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M
A
C
R
O
 Chapter 8 Aggregate expenditure in more
depth: exploring the multiplier 164
Introduction 165
How to find the multiplier 165
The size of the multiplier 169
An important refinement: net exports depend on income 171
An introduction to fiscal policy 175
Conclusion 179
Key points 180
Key terms 180
Study tools 180
Review the basics 180
Questions and problems 181

Chapter 9 Monetary policy: an overview 183

Introduction 184
Monetary policy in brief 184
Modern monetary policy: the basic philosophy 186
Monetary policy in more detail 187
Money demand, money supply and the interest rate 192
Asset markets 198
Monetary policy vs fiscal policy 204
Conclusion 205
Key points 205
Key terms 205
Study tools 206
Review the basics 206
Questions and problems 206

Chapter 10 Introducing the economic

fluctuations model 207
Introduction 208
Explaining the ‘typical’ business cycle 211
Introducing the AD curve 216
The short-run adjustment (SRA) line 224
Conclusion 227
Key points 227
Key terms 228
Study tools 228
Review the basics 228
Questions and problems 229

Chapter 11 Monetary policy and the economic

fluctuations model 231
Introduction 232
Inflation targets 233
Changes in monetary policy 236
Contents

Gains from credibility 241

viii
 Alternative short-run adjustment paths 245
Combining different scenarios 251
Alternative monetary policy regimes 254
Conclusion 257
Key points 258
Key terms 258
Review the basics 259
Questions and problems 259

Chapter 12 Fiscal policy: strategic issues 261

Introduction 262
Fiscal policy: an overview 264
The government budget 266
Two ways in which fiscal policy works 272
The structural versus the cyclical surplus 275
Stimulus vs austerity 278
Conclusion 281
Key points 281
Key terms 282
Review the basics 282
Questions and problems 282
Endnote 283

Chapter 13 Fiscal policy: analytical issues 284

Introduction 285
Countercyclical fiscal policy 285
The effects of cutting government expenditure 289
The trend interest rate 296
Conclusion 297
Key points 297
Key terms 298
Review the basics 298
Questions and problems 298
A wrap-up/synopsis 300
A quick overview: who said what 301

Part 3 The international dimension 303

Chapter 14 International trade in perspective 304
Introduction 305
Trends in international trade 305
Adam Smith and free trade 308
Comparative advantage 310
The transition to free trade 313
Arguments for trade barriers 313
How to reduce trade barriers 317
Contents

Conclusion 320

ix
 Key points 320
Key terms 320
Study tools 321
Review the basics 321
Questions and problems 321
Endnotes 322

Chapter 15 International finance 323

Introduction 324
Saving, investment and net exports 325
Balance of trade around the world 328
The balance of payments 329
Exchange rate determination 334
The Australian dollar 338
Reducing exchange rate risk 340
Fixed exchange rate systems 341
Fixed versus flexible exchange rates 344
Conclusion 347
Key points 348
Key terms 348
Review the basics 349
Questions and problems 349
Endnotes 350

Chapter 16 Economic development 351

Introduction 352
International comparisons 352
Why is economic development uneven? 357
New growth theory 359
Spreading and using technology: a long-term view 363
Conclusion 368
Key points 369
Key terms 370
Review the basics 370
Questions and problems 370
Endnotes 371

Economist’s toolkit 372

Glossary 403
Index 410
Contents

x
 Preface
Welcome to macroeconomics. Studying this subject is a major investment of your
time. For some students, it may yield a very high return. After studying this textbook,
you should be well placed to understand and evaluate debates in the media about the
behaviour of the macroeconomy and the conduct of macroeconomic policy.

Some textbooks are written as if first-year economics was mainly a mathematical

and statistical preparation for second-year economics and beyond. My focus is on
understanding concepts. In macroeconomics, unfamiliar ideas are what even the
technically strong students struggle with. This book strives to explore concepts
quite deeply without the unnecessary inclusion of mathematics and statistics. My
hope is to provide good preparation for ongoing economics students, as well as
explaining a freestanding body of ideas that everybody can use immediately.

