Metablognition

Gross Domestic Product (GDP) is the market value of all final goods and services. The aggregate supply in all domestic markets determines the maximum potential GDP at any given time. But aggregate demand, the national sum of all expenditures, measures true GDP because it measures how much actually is purchased from how much could potentially be purchased. Therefore we will focus mostly on what determines aggregate demand in order to understand what determines GDP.

Aggregate demand is the sum of all expenditures nationwide, which includes total consumption, investment, government expenditures, and net exports (exports minus imports). This may be expressed as AD = C + I + G + ( X – M )

C (consumption expenditure) includes household spending on goods and services, and it usually accounts for a hefty three quarters of the total aggregate demand in the United States. Some autonomous factors of consumption include real wealth, interest rate, household debt, consumer expectations, and tastes or preferences. The rest of consumption expenditure depends on the Marginal Propensity to Consume (MPC), the additional household consumption for each additional dollar of income. MPC is calculated by dividing the percentage change of disposable income by the percentage change in consumption.

I (investment) measures the total purchases of real capital goods. A firm will invest if its rate of return (earnings divided by amount spent to purchase capital) is expected to be greater than interest rates. Therefore I is a function of interest rates, as lower interest rates will encourage more investment, and rates of return.

G (government expenditures) is an arbitrary amount of money determined by normative political decisions. We treat this number as a given.

Net export expenditure ( X – M ) is simply the difference between how much a nation purchases from foreign nations and how much it sells.

Now let’s put it all together in a simple Keynesian Cross (Income Expenditure) model. First we will plot a hypothetical line where aggregate income is equal to aggregate output (Y=AE), which measures potential GDP. This will always be a forty-five degree angle. Next we will superimpose Aggregate Expenditures,

C + I + G + ( X – M)

(note that the slope is affected by the marginal propensity to consume calculated in C, which is called the “consumption function”, and that the Y-intercept crosses at a point above zero, which accounts for all autonomous factors of consumption). The point of macroequilibrium at any given time exists where the line for actual Aggregate Expenditures crosses the line for potential GDP.

GDP naturally expands and contracts through what are known as business cycles as a result of changes in spending. Over time, GDP will expand and peak in a prosperous, inflated boom only to regress into a recession plagued by high rates of unemployment. The process repeats itself, constantly gaining and losing gains. Hopefully, if the economy is well invested, there will be more gains than losses and GDP will increase in the long run.

The business cycle phenomenon can be explained by studying the nature of economic growth. Consider a production possibilities curve. Economic growth occurs when efficient production pushes our economy to the curve of maximum production. During this transition, GDP expands and booms when the economy reaches its maximum output potential. However, any more spending or investment on the edge of our production possibilities curve is wasted because the economy is already producing as much as it possibly can. As a result, prices inflate and production costs become unprofitable. The booming economy busts. Jobs are lost as production regresses back to the point where the economy was not producing to the best of its ability.

A government is an institution that functions to legislate and enforce laws. Most modern governments with successful economies are democracies in which citizens agree to sacrifice some of their rights in exchange for necessary protection. The United States government functions to supply goods and services for its citizens, to redistribute income, and to regulate and stabilize the economy.

Our government is a supplier of public, private, and externality goods and services. Public goods are nonexclusive. They are available to all people at all times, regardless of how many people are using them at any given time. Some examples of public goods would be national defense, a beautiful view, or breathable air. If one person is secured by national defense, looks at a beautiful view, or inhales a lungful of oxygen, that does not prevent another person from doing the same. Conversely, private goods are owned by individuals and can only be consumed in discrete instances. An apple can be eaten by one person, and then it is consumed. A classroom can house a number of people, and then it is full.

Major government expenditures at the federal level include Social Security, Medicare and health care, national defense, income security, and net interest on the national debt, all of which are funded primarily by income taxes. State and local budgets focus primarily on education, transportation and public welfare, all of which are funded primarily by property taxes, sales taxes, and income taxes.

The taxes used to fund government expenditures may be proportional or flat. Proportional taxes discriminate between levels of income, either progressively or regressively: progressive taxes take more money from higher-income households, while regressive taxes take more money from lower-income households. A flat tax does not redistribute income; instead it collects an equal percentage of money from each household regardless of its level of income. Whether the government ought to impose proportional taxes or flat taxes is often debated, because either tax can be viewed as more equitable than the other.

Governments can regulate the economy in a manner they view as most equitable by imposing price ceilings and price floors. Price ceilings are legally established limits on how high a price may be charged for a specific good or service. Likewise, price floors limit how low prices may be set.

A price ceiling can place a burden on the market if it’s set below the market equilibrium, because firms would not be able to set a price equal to demand. Instead, they must settle for the price where the Supply curve crosses the price ceiling. In this situation, the quantity supplied by producers does not meet the quantity demanded by consumers, creating a shortage. Likewise, a price floor set above the market equilibrium can create a surplus as producers supply more than what is demanded by consumers. In the graph (right) surplus is represented by the shaded triangle above the market equilibrium, and shortage the shaded triangle below the market equilibrium. Producers and consumers in the market whose price falls to the right of the dotted line experience no change, but those on the left of the dotted line lose out in the shortage or surplus.

