A-Z MACROECONOMICS SEMESTER

When something unexpected happens that affects one economy (or part of an
economy) more than the rest. This can create big problems for policymakers if
they are trying to set a macroeconomic policy that works for both the area
affected by the shock and the unaffected area. For instance, some economic
areas may be oil exporters and thus highly dependent on the price of oil, but
other areas are not. If the oil price plunges, the oil-dependent area would
benefit from policies designed to boost demand that might be unsuited to the
needs of the rest of the economy. This may be a constant problem for those
responsible for setting the interest rate for the euro given the big differences--
and different potential exposures to shocks--among the economies within the
euro zone.
ASYMMETRIC SHOCK

Boom and bust. The long-run pattern of economic growth and
recession. According to the Centre for International Business Cycle
Research at Columbia University, between 1854 and 1945 the
average expansion lasted 29 months and the average contraction
21 months. Since the second world war, however, expansions have
lasted almost twice as long, an average of 50 months, and
contractions have shortened to an average of only 11 months.
BUSINESS CYCLE

An economy that does not take part in
international trade; the opposite of an
OPEN ECONOMY. At the turn of the century
about the only notable example left of a
closed economy is North Korea.
CLOSED ECONOMY

Deflation is a persistent fall in the general
price level of goods and SERVICES. It is not
to be confused with a decline in prices in
one economic sector or with a fall in the
INFLATION rate (which is known as
DISINFLATION).
DEFLATION

People generally spend a smaller share of their BUDGET on food as
their INCOME rises. Ernst Engel, a Russian statistician, first made
this observation in 1857. The reason is that food is a necessity,
which poor people have to buy. As people get richer they can
afford better-quality food, so their food spending may increase, but
they can also afford LUXURIES beyond the budgets of poor people.
Hence the share of food in total spending falls as incomes grow.
ENGEL'S LAW

One of the two instruments of macroeconomic policy; monetary policy's side-
kick. It comprises public spending and taxation, and any other government
income or assistance to the private sector (such as tax breaks). It can be used
to influence the level of demand in the economy, usually with the twin goals of
getting unemployment as low as possible without triggering excessive
inflation. At times it has been deployed to manage short-term demand
through fine tuning, although since the end of the keynesian era it has more
often been targeted on long-term goals, with monetary policy more often
used for shorter-term adjustments.
FISCAL POLICY

Short for gross national product, another measure
of a country's economic performance. It is calculated
by adding to GDP the income earned by residents
from investments abroad, less the corresponding
income sent home by foreigners who are living in
the country.
GNP

Very, very bad. Although people debate when, precisely, very rapid INFLATION turns into
hyper-inflation (a 100% or more increase in PRICES a year, perhaps?) nobody questions that it
wreaks huge economic damage. After the first world war, German prices at one point were
rising at a rate of 23,000% a year before the country’s economic system collapsed, creating a
political opportunity grasped by the Nazis. In former Yugoslavia in 1993, prices rose by around
20% a day. Typically, hyper-inflation quickly leads to a complete loss of confidence in a
country’s currency, and causes people to search for other forms of MONEY that are a better
store of value. These may include physical ASSETS, GOLD and foreign currency. Hyper-inflation
might be easier to live with if it was stable, as people could plan on the basis that prices would
rise at a fast but predictable rate. However, there are no examples of stable hyper-inflation,
precisely because it occurs only when there is a crisis of confidence across the economy, with
all the behavioural unpredictability this implies.
HYPER-INFLATION

Investment from abroad; the opposite
of OUTWARD INVESTMENT.
INWARD INVESTMENT

The shape of the trend of a country’s trade balance following a DEVALUATION.
A lower EXCHANGE RATE initially means cheaper EXPORTS and more
expensive IMPORTS, making the current account worse (a bigger DEFICIT or
smaller surplus). After a while, though, the volume of exports will start to rise
because of their lower PRICE to foreign buyers, and domestic consumers will
buy fewer of the costlier imports. Eventually, the trade balance will improve on
what it was before the devaluation. If there is a currency APPRECIATION there
may be an inverted J-curve.
J-curve

