Fiscal Policy and Macroeconomic Debates Chapters 11 and

Fiscal Policy and Macroeconomic Debates Chapters 11 and 17

HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND • Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes. – Controlled by Congress and the President • Fiscal policy influences saving, investment, and growth in the long run. • In the short run, fiscal policy primarily affects the aggregate demand.

Changes in Government Purchases • When policymakers change the money supply or taxes, the effect on aggregate demand is indirect—through the spending decisions of firms or households. • When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly.

HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND • Expansionary Policy – Lower Taxes • What will be the effect on AD? • What will be the effect on GDP? – Raise Government Spending • What will be the effect on AD? • What will be the effect on GDP? – Effect on Budget?

HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND • Contractionary Policy – Raise Taxes • What will be the effect on AD? • What will be the effect on GDP? – Lower Government Spending? • What will be the effect on AD? • What will be the effect on GDP? – Effect on Budget?

The Federal Government • Federal Government Spending – Government spending includes transfer payments and the purchase of public goods and services. • Transfer payments are government payments not made in exchange for a good or a service. • Transfer payments are the largest of the government’s expenditures. • Entitlements – Discretionary VS Non-discretionary

Discretionary Fiscal Policy • When the government chooses to change G or T, it is called discretionary fiscal policy (i. e. , it is done at the discretion of Congress and the president).

Automatic Stabilizers • In addition to Congress and the President choosing to change G ot T, there also automatic stabilizers in the economy. • Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. • Automatic stabilizers include the tax system and some forms of government spending.

USING POLICY TO STABILIZE THE ECONOMY • Economic stabilization has been an explicit goal of U. S. policy since the Employment Act of 1946.

The Case for Active Stabilization Policy • The Employment Act has two implications: – The government should avoid being the cause of economic fluctuations. – The government should respond to changes in the private economy in order to stabilize aggregate demand.

The Case against Active Stabilization Policy • Some economists argue that monetary and fiscal policy destabilizes the economy. • Monetary and fiscal policy affect the economy with a substantial lag. • They suggest the economy should be left to deal with the short -run fluctuations on its own. • Classical VS. Keynesian

Changes in Government Purchases • There are two macroeconomic effects from the change in government purchases: – The multiplier effect – The crowding-out effect

The Multiplier Effect • Government purchases are said to have a multiplier effect on aggregate demand. – Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.

The Multiplier Effect • The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Figure 4 The Multiplier Effect Price Level 2. . but the multiplier effect can amplify the shift in aggregate demand. $20 billion AD 3 AD 2 Aggregate demand, AD 1 0 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion. . . Quantity of Output Copyright © 2004 South-Western

A Formula for the Spending Multiplier • The formula for the multiplier is: Multiplier = 1/(1 - MPC) • An important number in this formula is the marginal propensity to consume (MPC). – It is the fraction of extra income that a household consumes rather than saves.

A Formula for the Spending Multiplier • If the MPC is 3/4, then the multiplier will be: Multiplier = 1/(1 - 3/4) = 4 • In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

CASE STUDY: The Laffer Curve and Supply-side Economics • The Laffer curve depicts the relationship between tax rates and tax revenue. • Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues.

Laffer Curve

The Federal Government • The U. S. federal government collects about two-thirds of the taxes in our economy. – The largest source of revenue for the federal government is the individual income tax.

The Federal Government • Other taxes – Payroll Taxes: tax on the wages that a firm pays its workers. • Social Insurance Taxes: taxes on wages that is earmarked to pay for Social Security and Medicare. – Excise Taxes: taxes on specific goods like gasoline, cigarettes, and alcoholic beverages.

TAXES AND EFFICIENCY • Policymakers have two objectives in designing a tax system. . . – Efficiency – Equity

TAXES AND EFFICIENCY • One tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers. • An efficient tax system is one that imposes small deadweight losses and small administrative burdens.

TAXES AND EFFICIENCY • The Cost of Taxes to Taxpayers – The tax payment itself – Deadweight losses – Administrative burdens

Administrative Burdens • Complying with tax laws creates additional deadweight losses. – Taxpayers lose additional time and money documenting, computing, and avoiding taxes over and above the actual taxes they pay. – The administrative burden of any tax system is part of the inefficiency it creates.

