remains an important concern of
macroeconomists, the field has expanded to include the analysis of many other aspects of national
economies. Among the issues that macroeconomists study are the sources of long-run economic
growth and development, the causes of high unemployment and the factors that determine the rate
of inflation. Appropriately enough in a world in which economic ‘globalisation’ preoccupies
businesspeople and policy makers, macroeconomists also study how national economies interact.
Since the performance of the national economy has an important bearing on the availability of jobs,
wages and salaries, prices and inflation, as well as the cost of borrowing and the rate of return on
saving, it is clear that macroeconomics addresses bread-and-butter issues that affect virtually
everyone.
Macroeconomists are particularly concerned with understanding how macroeconomic policies work
and how they should be applied. Macroeconomic policies are government actions designed to
affect the performance of the economy as a whole (as opposed to policies intended to affect the
performance of the market for a particular good or service, such as oil or automobiles). The hope is
that, by understanding more fully how macroeconomic policies affect the economy, economists can
help policy makers do a better job in either preventing or reacting to events such as the downturn
which occurred in 2008–09.

THE MAJOR MACROECONOMIC ISSUES
We defined macroeconomics as the study of the performance of the national economy as well as the
policies used to improve that performance. Let us now take a closer look at some of the major
economic issues that macroeconomists study.
ECONOMIC GROWTH AND LIVING STANDARDS
Although the wealthy industrialised countries are certainly not free from poverty,
the typical person in those countries enjoys a standard of living better than at any
previous time or place in history. By standard of living we mean the degree to
which people have access to goods and services that make their lives easier,
healthier, safer and more enjoyable. People with a high living standard enjoy
more and better consumer goods: sports-utility vehicles, camcorders, mobile
phones and the like. But they also benefit from a longer life expectancy and better
general health (the result of high-quality medical care, good nutrition and good
sanitation), from higher literacy rates (the result of greater access to education),
from more time and opportunity for cultural enrichment and recreation, from
more interesting and fulfilling career options, and from better working

conditions. Of course, the Scarcity Principle will always apply – even for the
citizens of rich countries, having more of one good thing means having less of
another. But higher incomes make these choices much less painful than they
would be otherwise. Choosing between a larger flat and a nicer car is much easier
than choosing between feeding your children adequately and sending them to
school, the kind of hard choice people in the poorest nations face all the time.
p. 423
Americans and Europeans sometimes take their standard of living for granted, or even as a ‘right’.
But we should realise that the way we live today is radically different from the way people have lived
throughout most of history. The current standard of living in Europe is the result of many years
of economic growth, a process of steady increase in the quantity and quality of the goods and
services the economy can produce. The basic equation is simple: the more we canproduce, the
more we can consume. Also, consumption does not only include cars, iPods and foreign holidays,
etc. It also includes access to the better health and education services that sustained economic
growth makes possible.
One of the most widely used indicators of a nation's living standards is real income per head of the
population or the amount which the average person has to spend on goods, services, education,
health, etc. Figure 16.1 shows how real output per head in Europe, the United States and India has
varied since 1900. The diagram clearly illustrates the significant differences between the developed
Western economies and developing countries such as India. Relative to 1900, output per person has
increased by about seven times in Europe and the United States but by four times in India.
Figure 16.1 Real GDP per Person in Europe, the USA and India 1900–2009
In Europe (12 largest economies) and the United States output per person has increased
sevenfold since 1990 and in India fourfold.

Sources: The World Economy: Historical Statistics, OECD Development Centre, Paris 2003.
The Conference Board and Groningen Growth and Development
Centre,http://www.conference-board.org/economics.

(cid:131) How can we explain economic growth and rising living standards?
(cid:131) Why do some countries grow faster than others?
These are some of the questions macroeconomists try to answer.
p. 423 (continuation)
PRODUCTIVITY
In Chapter 20 we shall see that growth in output per person is closely linked to labour productivity or
the amount which the typical person can produce. Table 16.1 shows how average labour productivity
or output per person employed (that is, total output divided by the number of people working) has
changed over a period of more than 120 years.
Table Output per Person Employed, 1870–2009 (1990 International $)
16.1