Macroeconomics is the study of the economy as a whole. How to measure the economy as a whole is the first step before analyzing the state of the economy. Macroeconomists have identified at least three principal indicators of the state of the economy: growth rate of GDP, inflation rate, and unemployment rate.

GDP (Gross Domestic Product) is defined as the current market value of all final goods and services produced throughout the nation within a given year. Only the value of final goods and services are measured, because many goods are comprised of other goods that would be counted multiple times. GDP can be calculated as the sum of all expenditures or the sum of all income; both equations should return roughly the same number.

Inflation is a sustained, generalized increase in prices. Determining inflation rate involves comparing the price of a good on year versus another year in terms of percentage change.

A nominal growth rate of GDP can be determined by adding the percent change in price (inflation rate) and the percent change in national output. A real growth rate of GDP would simply be the percent change in national output, disregarding price.

Unemployment rate measures the percentage of people in the labor force, aged sixteen years and older, who are unable to become employed yet are willing to work. In the short term there is a strong correlation between amount of labor and amount of production, so a high rate of unemployment would yield economic hardships throughout the country. Unemployment rate can be estimated by surveying a sample of the labor force and asking them if they are unemployed yet seeking work.

Economist Arthur Okun assembled an equation called the Misery Index in an attempt to quantify how poorly the national economy is performing. His original equation called for the sum of inflation rate and unemployment rate, compounding two negative variables. The higher the Misery Index, the worse off everybody is. Other economists like Robert Barro have included other variables, such as subtracting the growth rate of GDP which, if negative, would augment the Misery Index even more.

Money emerges into existence, like language. While there is no inherent meaning in any unit of money or language, we humans arbitrarily assign meaning to each. The word “blog” perhaps meant little more than onomatopoeia before the creation of the Internet. But as web logs grew in popularity, people began to simplify the phrase “web log” into “blog” so commonly that a “blog” not only became a social and professional phrase but a whole literary genre. Likewise money is assigned meaning through repeated use. There comes a point when, having traded potato chips so often for other lunch goods, potato chips become the generally accepted currency for all lunch goods.

Because money has arbitrary meaning, everything theoretically has the potential to become money. But some things are much more likely than others to be accepted as money. The purpose of money is to be a universal tool for exchange, a raw manifestation of personal value; therefore money must be durable so that its value sustains, and it must have a thriving market in which consumers would readily accept it. People would be willing to accept something as money only if they believe others will accept it as a universal currency, because the true value of money exists in its ability to circulate. Our system of money today can be classified under three definitions, the latter of which include less liquid forms of money:

• M1 includes currency and checking deposits
• M2 includes currency, checking and small time deposits
• M3 includes currency, checking, small and large time deposits

Money is a financial asset; it yields income. We define finance as the channeling of resources from savers, who spend less than they earn, to borrowers, who spend more than they earn. Banking is a form of indirect finance in which money circulates through loans. Savers may deposit money into a bank and borrowers may withdraw from the deposits. It might seem counterintuitive to try to save money in a space where anybody may withdraw from, but most banks have adopted a method of ensuring that all depositors may at any time retrieve however much they have saved. Under the fractional reserve system, a fixed percentage of all deposits is reserved for withdrawal. With a pool of reserves at hand, banks may supply money to depositors in times of emergency.

The banking system is not flawless, though. If all depositors tried to withdraw their money at the same time in a bank run, the bank would implode, owing more than it owned, and it would not be able to provide for everybody. We call this bankruptcy. The Federal Deposit Insurance Corporation (FDIC) was established to protect depositors from losing their money, but in a sense the FDIC is just as vulnerable to bankruptcy because it, too, is a bank. But by gilding the banking system with credibility, what the FDIC really tries to prevent are bank runs from wary depositors.

We have identified the economic problem as such: humans, with their unlimited wants, live in a world with limited resources. Minimizing this problem requires an astute allocation of resources. Several different methods of resource allocation have been used throughout history, the most distinct of which are traditional, command, and market economies. Each economy has its own benefits and drawbacks.

The traditional economy is ritualistic, driven by cultural norms. In this economy, economic decisions and distributions may be based on inheritance, moral traditions or other social customs. Elements of traditional economy can be found in all societies; for example, many American businesses close on Sundays simply because it is common to do so. But there are societies that practice a fully traditional economy. Traditional societies enjoy economic stability at the expense of economic progress, which could be acceptable depending on the material comfort that society.