Lump-Sum Taxes • A lump-sum tax is a tax that is the same amount for every person, regardless of earnings or any actions that the person might take.

TAXES AND EQUITY • How should the burden of taxes be divided among the population? • How do we evaluate whether a tax system is fair?

Benefits Principle • The benefits principle is the idea that people should pay taxes based on the benefits they receive from government services. • An example is a gasoline tax: – Tax revenues from a gasoline tax are used to finance our highway system. – People who drive the most also pay the most toward maintaining roads.

Ability-to-Pay Principle • The ability-to-pay principle is the idea that taxes should be levied on a person according to how well that person can shoulder the burden. • The ability-to-pay principle leads to two corollary notions of equity. – Vertical equity – Horizontal equity

Ability-to-Pay Principle • Vertical equity is the idea that taxpayers with a greater ability to pay taxes should pay larger amounts. – For example, people with higher incomes should pay more than people with lower incomes.

Ability-to-Pay Principle • Vertical Equity and Alternative Tax Systems – A proportional tax is one for which high-income and low-income taxpayers pay the same fraction of income. – A regressive tax is one for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers. – A progressive tax is one for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers.

Ability-to-Pay Principle • Horizontal Equity – Horizontal equity is the idea that taxpayers with similar abilities to pay taxes should pay the same amounts. – For example, two families with the same number of dependents and the same income living in different parts of the country should pay the same federal taxes.

Three Tax Systems Copyright© 2004 South-Western

Tax Incidence and Tax Equity • The difficulty in formulating tax policy is balancing the often conflicting goals of efficiency and equity. • The study of who bears the burden of taxes is central to evaluating tax equity. • This study is called tax incidence.

Changes in Taxes • When the government cuts personal income taxes, it increases households’ take-home pay. – Households save some of this additional income. – Households also spend some of it on consumer goods. • MPC VS MPS • Tax Credits – Increased household spending shifts the aggregate-demand curve to the right. – Which would be bigger change in AD? • Taxes or Gov. Spending?

POLICY EFFECTS ON AGGREGATE SUPPLY

Goals of Monetary and Fiscal Policies • What are the goals of monetary and fiscal policy? • How are they designed to achieve that goal by shifting the AD curve?

Goals of Monetary and Fiscal Policies • Given the goals of economic growth, employment, and stable prices, how could a shift in AS lead to the desired outcomes?

Goals of Monetary and Fiscal Policies

Shifting Aggregate Supply • Policies that increase the quantity or quality of resources • Decreased price of economy-wide inputs (like labor and energy) • Improvements in productivity (e. g. , a technological advancement)

Long-Run Effects of Policies Shifting AD • Assume the economy starts in long-run equilibrium • Let’s say there’s a policy change, for example, the Federal Reserve increases the money supply. • The increase in the money supply decreases interest rates and therefore investment and interest-sensitive consumption increase, which increases aggregate demand.

Long-Run Effects of Policies Shifting AD • This leads to an increase in both the equilibrium level of output and price level. • This is a new short-run equilibrium with a level of real GDP above the full-employment level of real GDP. • As a result, nominal wages will rise (the demand for more workers to increase output allows workers to bargain for higher wages).

Long-Run Effects of Policies Shifting AD • The higher wages lead to a leftward shift of the AS curve until a new long-run equilibrium is reached at the full-employment level of output (but with a higher price level). • In the long run, the increase in the money supply has not changed real GDP, but has only led to an increase in the price level.

Long-Run Adjustment of Aggregate Supply

Let’s do an old FRQ…

THE DEFICIT AND THE DEBT

Discretionary Fiscal Policy • Recall that the two primary tools of discretionary fiscal policy are government spending (G) and taxes (T). • When government conducts expansionary fiscal policy to counteract recession, government spending increases and/or taxes decrease. • When the government conducts contractionary fiscal policy to alleviate inflationary pressures, government spending decreases and/or taxes increase.

An Unbalanced Budget • The gov’t budget is balanced when G = T. • When G increases and/or T decreases, the gov’t budget moves toward deficit. – A budget deficit occurs when the gov’t spends more than it collects in taxes and borrows to cover the difference (when G > T). – It does this by issuing bonds. • The sum of past deficits is the debt. – The debt incurs annual interest charges. • A gov’t budget deficit results in an increase in the D for loanable funds.

