Aggregate demand is the money value of all final goods purchased in the economy (usually defined to be a country, but it could refer to a state, or the world economy). Aggregate demand includes purchases by individual households, businesses, and the government. Purchases by foreign countries (exports) add to a country’s aggregate demand while the part of spending that goes to foreign goods and services (imports) subtract from national aggregate demand.
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Aggregate supply refers to the quantity of goods and services that all firms in an economy produce in a given period.
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Crowding Out occurs when government spending displaces private spending, particularly investment. For example, if the government begins constructing a new suspension bridge, it may drive up the price of steel. The higher cost of raw materials may lead automakers to reduce car production. In this case, higher government spending on the bridge decreases spending in the private economy as fewer cars are built and sold. Keynesians believe that crowding out only happens when the economy is producing at its potential output, because when the economy has unutilized resources government spending will bring them into service instead of pulling resources away from existing production.
Some Classical economists fear that crowding out may happen even when the economy is not at potential output, prompting them to discourage the use of deficit spending. The article Deficits and the Fear of Crowding Out shows that crowding out is not a real concern when an economy is in a recession.
A demand shock is an unexpected positive or negative change in aggregate demand. For instance, suppose that scientists announce that an asteroid is set to collide with the Earth next year, wiping out the planet. People would rush to enjoy life and spend all of their money, constituting a positive demand shock. (A rather unfortunate way to stimulate the economy!) More realistically, government policies, political conditions, and natural disasters may all cause demand shocks.
Changes in the spending behavior of households or firms could also be labeled a demand shock. A change in demand is usually called a “shock” if it deviates from previous trends and expectations. This observation suggests some ambiguity in the definition: what for one analyst might be an unanticipated “shock” could be for another what she has been predicting all along.
Government policy may also lead to demand shocks. Changes in government spending relative to previous trends are important sources of shocks to aggregate demand. Tax policy changes also can shock aggregate demand if they affect spending of firms or households.
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A dollar-denominated debt is one measured in dollars. For instance, when the US borrows money it sells bonds with values listed in dollars. The US then pays bondholders interest (and eventually the principal) in dollars. It may seem perfectly ordinary for a country to borrow in its own currency, but many developing countries have unstable currencies, so must borrow in foreign currencies. When a country must borrow in a currency it does not control, it is potentially vulnerable to defaulting on its debt if its economy weakens and the government is unable to trade domestic currency for the currency it needs to service its debts. In 2001, Argentina faced a debt default for these reasons, demonstrating the need for a country to hold foreign exchange reserves to ensure that it will be able to service its debt.
A fallacy of composition is a logical error that arises when a fact that holds for a component or part is extended and asserted to hold for an entire system or unit. For instance, while atoms are invisible to the human eye and the Earth is composed of atoms, the conclusion that the Earth is invisible is clearly invalid. Fallacies of composition appear in several prominent economic arguments. In the paradox of thrift, when a thrifty individual saves more, his or her net worth rises. However, higher saving across the economy will not increase societal net worth since saving more requires spending less, destroying income for another member of society. In fact, an increase in collective savings can actually lower wealth for everyone if it diminishes the size of the economic pie. For a more thorough explanation, see Paradox of Thrift: Keynesian Response to Say’s Law.
The Federal Reserve (or Fed) is the Central Bank of the United States. Its duties include conducting monetary policy, regulating banks, maintaining financial stability, and conducting banking services for other banks and for the US government. Some of the Fed’s important roles include setting interest rates and buying and selling US bonds to control the money supply. The Fed has a double mandate to control inflation and unemployment. During the Great Recession, the Federal Reserve expanded its traditional role in order to stabilize the financial industry, using unconventional methods such as Quantitative Easing.
A final good or service is one that is consumed in its present state. Intermediate goods, which are used to create other products, are distinct from final goods and are not including in the calculation of GDP. For example, a scrambled egg is considered a final good while an egg used to bake a cake is considered an intermediate good (the cake is the final good).
Fiscal Policy is the use of government spending and taxation to impact the economy. When the government increases spending or decreases taxes, it is engaged in expansionary fiscal policy. If the government raises taxes and cuts spending, it is performing contractionary fiscal policy. In the United States, fiscal policy is conducted through Congress and the President, who write and approve federal budgets and tax proposals.
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Foreign Exchange Reserves are the foreign bonds and currency held by a government or central bank. The dominant currency used as a foreign exchange reserve is the US dollar, but Euros, Yen, and British Pounds are also used as reserve currencies. Foreign exchange reserves are kept to moderate fluctuations in exchange rates. For instance, if China felt that the Chinese Yuan was exchanging for fewer dollars than it should (the Yuan was overvalued), China could sell dollars and buy Yuan. This would decrease the value of the Yuan and bring the exchange rate closer to the desired goal. Reserves may also be necessary to service debts denominated in foreign currencies. In this case, a lack of sufficient foreign exchange reserves can lead to debt default, as Argentina experienced in 2001.
Full employment refers to economic circumstances in which all individuals who wish to work at a job that they are qualified for and at the wage rate prevailing in the labor market have jobs.
