20 Recap: Back to space
(where we return to the ISS and summarise our economy)
Macroeconomics is about understanding the economy at large. Below you can see the live feed from the ISS and webcams from different places on Earth. During the course you have seen that living conditions vary wildly between countries, but that things like GDP, unemployment and inflation also vary over time within a country. I hope that after this course you understand a little more about how the economy works.
Here is a top‑10 list of points I think have been particularly important during the course. The first five items are things most macroeconomists agree on, while items 6–10 cover areas that remain fiercely debated.
In the long run our prosperity is determined by our ability to produce goods and services
Although GDP has its limitations as a welfare measure, it remains a central variable in macroeconomics. To understand why some countries become rich while others remain poor we must (assuming basic institutions are in place) look at three fundamentals: labour, capital and technology. The economy grows when more people work, when capital rises or when technology improves. How can economic policy stimulate growth? One of the most effective ways is to invest more for the future. That means both the state and households need to save more — which may feel unpleasant in the short run (less consumption), but it raises our living standards in the long run. When we invest more each worker has more capital to work with, which raises productivity. Other routes to higher prosperity are getting more people into work and stimulating technological progress. These are the same principles that determine Robinson Crusoe’s long‑run living standards on his island. More hours worked, better tools/machines and smarter methods make him richer over time. Exactly how technological progress arises is still partly a mystery. Take Formula 1 as an example: it used to take nearly a minute to change a tyre during a pit stop, but today mechanics do the same job in 1.78 seconds. What do you think has enabled this enormous improvement?
Globalisation raises GDP — but it also affects income inequality
Throughout history many countries have tried to isolate themselves. One example is Japan, which between 1603 and 1868 cut almost all ties with the outside world. Today North Korea is an equally extreme case — and many other countries have criticised globalisation and threatened higher tariffs. The debate raises many questions. Who is right?
Economic theory says openness and trade usually benefit all parties — why else would anyone agree to trade? The concept of comparative advantage can be tricky to grasp fully, but its importance is undeniable. Through specialisation and trade the total pie can grow. Just as Adam and Eve saved time by cooperating, countries can become richer by producing what they are relatively better at and trading for other goods and services that other countries produce more efficiently. Historically openness has almost always proved favourable for economic development.
Critics of globalisation are, however, probably right that free trade also affects a country’s income distribution. Globalisation tends to expand export sectors and shrink import‑competing sectors. In Finland’s case this will likely benefit the highly educated, since we export advanced goods and services that rely on skilled labour. Other sectors — for example low‑skill manufacturing jobs — face fierce competition from cheap imports, which often pushes down wages in those sectors. The issue is not black and white; there is also two‑way trade that delivers cheaper and better goods, which benefits everyone.
In the short run AD determines how much is produced
In the long run GDP is determined by our ability to produce goods and services — that is, aggregate supply. In the short run, however, GDP is also affected by how much goods and services we want (aggregate demand). The reason aggregate demand matters in the short run is that prices and wages tend to be sticky. In the short run it is hard for Fabbe to cut prices and wages if customer numbers suddenly fall; instead he must reduce production. Changes in AD therefore cause actual GDP to deviate from potential GDP in the short run — and business cycles arise. By analysing the individual components of aggregate demand we can make forecasts about the near future. More optimistic households and firms, or a better economic situation in our export markets, will likely raise our GDP. Moreover, both fiscal and monetary policy can be used to steer aggregate demand and thereby influence short‑run GDP in the desired direction.
In the short run policymakers can choose between unemployment and inflation
Besides GDP, unemployment and inflation are two other variables that affect a country’s welfare. With expansionary fiscal and monetary policy policymakers can raise AD, which — according to the Phillips curve — leads in the short run to lower unemployment but higher inflation. Conversely, tight policy leads to lower inflation but higher unemployment. In the short run each country can thus choose between high inflation and high unemployment — a kind of “menu” of trade‑offs. However, this trade‑off exists only in the short run. Using expansionary policy to push GDP above its sustainable level — thereby driving unemployment below the “natural” rate — inevitably leads over time to rising wages and prices, so that both GDP and unemployment eventually return to their long‑run levels.
In the long run (changes in) the money supply determines inflation but does not affect unemployment
In the long run there is no menu from which to choose inflation versus unemployment. Instead long‑run inflation is determined by how the money supply changes. When I handed out roughly five times more money during the lecture, the auction prices rose by about five times. Likewise, hyperinflation — for example in 1920s Germany — occurred because central banks let the presses run hot. Unemployment, however, is not determined in the long run by the money supply, just as the number of banknotes hardly mattered for Robinson Crusoe’s living standards on the island. The natural rate of unemployment is instead shaped by factors such as how well jobseekers match vacancies. To fight high inflation policymakers must ensure the money supply does not grow too fast. To fight high unemployment they must ensure the labour market functions well.
