Back To CourseEconomics 102: Macroeconomics
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Jon has taught Economics and Finance and has an MBA in Finance
Go with me as we take an air balloon ride far above the clouds. Air balloons are great for seeing the big picture, and that's what we want to do in macroeconomics. As we look down, we can see the clouds opening up and everything underneath the clouds down below. We're flying over two different countries, and we can see both of them at the same time from this height. On the left side is the land of Macro, where everything is big. Pizzas are 50 slices. Buffets go on for 100 yards. (Why's everything always about food in this course?) Department stores are big - five stories big. Everything is big in Macro. Right next door is the nation of Mini - where everything is small. Cars are small - mini Cooper small. Houses are small. Dinners are even smaller; however, I hear mini golf is pretty big there.
From where we are, we can begin to see something strange. There are some numbers written in the hillsides of both countries. That's right; someone named Bob has mowed the grass on the hillside in the shape of numbers, which happen to be the real GDP of each nation. What a coincidence! This year's real GDP can be seen by those traveling in hot air balloons, helicopters, airplanes and of course, weird aliens with telescopes (otherwise known as 'economists').
Anyway, suppose that in the land of Macro, real GDP is equal to $1.8 trillion. On the other hand, the land of Mini has a real GDP of only $600 billion. The question we want to answer is this: how well off are these two countries? With only this information, you'd probably say that the land of Macro is better off, right? So would I! As you can see, the real GDP is higher in the land of Macro: $1.8 trillion is definitely bigger than $600 billion.
Now, suppose that you take out a pair of super binoculars. As you look more closely, you can see how many people really live in each country. The population in the land of Macro is 1 billion people and the population in the land of Mini is only 8 million people. How well off are the people in the land of Macro compared to the land of Mini?
We can answer this question using what's called the standard of living. Standard of living is an indication of our economic well-being. In other words, it describes the material welfare and the quality of life of the people in a certain country.
Economists measure standard of living using real output per person or what they call real GDP per capita. Real GDP per capita is the value of national output divided by the population. The formula for real GDP per capita is simply: real GDP / population.
So, now we can see that in the land of Macro, the real GDP per capita = $1.8 trillion / 1 billion people, which is $1,800. In the land of Mini, the real GDP per capita is $600 billion / 8 million people, or $75,000.
So, which nation has the higher real GDP per capita? The land of Mini. In the land of Mini, the average person probably has a nicer house and more material possessions. Economists would say this: the standard of living is higher in the land of Mini.
When the real GDP per capita goes up, standard of living goes up. Why does it really matter who has more stuff? Because material things are a key element of economic well-being. A country that's able to produce more stuff with fewer resources is usually able to obtain other important things like food, shelter, clean water and freedom. In addition, people who live in countries with higher real GDP per capita tend to be more educated and live longer.
So, let's talk about the drivers of standard of living. In the long-run, a country's standard of living depends on three things:
If you're attempting to increase the standard of living of a nation, you'd look at these three things.
When a nation's savings rate increases, this increase in savings ultimately helps raise the standard of living. When people in the land of Macro save 5% of their incomes each year instead of 1%, the extra savings goes into the banking system and gets loaned out to entrepreneurs. The entrepreneurs borrow this money in order to invest into machinery and equipment that increases economic output. And if real GDP grows faster than the population does, then the standard of living goes up. So, the savings rate is an important determinant of a nation's standard of living.
Population is also a determinant. For example, if real GDP in the land of Macro increases by 3%, but at the same time the total population grows by 3%, then economic output went up, but the people living there are not any better off than they were before because real GDP per capita didn't change. If a nation's population growth slows from, say, 3% to 1%, then its standard of living is going to increase. Remember that the formula for real GDP per capita has two elements: it has the real GDP on top and the population on the bottom. Think about this for a minute. Since real GDP is divided by the population, a nation's real GDP must grow faster than the population grows in order for its standard of living to increase.
You can try to raise the savings rate in a nation for a while, but eventually people will save as much as they can. So, this is a short-term strategy. You can try to lower the growth of the population, but that's not going to last forever either. However, you can improve productivity forever.
By far the most important determinant of standard of living and the one that can be sustained in the long-term is productivity. To explain this, just think about what happened in the automobile industry during the 1920s. During this period, it took less and less time to assemble a Ford Model T, which was the most popular car. As a result, the price of automobiles went down, and the standard of living in America went up. More and more people decided to buy cars because they could afford it. The number of registered car owners went from 6.7 million in 1919 to 23.1 million in 1929. What does that mean? It means that within ten years, three times as many people drove cars after productivity increased. Improvements in productivity lead to a higher standard of living. Paul Krugman, in his book The Age of Diminishing Returns, said this: 'Productivity isn't everything, but in the long run it is almost everything. A country's ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.' That's why productivity's important.
So, what's the moral of the story? The next time you're in a hot air balloon comparing the standard of living of two nations (which I know is something that happens to you quite often), don't get stuck like most people, who only look at real GDP mowed into the hillside like a crop circle. Look more closely at the population and you can find out how well-off people really are.
To summarize, when a nation's savings rate increases, this increase in savings ultimately helps raise the standard of living.
Population is another determinant of the standard of living. Since real GDP is divided by the population, a nation's real GDP must grow faster than the population grows in order for its standard of living to increase.
Finally, the most important determinant of standard of living and the one that can be sustained in the long-term is productivity. Improvements in productivity lead to a higher standard of living.
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Back To CourseEconomics 102: Macroeconomics
15 chapters | 123 lessons