Unit 6: Government, Economic Systems, and Theories

Jim’s Guide to Unit 6

Portrait of John Maynard KeynesThe ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.  Indeed the world is ruled by little else.  Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.
–John Maynard Keynes, 1883-1946


Now we begin to shift our attention macroeconomics.  We’re now going to look at the “big picture” — what news announcers and politicians and businesspeople talk about when they use the phrase “THE ECONOMY”.  You’ve heard that phrase before.  You’ve heard it when your friends complain they can’t get a job (or lost their job) because of “THE ECONOMY”.  Or, you’ve heard it when a politician claims we need to raise or lower taxes in order to “boost THE ECONOMY”.  Or, you’ve heard it when a news announcer says “the government announced THE ECONOMY slowed last month”.  We’re going to study this thing called “THE ECONOMY”. We’re going to look at the big picture.

We live in some interesting times.  In 2007-09, not that very long ago, the U.S. and the world suffered the longest, most serious recession/depression and financial crisis since the Great Depression in the 1930′s.  Even today we haven’t fully recovered from it yet. Unemployment is distressingly high and slow to improve. Political and business “leaders” offer us conflicting advice about what we need to do to “get the economy going again”. Some say cut government spending, others say increase it. Some say raise interest rates, others say make money available.  It’s very confusing.  Yet it doesn’t have to be all that confusing.  As John Maynard Keynes (see above quote) observed during the last great economic crisis, the previously mentioned Great Depression,  our political and business “leaders” are in fact followers of what some long-ago economist wrote and theorized.  All we need to do is re-trace some steps and figure out what those now “defunct” economists were really saying.  That’s what we’ll do in this course.

In this first on macro, I want to cover two topics.  First, I want to introduce you to the discipline called “Macroeconomics” with a little bit of historical and social context.  Most textbooks don’t discuss this part.  They tend to present economics  as if it were some settled body of knowledge and facts to be transmitted from professor to student. It’s not. The field of macroeconomics is constantly changing – much more so than micro.  It’s evolving as we learn more and researchers propose develop and refine theories.  It’s also evolving because the economy itself is evolving. But it’s also a difficult and confusing field.  It’s full of arguments and researchers/economists who actively disagree with each other.  Part of this is because the subject matter, the economy itself, is incredibly complex and constantly changing. In a physical science like physics at least gravity works the same way it did 400 years ago.  An economy keeps changing.  Carl Sagan, a famous astronomer, once remarked that people who describe large numbers as “astronomically large” really should call them “economically large”.  He said there “billions and billions of stars” in the observable universe, but economies are measured in the trillions and trillions of dollars.

How do nations get wealthier?

Markets and trade have existed since before mankind began recording history. However, for most of history, markets haven’t been the primary means of organizing and coordinating economic activity. Political authority and power has been the most common. In other words, people produced whatever the King/Emperor/Ruler/Tribal Chief said they would. Distribution of goods was often settled by force – whoever was stronger took what they wanted and the others fought over the left overs. Overall, it wasn’t very motivating to say the least.

Gradually at first, and then much more rapidly in recent centuries, markets have come to play an increasingly important role in economies. In the last 200-300 years, markets have come to be the dominant economic institution in most economies around the world, particularly the developed & industrialized countries. Along with this growing importance of markets has been an explosion of economic growth and improvement in standards of living.

The increasing role of markets hasn’t been without controversy, though. One of the unique aspects about markets as social institutions is that nobody is in charge. There’s no central boss or authority who’s ultimately responsible for everything that happens. When there’s a clear authority figure, it’s easy to believe things will get better or that we’ll get richer. We place our trust in the authority figure – the King, the President, the Emperor, whoever. Historically, people have been more reluctant to trust markets. After all, there’s no clear “plan” where the market is taking the nation. There’s nobody to pin the blame on if we don’t grow richer. Another issue with markets as the leading economic institution, is that it’s not clear just exactly what the ruler (or government) should be doing economically. Are there economic decisions the government should continue to make? Or should the ruler/government completely get out of the picture?

These concerns have motivated the study and development of Macroeconomics. The way this course is laid out, we will retrace some of the key arguments, controversies, and theories about how a market-based economy can best grow and be managed. A critical issue will be trying to figure the best role for government in a market economy. Some understanding of how industrialized economies (like the US) have grown and evolved over the last 200-300 years is important to understanding these ideas.