There are major differences between this book and its American counterpart. The
Australian editions are still based on Taylor’s approach, but every page has been
significantly redrafted. Entire sections have been rewritten, and chapters have been
dismembered and rearranged. The analytical side of the adaptation remains loyal
to Taylor’s ‘New Keynesian’ approach and to his preferred models, but there are
several distinctive features. First, this book responds differently to the global financial
crisis. It looks more closely at the operation of financial markets and assets markets.
Crises can be traced to how these markets can malfunction. It explains the core ideas
of Keynesian economics in greater depth. Second, it adapts Taylor’s treatment of
monetary policy to fit better with what the Reserve Bank of Australia does. In Australia,
inflation is contained within a band, and this flexible approach has proved successful.

The major noteworthy changes in the content of this edition are:

1 The presentation of the core model used to explain the relationship between
inflation and interest rates has been further improved. This model gives direct
insight into the decision making of central banks in Australia, the United
States, Britain and elsewhere. Over the last few years, the importance of
being able to put oneself in the position of central bankers has increased.

2 New material on rival approaches to macroeconomics has been prepared. The

goal is to collect and compress the key ideas of value from the various schools of
thought.

Writing a textbook is a major investment. In Australia, nobody expects to earn much

in royalties from writing one – the Australian market is small, and the competition
is intense. Whether you are a lecturer or student, my hope is that I succeed in
communicating what macroeconomics is about and, more importantly, why it matters.

Dr Bruce Littleboy
School of Economics
St Lucia Campus
University of Queensland

xi
 Resources guide
As you read this text you will find a number of features in every chapter to enhance your study
of Macroeconomics and help you understand how the theory is applied in the real world.

When used in the text for the

first time, key terms are defined
in the margin and bolded for
easy identification. A full list of
For the student
key terms and definitions can be
Learning objectives give you a clear sense of what
found in the glossary at the back
each chapter will cover and what you should be able
of the book.
to do after reading the chapter.

Economics in action boxes demonstrate

applications of economic theory, examine current
issues and give examples of recent news stories
relating to economic concepts.
Margin notes highlight tips,
reminders, key points and
relevant online resources to
assist you in your study.

Drilling deeper boxes provide a closer look at key

questions and issues in Macroeconomics.

xii
 People and economics boxes relate directly to
people who have been significant to the development
Analyse this features challenge
of economic thought, or of specific economic theories.
you to evaluate the concepts you
Some key historical economic events and their impact
encounter.
on people are also highlighted in this feature.

Review boxes appear at the end of each major

section. These reviews summarise the key points as
the chapter evolves.

At the end of each chapter you’ll find several tools to help you to
review the chapter and key learning concepts, and also to help
extend your learning.

Each chapter’s Key points

are summarised and you
can Review the basics with
short-answer questions.

End-of-chapter Questions
and problems enable your
resources guide

comprehension of key
concepts to develop and
also give you the opportunity
to apply these concepts.

xiii
 ONLINE RESOURCES
Coursemate brings concepts to life with interactive learning, study
and exam preparation tools that support Macroeconomics: Principles
and Practice. Each new copy of Macroeconomics: Principles and
Practice includes access to loads of online resources.
Login to CourseMate for Macroeconomics: Principles and Practice
at http://login.cengagebrain.com to access:
❏❏ an ebook version of this text
❏❏ a suite of resources to help you study, with
➜➜ audio summaries
➜➜ graphing workshops
➜➜ interactive quizzes
➜➜ videos
➜➜ crosswords
➜➜ flashcards
➜➜ glossary
➜➜ weblinks
➜➜ and much more!
❏❏ Search me! economics. Fast and convenient, this resource is updated
daily and provides you with 24-hour access to full-text articles from
hundreds of scholarly and popular journals, e-books and newspapers,
including The Australian and The New York Times.

