Macroeconomic Theory for Policymakers: An Illustrated Guide

Macroeconomic Theory for Policymakers: An Illustrated Guide

Macroeconomic Theory for Policymakers: An Illustrated Guide

September 10, 2024

Congressional Research Service

https://crsreports.congress.gov

R48173

Macroeconomic Theory for Policymakers: An Illustrated Guide

Contents

Introduction ..................................................................................................................................... 1 The Economy and Long-Term Growth ........................................................................................... 2 Short-Term Economic Growth ........................................................................................................ 4 Economy-Wide Supply and Demand .............................................................................................. 6 Fiscal Policy: Taxes ......................................................................................................................... 8 Monetary Policy: Federal Funds Rate ........................................................................................... 10 The Dollar and Exchange Rates .................................................................................................... 12 The Labor Market .......................................................................................................................... 14

Acronyms ...................................................................................................................................... 16 Glossary ......................................................................................................................................... 17

References ..................................................................................................................................... 19

Contacts

Author Information ........................................................................................................................ 21

Macroeconomic Theory for Policymakers: An Illustrated Guide

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Introduction

This report is an introductory guide to macroeconomic theory from a policymaking angle. Macroeconomics focuses on the structure and performance of the economy as a whole (as opposed to microeconomics, which focuses on decisions by consumers and firms). Economists and policymakers alike analyze the macroeconomy and its fluctuations, as the strength of the economy contributes to the well-being of individuals participating in it. This report covers the basics of economic theory as it relates to economic growth, supply and demand, fiscal and monetary policy, currency, and the labor market.

Caveats: While this report is a primer for selected economic topics for a policymaking audience, it does not serve as a replacement for other foundational materials. More specifically:

• The theories in this report have been simplified and stylized for a non-specialist

audience and, therefore, may not match other sources. The depictions of these theories are meant to provide some basic economic context for in-depth CRS products or other sources.

• This report does not cover all possible economic theories, nor does it provide

competing versions of the same topic. The depictions shown in this report do not purport to be more accurate than other versions.

• Theories do not always accurately predict outcomes.

• This report does not analyze or judge policies or policy outcomes. Economic theory is

only one of many ways in which to analyze policies and policy outcomes.

Organization: There are seven main sections in this report, each of which focuses on a particular economic concept. The report starts with the size and structure of the economy and then delves into how the overall economy functions and how policy, international markets, and the labor market affect the overall economy. Each section provides theory, explanation, and real-world context for a given topic and is organized in the same manner, with three main parts:

1. Theory: Each section contains an introduction on the theoretical underpinnings of

the topic in question, including illustrative graphics.

2. The Role of Congress: Each section contains a brief explanation of how the topic in

question relates to Congress and how Congress can act in relation to the topic. Of note, these sections do not explicitly discuss the role of Congress in the collection and dissemination of economic statistics.

3. Real World Data: Each section contains real world economic data that illustrates the

topic in question.

Additional Resources:

• An acronym section defines all acronyms used throughout the report. (Acronyms will

additionally be defined the first time they appear in the report.)

• A glossary section provides more in-depth definitions and explanations of terms in

the report that are not fully defined or discussed. Terms that appear in the glossary are italicized the first time they appear in the report.

• A references section provides selected further resources by topic, including brief

explanations of the resources and what they contain.

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The Economy and Long-Term Growth

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Short-Term Economic Growth

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Economy-Wide Supply and Demand

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Fiscal Policy: Taxes

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Monetary Policy: Federal Funds Rate

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The Dollar and Exchange Rates

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The Labor Market

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Acronyms

GDP: gross domestic product

AS: aggregate supply

AD: aggregate demand

Fed: Federal Reserve

FFR: federal funds rate

QE: quantitative easing

LS: labor supply

LD: labor demand

RW: real wage

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Glossary

Arbitrage: an investment strategy by which lenders and borrowers take advantage of differing prices in two or more markets for the same or similar assets.

Board of Governors: the Federal Reserve body located in Washington, D.C., that oversees the Federal Reserve System. The board is composed of seven governors, including a chair and two vice chairs, one of whom is responsible for supervision.

Business investment: spending by private businesses and nonprofits on physical capital—long- lasting assets used to produce goods and services. Physical capital is generally grouped into three categories: equipment (e.g., machinery or computers), structures (e.g., offices or warehouses), and intellectual property (e.g., software development or research and development).

Commodities: basic raw materials or primary products that are often used in the production process and are substitutable for other goods of the same type. Some common examples include oil, corn, and gold.

Credit conditions: conditions that mark the ability of borrowers to obtain loans. Credit conditions can be influenced by market conditions, including interest rates, or due diligence practices or regulations that influence how or if lenders provide loans to specific borrowers.

Disposable income: income left after deducting income taxes.

Employment: as measured by Bureau of Labor Statistics surveys focused on labor markets, individuals are considered employed if they did any work for pay or profit in the previous week.

Externalities: a cost or benefit that arises as a result of economic activity that is paid for or received by parties not directly involved in the economic process. Externalities are not priced in to market dynamics. Pollution can be an example of a negative externality, whereas research and development can be an example of a positive externality.