Sources: The World Economy: Historical Statistics, OECD Development Centre Paris, 2003.
The Conference Board and Groningen Growth and Development
Centre,http://www.conference-board.org/economics.
p. 424
Table 16.1 shows that, in 2009, European and American workers could produce more than ten times
the quantity of goods and services produced by a worker in 1870, despite the fact that the working
week is now much shorter than it was in 1870. Economists refer to output per employed worker
as average labour productivity output per person employed .
The final row of Table 16.1 shows the ratio of US to European labour productivity. In 1950, US
workers were twice as productive as their European counterparts but the ratio declined over the next
50 years and especially between 1950 and 1973, which is sometimes referred to as Europe's catch-
up period. Economic Naturalist 16.1 looks at Europe's catch-up in greater detail.
Exercise 16.1
The last row in Table 16.1 shows that, between 1950 and 1973, average labour productivity in
Western Europe increased at a faster rate than in the United States. Calculate the same ratio for
each of the countries in Table 16.1. Was the rate of catch-up the same in all European
countries?

Average labour productivity and output per person are closely related. This relationship makes
sense: as we noted earlier, the more we can produce, the more we can consume. Because of this
close link to the average living standard, average labour productivity, and the factors that cause it to
increase over time, are of major concern to macroeconomists.
Although the long-term improvement in output per worker is impressive, the rate of improvement has
slowed somewhat since the 1970s. Between 1950 and 1973 output of the average European
employed worker increased by about 6 per cent per year. But from 1973 to 1995 the average rate of
increase in output per worker was 2.1 per cent per year. Slowing productivity growth leads to less
rapid improvement in living standards, since the supply of goods and services cannot grow as
quickly as it does during periods of rapid growth in productivity. Identifying the causes of productivity
slowdowns and speed-ups is thus an important challenge for macroeconomists.
(cid:131) How can we explain the long periods of sustained economic growth enjoyed by advanced industrial
countries such as the United Kingdom, France, Germany and the United States?
(cid:131) Why have many of the world's countries, including the developing nations of Asia, Africa and Latin
America as well as some former communist countries of Eastern Europe, not enjoyed the same
rates of economic growth as the industrialised countries?
(cid:131) How can the rate of economic growth be improved in these countries?
p. 425
Economic Naturalist 16.1
Explaining Europe's catch-up, 1950–73
Table 16.1 sh ows that in the 70 years preceding the Second World War, American labour
productivity not only exceeded European productivity, but that the gap between them widened.
However, in the decades following the war, the reverse occurred and Europe closed the gap on
the United States. Not only did the difference between American and European labour
productivity decline between 1950 and 1973, but European output per person increased from 52
to 73 per cent of American output per person. Why did this catch-up occur after 1950? One
obvious answer is that the catch-up was the result of reconstructing Europe's war-ravaged
economies, paid for in part by the US-financed Marshall Plan. Reconstruction certainly played a
role but it is not the only reason for Europe's catch-up period between 1950 and 1973. The
American economist Robert J. Gordon discusses this issue and presents a number of reasons
why Europe did so badly before the Second World War and so well afterwards.1 One of
Gordon's hypotheses is that we can understand Europe's catch-up only if we first understand
why the United States surged ahead during the nineteenth century and the first half of the
twentieth century. In answering this question, Gordon highlights the fact that America was a
full political, monetary and economic union long before Europe, and that the creation of an
internal, or single, market enabled the United States to exploit the advantages of mass
production and key inventions such as electricity and the internal combustion engine. In
contrast, Europe was fragmented by nation states, trade barriers and war. As Gordon puts it:
Looking back at the long history of Europe falling behind the US and then catching up, it is
hard to avoid the conclusion that this topic has more to do with politics and history rather
than with economics. The sources of US advantage prior to 1913 centre on its internal
common market, an achievement of the Founding Fathers, Abraham Lincoln and the Union
Army, rather than any particular genius at business or technology, and free internal trade led
in turn to exploitation of raw materials and leadership in materials-intensive manufacturing.
Post-war Europe gradually rid itself of internal trade barriers and largely caught up to the
American productivity frontier as a result.

Gordon's hypothesis raises several interesting questions. First, as the European single market
and the common currency intensify the pace of economic and political integration, will Europe
become ‘more like America’ and further close the gap on the United States? Second, and
somewhat more trivial, Gordon's argument is an obvious boost to the ‘what if’ theorists. What if
the Union Army had been defeated at Gettysburg in July 1863 and the Confederacy emerged
victorious in the Civil War of 1861–65? Would America have fragmented into nation states and
become ‘more like the Europe of the late nineteenth century’, with internal strife, trade barriers
and impediments to the free movement of labour? If so, would the economic and political
histories of Europe and America have been dramatically different?