The command economy, also referred to as the “planned” economy, allocates resources through the centralized decisions of some authority, usually the government. Businesses are publicly owned, and resources attempt to be equally distributed based on need. Few command economies enjoy substantial longevity because of two inherent problems. The first difficulty with the command is that it creates poor work incentives. Workers are rewarded simply for working, not for working well, which often results in a lack of quality and productivity. The second difficulty with the command economy is that it tends to be an inefficient means of allocation. To meet the needs of society would require extensive knowledge of every individual, an almost impossible task. Nevertheless, command economies can be temporarily effective during times of economic crisis or political turmoil.

The market economy places the responsibility of economic decision making in the hands of each individual, rather than a single commanding entity. A purely free market would be anarchy. This might seem chaotic, but it is actually one of the most efficient forms of economy so long as three conditions are met: there must be a product, obviously; there must be many potential consumers and producers of the product; and there must be clear communication between the consumers and producers. The reason why the market economy is so efficient is that individuals know exactly what they want and need. Little is wasted through guesswork because nobody needs to determine who demands what. Instead, the market determines how much of a product is produces and at what price as a result of the exchange behavior between consumer and producer. Simply put, everybody wants to win in the market, so people naturally compromise in a win-win fashion.

One disagreement between command and market economies would be whether or not it is better to allocate resources efficiently or equitably. Markets are highly efficient, but they tend to create a huge divide between the rich, the vast middle, and the poor. Command economies are much less efficient, but there is theoretically less of a divide between the classes. However, recent history has shown us that Communism produces a divide between the masses and the wealthy elite. I would also argue that the inefficiency of command economy, even if it does reduce the class gap, would create a society that is equitably poor.

It’s interesting to note the names of the Supply and Demand curves. Both curves have an aspect of desire, of a need to achieve a goal. On the Demand side, there is a desire to obtain goods and services. On the Supply side, there is a desire to obtain profit. Both have a motivation to gain; yet we name the Demand curve such as it is, drawing up an image of a bellowing, fist shaking consumer, and we deem those who provide their desired goods and services to be Suppliers. Let’s flip the image around. Can the Suppliers not be caricatured as a pack of bellowing, fist shaking profiteers, and the consumers as the subservient providers of the profit? Certainly. Both have a subtly different means to the same end: gain.

The etymology of Supply and Demand suggest a tidbit of human nature. Both sides have a desire to gain, and in the long run the people running both ends of the market will want goods and services. Profits can be used by suppliers to gain their own goods and services, during which transactions they would switch their role to a consumer; however, as the chief instigator of the economic problem, goods and services take the center stage for each individual transaction. Thus the receivers of goods and services are the Demanders, and those who quench with goods and services are the Suppliers.

So we start with effective Demand, a measure of a how much a group or individual is willing and able to make a purchase. Essentially, Demand is affected by Price, income, personal tastes and preferences, price of related goods, and expectations for a change in supply. Supply, though effected by Demand, fundamentally exists to serve Demand as a means to receive profit. Supply is affect by things like Price, cost of production, available technology, and expectations for a change in demand. These determinants of Supply and Demand are largely external, except for Price. Price is a special determinant shared by the two, born of the marriage between them.

The Supply and Demand model illustrates how price is finally determined. By overlaying the Supply and Demand curves, the two cross at a point mutually beneficial for both parties. That point marks the equilibrium market price, where the output of goods, services and profits are maximized in the most efficient manner. If this value was always known, there might theoretically be no waste of resources, ceteris paribus.

To set the stage, economics is a way of thinking about the world and how we use it. It’s a study of choice making, a method of determining the most efficient possible choice in any current or projected situation. The problem is that our world is scarce, or finite, while our human needs and desires are seemingly infinite. Because of scarcity we are forced to decide what to receive at the expense of something else, physically or psychologically. This problem extends to everybody, individuals and groups alike.

But what would happen if one were to break through the economic problem and share it with the world? Would the problem erase if we had at last found a way to fully adapt to scarcity? This question might have been unintentionally answered in the animated short-film MORE, by Mark Osborne.

“More” is the word that clicks our human gears into motion. We need more time and money, more freedom, more happiness. In Osborne’s film, that desire for more had at last been sated by the invention of Bliss. The utilitarian would say that Bliss would have erased the economic problem, because our desire to fulfill wants or needs would have been forever quenched by a sense of happiness and satisfaction. Osborne is not so optimistic. For him there is no quenching the desire for more. Humans build a tolerance to satiation, and their desire only increases. In this sense a life of wealth and bliss amounts to nothing more than that of the day to day laborer, and in the end we can do nothing but look back on our childhood when the problem of economics was only budding.

Take about six and a half billion people with this desire for more and put them on a small, remote planet somewhere in the universe; you have the economic problem. Macroeconomics is the process by which those six and a half billion people will attempt to share the world. To familiarize ourselves with the macroeconomic way of thinking, then, would be to involve our brains in macroeconomic activity, to keep track of what’s going on, and hopefully to make educated judgements about where we could and should go; lest the human race fall globally into starvation, disease and despair.