The concept is related empirically to surveys that measure the employment status of individuals who are working or have actively been searching for a job. These surveys are the basis of the unemployment statistics released by the government. Empirically, the “actively searching” component is often considered controversial, as discouraged workers who have given up searching are not represented in most widely reported unemployment statistics. The standard unemployment rate also fails to capture the presence of the “under-employed,” who hold jobs that do not take advantage of their full range of skills or who desire full-time work but are only able to find part-time jobs.
Economists often estimate that practical full employment corresponds to an unemployment rate of 3% to 5% (sometimes even higher), rather than actually reaching zero. Even if jobs are readily available, a small percentage of people may be unemployed at any point in time as they enter and exit the labor market or search for new employment opportunities (this is known as frictional unemployment).
The output produced with full employment is either referred to as potential output or full-employment output.
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Gross Domestic Product is the money value of all final goods and services produced within the borders of a country in a given year. The components of GDP are consumption, investment, government expenditures, and net exports (net exports = imports – exports ). In order to avoid double counting production, GDP excludes intermediate goods (which become inputs used to produce final goods) and used goods which are resold. In 2011, the U.S. GDP was $15.1 trillion, representing 20-25% of global output.
Investment as a macroeconomic term should not be confused with its more common use as a financial term. Specifically, investment in macroeconomics does not refer to stocks or retirement portfolios.
Rather, investment occurs when goods are purchased for future production, instead of for immediate consumption. For example, households invest by buying houses and building future skills through education. The most prominent use of the term in macroeconomics, however, refers to investment by firms, which can include spending on equipment, technology, research, and facilities.
Investment, consumption, government spending, and net exports are the factors that contribute a country’s GDP.
Liquidity describes how easily an asset can be sold without losing value. For instance, US government debt is highly liquid because the market for it is large and stable. US debt can be sold for its entire value almost instantly. On the other hand, a rare piece of art is illiquid. In order to sell a sculpture for its full value, an auction must be arranged, art connoisseurs must be notified, and payment must be collected.
Liquidity is a valuable attribute because it allows an investor to change her mind about an investment quickly and exit a market if she loses confidence in it. As such, there is often a tradeoff between the liquidity of an asset and its rate of return. The importance of liquidity is especially apparent in a liquidity trap scenario.
A liquidity trap may occur when many investors lose confidence in a market and refuse to invest their money at any interest rate, but choose to hold it as cash instead. This represents a change in investor preferences toward liquid assets. As lending collapses, the entire industry may struggle to pay short-term costs and remain solvent. Japan experienced a liquidity trap in the 1990s, and aggressive action by the Federal Reserve was necessary to avoid a liquidity trap in the US financial sector in 2007.
The Marginal Propensity to Consume reflects the share of additional income that an individual spends. If a person earned $1 more in income and spent 85 additional cents, his MPC would be 0.85.
Most economic models assume, and some empirical studies confirm, that low-income Americans tend to have higher marginal propensities to consume than do high-income Americans. If this is the case, additional income that lands in the pockets of lower income people will raise demand more than the same rise in the income of the affluent.
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A central bank or other regulatory agency conducts monetary policy when it sets interest rates and the size of the money supply. When a central bank increases the rate at which the money supply grows or lowers interest rates, it is conducting expansionary monetary policy. Contractionary monetary policy is when a central bank decreases the rate at which the money supply grows or raises interest rates.
In the United States, monetary policy is conducted by the Federal Reserve Board (specifically, the Federal Open Market Committee). The Fed can buy and sell U.S. Treasury securities, set interest rates (the discount rate), and place reserve requirements on banks in order to manipulate the money supply.
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The multiplier is a numeric measure of how a change in spending affects the economy. Think of the multiplier like a snowball effect: when an individual or the government spends it creates income for another individual. If this individual spends a portion of her new earnings, she creates income for a third individual, who then creates income for a fourth individual…and so on. Therefore, spending $1 may create several dollars worth of new income in the economy. The multiplier says exactly how much income is generated by an extra $1 in spending. For example, if the multiplier is 1.5, $1 in spending leads to a $1.50 increase in income.
The magnitude of the multiplier depends on the share of new income that people spend, a concept called marginal propensity to consume (MPC). Intuitively, a higher MPC leads to a larger multiplier.
Estimates of the U.S. multiplier vary widely, but a middle-of-the-road estimate is about 1.5. In a recent paper, Professor Fazzzari and his co-authors James Morley and Irina Panovska find estimate a multipler in the range of 1.6 to 2.0 when the economy has slack resources . They find a multiplier less than 1.0, however, when the economy is closer to full employment. This finding is consistent with the implications of basic Keynesian macroeconomics: additional spending should be more stimulative when the economy has unemployment.
A real value or rate is adjusted to remove the effects of inflation, while a nominal value or rate includes inflation. For instance, if a bank offers you a loan with a stated 8% interest rate, this represents a nominal rate. The real rate can be found by deducting the inflation rate. Suppose that you are borrowing $100 for one year, with an 8% nominal interest rate in an economy with 3% inflation. The real interest rate you pay is 5% (8%-3%). At the end of the year, you must repay $108 ($100*1.08), which is worth $105 after subtracting inflation. Another interpretation is that real values correspond to purchasing power, while nominal values indicate purchasing power plus inflation.
