Happy 4th of July to everyone—especially to my stepfather, who earned a Purple Heart in Okinawa.
Consider the following two definitions of macroeconomics:
1. Macro is the study of aggregate economic variables, including inflation, real output, unemployment, interest rates and exchange rates.
2. Macro studies the effects of the market for the medium of account, in a world of nominal contracts.
The first definition is more conventional, but I find the second to be more useful. Before explaining why, consider the following analogy:
Suppose the global oil market has a monopoly supplier of barrels. Each barrel is exactly 42 gallons. Now suppose the barrel company becomes more erratic. During one month the barrels are only 40 gallons. Another month they are 45 gallons. The size moves around according to a random walk.
If all oil were traded in spot markets, then that would be a mild inconvenience, but nothing more. Prices per barrel would adjust to reflect changes in the size of barrels. Price per gallon would be unaffected.
If oil was also traded in futures markets, and continued to be priced per barrel, then fluctuating barrel size would cause major problems for the oil majors. They would hire a bunch of experts to study the monopoly supplier of barrels, trying to forecast whether the next batch would be larger or smaller than the current batch of barrels.
Part II: A monetary economy
In a simple barter economy, it’s not clear that macro would even exist, at least in its present sense. Economics would be the study of a bunch of individual markets, focusing on the relative prices of each good. At best, there would be a field called “growth theory”, which would contain a small portion of modern macro.
Now let’s consider switching from barter to an economy where silver is the medium of account. The term numeraire is often used for medium of account; it is the good in terms of which all other prices are measured. Because the current price of silver is just under a dollar per gram, I’ll assume that this country uses grams of silver as the measuring stick of value. One gram of silver is a “dollar”. Silver is the medium of account; dollar is the unit of account.
Is that enough to create a need for macroeconomics? It depends. If people did not suffer from money illusion, they presumably wouldn’t care at all about “inflation”. All people would care about is real or relative prices, which are not directly impacted by the choice of the medium of account. I suppose you could create the field of macro to satisfy the curiosity of some oddball that cares about the “cost of living”, aka the “price level”, in terms of silver. But most rational people simply would not care.
But if you add money illusion, then everything changes. People stop thinking in terms of relative prices, and instead focus on nominal prices—i.e., prices measured in terms of silver. The discovery of a massive silver hoard at Potosi would cause nominal prices to rise significantly—voters would become upset about “inflation” (meaning depreciation in the relative price of silver.)
Money illusion also causes people to negotiate long-term labor contracts in nominal terms. Now shocks to the silver market don’t just affect the “price level”, they cause cycles in employment and output. And the existence of long-term nominal financial contracts means that silver market shocks also causing financial turmoil. As a result, silver market shocks lead to both changes in the overall level of real income and the redistribution of existing income. Suddenly, unstable nominal variables are a BFD.
In one sense, silver is not that important—just one good out of tens of thousands that are traded in the economy. But if silver is one side of each of the billions of transactions that take place each year, it becomes very important. Thus while in a real sense silver would be a tiny fraction of the economy, in a nominal sense it would be 50% of GDP. Half of the entire economy!
Without money illusion and nominal contracts, no one would pay much attention to silver, despite it representing one side of almost every transaction. But if there are lots of contracts written in silver terms, and if the silver market is subject to “shocks”, then people would care a great deal about what’s happening to the nominal (silver) economy.
That’s why I believe that macro is basically a study of the implications of changes in the value of the medium of account in an economy with long-term contracts that are denominated in nominal terms.
And if it isn’t, it should be.