Understand How the U.S. Economy Works

Macroeconomics is a branch of economics that looks at aggregate or total economic variables to study the behavior of a national economy as a whole.

This is in contrast to Microeconomics which looks at production and prices within specific markets.

When Macro-economists study an economy, they look at 3 major variables. These are output, the unemployment rate, and the inflation rate.

1. Output is the level of production in an economy as a whole. The measure of aggregate output in the U.S. is known as the Gross Domestic Product, or GDP. It can be thought of from 2 different perspectives, production and income.

From the production side: GDP is the value of the final goods and services produced in an economy during a given period. GDP is also the “value-added” that all the businesses added to the economy during a given period.

From the income side: GDP is the sum of incomes in the economy during a given period. This is the income or revenue that a business (a) is left with as profit, (b) pays to the government as taxes, and (c) pays to employees as wages.

2. The unemployment rate is the proportion of workers in an economy who are not employed but are seeking work. The total labor force is a combination of people who are working plus those who are not working but want to work.

In the U.S., the Bureau of Labor Statistics conducts the Current Population Survey or CPS. It interviews about 50,000 households each month to determine if the adults are employed.

The survey classifies an individual as employed if they have a job at the time of the interview and as unemployed if they don’t have a job but have been actively seeking a job within the prior 4 weeks.

If someone isn’t working and doesn’t want to work, they are not counted as part of the labor force.

So the unemployment rate is the number of unemployed people seeking work divided by the total labor force. The lower the unemployment rate, the more people are working, and this results in higher economic output.

3. Inflation is a sustained rise in the general level of prices. The inflation rate is the rate at which the average price of goods in an economy increases over time.

And deflation is the rare opposite, a sustained decline in price levels. Deflation is also called negative inflation.

Here are some more economic scenarios: hyperinflation is extreme inflation and stagflation is when inflation gets combined with economic stagnation.

Macro-economists measure the cost of living by the consumer price index, or CPI. The CPI has been used since 1917 and is published monthly. It gives the cost in dollars of a specific list of goods and services over time.

U.S. Bureau of Labor Statistics employees actually visit over 22,000 locations in 85 cities to see what’s happening to the prices of products on the CPI list such as cars, gas, clothing, food, etc.

As an index, the CPI is set equal to 1 in the base period chosen. This is so its level has no particular significance. The current base period are the years 1982 to 1984, thus the average for the period 1982 to 1984 is equal to one.

In the year 2000, for example, the U.S. CPI was 1.71. This means that when comparing prices for similar products, they were 71% higher in 2000 than they were in the time period 1982-1984.

When demand rises, this is called a Boom and it leads to inflation. Follow this:

When consumer demand increases, the goal of production is, of course, to keep up with that consumer demand. This entails paying workers overtime or hiring additional workers to beef up output. All this extra work means that labor costs rise because more people are being paid to do the work. These increased labor costs are passed on to the consumer in the form of higher prices. And higher prices, as we’ve said, are the definition of inflation.

When demand falls, this is called a Recession and it leads to deflation. Follow this:

When consumer demand falls, workers get laid off or have their working hours cut back. If production needs decrease, fewer workers are obviously needed to fill the decreases in demand. The decreased labor costs are passed on to the consumer in the form of lower prices. Companies must reduce their prices to stay competitive in a shrinking marketplace. And lower prices are the definition of deflation.

Recession is a period of negative GDP growth. The time frame for a recession is debated. Many macro-economists insist that negative growth must last for at least 2 consecutive quarters.

Others define recession more loosely, as a significant decline in growth that lasts more than a few months. A sustained recession is called an economic depression.

“A creative economy is the fuel of magnificence.” -Ralph Waldo Emerson (1803-1882)