Macroeconomics for managers pdf

Macroeconomics for managers
Macroeconomics for managers
Michael K. Evans
© 2004 by Michael K. Evans
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First published 2004 by Blackwell Publishing Ltd
Library of Congress Cataloging-in-Publication Data
Evans, Michael K.
Macroeconomics for managers / Michael K. Evans.
p. cm.
Includes bibliographical references and index.
ISBN 1-4051-0144-X (hardcover : alk. paper) – 1-4051-0145-8 (pbk. : alk. paper)
1. Managerial economics. 2. Macroeconomics. I. Evans, Michael K.
HD30.22.E85 2003
339/.024/68–21
2002156369
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Contents
Preface and Acknowledgments xv
Part I: Introductory Concepts 1
Chapter 1: The Importance of Macroeconomics 3
Introduction 3
1.1 What is Macroeconomics? 5
1.2 Links Between Macroeconomics and Microeconomics 8
1.3 Current Core of Macroeconomic Theory 10
1.4 Macroeconomics – an Empirical Discipline 11
1.5 The Importance of Policy Applications 13
1.6 Positive and Normative Economics: Why Macroeconomists
Disagree 14
1.7 Roadmap of this Book 17
Key Terms and Concepts 19
Summary 19
Questions and Problems 20
Appendix: Thumbnail Sketch of the Development of Macroeconomics 22
Notes 27
Chapter 2: National Income and Product Accounts (NIPA) 28
Introduction 28
2.1 How the National Income and Product Accounts are
Constructed 28
2.2 Components of GDP: Final Goods and Services 30
2.3 Differences Between Final and Intermediate Goods and Services 36
2.4 Components of National Income 37

2.5 Balancing Items Linking GDP, NI, PI, and DI 46
vi CONTENTS
2.6 Value Added by Stages of Production: An Example 51
2.7 Inclusions and Exclusions in the NIPA Data 52
2.8 Circular Flow Between Aggregate Demand and Production 56
Key Terms and Concepts 57
Summary 58
Questions and Problems 59
Appendix: Key Macroeconomic Identities 62
Notes 63
Chapter 3: Key Data Concepts: Inflation, Unemployment, and
Labor Costs 65
Introduction 65
3.1 Measuring Inflation: Three Different Types of Indexes 65
3.2 Factors Causing the Inflation Rate to be Overstated 68
3.3 Could the Inflation Rate be Understated? 75
3.4 Different Measures of Unemployment 78
3.5 Collecting the Employment and Unemployment Data 80
3.6 The Concept of Full Employment 86
3.7 Unit Labor Costs 91
3.8 Summarizing the Economic Data: Indexes of Leading and
Coincident Indicators 96
3.9 Methods and Flaws of Seasonally Adjusted Data 97
3.10 Preliminary and Revised Data 99
Key Terms and Concepts 100
Summary 100
Questions and Problems 101
Notes 104
Part II: Aggregate Demand and Joint Determination of Output and Interest Rates 105
Chapter 4: The Consumption Function 107

Introduction 107
4.1 Principal Determinants of Consumption 108
4.2 Short-Term Links Between Consumption and
Disposable Income: The Marginal Propensity to Consume 111
4.3 Long-Term Links Between Consumption and Income:
The Permanent Income Hypothesis 114
4.4 Consumer Spending and Changes in Tax Rates 115
4.5 Importance of Cost and Availability of Credit in
the Consumption Function 119
4.6 Consumption, Housing Prices, and Mortgage Rates 122
CONTENTS vii
4.7 Other Links Between Consumer Spending, the Rate of Interest,
and the Rate of Return 124
4.8 Credit Availability and the Stock of Debt 126
4.9 The Role of Demographic Factors and the Life Cycle Hypothesis 129
4.10 The Relationship Between Consumption and Household
Net Worth 130
4.11 The Effect of Changes in Consumer Confidence 135
4.12 Review 137
Key Terms and Concepts 138
Summary 138
Questions and Problems 139
Appendix: Historical Development of the Consumption Function 141
Notes 149
Chapter 5: Investment and Saving 151
Introduction 151
5.1 The Equivalence of Investment and Saving 151
5.2 Long-Term Determinants of Capital Spending 153
5.3 The Basic Investment Decision 155
5.4 The Cost of Capital 157

5.5 The Availability of Credit 159
5.6 The Role of Expectations 162
5.7 Lags in the Investment Function 163
5.8 The Effect of Changes in Tax Policy on Capital Spending
Decisions 164
5.9 Determinants of Exports and Imports 173
5.10 The Role of Government Saving 182
5.11 Recap: Why Investment Always Equals Saving on
an Ex Post Basis 183
Key Terms and Concepts 184
Summary 184
Questions and Problems 185
Appendix: The Theory of Optimal Capital Accumulation 187
Notes 194
Chapter 6: Determination of Interest Rates and Introduction to
Monetary Policy 195
Introduction 195
6.1 Definitions of Key Interest Rates and Yield Spreads 197
6.2 The Role of Monetary Policy 202
6.3 The Federal Reserve System 204
6.4 Determination of the Federal Funds Rate 206
6.5 Effect of Federal Reserve Policy on the Availability of Credit 212
viii CONTENTS
6.6 Determinants of Long-Term Interest Rates 213
6.7 The Difference Between Changes in Monetary Conditions and
Monetary Policy 216
6.8 Factors Causing the Yield Spread to Fluctuate 217
6.9 Transmission of Monetary Policy 221
6.10 The Importance of the Yield Spread as a Predictive Tool 224
6.11 Why Targeting Interest Rates Doesn’t Always Work:

The Conundrum 227
Key Terms and Concepts 228
Summary 229
Questions and Problems 230
Notes 232
Chapter 7: Joint Determination of Income and Interest Rates:
The IS/LM Diagram 234
Introduction 234
7.1 Review of the Effect of Changes in Interest Rates and
Income on Saving and Investment 235
7.2 Equilibrium in the Goods Market 237
7.3 Derivation of the IS Curve 238
7.4 Slope of the IS Curve under Varying Economic Conditions 242
7.5 Factors that Shift the IS Curve 242
7.6 The Demand for Money: Liquidity Preference and
Loanable Funds 244
7.7 Equilibrium in the Assets Market: Derivation of the LM Curve 246
7.8 Slope of the LM Curve under Varying Economic Conditions 247
7.9 The IS/LM Diagram and Introduction to Monetary and
Fiscal Policy 250
7.10 The IS/LM Diagram in Booms and Recessions 252
7.11 Factors that Shift the IS and LM Curves 253
7.12 A Numerical Example: Solving for Income and
Interest Rates using the IS/LM Model 254
Key Terms and Concepts 262
Summary 262
Questions and Problems 263
Notes 266
Part III: Aggregate Supply: Inflation, Unemployment, and Productivity 267
Chapter 8: Causes of and Cures for Inflation 269

Introduction 269
8.1 In the Long Run, Inflation is a Monetary Phenomenon 271
CONTENTS ix
8.2 In the Short Run, Inflation is Determined by
Unit Labor Costs: The Price Markup Equation 272
8.3 Monetary Policy and the Role of Expectations 280
8.4 Determinants of Changes in Unit Labor Costs 284
8.5 Malign and Benign Supply Shocks 291
8.6 Lags in Determining Wages and Prices 295
8.7 The Beginnings and Ends of Hyperinflation 297
8.8 Summary of Why Inflation Remained Low in
the 1990s – and What Might Occur in the Future 300
Key Terms and Concepts 304
Summary 304
Questions and Problems 305
Appendix: Historical Explanations of Inflation: The Rise and
Fall of the Phillips Curve 307
Notes 314
Chapter 9: Why High Unemployment Persists 316
Introduction 316
9.1 The Basic Labor Market Model 317
9.2 Real Growth and Unemployment: Okun’s Law 322
9.3 Why Stimulatory Monetary and Fiscal Policy Might Not
Reduce Unemployment 324
9.4 Theories Based on Labor Market Imperfections: Summary 326
9.5 Sticky Prices and Nominal Wage Rates 329
9.6 Sticky Real Wage Rates: Efficiency Wages 332
9.7 Sticky Real Wage Rates: Insider/Outsider Relationships 334
9.8 Barriers to Market-Clearing Wages: The Minimum Wage 337
9.9 The Wedge Between Private and Social Costs of Labor 348

9.10 High Unemployment Rates and Hysteresis 351
9.11 The Structuralist School 352
Key Terms and Concepts 357
Summary 357
Questions and Problems 358
Notes 361
Chapter 10: Aggregate Supply, the Production Function, and
the Neoclassical Growth Model 363
Introduction 363
10.1 Productivity Growth and the Standard of Living 364
10.2 The Long-Term Historical Growth Record 368
10.3 The Aggregate Production Function and Returns to Scale 372
10.4 The Cobb-Douglas Production Function 373
10.5 Why Growth Differs among Nations: The Importance of
Saving and Investment 374
x CONTENTS
10.6 Other Factors Affecting Growth: The Framework of
Growth Accounting 376
10.7 Causes of Growth in the US Economy 378
10.8 The Worldwide Slowdown in Productivity after 1973 381
10.9 The Neoclassical Growth Model and the Slowdown of
Mature Economies 387
10.10 Endogenous Growth Theory and Convergence Models 388
10.11 Additional Importance of Saving and Investment 392
Key Terms and Concepts 394
Summary 394
Questions and Problems 395
Notes 397
Part IV: The International Economy 399
Chapter 11: Basic Determinants of Exports and Imports 403

11.1 The Balance Between Current and Capital Accounts 403
11.2 Fixed and Flexible Exchange Rates 408
11.3 US Exports and Imports: Empirical Review 411
11.4 Income and Price Elasticities of US Exports and Imports 413
11.5 The Repercussion Effect 419
11.6 How Serious is the Burgeoning Trade Deficit? 421
11.7 Recent Progress Toward Free Trade 428
11.8 Arguments For and Against a Trade Deficit 434
11.9 Foreign Purchases of US Assets: A Non-Event 437
Key Terms and Concepts 439
Summary 439
Questions and Problems 441
Appendix: The Theory of Comparative Advantage and
the Modern Theory of International Trade 442
Note 444
Chapter 12: International Financial Markets and
Foreign Exchange Policy 445
Introduction 445
12.1 The World Dollar Standard and Major Trends in
Other Key Currencies 446
12.2 Nominal and Real Exchange Rates 452
12.3 Measuring International Labor Costs 453
12.4 The Concept of Purchasing Power Parity 455
12.5 Factors that Determine Foreign Exchange Rates 460
CONTENTS xi
12.6 Why Foreign Exchange Markets Overshoot Equilibrium:
The J-Curve Effect 470
12.7 Other Factors Causing Currency Rates to
Diverge from Equilibrium 475
12.8 Managed Exchange Rates: Bands and Crawling Pegs 477