FOR THE INSTRUCTOR ExamView test bank

Instructor’s manual
The Instructor’s manual provides you with a wealth
of content to help set up and administer your
macroeconomics subject. It includes answers to
end-of-chapter questions and problems, teaching
notes and additional resources.
PowerPoint presentations
Chapter-by-chapter PowerPoint presentations
cover the main concepts addressed within the text
and can be edited to suit your own requirements.
Use these slides to enhance your lecture
presentations and to reinforce the key principles of
your subject, or for student handouts.
RESOURCES GUIDE
ExamView helps you to create,
customise and deliver tests in minutes for both
print and online applications. The Quick Test
Wizard and Online Test Wizard guide you step
by step through the test-creation process. With
ExamView’s complete word-processing abilities,
you can add an unlimited number of new questions
to the bank, edit existing questions and build tests
of up to 250 questions using up to 12 question
types. You can also export the files into Blackboard
or WebCT.
Artwork
These digital files of graphs, tables, pictures and

flow charts from the text can be used in a variety

of media. Add them into your course management
system, use them within student handouts or copy
them into lecture presentations.

xiv
 About the authors
Bruce Littleboy: Who I am explains why I have written this book. I have volunteered to teach
first-year macroeconomics at the University of Queensland for over 25 years. Macroeconomic events and
policies have enormous social impacts. Experts can disagree, and it is important to understand why. Debates
in economics are sometimes about what the facts are; more often, they are about what the facts mean.

My research area is in the history of economic ideas, especially those surrounding the meaning
and significance of the theories of John Maynard Keynes, who is still a central figure in introductory
macroeconomics. My PhD was published as a book, On Interpreting Keynes.

I thank Jerome Bredt, who drew the caricature. Jerome, a former student, confessed after a few
years that he had sketched it during a lecture.

John B. Taylor is one of the field’s most inspiring

Jerome Bredt

teachers. As the Raymond Professor of Economics at Stanford

University, his distinctive instructional methods have made him a
legend among introductory economics students and have won him
both the Hoagland and Rhodes prizes for teaching excellence.

Professor Taylor is also widely recognised for his research on the

foundations of modern monetary theory and policy. One of his well-
known research contributions is a rule – now widely called the Taylor
Rule – which is used at central banks around the world. Taylor has
had an active career in public service, including a four-year stint as
the head of the International Affairs division at the United States
Treasury, where he had responsibility for currency policy, international
debt, and oversight of the International Monetary Fund and the World Bank, and worked closely with
leaders and policymakers from many countries. He has also served as economic adviser to the governor
of California, to the U.S. Congressional Budget Office, and to the President of the United States, and has
served on several boards and as a consultant to private industry.

Professor Taylor began his career at Princeton, where he graduated with highest honours in
economics. He then received his PhD from Stanford and taught at Columbia, Yale and Princeton
before returning to Stanford.

Akila Weerapana is an Associate Professor of Economics at Wellesley College. He was

born and raised in Sri Lanka and came to the United States to do his undergraduate work at Oberlin
College, where he earned a BA with highest honours in economics and computer science in 1994. He
received his PhD in economics from Stanford in 1999, writing his dissertation on monetary economics
under the mentorship of John Taylor. Since then, Professor Weerapana has taught in the Economics
Department at Wellesley College. His teaching interests span all levels of the department’s curriculum,
including introductory and intermediate macroeconomics, international finance, monetary economics
and mathematical economics. He was awarded Wellesley’s Pinanski Prize for Excellence in Teaching in
2002. He also enjoys working with thesis students, advising projects that have ranged from a study of
the economic benefits of the eradication of river blindness in Ghana to an analysis of the determinants
of enterprise performance in Russia.

In addition to teaching, Professor Weerapana has research interests in macroeconomics,

specifically in the areas of monetary economics, international finance and political economy.

xv
 Acknowledgements
Cengage Learning and the authors would also like to thank the following reviewers for their incisive and
helpful feedback. All suggestions were considered carefully in light of the constraints of time and space.

❱❱ Ishita Chatterjee, University of Western Australia

❱❱ Galina Ivanova, Central Queensland University
❱❱ Craig MacMillan, Macquarie University
❱❱ Anita Medhekar, Central Queensland University
❱❱ Stuart Mounter, University of New England
❱❱ Glenn Otto, University of New South Wales
❱❱ Max Tani, Macquarie University
❱❱ and several anonymous reviewers

xvi
 1
Part
Macroeconomic issues
and challenges
1 Macroeconomics: the big picture

2 Macroeconomics: getting started

3 Measuring gross domestic product

4 Long-term economic growth

5 Labour and the macroeconomy

6 Money, banks and inflation

1
 1
Chapter

Macroeconomics:
the big picture
After studying the material in this chapter,
you should be able to:
1 define macroeconomics
2 compare macroeconomics with microeconomics
3 see that macroeconomic analysis can help decision making by
individuals, governments and firms

4 describe the role of macroeconomic models in economic analysis

5 differentiate between normative economics and positive economics
6 draw connections between macroeconomics and some broader
social goals.