A branch of ECONOMICS, based, often loosely, on the ideas of KEYNES, characterised by a
belief in active GOVERNMENT and suspicion of market outcomes. It was dominant in the 30
years following the second world war, and especially during the 1960s, when FISCAL POLICY
became bigger-spending and looser in most developed countries as policymakers tried to kill
off the BUSINESS CYCLE. During the 1970s, widely blamed for the rise in INFLATION, Keynesian
policies gradually gave way to monetarism and microeconomic policies that owed much to the
NEO-CLASSICAL ECONOMICS that Keynes had at times opposed. Even so, the idea that
PUBLIC SPENDING and TAXATION have a crucial role to play in managing DEMAND, in order
to move towards FULL EMPLOYMENT, remained at the heart of MACROECONOMIC POLICY in
most countries, even after the monetarist and supply-side revolution of the 1980s and 1990s.
Recently, a school of new, more pro-market Keynesian economists has emerged, believing that
most markets work, but sometimes only slowly.
KEYNESIAN

Old news. Some economic statistics move
weeks or months after changes in the
BUSINESS CYCLE or INFLATION. They may not
be a reliable guide to the current state of an
economy or its future path. Contrast with
LEADING INDICATORS.
LAGGING
INDICATORS

The big picture: analysing economy-wide phenomena such as GROWTH,
INFLATION and UNEMPLOYMENT. Contrast with MICROECONOMICS, the
study of the behaviour of individual markets, workers, households and FIRMS.
Although economists generally separate themselves into distinct macro and
micro camps, macroeconomic phenomena are the product of all the
microeconomic activity in an economy. The precise relationship between
macro and micro is not particularly well understood, which has often made it
difficult for a GOVERNMENT to deliver well-run MACROECONOMIC POLICY.
MACROECONOMICS

The school of ECONOMICS that developed the free-market ideas of CLASSICAL
ECONOMICS into a full-scale model of how an economy works. The best-
known neo-classical economist was ALFRED MARSHALL, the father of
MARGINAL analysis. Neo-classical thinking, which mostly assumes that
markets tend towards EQUILIBRIUM, was attacked by KEYNES and became
unfashionable during the Keynesian-dominated decades after the second
world war. But, thanks to economists such as
MILTON FRIEDMAN, many neo-classical ideas have since become widely
accepted and uncontroversial.
NEO-CLASSICAL
ECONOMICS

How far an economy’s current OUTPUT is below what it would be at full
CAPACITY. On average, INFLATION rises when output is above potential and
falls when output is below potential. However, in the short run, the relationship
between inflation and the output gap can deviate from the longer-term
pattern and can thus be misleading. Alas for policymakers – because nobody
really knows what an economy’s potential output is, the size and even the
direction of the output gap can easily be misdiagnosed, which can contribute
to serious errors in MACROECONOMIC POLICY.
OUTPUT GAP

A In 1958, an economist from New Zealand, A.W.H. Phillips (1914-75),
proposed that there was a trade-off between INFLATION and
UNEMPLOYMENT: the lower the unemployment rate, the higher was the rate
of inflation. Governments simply had to choose the right balance between the
two evils. He drew this conclusion by studying nominal wage rates and jobless
rates in the UK between 1861 and 1957, which seemed to show the
relationship of unemployment and inflation as a smooth curve.
Economies did seem to work like this in the 1950s and 1960s, but then the
relationship broke down. Now economists prefer to talk about the NAIRU, the
lowest rate of unemployment at which inflation does not accelerate.
PHILLIPS CURVE