Factors of production: general categories of inputs to the production process. Typically defined as land, labor, capital, and sometimes entrepreneurship.

Gross domestic product: total domestic spending in the U.S. economy, as measured by the Bureau of Economic Analysis (BEA). The measure is broken up into four main types of spending: personal consumption expenditures (consumer spending), gross private domestic investment (business investment), net export of goods and services (total exports minus total imports), and government consumption expenditures and gross investment (government spending).

Income: a measure of the total resources that accrue to an individual or business over a period of time. Individuals typically receive income from wages/benefits, assets, and government transfers.

Industrial production: based on the index produced by the Federal Reserve, industrial production refers to the output by all industries in the mining, manufacturing, and electric and gas utilities industries.

Interest-sensitive spending: spending that is contingent on borrowing. For example, business physical capital investment, consumer durables, and residential investment often rely on borrowing and, therefore, will be affected by movements in interest rates.

Labor force: all employed and unemployed individuals ages 16 and older, excluding active-duty military personnel and the institutionalized.

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Open market operations: the Federal Reserve’s purchase or sale of securities in the open market. When the Federal Reserve buys a security, that security is noted as an asset on its balance sheet. To balance the purchase, the Federal Reserve typically increases bank reserves held at the Fed, a liability.

Price shock: a type of supply shock in which supply conditions are unexpectedly changed by an external event, causing prices of one or more commodities to rise. For example, the oil crises in the 1970s were price shocks.

Productive capacity: highest amount of output possible given the current amount and productivity of factors of production.

Quantitative easing: a type of monetary policy tool that involves the large-scale purchase of assets by the Federal Reserve, including Treasury securities and mortgage-backed securities. This tool is meant to provide liquidity to the financial system and push down longer-term interest rates.

Repurchase (repo) market: the market in which contracts are arranged between two parties to sell a security and then repurchase it at a later date at a higher prearranged price.

Reserve balance: accounts banks have at the Federal Reserve where they hold liquid cash balances.

Real gross domestic product: gross domestic product adjusted for inflation (see also gross domestic product).

Unemployment: the number of individuals who do not have jobs, have actively looked for work in the previous four weeks, and are currently available to work. This most common unemployment measure is called the U3 unemployment rate. Other unemployment rates are either more or less inclusive of individuals who are not working.

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References

The following list provides selected resources, both by CRS and external authors, that provide more in-depth information on the topics included in this report. This list is not all inclusive.

General Resources

There are many macroeconomics textbooks available at the introductory, intermediate, and advanced levels. A few examples include Principles of Macroeconomics and Macroeconomics by N. Gregory Mankiw, Macroeconomics by Olivier Blanchard and David R. Johnson, and Advanced Macroeconomics by David Romer.

CRS Report R43295, Resources for Key Economic Indicators, by Ben Leubsdorf and Jennifer Teefy. This report describes many economic indicators, including definitions and where to find data, among other topics.

Federal Reserve Bank of St. Louis, Resources for Teachers and Students in Economics and Personal Finance, https://www.stlouisfed.org/education. This website provides educational resources on a wide variety of economic and financial topics, including many of those discussed in this report.

CRS Introduction to U.S. Economy In Focus Series. This series of two-page explainers delve into selected economic topics and provide information on definition, measurement, and recent trends. These can be searched for on crs.gov, and several are provided below as well.

The Economy and Long-Term Growth

CRS In Focus IF10408, Introduction to U.S. Economy: GDP and Economic Growth, by Mark P. Keightley and Lida R. Weinstock. This CRS product introduces economic activity and long-term growth, including GDP and how it is measured, the determinants of long-term growth, and trends in U.S. economic growth over time.

CRS In Focus IF10557, Introduction to U.S. Economy: Productivity, by Lida R. Weinstock. This CRS product introduces productivity and productivity growth, including measures and sources of productivity growth, productivity growth’s relationship to economic growth, and trends in U.S. productivity growth.

CRS In Focus IF11020, Introduction to U.S. Economy: Business Investment, by Lida R. Weinstock. This CRS product introduces business investment and its relationship to economic growth, including the drivers of business investment and trends in domestic and foreign investment.

The Business Cycle and Short-Term Growth

CRS In Focus IF10411, Introduction to U.S. Economy: The Business Cycle and Growth, by Lida R. Weinstock. This CRS product introduces the business cycle and short-term economic growth, including how the business cycle is dated, causes of the business cycle, and policy options for smoothing the business cycle.

CRS Report R47479, Common Causes of Economic Recession, by Lida R. Weinstock. This CRS product provides an in-depth look at the business cycle and recessions, including common causes of recession and policy options.

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Economy-Wide Supply and Demand

CRS In Focus IF11253, Introduction to U.S. Economy: Fiscal Policy, by Lida R. Weinstock. This CRS product introduces fiscal policy and its economic effects as well as trends in the federal budget over time.