2
Introduction
Macroeconomics is the study of the economy as a whole. You probably know already from experience
that the health of the economy as a whole can have an impact on you as an individual. But the processes
at work are sometimes remote and bewildering. Besides, it is not always clear what you can do to protect
yourself from adverse changes going on around you, or how you can take personal advantage of positive
changes. Knowing some macroeconomics will help you make smarter and better informed decisions.
Changes in interest rates, for example, clearly affect the entire economy, not just the banking sector.
But you might not know why interest rates change or how to use this knowledge. In theory (and in fact),
if interest rates fall by half and remain low, the price of long-lived assets (shares, houses etc.) tends to
double. Those who judge correctly and act quickest will profit most.
How well a country’s economy and even the global economy perform over time has a profound impact
on the welfare of citizens collectively, for good and bad. A stable, growing economy offers not only the
opportunity for improved material wellbeing, but also the capacity and resources to address social and
environmental problems. At the other extreme, major economic breakdowns are often accompanied by
social breakdowns. If output collapses, so does employment. Severe poverty and wars can result from
widespread economic collapse and government mismanagement.
Even economies that have performed well for several years can suddenly falter, leading to higher
unemployment, economic hardship and social isolation. When production declines across a wide range
of industries, many unemployed people cannot find alternative jobs. Business profits decline during
contractions of the economy, and bankruptcies can happen very quickly. More people commit suicide
and more families break down.1 It is crucial, therefore, that we have a sound understanding of how the
economy works to avoid the problems created by economic declines and to enable people to achieve their
human and productive potential. This is the job of the macroeconomist: to study and understand the ‘big
picture’ in economics and to apply this knowledge to create better outcomes for society.
A central concern of macroeconomics is how the economy as a whole grows and changes over time.
Economic growth can produce astonishing transformations in material living standards over time.
Young Australians today could choose to work only two months of the year and still consume the same
amount as they would have consumed 100 years ago. Since the mid-1970s, however, growth has slowed
and many young Australians now are probably not much better off than their parents were. Levels of
unemployment have also varied greatly over time. Unemployment was at about 20 per cent in the 1930s,
then about 2 per cent in the 1960s, and now 5 per cent is considered a low outcome. Another issue is
inflation – the increase in the price of almost everything in the economy, which has caused a $2 (£1)
commodity in 1950 to be priced at over $46 today. The RBA’s Inflation
Calculator is an
Macroeconomics strives to explain why these economy-wide changes occur. Skilful government interesting tool for
policy can provide for high economic growth, low unemployment and low inflation. But bad economic looking at the change in
cost of representative
policy can damage the economy. Macroeconomics is essential to determining good policy and building purchases over time:
www.rba.gov.au
economic systems that are prosperous, environmentally sustainable and resilient against disturbances. /calculator/
This chapter describes the discipline of macroeconomics and the role of macroeconomists.

Thinking like a macroeconomist

Economists are social scientists. They are interested in society’s economic dimension and in putting
their knowledge to practical use. Economists think in abstract terms to cut through the complexities and
isolate the important causal processes at work. Sometimes, this task requires a familiarity with graphs,
basic arithmetic and algebra. Equally important, however, is an ability to relate economists’ thinking