12.9 Optimal Trade and Foreign Exchange Rate Policy 481
Key Terms and Concepts 483
Summary 483
Questions and Problems 484
Notes 486
Chapter 13: The Mundell-Fleming Model: Joint Determination of
Output, Interest Rates, Net Exports, and the Value of the Currency 487
13.1 Links Between Domestic and International Saving and
Investment 487
13.2 The Basic Model: Joint Determination of Real Interest Rates,
Output, Currency Value, and the Current Account Balance 489
13.3 The Mundell-Fleming Model for a Small Open Economy 492
13.4 The Repercussion Effect in the Mundell-Fleming Model 494
13.5 The Depreciation Effect in the Mundell-Fleming Model 496
13.6 Shifts in the NX and NFI Curves Caused by
Changes in Inflation and Productivity 499
13.7 Effects of the Reagan and Clinton Fiscal and Monetary Policies 500
13.8 Economic Impact of an Exogenous Change in Net Exports 504
13.9 Short- and Long-Run Effects of an Exogenous Change in
the Value of the Currency 507
Key Terms and Concepts 511
Summary 511
Questions and Problems 513
Notes 516
Chapter 14: Case Studies in International Trade 517
Introduction 517
14.1 International Trade in the European Economy 517
14.2 International Trade in the Asian Economy 527
14.3 International Trade in Latin America 539
14.4 Pros and Cons of Free Trade in an Imperfect World 545

14.5 What Factors Will Determine World Leaders of the
Twenty-First Century? 551
Summary 554
Questions and Problems 555
Note 557
xii CONTENTS
Part V: Cyclical Fluctuations 559
Chapter 15: Business Cycles 561
Introduction 561
15.1 The Long-Term Historical Record 562
15.2 Measuring the Business Cycle: The Indexes of
Leading, Coincident, and Lagging Indicators 564
15.3 Cyclical Behavior: Recurring but Not Regular 567
15.4 The Phases of the Business Cycle 572
15.5 The Role of Exogenous Shocks in the Business Cycle 577
15.6 The Role of Technology in the Business Cycle 582
15.7 The Role of Fiscal Policy in the Business Cycle 586
15.8 The Role of Monetary Policy in the Business Cycle 590
15.9 Global Transmission of Business Cycles 593
15.10 Could the Great Depression Happen Again? 594
15.11 Recap: Are Business Cycles Endogenous or Exogenous? 598
Key Terms and Concepts 600
Summary 600
Questions and Problems 601
Notes 602
Chapter 16: Cyclical Fluctuations in Components of
Aggregate Demand 605
Introduction 605
16.1 The Stock Adjustment Principle 606
16.2 Empirical Review: The Components of Capital Spending 608

16.3 The Role of Business Sentiment in Capital Spending 608
16.4 Investment in Residential Construction 612
16.5 The Role of Inventory Investment in the Business Cycle 622
16.6 Inventory Production and Control Mechanisms 627
16.7 Cyclical Patterns in Purchases of Motor Vehicles 629
16.8 Cyclical Patterns in Other Components of Consumption 634
16.9 Recap: What Determines Cyclical Fluctuations in
Aggregate Demand 635
Key Terms and Concepts 637
Summary 637
Questions and Problems 638
Notes 641
Chapter 17: Financial Business Cycles 643
Introduction 643
17.1 Cyclical Patterns of Monetary and Credit Aggregates 644
17.2 Cyclical Patterns in the Yield Spread 647
CONTENTS xiii
17.3 Cyclical Patterns of Stock Market Prices 649
17.4 The Present Discounted Value of Stock Prices and the
Equilibrium Price/Earnings Ratio 653
17.5 Determinants of the Risk Factor 655
17.6 Impact of the Budget Ratio on Bond and Stock Returns 665
17.7 Impact of Changes in the Expected Rate of Inflation on
Bond and Stock Returns 669
17.8 Impact of Changes in Capital Gains Taxes on Stock Prices 670
17.9 Long-Term Performance of Stocks, Bonds, and Liquid Assets 672
17.10 Cyclical Fluctuations in Returns on Stocks, Bonds, and
Liquid Assets 674
17.11 Recap: The Importance of Financial Markets and
Asset Allocation 675

Key Terms and Concepts 676
Summary 676
Questions and Problems 677
Notes 679
Part VI: Policy Analysis and Forecasting 681
Chapter 18: Fiscal Policy and Its Impact on Productivity Growth 683
Introduction 683
18.1 Automatic and Discretionary Stabilizers 684
18.2 Components of the Federal Government Budget 689
18.3 Advantages and Disadvantages of Federal Budget Surpluses
and Deficits 694
18.4 The Concept of the Fiscal Dividend 699
18.5 The Role of Fiscal Policy in Determining Productivity Growth 702
18.6 Simplifying the Tax Code 705
18.7 ‘‘Saving’’ Social Security and Medicare 707
18.8 Recap: Fiscal Policy and Productivity Growth 713
Key Terms and Concepts 715
Summary 715
Questions and Problems 716
Notes 718
Chapter 19: Monetary Policy and Its Impact on Inflation and Growth 719
Introduction 719
19.1 The Overall Goals of Monetary Policy: Insure
Adequate Liquidity, Reduce Business Cycle Fluctuations, and
Keep Inflation Low and Stable 720
19.2 The Negative Effects of Higher Inflation 724
19.3 The Optimal Rate of Inflation is Not Zero 726
xiv CONTENTS
19.4 The Role of Monetary Policy in Financial Crises 730
19.5 Demand-Side Policies: Punchbowls and Preemptive Strikes 733