Adam Smith’s famous book in 1776  An Inquiry into the Nature and Causes of the Wealth of Nations. That is, in essence, what macroeconomics is about:

  • How can a nation, or the people of a nation, get richer?
  • Why do some countries and nations get richer and others don’t?
  • Is there anything we can all do to make sure we all get richer and have a better life?
  • What should the government do about “the economy”?
  • How do we make the economy better and more predictable?

An economy is a very complex thing. After all, it’s the total of all the economic behavior and decisions of everybody in the economy. If we’re talking about the US economy, that means the behavior and decisions of over 310 million of us!

Disruption, Structure,  and Change in Economic History

The history of most economies is one of disruption and change.  Historically, economies are extremely unpredictable and highly variable. Equilibrium, a state where the circular flow is constant and unchanging is rarely occurs, if ever.  Yet the concept of an economy at equilibrium can be very useful.  It allows us to analyze and focus on how specific disruptions are going to change macro-economic performance.

For example, suppose the weather is particularly bad during some year in a heavily agricultural country.  Crops are likely to be poor.  Farm land will be less productive than normal.  Farmers will have fewer goods (food) to sell.  It’s likely that with less crops to sell, farmers will receive less money from the goods markets.  Their profits will be smaller.  The smaller profits will mean the farm households have less money to spend on other goods and services.  When the farmers stop buying other people’s goods (clothing, vehicles, entertainment, etc) then the other businesses also receive less money.  Their profits and wages decline – they pay their workers and owners less.  Now those workers have to cut back their spending and standard of living.  And of course, since the flow is circular, the impact of a change in the weather ripples through all parts of the economy and eventually affects everybody in the society, even if they aren’t a farmer.  Just how much the change in the weather will reduce the flow is the kind of question a macro-economist studies.

Changes in the weather or in the amount of available resources are often visible, although the full potential impact is not.  Other kinds of changes happen to economies subtly and their impacts are noticed at first.  These kinds of changes are often called “structural” changes.  Our economy is going through a very dramatic structural in recent years.  A few decades ago, computers were non-existent.  Much of the work currently done by computers was done in businesses by large numbers of clerks, secretaries, and paper-pushers.  The introduction of computers into businesses has had many profound effects on how firms and households operate.  It affects the circular flow and it affects how the macro-economy performs.

Macroeconomic Theory Changes, Too

Economists can only build models or theories to explain the economies we observe.  When the structure of the economy changes, it sometimes means that the assumptions upon which economic models/theories were built are no longer valid.  This means that the macro-economic theories that may have adequately described or predicted economic performance for years or decades suddenly no longer work very well.  When this happens, it’s time for economists to “go back to the drawing board” and either modify existing models or create new ones that explain things better.   Many macroeconomic models and theories are easier to understand if we know what was happening to the economy and in the economy at the time the theory was developed.  In other words, knowing the motivation for the theory and the assumptions of the theory often make it easier to understand.

Measuring the Amount of Economic Activity:  GDP

We can measure the total production (called output) of the economy using a measure called Gross Domestic Product (GDP). Then we will evaluate that measure to see if it really tells us what we want to know.  As a result, we will derive a couple of modifications to this measure that result in measures called Per-Capita GDP.  Then we will see how changes in the value of money over the years can distort our measure of GDP. This will force us to develop another concept and measure called “Real GDP”.  Finally, we will survey what economists have concluded are the real sources of economic growth over the long-run.

Goal: Economic Growth

More and faster is better — that means we have more stuff, more goods, more needs being satisfied.. No real surprise here. Just as most people would rather have more and/or better goods and services for them to consume, as a society we want more also.  So, the first goal for an economy is to produce a growing supply of goods and services for us to consume.

A Jim’s Observation:

Mainstream economics assumes that more-and-more goods is the goal; that’s it’s a good thing for society.  Some critics (myself included) have criticized this assumption, particularly environmentalists and a growing minority of economists called “ecological economists” have criticized it.  They maintain that the goal of society should be a sustainable, improved quality of life, not just more consumption of more goods.  To a degree, these critics have a valid criticism.  Mainstream macroeconomics is largely the result of 200 years of study, during which time nations clearly did not have enough goods. Mainstream macro has not fully developed theories for economies that are mature in their ability to provide goods and a high-living standard for all.   This is clearly an opportunity for new research and theorizing.  On the other hand, the criticism is not completely valid since our methods of measuring the amount of goods actually measures the value of the goods – not the physical quantity.  In other words, an economy which produces the same physical quantity of goods each year, but increases the quality and value of those goods each year would still show as having a growing GDP. For this course, we will stick to the mainstream approach.