chapter 1 Macroeconomics: the big picture 3


microeconomics
the branch of economics
that examines individual
decision making by
firms and households,
and the way in which
they interact in specific
industries and markets
macroeconomics
the branch of economics
that examines the
workings and problems
of the economy as
a whole
gross domestic
product (GDP)
a measure of the value
of all goods and services
newly produced in
an economy during a
specified period of time
price level (P)
the average price of
total output
4 Part 1 Macroeconomic issues and challenges
back to the real world. The public sometimes impatiently dismisses scientific terminology as intimidating
jargon. But working with science means carefully defining your terms, trying to measure what is relevant
and building chains of causal reasoning.
The discipline of macroeconomics
There are two main branches of economics: microeconomics and macroeconomics. Microeconomics studies
the behaviour of individual firms and households, or specific markets (such as the market for movies, or the
university graduate market). It looks at relatively small parts of the economy. Macroeconomics focuses on the
whole economy; that is, the whole national economy or even the whole world economy.
In general, macroeconomics is the study of aggregates or whole systems. It looks at how the big parts
fit together. Macroeconomic aggregates include gross domestic product (GDP), which in simple terms is
the total output of goods and services produced in a country over a given period of time, normally a year.
Another is the general price level (P), which is a measure of the average price of all the goods and services
in an economy. These aggregates provide valuable information about the health of the economy as a whole
and how it is changing over time. They also provide the basis for the macroeconomic theories that seek to
explain how the economy works and how problems can be remedied.
If you have already studied microeconomics, it is important to recognise that macroeconomics is not
simply a scaled-up version of microeconomics. The general message of microeconomics is that markets
work well to absorb disturbances: relative prices adjust and resources find alternative uses. In parts of
macroeconomics, however, an initial disturbance can be amplified. An absolute decline in one important
part of the economy can spill over into others, so the system worsens before it begins to recover. A
collapse in share or house prices, for example, causes people to cut spending generally. This results
in a wider impact on sales and earnings in industries that seem unrelated to share and house markets.
A loss of confidence in one sector can spread infectiously to others, resulting in severe turbulence. In
microeconomics, less production of one thing means more production of something else. If the demand
for houses falls, their market price falls relative to the price of other things. There is a decrease in the
quantity of houses supplied, and other industries will expand a little and use the resources no longer
needed to make houses. By contrast, in macroeconomics, almost the entire economy may be performing
poorly, and idle resources have nowhere to go except into unemployment. Furthermore, national
economies are interconnected; that is, large disturbances in one country spread to other countries.
The response of a system to a large (macro) disturbance can be very different from its response to a
small (micro) one. Size matters. If you prick your finger, your body’s restorative systems will probably
cope: the blood clots automatically and there is no need to call a doctor. Similarly, an economy would not
have survived and evolved to great complexity if it were unable to cope adequately with small disturbances.
Contrast a traumatic injury. Completely different dynamic processes are observed in the body, and medical
intervention is necessary. Again, similarly, some very large macro disturbances can overcome the ability of
the economic system to cope. But well-designed and well-managed systems perform better.
Macroeconomists do sometimes use microeconomic logic for particular purposes. Compositional issues
can affect aggregate outcomes – for example, the share of resources devoted to education can raise the long-
term growth of GDP. Also, supply and demand reasoning is sometimes used in later chapters of this book to
analyse quite large and important markets, such as the labour market and the market for money. If required,
you will find a quick refresher course in microeconomics in those chapters. Furthermore, there is no exact
definition of ‘large’ or ‘small’, so the borderline between macro and micro is not precise.
The government and key institutions such as the central bank play an important role in
macroeconomic thinking and practice. The Reserve Bank of Australia, for example, has the task of
ensuring the stability of the financial system as a whole. Financial systems build complex chains and
networks of credit. I owe you money, and you owe her, and she owes him. If I cannot pay you, then you
cannot pay her, and she cannot pay him. If one link in the chain defaults, therefore, severe problems result
for everyone further down the chain: their cash flows are suddenly disrupted and their businesses can
fail even if they are viable over the longer term. In later chapters, we examine the policy tools used by the
government and the central bank to manage the financial system and the economy as a whole.