19.6 Supply-Side Shocks and Sticky Prices and Wages:
How the Fed Should React 736
19.7 Why Targeting Interest Rates Doesn’t Always Work:
The Conundrum Revisited 737
19.8 Budget Deficits and Monetary Policy 738
19.9 Monetary Policy in an Open Economy 740
19.10 Why Higher Inflation Leads to Lower Productivity 741
19.11 Recap: The Case for Active Monetary Policy and
Optimal Policy Rules 743
Key Terms and Concepts 746
Summary 747
Questions and Problems 748
Notes 750
Chapter 20: Macroeconomic Forecasting: Methods and Pitfalls 751
Introduction 751
20.1 Sources of Forecasting Error in Econometric Models: Summary 751
20.2 Inadequate and Incorrect Data and the Tendency to Cluster 752
20.3 Examining Exogenous Shocks: Impulse and
Propagation Revisited 756
20.4 Market Reaction to Economic Data 759
20.5 Unknown Lag Structures and the Conservatism Principle 761
20.6 Summary of Noneconometric Forecasting Methods 765
20.7 Naive Models and Consensus Surveys of Macro Forecasts 766
20.8 Using the Index of Leading Economic Indicators to
Predict the Economy 771
20.9 Survey Methods for Individual Sectors 774
20.10 Recap: How Managers Should Use Forecasting Tools 781
Key Terms and Concepts 784
Summary 784
Questions and Problems 785

Notes 787
Bibliography and Further Reading 788
Index 790
Preface and Acknowledgments
The focus of macroeconomics has changed dramatically since I first taught this
subject in 1962. Then, crude Keynesian economics – the use of simplistic rules of
fiscal stimulus – and the Phillips curve – the tradeoff between inflation and unem-
ployment – reigned supreme, and virtually all mainstream economists thought
macroeconomic performance could be optimized by pushing the right buttons and
pulling the right levers. After the US economy fell flat on its face in the 1970s,
with four recessions in 12 years, two bouts of double-digit inflation, double-
digit unemployment rates, and a prime rate as high as 21
1
2
%, existing theory
was scrapped, and replaced by the doctrine of rational expectations, including
the mantra that fine tuning would never work, and the best policies were a
full-employment balanced budget and equilibrium short-term interest rates set
at the growth rate of nominal GDP. More recently, macroeconomics has focused on
the difference between short-term and long-term explanations for changes in real
GDP, inflation, and the unemployment rate. Debate still rages in certain quarters
between the ‘‘new classical’’ economists, who think all markets clear quickly in
the absence of government intervention, and the ‘‘new Keynesian’’ economists,
who think some markets clear very slowly or not at all. Yet while these debates
are of great interest to certain academics, they are generally ignored by business
managers, the audience for whom this book is addressed.
I have always thought that macroeconomics should be approached as an empiri-
cal discipline: theories that are not supported by the facts should be discarded. The
problem withthisapproach, of course, is that the ‘‘facts’’ frequently change. Human
beings are not machines, and they often react differently when the same situation is

repeated. In some cases, they learn by their past mistakes. In other cases, the ‘‘facts’’
are not really the same because underlying conditions have changed. Thus promul-
gating even simple rules that are designed to improve economic performance may
have unintended consequences.
The modern study of macroeconomics began with John Maynard Keynes,
who sought to cure the Great Depression while saving capitalism and democ-
racy. Even today, governments rise and fall – some at the voting booth, some
xvi PREFACE AND ACKNOWLEDGMENTS
through revolution – when governments cannot provide conditions that reason-
ably approximate full employment, price stability, and a rising standard of living.
Of course they are not always successful, but that is not really the message imparted
here. Governments will keep these goals in mind, and will implement changes in
monetary, fiscal, trade, and regulatory policies if they are not met. Business man-
agers should be aware of how these policies are likely to change – and how that
will affect their sales and profits.
Many recessions are caused entirely or primarily by exogenous shocks: wars,
energy crises, major strikes, or terrorist attacks. Obviously macroeconomists can-
not be expected to predict these variables: indeed, any economist who accurately
predicted the 9/11 terrorist attack probably would have been detained indefinitely
for prolonged questioning. That is not the only reason that macroeconomists have
never been able to predict any of the recessions in the US economy, but it is a con-
tributing factor. That pattern is likely to continue in the future. Indeed, if private
and public sector economists widely agreed that a recession was about to start, pol-
icy shifts would probably be taken to reduce if not entirely eliminate the likelihood
of an actual downturn.
Nonetheless, macroeconomics can offer valuable advice and guidance even if it
provides no hint of when these shocks will strike next. Based on how consumers,
businesses, and government policymakers react to these shocks, managers are
often able to determine how they should alter their own business plans. Often, the
biggest business mistakes are not made because of inability to foresee these shocks,