Potential Output describes what an economy can produce with its current technology, equipment, natural resources, and willing workers. When an economy produces at its potential output, it operates at full employment.
Potential output is the target for good economic performance. It need not be the absolute maximum that could be produced. For example, it might be possible to increase production by forcing more people to work or to force longer hours on the people already working. That outcome would not be desirable, of course. Potential output represents the full use of resources consistent with the voluntary choices made by firms and workers in the economic system.
Purchasing power is the amount of goods and services that can be purchased with $1. For instance, the purchasing power of $1 was greater in 1900 than in 2000 because it could be exchanged for a greater quantity of goods and services. Purchasing power tends to decline over time as inflation increases the price level.
Quantitative Easing is a type of expansionary monetary policy that a central bank may engage in when the traditional tools of monetary policy are insufficient to address economic conditions. The central bank engages in quantitative easing in order to increase the money supply, perhaps to encourage investment and consumption in a liquidity trap scenario or when faced with the zero bound problem. In ordinary times, the central bank increases the money supply by buying U.S. government bonds from private bondholders. The Fed pays cash for these bonds, so after the transaction there are fewer bonds and more dollars present in the economy, increasing the money supply. When bond purchases fall short of the monetary expansion the Fed desires, it engages in quantitative easing by purchasing other types of assets, such as corporate bonds, from institutions such as banks. Japan pioneered quantitative easing in the early 2000s to fight deflation, and the U.S. Federal Reserve conducted several rounds of quantitative easing to combat the Great Recession between 2007 and 2011.
Say’s Law essentially states that “supply creates its own demand.” The logic is that when a firm employs workers, resources, and technology to produce output, it creates incomes as it pays for raw materials, wages, and interest. If the firm turns a profit, this becomes income for the owners. Therefore, the entire value of the production becomes income for someone in society, so the society must have enough income to purchase the output. If Say’s Law is true, insufficient demand in the economy as a whole can never constrain overall production and employment. In this sense, Say’s Law directly opposes the core logic of Keynesian macroeconomics.
Say’s Law was a guiding principle of Classical economics until John Maynard Keynes published the General Theory of Employment, Interest, and Money in 1936. The General Theory, as this famous book is usually known, explicitly refutes Say’s Law. For further discussion that largely parallels Keynes’s discussion in chapter 14 of the General Theory, see Interest Rates, Aggregate Demand, and the Paradox of Thrift.
Although the name “Say’s Law” refers to late 18th century French economist Jean-Baptiste Say, the closest formulation actually used by Say was “products are paid for by products.” Furthermore, Say does not appear to have supported the common Classical interpretation of Say’s Law, as he advocated public works in order to rectify a shortfall in aggregate demand. Nonetheless, his name is associated with this controversial idea, which continues to be a major dividing line between macroeconomic schools of thought.
Prices and wages are “sticky” if they do not immediately rise or fall to reflect changes in demand and supply. For example, suppose the price of tomatoes increases, raising costs for the owner of an Italian restaurant. The owner would like to charge more for the meals that he serves, but doing so requires him to print a new set of menus. The owner may decide that the cost and hassle of redoing the menus is not worth it, and keep prices unchanged. In this case, the price of an Italian restaurant meal is sticky.
Similarly, suppose a worker as a 3 year wage contract with her employer. Even if many other workers become unemployed and the employer finds that he could now hire workers for less pay, the employee is guaranteed a fixed wage in her contract. This is a sticky wage.
A supply shock is a sudden, unexpected positive or negative change in total supply. For instance, suppose that a vast diamond mine is discovered. The global supply of diamonds may suddenly increase substantially as part of this positive supply shock. Similarly, if bad weather destroyed much of the global tomato crop, supply would fall in a negative supply shock.
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The Zero Bound Problem is a monetary policy limitation that a central bank might encounter during a recession. It occurs when the central bank lowers interest rates to 0% and would optimally lower them further, but cannot do so because it does not have the power to set a negative interest rate (if interest rates were negative, everyone would choose to hold their money as cash instead of investing it). The zero bound is troubling because it restricts the actions that a central bank can take to combat a recession. The problem may be lessened by maintaining moderate inflation, because if the inflation rate is positive a central bank can attain a negative effective (real) interest rate. As an illustration, suppose that inflation is 3%, and the central bank sets the (nominal) interest rate to 0%. A saver in this economy invests $100, and receives $100 back at the end of the year. However, due to inflation this is only worth $97 at the end of the year, showing that the effective (real) interest rate was -3%.
The zero bound is not just a theoretical possibility, but has actually arisen several times in recent years. Japan encountered the zero bound in the midst of a severe recession in the 1990s and 2000s and the US Federal Reserve now faces the problem during the Great Recession. Keynesians take the zero bound problem seriously because they believe a central bank should have as many tools as possible available to respond to a recession.