Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Sorting levels from growth rates


Another source of confusion is the level of a variable versus its growth rate:


Level: The value that a variable takes at a particular time.

Growth rate: The percentage change in a variable over a period of time

(usually a year).


Here’s an example: one of the economic success stories of the recent past is China. Over the last decade or more, the Chinese economy has grown by around 10 per cent per year. At the same time, growth in the West has been a paltry few percentage points a year (if at all). No doubt China has made huge strides and the living standards of its people have improved substantially. But does this mean that the Chinese economy is now ‘better’ than the economies of the West?

Well, to an economist probably not. Although China has experienced substantial economic growth, it started off from a very low level: average income in 2000 was around $1,000 per person, whereas at that time in the US average income per person was around $40,000. So, even though the Chinese economy has grown a lot since then, living standards in China are still far below living standards in the US. The average American today still earns over 7 times more than the average Chinese.

The lesson is: although growth rates of variables are important, don’t lose sight of the overall level of the variable.

Here are some other examples of variables that are levels: the amount of unemployment, the overall price level, the value of a stock index and the average house price in London. The percentage change of these variables is a growth rate; for example, the percentage change in the price level over a year is called the rate of inflation: it’s the growth rate of the price level.

Investigating interest rates: The price of money

Economists say that the price of money is the interest rate: It tells you the cost of borrowing money and how much return you can expect if you lend out your money. (As anyone who’s tried to borrow money knows, these two rates are rarely the same! Ignore this complication for the moment.)

The interest rate is an important variable in macroeconomics – it can

have a big impact on the behaviour of individuals and firms:


Individuals: Imagine that the interest rate is very high, so you get a large return on your savings. How would that affect your choices? Well, probably you’d think twice before spending your money. After all, if you spend it now, you give up the opportunity to save it and earn a high return. In this situation, economists say that the opportunity cost of consuming is high. Similarly, if you want to buy a car or a house and you need to borrow money, you’re much less likely to do so if the interest rate is high.

These two effects mean that, when the interest rate is high, consumption is relatively low, and when the interest rate is low, consumption is relatively high.

Firms: Large firms, especially, often have surplus cash lying around. What should they do with their excess cash? One option is to save it and earn the interest rate. Another option is to buy some more capital (stuff such as machines – check out the earlier section ‘Differentiating investment and capital’). If the interest rate is high, buying a new machine had better give the firm a really good return – otherwise it should have just saved the cash and earned the interest rate. In this situation, economists say that the opportunity cost of investment (buying capital) is the return the firm would’ve earned if it had just saved the money.

If the interest rate is high, not many firms want to engage in investment.

Conversely, a low interest rate makes investment very attractive.

The interest rate is such a powerful tool that setting it is the responsibility of the central bank. This is known as monetary policy, something we look at closely in Chapter 10.