but the inability to adjust to them once they have occurred.
Recent macroeconomic textbooks have tended to focus more on the long-run
determinants of the economy, relegating short-term fluctuations to a less prominent
position: I do not follow that practice. To a certain extent, that may have been due to
a lingering belief that we do not have business cycles any more. The 2001 recession
exposed this hypothesis as a cruel mirage. The recession itself was quite mild; on an
annual basis, real GDP rose slightly in 2001, and the unemployment rate increased
less than 2%, the smallest gain in any official recession. Nonetheless, the decline
of 50% in the S&P 500 index and 75% in the Nasdaq composite index could not be
so easily ignored, and set the stage for an extended period of sluggish growth. As
capital spending failed to recover, and as the trade deficit widened at record rates,
more and more economists – and politicians – became concerned that the US could
be headed down the path of extended stagnation that plagued Europe and Japan in
the 1990s. As this is being written, no one knows what course the US economy will
follow in the next several years and decades, but the 2001 experience has made
it clear that the ‘‘best and the brightest’’ still do not know what macroeconomic
policies to use to generate optimal performance.
In part that is because consumers and business executives react differently to the
same changes in fiscal policy at different times. Recent evidence shows that while
consumers spent 80% to 90% of the Reagan tax cuts, they spent only 20% to 25%
of the Bush tax cuts.
1
Similarly, the investment tax credit spurred investment in
the early to mid 1960s and again in the late 1970s, but a 30% ‘‘bonus depreciation’’
PREFACE AND ACKNOWLEDGMENTS xvii
adjustment in late 2001 hardly boosted capital spending at all in 2002. Results
of this sort cause most macroeconomists to take a decidedly dim view about the
short-term benefits of fiscal policy stimulus.
Because of results of this sort, very few macroeconomists still think that
models can be used for policy purposes, and this textbook does not contain

a section on that topic. Many years ago, it was widely believed that macro-
economic models could be used to improve forecast accuracy, but that concept
has also disappeared. Especially telling, in my view, has been the inability to
predict the downturns of 1991 and 2001, when the excess baggage of misleading
Keynesian nostrums had been widely discarded, and proliferation of inexpen-
sive computer time permitted exhaustive testing of a wide variety of alternative
hypotheses and models. The fact that these recessions were caused primarily
by exogenous shocks reemphasizes the degree to which unforeseen shocks are
likely to buffet the US – and the world – economies from time to time in
the future.
If macroeconomic analysis cannot be used for policy prescriptions, and it cannot
be expected to predict recessions in the future, how can a study of macroeco-
nomics benefit business managers? This text addresses the following questions
and attempts to supply relevant answers.
• What are the current economic data telling us right now? How can they best be
monitored and related to my company sales and profit outlook? To what extent
do various components of the leading indicators supply an accurate view of the
near future?
• What moves are the Federal Reserve – and the central banks in other major
countries – likely to take in the near future, and how will that affect business
conditions?
• The ratio of the Federal budget to GDP has recently changed from a 2% surplus
to a 3% deficit. How will that affect interest rates, inflation, productivity growth
– and how will changes in those variables affect my business situation?
• To what extent do international fluctuations affect my business – and to what
extent is the US economy still the ‘‘straw that stirs the drink’’? What factors
will determine whether an increasing proportion of manufacturing activity will
move to foreign locations – and where should my company be setting up new
plants?
• What linkages between interest rates and major components of consumption

and investment are most likely to hold in the future, and will enable me to gauge
the response of changes in interest rates, whether or not they are caused by the
central bank?
• The next time a recession starts, will it beshort and mild, or long and severe? And
perhaps even more importantly, will the recovery be robust or stagnant? What
will that mean for monetary and fiscal policy, and how will it affect my
business?
xviii PREFACE AND ACKNOWLEDGMENTS
There are many other relevant questions that can be asked, and hopefully can
be answered, by the material found in this text. While respectfully drawing on
the theoretical developments in macroeconomics that have been made by others,
I have sought to infuse this text with a more empirical flavor and offer a valuable
guide for business managers.
Most of this material was developed when I was teaching macroeconomics at
the Kellogg Graduate School of Management at Northwestern University. In devel-
oping the course material, my perception indicated that while there were several
useful macroeconomic texts for the academic market, none of them – including my
own previous text – adequately addressed the issue of how business managers and
executives can use macroeconomic data and information to improve the perfor-
mance of their businesses. This book is the outcome of those efforts. For those who
prefer the more traditional treatment of certain key economic topics, such as con-
sumption, investment, and inflation, that material has been retained in appendixes
to some chapters. Also, the IS/LM diagram and Mundell-Fleming model are cov-
ered for optional reading; in my opinion they still offer a useful groundwork for
explaining how the economy actually works. Yet most of the exposition focuses on
how managers and executives should react to unexpected changes in key economic
variables. After all, if changes inthe economyare expected, presumably there won’t
be any need to alter those business plans.
Notes
1. For a summary of these results, see ‘‘History Casts Doubt on Efficacy of Tax Cuts,’’ Wall