Macroeconomists do it with models

To explain economic facts and observations, economists need an economic theory, or a model. (In
practice, the terms ‘theory’ and ‘model’ are often used interchangeably.) A macroeconomic model is macroeconomic
model an explanation of
an explanation of how the economy or a large part of the economy works. Macroeconomic models are how the macroeconomy
abstractions, or simplifications, of the real world that can be described with words, numerical tables, or part of the
macroeconomy works
graphs and algebra. They take complicated phenomena, such as the spending behaviour of millions of
individuals, and simplify them. While macroeconomic models are simplifications, they are not always
To review key
simple. They often use sophisticated computer simulations to show how the economic system responds concepts of which
to changes. Governments and firms employ graduates to help them formulate their strategies using you should be aware
when interpreting
computer analyses of statistical data. economic data and
Economic models simplify, and we use them to help answer ‘what if’ questions. If the output of models, refer to the
‘Economist’s toolkit’
an economy grows by 10 per cent this year, what is likely to happen to the inflation rate? We can trace (see page 372). Topics
causation between output growth and inflation only by assuming no other disturbances. In reality, covered include economic
variables, correlation
other changes will be occurring (weather events, changes in government policy and so on) that affect the and causation, and
output and inflation outcomes. To make the analysis manageable, we hold these other things constant interpreting
graphs.
(or we ‘assume them away’) so we can think through the effects of a specified hypothetical change.
Macroeconomic models use a ceteris paribus assumption, which means that our models hold ‘other ceteris paribus
things equal’. Being aware of what you are holding constant in a model and being able to use this model holding other things
constant
wisely in a complex and changing environment is a rare but important skill. People make ceteris paribus
assumptions in ordinary life. When you say, ‘See you tomorrow’, for example, everybody understands
that you are assuming you will not be run over by a bus this afternoon.
Like models in other sciences, macroeconomic models change and new models are developed. Many
of the models in this book are very different from the models in books published 40 years ago. New
macroeconomic models evolve when existing models cannot explain some new observations. People
learn from experience and change their behaviour. But the development of new models or theories in
macroeconomics is similar to that in any other science. First, one develops a hypothesis, or a hunch, to
explain a puzzling observation. Then, one tests the hypothesis by checking whether it predicts well in
explaining other observations. If the hypothesis passes this test, then it becomes accepted.
In practice, however, this is a rough description of the process of scientific discovery in
macroeconomics. Testing a macroeconomic hypothesis against observed facts is difficult because social
systems evolve while we are studying them. Policy intervention by government and its institutions can
also confuse matters. Furthermore, one set of facts can be consistent with more than one explanation.
Suppose there is a long queue of unemployed people at the door of a charity. One economist could
say, ‘Those people would have a job if they were willing to work for less pay’, while another economist
could say, ‘Those people are victims of bad macroeconomic policy who have been thrown out of work
through no fault of their own’. The same evidence can have more than one reasonable interpretation.
In many sciences – certainly psychology, physics and biology – investigators perform controlled
experiments to determine whether one event causes another event. Unfortunately, such controlled
experiments are generally impossible in macroeconomics. In the case of education levels and growth, we
cannot go back and repeat the past 10 years with a lower education level intake to see what would happen

chapter 1 Macroeconomics: the big picture 5

 to growth. True, we could look at other countries’ experiences or the experiences

©iStockphoto.com/Syldavia
of different States or Territories within Australia; macroeconomists use such
comparisons to help determine causation. But, unfortunately, no two countries
or States/Territories are alike in all respects. Attempting to control for other
factors in macroeconomics is thus not as easy as in clinical trials.
As more evidence is accumulated over time, some rival theories usually
become increasingly regarded as unconvincing and are rejected. Some debates
in macroeconomics go on and on, however. Sometimes, parts of models rejected
in the past are combined with something new. In these situations, knowing the
history of a debate about one theory can help generate new theory. One economist,
Progress in economics is sometimes like unsteadily Axel Leijonhufvud, remarked that economics is sometimes like unsteadily
climbing a spiral staircase. Let’s hope this stairwell was not climbing a spiral staircase: we go around in circles but we still ascend.
inspired by MC Escher!
In their search for stable relationships or repeated patterns of events,
macroeconomists have discovered important regularities; some of the regularities point to policy
interventions that tend to achieve desired outcomes. Sometimes, logic, observation, study of historical
episodes, intuition and words are used to make important discoveries. Commonly, however, most of the
cutting-edge analysis nowadays is more formal and resembles the methods of the physical sciences, whereby
mathematics and statistical analysis are central. This approach to analysis is called econometrics.