Points 1–5 are things most economists would agree on. Here are five issues economists often deeply disagree about:
How do you raise potential GDP in practice?
According to growth theory potential GDP depends on the amount of capital, the number of workers and the economy’s technology. For Finland to be richer in the long run we therefore need more people working, more capital per worker, and/or better technology. But achieving this is costly.
Raising capital requires more saving and investment instead of consumption. Many economists therefore argue we should save more. But if the state and households save more that means consuming less today. Is it really right to cut your study grant or reduce elderly care so future generations can enjoy higher living standards?
Getting more people into work requires lowering the natural rate of unemployment, and that is also difficult. For example, frictional unemployment can be reduced by tightening benefit systems — but is it fair to squeeze precisely those who are already vulnerable?
Or should we instead rely on continued technological progress? Technological improvement is the key reason global poverty has receded, but economists still disagree about why technological progress happens in the first place.
Should we try to stabilise the economy?
The business‑cycle model showed that AD and AS shocks generate economic fluctuations and that fiscal and monetary policy can be used to steer the economy. Some economists argue that policymakers should use fiscal and monetary policy to stabilise GDP and unemployment around their long‑run levels. This can avoid deep crises and prevent problems such as mass unemployment and hysteresis. Other economists contend the economy would be better off if politicians kept their hands off fine‑tuning AD. They point out it is hard to predict the economy’s path and that clumsy policy can worsen business‑cycle swings. They also warn that politicians tend to abuse their power for re‑election.
How dangerous is inflation — and what does it cost to bring it down?
No one doubts that living in a society where a biscuit costs €0.10 on Monday, €225 on Tuesday and €225,000 on Wednesday is exhausting. Menu costs, shoe‑leather costs and the difficulty of interpreting price signals become huge. But how bad is it to live in a country with 10 percent annual inflation? Generally speaking lower inflation is preferable, but the key question is what it costs to reduce inflation from, say, 10 percent to 2 percent. The short‑run Phillips curve shows that unemployment must rise first if inflation is to fall in the long run. Economists often disagree about whether the price paid in terms of recession and unemployment is worth it to bring inflation down. Some stress the risk of hysteresis — that a temporary downturn will inflict permanent damage via scarring and lost human capital. Others argue the opposite: the recession can be mild and short if low‑inflation policy is credible.
How dangerous are deficits and large public debts?
Finland’s gross public debt is currently about 88 percent of GDP, a level that has risen steadily over the past 17 years. How dangerous is this, really? When the public sector runs deficits we must borrow, which increases the public debt. One risk is that in the future we will have to repay debts instead of making important investments. Large public debts can therefore inhibit growth. Other economists argue borrowing is not so harmful provided the funds are used wisely. If growth continues roughly as it has over the past century, future generations will be considerably richer than we are and can easily repay our debts.
Does new technology destroy jobs?
Technological progress — our growing ability to produce goods and services with a given set of resources — has transformed society from one of scarcity to one in which most of us live in abundance. But new technology also destroys old jobs. This structural transformation makes us richer overall, yet it can be painful for those who are no longer needed in the short run. History is full of failed attempts to stop progress, from Luddites smashing textile machines in the early 19th century to attempts by Swedish unions to ban disco music in the 1970s. Right now artificial intelligence (AI) is a hot topic. Many economists view AI as yet another example of structural change: although AI may replace some jobs, in the long run it will create more prosperity. Others warn AI may be different — they fear that, perhaps for the first time, new technology will destroy more jobs than it creates. Exciting times lie ahead.
Here are some past exam examples. Remember to always answer questions in a way that makes the grader understand that you really understand.
This concludes the Introductory Course in Macroeconomics. I hope you now understand a bit better why the world looks the way it does. You have learned about economic growth that has lifted large parts of humanity out of extreme poverty, and you know quite a lot about why economies sometimes crash and what can be done to counteract it.
Recent years have been shaped by the pandemic and by inflation. One fascinating thing about economics is that something new and unexpected always happens. So what will the next big event be? What happens to the world economy if Donald Trump invades Greenland or if Russia attacks another neighbour? Right now a handful of US tech stocks account for a wildly large share of global market capitalisation — what if those stocks crash? Is there a housing bubble, and are some countries’ public debts unsustainably large? At the same time new AI technologies and the spread of remote work might accelerate growth while giving us more leisure. Or will the future be dominated by something you cannot even imagine in your wildest dreams?
This concludes the Introductory Course in Macroeconomics. But the story doesn’t end here — there’s more to come. In the next chapter you’ll read about what it’s like to study economics.