Street Journal, November 11, 2002, p. 2.
Acknowledgments
I would like to thank Al Bruckner at Blackwell Publishing, who originally sug-
gested this approach, and Seth Ditchik and Elizabeth Wald, who carried the project
to its fruition. Numerous students at Kellogg improved this material, but in par-
ticular I would like to thank Michael Locke and Michael Sununu for many helpful
comments. Nicholas Stadtmiller also read an early draft and offered a number of
useful comments. Finally, as always, I would like to thank Susan Carroll for stand-
ing by me in good times and bad and serving as a constant source of inspiration
and encouragement.
Michael K. Evans
Boca Raton, Florida
November, 2002
part I
Introductory concepts
The first three chapters of this book discuss the basic concepts of macroeconomics. The first chapter
provides a brief introduction and roadmap of what lies ahead in the remainder of this book. While it
is often stated that macroeconomists have a great deal of difficulty agreeing on basic concepts – a
condition that often stems from differing political viewpoints – there is nonetheless a common core of
principles to which virtually all macroeconomists currently subscribe. These are presented in chapter 1,
followed by a discussion of why policy disagreements so often occur in this field. It is important to
distinguish between the rules of macroeconomic relationships that invariably reoccur, and the policies
that are advanced to improve the state of the economy based on whether one espouses a liberal or
conservative point of view. Thus, for example, during the 2001 recession and sluggish 2002 recovery,
almost all economists agreed that some fiscal stimulus was desirable, but opinion was sharply split
about whether this should take the form of increased government spending or tax reduction; and, if
the latter, whose taxes should be cut the most. These discussions and disagreements will presumably
continue in the future; it is the role of the macroeconomist to set the ground rules so that the arguments
are at least based on a common set of assumptions. The groundwork laid in the first chapter should alert
managers to spot macroeconomic arguments that are based on spurious reasoning or political opinions,

as opposed to those that will help them direct the future course of their businesses.
Chapters 2 and 3 provide a brief discussion of the most important concepts used in macroeconomics,
and briefly investigate some of the more important issues in measuring these concepts. This latter area
may appear to be arcane to some, yet it is important to realize that if the government statistics say the
unemployment rate is falling when it is actually rising, or the rate of inflation is declining when it is
actually increasing, a set of seriously misguided policies could be implemented that will have adverse
effects on the economy in later years.
The macroeconomic framework is built on the concept of double-entry bookkeeping: the amount that
economic agents want to purchase is balanced by the amount that is produced. Besides serving as a
useful explanation of how the economy functions, this methodology should help to insure that the statistics
are accurate, since both sides must balance. When complete statistics are available, that is invariably
the case. However, since some of these statistics are based on tax records and various statistical surveys
that are not fully available until three to five years later, preliminary data are sometimes misleading.
Managers should be aware when current economic results are likely to contain errors that could affect
their business in the future. Some of the more likely sources of these errors are also discussed in
chapters 2 and 3.
Macroeconomics for Managers
Michael K. Evans
Copyright © 2004 by Michael K. Evans
chapter one
The importance of macroeconomics
Introduction
Macroeconomic events and policies affect the daily lives of almost everyone,
especially business managers. Whether your company offers financial services,
produces cyclical consumer or capital goods, or is at the cutting edge of fast-
breaking technology, it is not immune to events that unfold in the economy.
Virtually all political leaders of capitalist countries want their economies to grow
rapidly at full employment with low, stable inflation and rising stock prices. The
global track record of the past two decades has improved with respect to keep-
ing inflation low, but outside the US growth in most regions of the world has

been below average. As various measures are implemented to improve economic
performance, companies around the globe must alter their own business strategies.
Trying to forecast the future is a hazardous occupation. After having tried to pre-
dict the economy and monitoring other forecasters for four decades, it has become
obvious that no one ever gets it right all the time. Failure to forecast creates a
planning void that leads to suboptimal decisions. It is not possible to predict truly
exogenous events, such as energy shocks or terrorist attacks. Nonetheless, it is
vitally important to know how the economy will react to these shocks once they do
occur. Macroeconomics can provide useful answers to these questions. It can also
alert managers to upcoming endogenous shifts in the economy.
Even if the sales of your company are not directly affected by the twists and
turns in the economy – and many dot.com companies belatedly realized that they
were not isolated from the business cycle – the ability to construct an optimal
capital structure is vital for every corporation. Managers must understand how
much to borrow, when to borrow, and the appropriate debt/equity mix. A clear
understanding of the macroeconomic factors that determine financial market prices
is also essential for successful business management.
While all branches of economics are evolving disciplines, that is particularly true
for macroeconomics. To a certain extent, all social sciences are a blend of ‘‘art’’ and
‘‘science.’’ The ‘‘science’’ consists of various relationships that hold if other things
Macroeconomics for Managers
Michael K. Evans
Copyright © 2004 by Michael K. Evans
4 INTRODUCTORY CONCEPTS
remain the same, often known as ceteris paribus. For example, if personal income
rises, consumers will spend more, ceteris paribus – that is, assuming no change in
monetary conditions, the stock of wealth, or consumer attitudes. If interest rates
decline and expectations about future sales and profitability remain the same, firms
will invest more. If the cost of production rises and demand does not decline,
prices will also rise, and so on.

However, economics is not a laboratory science, and in most cases, other
things are changing. If personal income rises because workers receive bigger pay
increases, that might boost inflation, hence raising interest rates, which would off-
set the gain in income. Under those circumstances, consumption might not rise at
all. If interest rates decline, capital spending might also fall for a while because
the drop in interest rates reflects a decrease in loan demand because of an ongoing
recession. As a consequence, the results indicated by theory must invariably be
examined in the context of what else is changing in the economy.
The ‘‘art’’ of interpreting the facts occurs when there is no clear-cut conclusion.
For example, will a capital gains tax cut raise or lower tax revenues? If a smaller
budget deficit is desired, is this goal better accomplished with spending cuts or
tax increases? What determines the personal saving rate? Is the economy better off
with a stronger or a weaker dollar? Should the budget surplus be spent on tax cuts
for the rich or medical care benefits for the poor?
Furthermore, macroeconomics will never be an exact science because of the crit-
ical role of expectations. Consumer spending is based in part on what individuals
think their income will be in the future. Purchases of capital goods depend on
expected future profitability and the expected real rate of interest, measured as the
current rate minus the expected rate of inflation. Financial market decisions are
based almost entirely on expectations about future changes in profits, inflation,
and government policies. Thus it is virtually impossible to explain how the overall
economy functions without making explicit assumptions about how expectations
will be affected by changes in policies. Also, it is not possible to generate useful
forecasts without providing accurate guesses about how expectations will change
in the future.
In addition to the problems posed by changing expectations, though, macro-
economics is unusually vulnerable to personal opinions masquerading as facts
that affect all of our daily lives. The issues of whether or not someone has a job, the
interest rate at which one can borrow to purchase a car or home, how much income
will rise – and how much of it will be taxed away – are all part of macroeconomics.