CRS Report R45723, Fiscal Policy: Economic Effects, by Lida R. Weinstock. This CRS product provides and in-depth look at fiscal policy, including the effects of expansionary fiscal policy, persistent fiscal stimulus, and withdrawing stimulus, as well as trends in the U.S. fiscal policy stance.

CRS In Focus IF11751, Introduction to U.S. Economy: Monetary Policy, by Marc Labonte. This CRS product introduces monetary policy and its effects on the economy, including various monetary policy tools, how monetary policy is achieved, and congressional issues.

Fiscal Policy: Taxes

U.S. Department of the Treasury, How Much Revenue Has the U.S. Government Collected This Year?, https://fiscaldata.treasury.gov/americas-finance-guide/government-revenue/. This webpage provides information on federal revenue, including sources of revenue, trends, and how revenue compares to the size of the economy.

CRS In Focus IF11253, Introduction to U.S. Economy: Fiscal Policy, by Lida R. Weinstock. This CRS product introduces fiscal policy and its economic effects as well as trends in the federal budget over time.

CRS In Focus IF11037, Debt and Deficits: Spending, Revenue, and Economic Growth, by Grant A. Driessen and Donald J. Marples. This CRS product provides a brief overview of the federal budget, including trends in spending and revenue.

Monetary Policy: Federal Funds Rate

CRS In Focus IF10054, Introduction to Financial Services: The Federal Reserve, by Marc Labonte. This CRS product introduces the structure and responsibilities of the Federal Reserve, congressional oversight, and other policy issues.

CRS In Focus IF11751, Introduction to U.S. Economy: Monetary Policy, by Marc Labonte. This CRS product introduces monetary policy and its effects on the economy, including various monetary policy tools, how monetary policy is achieved, and congressional issues.

CRS Report R47377, Federal Reserve: Policy Issues in the 118th Congress, by Marc Labonte, section titled “Monetary Policy”. This section of the CRS report details the post-financial-crisis monetary policy framework, the inflation and interest rate environment, the normalization of the Federal Reserve’s balance sheet, and the Federal Reserve’s mandate and monetary policy strategy.

Federal Reserve Bank of St. Louis, How Does the Fed Influence Interest Rates Using Its New Tools?, https://www.stlouisfed.org/open-vault/2020/august/how-does-fed-influence-interest-rates- using-new-tools. This blog post details the methods by which the Federal Reserve influences the federal funds rate, including explanatory graphics.

Federal Reserve Bank of St. Louis, Making Sense of the Federal Reserve: How the Fed Implements Monetary Policy with Its Tools, https://www.stlouisfed.org/in-plain-english/the-fed-implements- monetary-policy. This article explains the tools the Federal Reserve uses to implement monetary policy, including the interest on reserve balances, the overnight reverse repo facility, the discount rate, and open market operations.

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The Dollar and Exchange Rates

CRS In Focus IF12319, Strong Dollar: Implications for U.S. Economy, by Marc Labonte and Lida R. Weinstock. This CRS product takes a brief look at recent trends in the exchange value of the dollar and how it affects the U.S. economy.

CRS In Focus IF11296, U.S. Dollar Intervention: Options and Issues for Congress, by Marc Labonte and Martin A. Weiss. This CRS product discusses policy options for and economic effects of influencing the value of the dollar.

CRS Report R45148, U.S. Trade Policy Primer: Frequently Asked Questions, coordinated by Cathleen D. Cimino-Isaacs. This CRS product provides background on several aspects of trade, including the economics of trade and its effects on various aspects of the economy as well as trends and policy issues and tools.

The Labor Market

CRS Report R47241, Workforce and Labor Policy: Resources for Congressional Offices, coordinated by Abigail R. Overbay. This CRS product provides an in-depth look at the federal government’s role in workforce and labor policy.

CRS Report R43089, The Federal Minimum Wage: In Brief, by Sarah A. Donovan. This CRS product provides an in-depth look at the federal minimum wage, including coverage, information on minimum wage workers, and policy issues.

CRS In Focus IF10443, Introduction to U.S. Economy: Unemployment, by Lida R. Weinstock. This CRS product introduces unemployment and its relationship to the rest of the economy, including how it is measured, reasons for it, and trends.

Author Information

Lida R. Weinstock, Coordinator Analyst in Macroeconomic Policy

Marc Labonte

Specialist in Macroeconomic Policy

Mark P. Keightley Specialist in Economics

Acknowledgments

The authors thank Amber Wilhelm, CRS Visual Information Specialist, for her contributions to this report.

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Disclaimer

This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff to congressional committees and Members of Congress. It operates solely at the behest of and under the direction of Congress. Information in a CRS Report should not be relied upon for purposes other than public understanding of information that has been provided by CRS to Members of Congress in connection with CRS’s institutional role. CRS Reports, as a work of the United States Government, are not subject to copyright protection in the United States. Any CRS Report may be reproduced and distributed in its entirety without permission from CRS. However, as a CRS Report may include copyrighted images or material from a third party, you may need to obtain the permission of the copyright holder if you wish to copy or otherwise use copyrighted material.