The foundation stone of MONETARISM. The theory says that the quantity of MONEY available
in an economy determines the value of money. Increases in the MONEY SUPPLY are the main
cause of INFLATION. This is why Milton FRIEDMAN claimed that 'inflation is always and
everywhere a monetary phenomenon'.
The theory is built on the Fisher equation, MV = PT, named after Irving Fisher (1867-1947). M
is the stock of money, V is the VELOCITY OF CIRCULATION, P is the average PRICE level and T
is the number of transactions in the economy. The equation says, simply and obviously, that
the quantity of money spent equals the quantity of money used. The quantity theory, in its
purest form, assumes that V and T are both constant, at least in the short-run. Thus any
change in M leads directly to a change in P. In other words, increase the money supply and
you simply cause inflation.
QUANTITY THEORY
OF MONEY

Policies to pump up DEMAND and thus
boost the level of economic activity.
Monetarists fear that such policies may
simply result in higher INFLATION.
REFLATION

GOVERNMENT policies intended to smooth the economic cycle, expanding
DEMAND when UNEMPLOYMENT is high and reducing it
when INFLATION threatens to increase. Doing this by FINE TUNING has mostly
proved harder than KEYNESIAN policymakers expected, and it has become
unfashionable. However, the use of automatic stabilisers remains widespread.
For instance, social handouts from the state usually increase during tough
times, and taxes increase (FISCAL DRAG), boosting government revenue, when
the economy is growing.
STABILISATION

Payments that are made without any good or
service being received in return. Much PUBLIC
SPENDING goes on transfers, such as pensions
and WELFARE benefits. Private-sector transfers
include charitable donations and prizes to
lottery winners.
TRANSFERS

If you pay your cleaner or builder in cash, or for some reason neglect to tell
the taxman that you were paid for a service rendered, you participate in the
underground or black economy. Such transactions do not normally show up in
the figures for GDP, so the black economy may mean that a country is much
richer than the official data suggest. In the United States and the UK, the black
economy adds an estimated 5-10% to GDP; in Italy, it may add 30%. As for
Russia, in the late 1990s estimates of the black economy ranged as high as
50% of GDP.
UNDERGROUND
ECONOMY

This usually refers to FIRMS, where it is defined as the value of the firm's OUTPUT minus the
value of all its inputs purchased from other firms. It is therefore a measure of the PROFIT
earned by a particular firm plus the wages it has paid. As a rule, the more value a firm can add
to a product, the more successful it will be. In many countries, the main form of INDIRECT
TAXATION is value-added tax, which is levied on the value created at each stage of
production. However, it is paid, ultimately, by whoever consumes the finished product.
Another definition of value added refers to the change in the overall economic value of a
company. This takes into account changes in the combined value of its SHARES, ASSETS, DEBT
and other liabilities. Part of the pay of company bosses is often linked to how much economic
value is added to the company under their management.
VALUE ADDED

The difference between basic pay and total earnings.
Wage drift consists of things such as overtime
payments, bonuses, PROFIT share and performance-
related pay. It usually increases during periods of
strong GROWTH and declines during an economic
downturn.
WAGE DRIFT

Producing OUTPUT at the minimum possible cost. This is not
enough to ensure the best sort of economic EFFICIENCY, which
maximises society's total CONSUMER plus PRODUCER SURPLUS,
because the quantity of output produced may not be ideal. For
instance, a MONOPOLY can be an X-efficient producer, but in order
to maximise its PROFIT it may produce a different quantity of
output than there would be in a surplus-maximising market with
PERFECT COMPETITION.
X-efficiency

The annual income from a SECURITY, expressed as a
percentage of the current market PRICE of the
security. The yield on a SHARE is its DIVIDEND
divided by its price. A BOND yield is also known as
its INTEREST RATE: the annual coupon divided by
the market price.
YIELD

When the gains made by winners in an economic transaction equal
the losses suffered by the losers. It is identified as a special case in
GAME THEORY. Most economic transactions are in some sense
positive-sum games. But in popular discussion of economic issues,
there are often examples of a mistaken zero-sum mentality, such as
“PROFIT comes at the expense of WAGES”, “higher PRODUCTIVITY
means fewer jobs”, and “IMPORTS mean fewer jobs here”.
ZERO-SUM GAME

A-Z MACROECONOMICS SEMESTER

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