Hence opinions and emotions often run deeper here than in other social sciences;
and in macroeconomics more than microeconomics.
One other critical difference exists between economics and other disciplines,
and for that matter between social and physical sciences generally. Suppose the
National Weather Service can accurately predict that a major hurricane will soon
strike the East Coast. Low-lying areas can be evacuated, and buildings can be
boarded up, but nothing can be done to divert the hurricane. However, suppose
the economics profession can accurately predict that a sharp rise in theinflation rate
THE IMPORTANCE OF MACROECONOMICS 5
will occur if current policies are continued. The central bank can raise interest rates
and curtail the expansion of credit, and Congress and the President can vote to
reduce expenditures. If such steps are taken, the increase in inflation probably will
not occur. Indeed, many economists believe that timely action by the monetary and
fiscal authorities in 1994 held inflation at 3% even though forecasters and financial
market investors expected it to increase that year.
Individuals learn from the past and correct their mistakes, so their behavior
patterns often tend to shift over time. That has led some economists to argue that
there are no stable theoretical relationships that can be used for forecasting. It is
generally true that consumers react differently to an economic phenomenon after
it has become familiar. Consumer reactions to tax cuts, changes in monetary policy,
and energy shocks have varied considerably over the past 30 years.
Yet many stable patterns in consumer and business behavior have lasted over
decades and even generations, and can be used to form the core of macroeconomic
theory. Many of the empirical relationships among macroeconomic variables, while
far from ‘‘perfect’’ and subject to change, provide links strong enough to improve
our understanding of how the economy works. They can be used for accurate fore-
casts, and can serve as the basis for intelligent policy decisions. While expectations
do change, they are not formed in a vacuum but in most cases are tied to underlying
economic relationships.
Besides providing the underlying relationships that form the foundation of mod-

ern macroeconomics, these theories should be empirically verified. Thus as each
topic is introduced, the relevant facts and figures are presented, and key economic
relationships are shown empirically as well as theoretically. Even for those who do
not choose to use formal models, empirical implementation reinforces the view-
point, found throughout this text, that if a theory cannot be empirically verified, it
probably does not explain how the real world actually works.
Empirical testing is an important tool for obtaining the answers to questions for
positive economics – what actually happens. Such decisions can be compared to
normative economics – what ought to be – where there are no ‘‘right’’ answers.
For example, it is not clear how much a democratic society should tax the ‘‘rich’’
to provide a decent standard of living for the ‘‘poor.’’ Taking such points into
consideration, this chapter also offers a brief discussion of why macroeconomists
are more likely to disagree than their counterparts in microeconomics. Finally, after
discussing these methodological issues, the chapter concludes with a roadmap for
this book.
1.1 What is macroeconomics?
Macroeconomics is the study of aggregate economic relationships. It focuses on
the interrelationships between aggregate economic variables: real output, the rate
of inflation, the growth rate, employment and unemployment, interest rates, the
value of the currency, and major components of aggregate demand and income.
6 INTRODUCTORY CONCEPTS
Macroeconomic relationships explain the aggregate behavior of economic agents –
individuals and firms – for various levels of income, assets, liquidity, interest rates,
relative prices, and other economic variables.
Any economy consists of purchasers of goods and services, and producers of
those goods and services. In the aggregate, consumers and businesses who pur-
chase goods and services are the same economic agents as the employees and firms
who produce these items. However, most consumers and businesses produce only
one good or service, whereas they purchase a large variety of different goods and
services. Thus, in the short run, planned purchases may not be the same as planned

production, whereas in the long run they are always equal unless government
forces interfere with market activity.
The key long-run relationships of macroeconomics explain consumer spending,
purchases of capital goods, exports and imports, the cost and availability of debt
and equity capital, the value of the currency, inflation, employment and unem-
ployment, wage rates, profit margins, productivity, and the maximum sustainable
growth rate of the economy. The growth rate determines the maximum amount
of goods and services that can be produced in the long run. In the short run,
planned purchases may be either more or less than total maximum production.
If planned purchases exceed maximum production, inflation will usually rise as
the market uses higher prices as a rationing device. If planned purchases fall below
maximum production, the unemployment rate will rise. If the long-term growth
rate of the economy remains sluggish, either there will not be enough jobs for those
desiring employment, or the available work will be divided among more people,
resulting in a declining standard of living.
The principal macroeconomic goals of any society are to provide a job for every-
one who wants to work, keep the rate of inflation low and stable, and generate
rapid growth in productivity and the standard of living. In the long run, virtually
all economists agree that markets clear unless they are constrained or reversed by
government policies that prohibit market prices – including interest rates and for-
eign exchange rates – from reaching equilibrium values. The long-run equilibrium
relations that form the core of macroeconomics are well defined and can be stated
rigorously; the policy prescriptions are also well defined. In the short run, however,
markets adjust at different rates, so the short-run impact of changes in the econ-
omy may be different than the long-run impact. Thus when outside forces, known
as exogenous shocks, temporarily derail the economy from its long-term optimal
path, the appropriate government policies may be different in the short run than
in the long run. These policies can be divided into the following categories.
• Monetary policy consists of decisions made by the central bank to change the
cost and availability of money and credit, the cost of money being the rate of