Review •• Macroeconomics is a social science that studies

the behaviour of large aggregates, such as an
•• To focus on the key relationships, economists use
the ceteris paribus approach and assume away
economy’s total output. complicating factors.

•• Macroeconomies sometimes seriously malfunction,

especially when affected by a large disturbance.
•• Scientists often disagree: often this is because the
same evidence can support different theories.

•• Because reality is complicated, scientists use

simplified models and theories that focus on key
•• Macroeconomists cannot perform controlled
experiments, but statistical analysis (econometrics) can
relationships. sometimes be used to test the validity of rival theories.

Science, values and ethics

Macroeconomics has many uses in business, government and personal life. But we also study economics
to determine the economic approach that suits our community’s objectives. This raises issues of science,
values and ethics. Social scientists should act ethically.

Positive versus normative economics

Scientists study the world, but their discoveries can be used to change it. This is the basis of the
positive economics distinction between positive and normative economics. Positive economics is about how the economy
how the economy in
fact works works. Normative economics is about whether we approve of these economic processes and the resulting
normative economics
outcomes; it is about advocating to either change things or leave them alone.
debating our goals and Positive economics relates to the realm of facts – what is, what was, what would happen in response to
preferred economic
outcomes some event or new policy, and what could happen in the future. You can, in principle, observe or deduce
whether a statement of fact is true. Positive economics tries to explain why economic growth happens, for
example. It does not take a normative position on whether growth is desirable. Normative economics goes
further to recommend particular policies that encourage a desired amount (or type) of growth. Positive

6 Part 1 Macroeconomic issues and challenges

economics is about whether a policy method is likely to be effective; normative economics is about
whether the policy outcome, or the method chosen to reach it, is desirable.
Macroeconomists advise governments and decision makers generally about the probable factual
consequences of choosing alternative options. As a citizen in a free country, a macroeconomist can urge
governments to decide one way or another, but politicians have the job of deciding what the community
thinks is right or wrong. Macroeconomists do not regard making normative policy decisions as their job,
but they still try to do their scientific work in an ethical way without bias and misrepresentation. To this
extent, values about right and wrong definitely affect the work of macroeconomists.

Inside Job Peo p l e and

eco no mics

The multi-award-winning 2010 documentary Inside Job

Sony Pictures Classics/The Kobal Collection

features interviews with several major macroeconomists,
who are asked about the roles they played in creating
the conditions that almost resulted in a meltdown of
the global financial system. They had publicly argued
in favour of financial deregulation, but many had also
received large and undisclosed consultancy and other
payments from the financial institutions who wanted less
regulation. As a result, in January 2012, the American
Economic Association introduced a voluntary code
of ethics that urges the disclosure of any significant
financial interest.

Macroeconomics as a science versus

a partisan policy tool
Although economics, like any other science, is based on facts and theories, it is not always used in a purely
scientific way. Sometimes, it can be hard to separate positive from normative issues because people may see
what they want to see in the data. We approach the data with preconceptions and biases. Our assumptions
may be inappropriate. In addition, changes in economic policies often result in some people gaining and
others losing. Some people will think this redistribution is desirable, but others won’t. The application of
positive scientific theories, therefore, can have normative consequences that can be politically controversial.
In political campaigns, an economist may support one candidate and criticise another. If economists
assist one side purely on the basis of providing honest, competent and unbiased positive analysis,
however, this is different from being an unethical spin doctor or a ‘hired gun’ who argues either side for
enough payment. A good reason to study macroeconomics is to detect bad arguments.
Be alert to how easy it is to blur the positive scientist / normative advocate distinction in political
debate. Suppose an economist says, ‘Efficiency raises output of goods and services, which tends to raise
economic welfare, so we should have less government interference in markets to enhance efficiency’. The
first claim is positive (and also likely to be true, given how economists define ‘efficiency’ and ‘economic
welfare’). The second suggestion is entirely normative. Many economists slide too easily from scientist to
partisan advocate. Society might have more important goals than ‘welfare’ as economists define it. Some
people value job security and a sense of community ahead of expanding the domain of market exchange.

