13.6 Macroeconomics and Economic Decision-Making

An understanding of macroeconomic fluctuations and countercyclical macroeconomic stabilization policy is crucial to economic decision-making, not only for business managers but also for households and individuals. For managers, forecasting economic activity is crucial to decisions about employment, production, and capital investment. For example, if the government reduces individual income tax rates, managers will expect increases in GDP and household disposable income. Since increased disposable income leads to additional consumption spending, managers will likely expand production in anticipation of higher demand for their products. Because the expansionary tax policy has a permanent effect on income, managers will hire more employees rather than using overtime to meet the increased demand for their products. In addition to using more labor, managers will have an incentive to increase their use of capital in the long run to produce their products in the most efficient way.

Managers’ decisions to invest in more capital depend not only on expected future demand for their product, but also on market interest rates. Because interest rates—the opportunity cost of investing in real capital—are affected by macroeconomic stabilization policies, managers should be aware of the likely interest-rate effects of monetary and fiscal policy. In our example, the government introduces expansionary fiscal policy. As you have learned, expansionary fiscal policy causes market interest rates to increase, other things equal. Higher interest rates make investment less profitable, so prudent managers would take that into account and plan for less new investment. This is an example of the crowding-out effect of expansionary fiscal policy. However, if the Federal Reserve announces an interest-rate target to prevent crowding out (accommodating monetary policy), managers will be confident that interest rate increases will not require them to reduce their desired investment level.

Individuals can improve their economic decisions by utilizing their knowledge of how the overall economy works and how macroeconomic stabilization policies are used to moderate macroeconomic fluctuations. Suppose that you are thinking of purchasing a house. Whether and when to buy a house depends on many factors, including your current and expected income, your savings and debts, housing prices, and interest rates. Because of macroeconomic fluctuations and the effects of macroeconomic stabilization policies designed to moderate those fluctuations, the timing of a house purchase is crucial. During periods of economic expansion, housing prices tend to increase faster than the general rate of inflation, then decrease during recessions. Interest rates are also affected by business fluctuations. Economic expansion is accompanied by increased consumption demand and investment demand, which require additional money to facilitate the new purchases of consumer and capital goods. As a result of increased demand for money, interest rates rise. Recessions are accompanied by sharp reductions in investment spending, as well as reduced consumption spending. Hence, demand for money and interest rates fall. In addition, the Fed is likely to implement expansionary monetary policy to reduce the magnitude of an expected economic downturn, further reducing interest rates by increasing the supply of money. Since you know how macroeconomic fluctuations and stabilization policy affect interest rates and home prices, you can try to time your home purchase when both housing prices and interest rates are low.

In recent years, inflation has been an important economic and political issue. In Chapter 12, you learned that expectations of inflation can cause shifts in the aggregate-supply curve, causing cost-push inflation that is difficult to reverse. You probably wonder whether inflation will continue in the future. There is a simple rule-of-thumb method that can be used to determine what rate of inflation financial markets expect in the future. Because the nominal (market) interest rate (i) is equal to the real interest rate (r) plus the expected rate of inflation (p*), shown as i = r + p*, the expected rate of inflation is found by subtracting the real interest rate from the nominal interest rate, i.e., p* = i − r. Suppose the mortgage interest rate for a 30-year fixed mortgage is 7 percent. Because the real interest rate lenders expect to receive on a safe asset like a house is about 3.5 to 4 percent, the inflation rate the financial markets are expecting over the next 30 years must be 3 or 3.5 percent (7 percent minus 3.5 or 4 percent). Similar analysis could be used to determine shorter-term expectations by using 10- or 15-year mortgage rates.