A Fairly Simple Way to Think About Macroeconomics

I've been thinking a bit about macroeconomics.  As always, I make no claim to originality.  Just thinking things through "out loud."

Okay, so take this as a rough sketch of the economy.  There are productive resources that can be used to satisfy people's desires.  People express those desires through consumption and investment decisions, and often people can choose to consume/invest now or later.  The central bank sets short-term interest rates.  If people collectively decide to buy more economic output than can be supported by the economy's productive resources, then prices are driven up and the result is inflation.  On the other hand, if people collectively decide to buy less economic output than can be supported by the economy's productive resources, then resources are left idle.  One of those resources is labor, and when it is left idle this results in elevated unemployment.  (A quick note:  we can never achieve absolutely full employment of all resources in the economy.  Even in a wartime economy, some resources are wasted or simply can't be used at a reasonable price.  So there's a concept of using resources to the maximum degree possible without causing inflation, and this is considered full employment.  A separate project, which the central bank is not usually responsible for, involves trying to increase the amount of consumption that the economy can support at full employment.)

I've slipped in a few implicit assumptions to which we will return, but first think about what the central bank is trying to do.  It is trying to set interest rates so as to shift purchasing forward or backward in time to avoid inflation (on the one hand) or idle resources (on the other).  You can think of it almost like inventory management at a factory.  Given time periods T1, T2, ... T10, you are just trying to shift spending around from period to period to maintain a steady level of economic activity.  It's a quite dry and technical thing.  You've got essentially a supply of economic resources, and a demand for those resources, which is capable of being shifted across time.  You're just trying to line them up, chronologically, so that they are in balance as much as possible.

And the tool to shift spending across time is the interest rate.  The price of purchasing something now as opposed to later is the rate of interest, which puts an opportunity cost on spending money.  (You can spend $100 today or $100(1+x) next year, where x is the interest rate you could obtain in the market.)  Alternatively, the interest rate is a direct cost of borrowing money.  (You can spend $100 today if you promise to repay $100(1+x) next year.)  So the central bank is just trying to set the "right" price for immediate purchasing power, and that price is the same thing as the interest rate.  Again, if it sets the price too high, people will shift their spending into the future even though resources are available, and those resources will go unused in the present.  If it sets the price too low, people will shift their spending into the present even though the economy is already at full employment, and instead of increasing economic activity, people will simply bid up the price of scarce resources.  The result is inflation.

(Inflation is not a simple function of money supply.  It results from an interaction between purchasing decisions and available resources.  You might say that money only has the potential to cause inflation when it is put into motion.  By analogy, money is electrons and spending is electric power.  Power systems don't go down because of a shortage of electrons, they go down because of a shortage of power to push/pull those electrons through the system.  Likewise for money in the economy.  In fact I like this analogy very much.  The central bank is like a utility that raises and lowers electricity rates in an effort to match supply and demand of power on the grid.  It is not an exact metaphor, but it gets at the technical nature of the project.)

(One other note.  Spending is not always a straightforward function of the interest rate.  For instance, imagine that my goal is to have $x when I retire.  If the interest rate goes up, then I might be able to save less today in order to generate $x when I'm 65.  So as the interest rate rises, my spending might actually go up!  I think on balance, though, it is plausible that interest rates generally work in the more straightforward way.)

I think this is a (highly simplified) version of the model that most people use to think about these issues.  Two implications that follow:  (1) if inflation is low and steady, then by definition interest rates are not too low, and (2) the "correct" interest rate could in theory be negative, in which case the economy will not be at full employment even if the central bank lowers interest rates as low as they can go (zero).  At that point, government spending is cheap or free (from a social perspective, if not a fiscal one), because it mobilizes resources that would have been idle otherwise.  You see these themes again and again in, for instance, Krugman's writing.

Note that there is an asymmetry built into this model:  prices are assumed to adjust upwards quickly if interest rates are too low (inflation), but prices are assumed not to adjust downwards so quickly if interest rates are too low (deflation).  In theory a rapid deflation could leave prices so low that all resources are put to use.  This is more or less the anti-Keynesian position, I believe:  prices will adjust so that resources are always used at an appropriate level, and so the central bank has no business trying to achieve a particular level of economic activity.  Recessions are market outcomes and are therefore good for one reason or another.  Just let prices adjust and the market will take care of everything.  New Keynesians reply that prices aren't so flexible ("menu costs"), so resources end up going idle after all, and a whole literature has developed around this question.  But anyway price flexibility is worth thinking about.  In a sense it is the core of the debate.  I think there are other reasons, besides the New Keynesian ones, to suspect that deflation is not adequate to bring about full employment.  A topic for another time.

One thing that occurs to me is that certain products aren't really subject to inflationary pressure, at least directly.  Imagine that the central bank has set interest rates too low, and so people are spending more money than they otherwise would have.  If they buy things like refrigerators, clothes, etc., then of course they will use up existing inventories and draw resources into production, and when those resources become scarce the result will be inflation.  But if they just start streaming expensive movies/TV shows over the internet (instead of bargain movies/TV shows), then there really aren't any inventories to deplete or resources that need to be drawn into use.  It's a windfall for whoever owns the streaming rights to premium content, but no resources are being diverted from other uses.  I guess the indirect effect is that resources might be drawn into production of premium movies and TV shows, but that's not 100% clear.  It depends on market structure and exactly what TV/movies people want.

Anyway, just a thought.  Overall I think the framework is a nice, simple way of capturing the current macroeconomic debates.  I think it's also a good foundation onto which to add other concepts, which maybe I will do in the next few posts.