interest. In the 1980s and 1990s, changes in monetary policy were the most
common method used to affect economic activity. In the long run, changes in
monetary policy affect the rate of inflation but not the real growth rate. In the
short run, however, various markets take different amounts of time to return
THE IMPORTANCE OF MACROECONOMICS 7
to equilibrium following an exogenous shock. As a result, changes in monetary
policy affect output as well as prices. The adjustment time often varies because
of changes in expectations, which in general cannot be predicted accurately.
• Fiscal policy consists of changes in tax rates or government spending programs
to influence the state of the economy. In the 1960s and the 1970s, fiscal policy
was used to try and regulate short-run changes in output and inflation, but the
results were generally counterproductive, so these methods are not used very
often – although the Bush tax cut was accelerated by issuing rebate checks during
the third quarter of 2001 because of the ongoing recession that year. In the long
run, the major role played by fiscal policy is to determine the growth rate of the
economy by influencing the growth rates of labor, capital, and technology.
• Trade policy consists of decisions to determine the level of tariffs and quo-
tas on imports, and subsidies on exports, that affect the size of the net export
balance. It also includes various measures used to influence the value of the
currency. Restrictions on foreign trade may appear to benefit certain domestic
industries, but blunting foreign competition and forcing consumers to accept a
smaller choice of goods at higher prices reduces the standard of living in the
long run.
• Regulatory policy consists of issuing government standards that influence
the performance of the economy in order to accomplish stated regulatory
goals. These include requirements for cleaner air or water, occupational safety
and health standards, consumer product safety, and equal opportunity laws.
Although these are also determined by the President and Congress, and may
impose substantial costs on businesses and consumers, they are not considered
part of fiscal policy because they do not usually involve significant changes in

government spending programs.
The amount of aggregate purchases and production, and the relationships
between these two sides of the economy, determine output, interest rates, inflation,
employment and unemployment, the net export balance, value of the currency, and
the long-term growth rate. To the extent that outcome is not deemed satisfactory,
monetary, fiscal, trade, and regulatory policies are used to improve the eco-
nomic situation, consistent with various political goals determined by elected
representatives.
In the past, some economists and policymakers believed that the real growth
rate and the standard of living could be enhanced by printing more money, boost-
ing government spending, or reducing the value of the currency. During periods of
slack capacity and excess labor, these policies can boost the growth rate in the short
run. In the long run, though, the growth rate or the standard of living cannot be
boosted by such measures; only the rate of inflation is increased, which generally
tends to reduce the standard of living. To that extent, macroeconomic policies gen-
erally produce more desirable results than occurred during much of the twentieth
century. In particular, business cycle recessions in the US are now far less frequent
than was the case before 1982.
8 INTRODUCTORY CONCEPTS
1.2 Links between macroeconomics and microeconomics
At one time, macroeconomics and microeconomics used to be considered separate
disciplines: one determined how the overall economy changed, while the other
explained the behavior of individual consumers and firms. However, this artificial
distinction pleased few economists. After all, if individual consumers base their
purchasing decisions on income, assets, liquidity, interest rates, and other vari-
ables, then at the aggregate level, total consumption should be related to the same
variables in some fashion that approximates the weighted average of individual
decisions. Similarly, decisions of individual firms about how much to invest, how
many workers to employ, and how to determine prices for individual products
and services should be based on the same factors at both the micro and the macro

level.
Thus it is now generally recognized that the core theories of economics for con-
sumer, business, and financial market behavior are based on a common set of
assumptions and principles. Nonetheless, the linkages between these two disci-
plines are not always straightforward. In particular, the following factors should
be taken into consideration.
• Rigidities – markets do not always clear immediately, and the response time varies
for different markets. In particular, macroeconomic markets such as labor mar-
kets may take much longer to clear than microeconomic markets for commodities
or services such as steel or airline travel.
• Liquidity – individual economic agents may be constrained in their purchases,
so short-run spending decisions are not always based on long-run expected
income.
• Knowledge – since information is expensive to obtain, lack of knowledge may
lead to markets that do not clear, since one party (the seller) may know more
than the other party (the buyer).
• Expectations – microeconomics markets are invariably based on the presumption
that when price rises, the quantity demanded falls and the quantity supplied
rises. However, if expectations change, rising prices may be accompanied by an
increase in demand for a while (buy it now before it becomes even more expen-
sive), which will defer a return to equilibrium indefinitely. That is particularly
true in financial markets.
In an attempt to link microeconomics and macroeconomics, and also to
strip away inessential assumptions, some macroeconomists start with two basic
premises: private sector economic agents will always try to maximize their utility
at any given time, andin the long run all markets clear unless prohibited from doing
so by government action. Perhaps it seems difficult to argue with these assump-
tions. Yet because some markets do not clear for several years, it is important for
macroeconomics to explain what happens in the interim.