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1.1 Macroeconomics Issues and Ideas

Macroeconomics is concerned with the structure, performance and behaviour

of the economy as a whole. The prime concern of macroeconomists is to

analyse and attempt to understand the underlying determinants of the main

aggregate trends in the economy with respect to the total output of goods and

services (GDP), unemployment, inflation and international transactions. In

particular, macroeconomic analysis seeks to explain the cause and impact of

short-run fluctuations in GDP (the business cycle), and the major determinants

of the long-run path of GDP (economic growth). Obviously the subject

matter of macroeconomics is of crucial importance because in one way or

another macroeconomic events have an important influence on the lives and

welfare of all of us. It is difficult to overstate just how important satisfactory

macroeconomic performance is for the well-being of the citizens of any

country. An economy that has successful macroeconomic management should

experience low unemployment and inflation, and steady and sustained economic

growth. In contrast, in a country where there is macroeconomic

mismanagement, we will observe an adverse impact on the living standards

and employment opportunities of the citizens of that country. In extreme

circumstances the consequences of macroeconomic instability have been devastating.

For example, the catastrophic political and economic consequences

of failing to maintain macroeconomic stability among the major industrial

nations during the period 1918–33 ignited a chain of events that contributed

to the outbreak of the Second World War, with disastrous consequences for

both humanity and the world economy.

Because macroeconomic performance and policies are closely connected,

the major macroeconomic issues are also the subject of constant media attention

and inevitably play a central role in political debate. The influence of the

economic performance of the economy on political events is particularly

important and pertinent in liberal democracies during election campaigns.

Research has confirmed that in the post-war period the outcome of elections

has in many cases been affected by the performance of the economy as

measured by three main macroeconomic indicators – inflation, unemployment

and economic growth. While there are obviously many non-economic

factors that influence the ‘happiness’ of voters, it is certainly the case that

economic variables such as employment and income growth are an important

explanatory factor in voting behaviour. Furthermore, ideological conflict often

revolves around important macroeconomic issues (see, for example, Frey

and Schneider, 1988; Alesina and Roubini with Cohen, 1997; Drazen, 2000a).

To get some idea of how two major economies have performed with respect

to unemployment and inflation consider Figures 1.1 and Figure 1.2. Here we

can clearly see that the pathologies of high unemployment and inflation occasionally

take on proportions that are well above the norm. Figure 1.1 traces the

path of unemployment in the US and UK economies for the twentieth century.

The impact of the Great Depression (1929–33) on unemployment is dramatically

illustrated for both countries although the increase in unemployment in

the USA was much more dramatic than in the UK, where unemployment was

already high before 1929 (see section 1.4 below and Chapter 2).

Source: Britton (2002).

Figure 1.1 Unemployment in the US and UK economies over the course of

the twentieth century

25

20

15

10

5

0

US unemployment UK unemployment

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

Source: Britton (2002).

Figure 1.2 Inflation in the US and UK economies over the course of the

twentieth century

25

20

15

10

5

0

–5

–10

–15

–20

US inflation UK inflation

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

Figure 1.2 shows how inflation has varied in the US and the UK economies

throughout the twentieth century. Notable features here include: the dramatic

increase in inflation associated with the two world wars (1914–18, 1939–45)

and the Korean War (1950–53); the deflations of the early 1920s and 1930s;

and the ‘Great Inflation’ of the 1970s (Taylor, 1992a). As DeLong (1997)

notes, ‘the 1970s are America’s only peacetime outburst of inflation’.

Several questions confront economists with respect to these exceptional

episodes: were they due to specific large shocks, the failure of adjustment

mechanisms, the result of policy errors, or some combination of all three?

Finding answers to these questions is important because the contemporary

conduct of stabilization policy must reflect the lessons of history and the

theoretical and empirical research findings of economists.