Lectures in Macroeconomics, No. 1
By Arnold Kling
These lectures will cover macroeconomics as I think it should be taught, not the way it is normally taught. The focus is not on model-building. The focus is on the two most troubling questions in macro.
1.How is it that financial markets affect the real economy?
2.How is it that an economic slump involves unemployment?
This lecture will be focused on the second question. However, I will not get to the answer in this lecture. The focus of this first lecture will be on ordinary labor market dynamics, both in theory and in practice.To a non-economist, the answers to the two fundamental questions may seem obvious. The answer to the first question is that when the stock market goes down, that tells everyone that times are bad, so consumers and businesses tighten their belts. The answer to the second question is that when times are bad, people cannot find work, until somebody can figure out a way to create jobs.
To a first approximation, the non-economist’s answers violate fundamental economic logic. That does not mean that those answers are wrong. However, the economist cannot simply give those answers and leave it at that. Even if the non-economist’s intuition is right (and I am not saying that it is), we need to reconcile it with microeconomic analysis that we know works well in other contexts.
Take the issue of unemployment. Thirty years ago, Lester Thurow was fond of trotting out a tale of a basketball coach asked by a player, “Why is the basketball round?”
“Son, you’ve asked two questions,” Thurow’s fictional coach replies. “First, ‘why?'” That is a very deep question, one which the great philosophers have struggled with for years. I cannot help there.”
“Second, you’ve asked, ‘Is the basketball round?’ The answer to that is yes.”
Thurow took the basketball coach’s approach to the question of why there is unemployment. Do not ask why, just take it as given that there is unemployment. That might work for Thurow, but it does not work for us. If macroeconomic theory is to be of any use at all, it must include an explanation for unemployment.
From a traditional economic perspective, unemployment looks like a labor surplus. Surpluses and shortages are corrected by the pricing mechanism. So, if there are surplus workers, then a simple drop in wages should solve the problem. Bring wages down and you reduce labor supply, increase labor demand, and get rid of the labor surplus. There cannot be any unemployment, at least if the wage-adjustment mechanism works properly.
The classical economic logic may be easier to understand if we think about the reverse of a labor surplus–a labor shortage. What would happen if there were a shortage of, say, computer network administrators? (I picked network administrators because I want to stay away from other occupations, such as nursing, where regulations impede the operation of the laws of supply and demand.)
If there were a shortage of network administrators, I would expect the salaries of network administrators to rise. That would cause some firms to look for ways to economize on their use of network administrators. Perhaps they would outsource the function to service providers. Perhaps they would select computer systems that require lower levels of manual administration.
Another effect of higher salaries would be to draw more people into network administration. People who happen to be working in other jobs but who have experience in network administration might return to the field. Others might take training courses that would allow them to qualify for job openings.
The American economy is dynamic. People often quit jobs, take new jobs, or drop out of the labor force to retrain themselves. When the aggregate unemployment rate is 5 percent, the typical person who is out of work finds a new job within one or two months. Of course, there will be a significant minority of unemployed workers whose unemployment spells last much longer than that.
Each month, there are millions of new quits and millions of new hires. The monthly change in employment is equal to the net difference between the two. If there are 3.1 million new hires and 3.2 million new quits, then unemployment goes up by 100,000. These net figures– monthly changes in the number of unemployed–tend to be plus or minus 200,000 in any month. That is really quite low relative to the gross flows in and out of unemployment.
For further reading on labor market dynamics in practice, I recommend Steven J. Davis, R. Jason Faberman and John Haltiwanger. Some excerpts (note that most of their period of analysis is 1990-2005, and today’s labor market may be working differently):
for every dozen or so filled jobs at a point in time, on average one job disappears in the following three months. In a growing economy, a somewhat larger number of new jobs are created at new and expanding establishments.
…job flow rates are three times larger in construction than in manufacturing, and worker flow rates are three times larger in leisure and hospitality than in manufacturing.
…in the third quarter of 2001, 31 percent of establishments contracted during the quarter and so contributed to job destruction. Another 26 percent expanded and so contributed to job creation. Most job destruction, 68 percent, occurred at establishments that contracted by 10 percent or more during the quarter. Perhaps more surprising, 63 percent of job creation occurred at establishments that expanded by 10 percent or more. In fact, the prevalence of such large employment changes is the norm in both booms and busts. Hence, most job destruction cannot be interpreted as the product of modest contractions achieved by normal rates of worker attrition. Neither can most job creation be seen as the outcome of modest establishment-level growth rates. That is, although most establishments experience little or no employment change within a quarter, job flows mainly reflect lumpy employment changes at the establishment level
Because unemployment escape rates are high, spikes in job destruction and layoffs lead to short-lived rises in the unemployment rate unless the spike itself is long-lived. The unemployment escape rate is also highly procyclical, and movements in the unemployment escape rate account for most of the time variation in the unemployment rate