While you, I, and even individual firms don’t usually have a hard time measuring whether or not we are more productive than in the past, it is a difficult question when asked in the aggregate.  For example. suppose an economy only produced four goods:  pounds of beef, gallons of Coke, movies, and automobiles. We could actually count the physical quantities of these four goods produced each year.  If next year we produce more of all four goods, then fine, we know we have grown our aggregate output.  But what if we produce more movies and Coke, but less beef, and the same number of cars?  Do we conclude that total output has increased or decreased?  It’s the old “adding apples and oranges problem” that your elementary math teacher always warned you about.  Now think about the problems involved when there aren’t four goods, but there are millions of different products!  How do we add Buicks and pizzas? Or add haircuts-provided and schools-built?

Economists have developed a solution to this “apples-and-oranges, Buicks-and-pizzas” problem.  Instead of counting the physical quantities of output, we count the value of what was produced.  How do we know the value of each item produced?  We use the money price when the item was sold.  So, if a new Buick is sold for $35,000 and a new pizza is sold for $5, then it takes 7,000 pizzas to equal one Buick.  In other words, we don’t really count the physical quantities of goods produced, we count and add up the dollar value of the goods produced.  The process of counting and reporting the value of all these things produced in the economy is a task of the Census Bureau and Commerce Dept. of the Federal Government (they don’t just count people!).   They actually produce a set of records for the economy, much like a business produces accounting statements.  The process and logic involved is called National Income Accounting.  And, the bottom line, the total number for the whole economy is a number called GDP – Gross Domestic Product.

GDP: The Key Measure

GDP – It’s important to think of GDP as a measure of the value of everything produced. Since we have to produce before we consume, it’s also a measure of what’s available to society to consume. More GDP –> more stuff –> better living.  It helps us measure how well society and the economy is performing in addressing the “economic problem”.

GDP is the total value (in $) of everything they produce and sell each year. Since everything that is sold is also being bought at the same time, GDP is the same as the total spending, or Aggregate Expenditures, for the economy. This total spending can be broken down into four categories or types of spending, depending upon who is doing the spending and why. The four types of spenders are consumers (C for Consumption Spending), businesses investing new capital (I for Investment), governments spending on all kinds of things (G for Government spending), and whatever the rest of the world buys from us (called Net Exports). Since we also buy from the rest of the world, we measure Net Exports as (X-M) where X stands for total eXports and M stands for total iMports. Count what everybody buys and you get Aggregate Expenditure. Since we had to produce it to be able to buy it, Aggregate Expenditure must be equal to total production, which is what GDP is.

Reading Guide – Assigned Readings

In addition to the Jim’s Guide (above), you should read and study in your Mandel Economics: The Basics textbook:

Chapter  6 –Government and the Economy
JIm’s Comment: This chapter serves mostly as a transition to broaden our thinking about the larger economy – what economists call the macro-economy.  Read the first part of the chapter)p 99 – 108) mostly as historical background.  Skip the last section (pp 109-115) as we will address it in later units.

  • All economists have some ideological preferences despite their claims of “Scientific neutrality”.  The author of this textbook is what is commonly referred to as “neo-classical” in in economics..  He asserts that “most economists” prefer free markets and start with the assumption that private property and markets are assumed “innocent” until proven failures.  This is not true. A very large number of economists have alternative views.  In the crisis of 2008-09 these alternative economists, called heterodox economists, proved very prescient while the mainstream neo-classical theories failed miserably.  Keep this in mind while reading.

Chapter  7 –Government and the Economy
JIm’s Comment: We begin our study of the macro-economy by looking at how we measure the economy using GDP.  This entire chapter is very important.  My only complaint about this chapte is the author’s separation of the Investment Spending  category into 3 sub-categories of  of Residential, Non-residential, and Inventory changes.  I find it easier to keep all three grouped together as “I” or “investment spending”.

Practice Quiz

Click here for the Unit 6  practice quiz.  The practice quiz will open in a new tab/window.


There is no worksheet for this unit.  However, there is a required posting on the discussion forum for this unit.

Closer Look

A couple of videos if you need further help:

What’s Next?

In the next unit we extend our look at how we measure the economy by looking at two of the major issues facing the macro-economy: unemployment and inflation/deflation. This will also entail a look at what goals we have for the macroeconomy.