chapter 1 Macroeconomics: the big picture 7

 No scientist has special authority to tell others what they should do. At most, they can say only that if
society has particular goals, then these specific policies would tend to achieve them effectively.
Other criteria, such as national security, could also override narrowly economic considerations.
Although economists tend to recommend free exchange, a free market for nuclear weapons would be a
bad idea. On the other hand, many restrictions to free trade, claimed to be needed on national security
grounds, could be partisan. One stated reason for low-cost Australian rice not being allowed to freely
enter Japan, for example, is that it is important for Japan to have its own rice industry in case the country
becomes isolated during war. But did Japan lose the Second World War because it ran out of rice? Maybe
the real reason for the trade restriction is that the Japanese Government wants the political support of rice
farmers. A later chapter explores the arguments (good and bad) for and against free trade, and related
concerns over the proper domain of globalisation and free trade.

Policy goals
Taking a step towards one policy goal can take you further from another. Some goals are quite compatible,
but others tend to conflict. The task of the decision maker is to find the best trade-off. You cannot stand
everywhere simultaneously. Moving closer to a dynamic, prosperous and innovative world that is based
on the freedom of individual choice tends to take you away from a stable, secure and egalitarian world.
Where the best place is depends on your normative beliefs about what economic outcomes and processes
should be. Some goals matter more to you than others. Figure 1.1 is a map that plausibly shows how close
various goals are relative to each other.

Figure 1.1 Some macroeconomic and broader social goals. Where do you stand on this normative map?

If you stand near A,

you probably advocate
broad government
interventions. If you
prefer to stand at B,
you probably advocate
small government Innovation and
and reliance on National security flexibility
free markets.
Environmental Material prosperity
protection

Individual freedom
from government
restriction

Macroeconomic
Redistribution of income stability
Job and income
security for individuals
Helping only the poorest
A

Social stability

8 Part 1 Macroeconomic issues and challenges

 Since the 1980s, the public image of macroeconomists is that we all believe in free trade and small,
lean, efficient governments. As a group, we seem to urge ‘downsizing’ and cutting costs. Our public Login to
CourseMate
image is that most of us stand near B, but this could be an unfair stereotype. Not many people have a to take the online
clear idea of what macroeconomics is and what macroeconomists do. Macroeconomists are a diverse revision quiz
for this chapter
group, and we engage in fruitful scientific debates about how well markets work in practice to serve
society’s diverse goals. As a result of the recent global financial crisis, many economists are reconsidering
both how the world actually works and where they stand normatively.

••Positive statements are about what is factually true

or false.
••Sometimes, macroeconomists disagree on scientific
grounds about what the facts are and what the data Review
••Normative statements are about what we approve
of or disapprove of.
mean; sometimes, they disagree with each other
because they have different normative beliefs
and goals.

Key points
❱❱ Macroeconomics examines the workings and
problems of the economy as a whole. Economic
growth, employment levels and inflation are key
macroeconomic issues.
❱❱ Macroeconomic theory can be used to improve
economic decisions by individuals, firms
and governments.
❱❱ Macroeconomists use economic models to explain
their economic observations. These economic
models are similar to models in other sciences.
They are abstractions, or simplifications, of reality.
But economic models are different from models in
the physical sciences because they deal with
human behaviour.
❱❱ Macroeconomics is a separate discipline from
microeconomics because large systems can
behave differently from small systems, and large
disturbances can have different effects from those
of small ones.
❱❱ Macroeconomists need to know some
microeconomics. There is no exact definition of
‘large’ or ‘small’.
❱❱ New economic models are developed in part
because existing models cannot explain facts or
observations.
❱❱ In principle, positive economics and normative
issues are different, but in practice it can be difficult
to keep them separate.

Key terms
❱❱ ceteris paribus ❱❱ microeconomics
❱❱ gross domestic product (GDP) ❱❱ normative economics
❱❱ macroeconomic model ❱❱ positive economics
❱❱ macroeconomics ❱❱ price level (P )

Review the basics

1 What is the difference between microeconomics 3 What is the difference between positive and
and macroeconomics? normative economics?
2 How do economic models differ from the economic 4 How do economists use the ceteris
phenomena they explain? paribus assumption?

chapter 1 Macroeconomics: the big picture 9

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