An Unbalanced Budget • A budget surplus occurs when the gov't taxes more than it spends (T > G). • A budget surplus reduces the demand for loanable funds. • It results in an increase in the supply of loanable funds if gov’t pays off the debt.

Effects of Gov’t Deficit on Loanable Funds Market • I and i are the initial equilibrium values. • D = private sector demand for funds (investment). • D + (G – T) = private + government demand for funds. • I 1 and i 1 are the new equilibrium values. • I 2 = new level of private investment. • I 1 – I 2 = government demand for funds (G – T).

POLICY LAGS AND THE CROWDING-OUT EFFECT

Lags Associated with Policy Making • Two lags: – Inside lag: time it takes for data to be collected, for policy makers to recognize that policy action is necessary, make a decision about which policy should be taken and then implement the policy – Outside Lag: time it takes the economy to respond to the new policy • These lags differ in length for monetary and fiscal policies

Monetary and Fiscal Policies • How can government increase its spending? – EXPANSIONARY POLICY • What happens to the government’s budget when it increases spending? – DEFICIT

Effects of Monetary/Fiscal Policies • What happens when Fed buys/sells bonds? • What happens when gov’t lowers/raises taxes?

How should money for spending be acquired? • Should gov’t borrow money or increase taxes? • Remember the multiplier effect! – Government spending multiplier = 1/MPS – Tax multiplier = -MPC/MPS • Which has a greater effect, and why?

How does government borrow money? • Through sale of treasury bills, notes, or bonds • What is the impact of government borrowing to finance an increase in spending? – When the government borrows money to finance its deficit, this results in an increase in the demand for money, or, alternatively, the demand for loanable funds. – This in turn results in an increase in the interest rate.

Government Demand for Funds Increases the Demand for Money

Government Demand for Funds Increases the Demand for Money • What happens to investment or other interest-sensitive components of aggregate demand when the gov’t demand for funds increases?

The Crowding-Out Effect • Fiscal policy may not affect the economy as strongly as predicted by the multiplier. • An increase in government purchases causes the interest rate to rise. • A higher interest rate reduces investment spending.

The Crowding-Out Effect • This increase in demand that results when a expansionary fiscal policy raises the interest rate is called the crowding-out effect. • The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

Figure 5 The Crowding-Out Effect (a) The Money Market Interest Rate Price Level Money supply 2. . the increase in spending increases money demand. . . r 2 3. . which increases the equilibrium interest rate. . . (b) The Shift in Aggregate Demand $20 billion 4. . which in turn partly offsets the initial increase in aggregate demand. AD 2 r AD 3 M D 2 Aggregate demand, AD 1 Money demand, MD 0 Quantity fixed by the Fed Quantity of Money 0 1. When an increase in government purchases increases aggregate demand. . . Quantity of Output Copyright © 2004 South-Western

The Crowding-Out Effect • When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

Back to our example… • Remember, gov’t needs to increase its spending • No monetary policies have been implemented yet • What can monetary authorities do to prevent a reduction in investment?

Loanable Funds Market • I and i are the initial equilibrium values • D = private sector demand for funds (Investment) • D + (G–T) = private + government demand for funds • I 1 and i 1 are the new equilibrium values. • I 2 = new level of private investment • I 1 – I 2 = government demand for funds (G–T)

Barro-Ricardo Effect • What is it? – Possibility that gov’t budget deficits will lead to an increase in private savings and a decrease in consumption that will offset the predicted expansionary effects of expansionary fiscal policy • How will this affect loanable funds market?

Barro-Ricardo Effect • The supply curve for funds will shift rightward. • The rightward shift in the supply curve reduces the increase in the interest rate and reduces the decrease in the private sector demand for funds. • Thus, the crowding-out effect is reduced if there is a Barro-Ricardo effect. • There is little evidence that the Barro-Ricardo effect is very large. • However, crowding-out can be significant, depending on the elasticity of investment and interest-sensitive components of aggregate demand.

The Effects of Policy Changes in Multiple Markets • Suppose that, in response to the economic situation, the federal government decides to increase its spending without increasing taxes and the Fed keeps the money supply constant. • There is no Barro-Ricardo effect. • Explain what would happen in the three markets shown on the following slide.

The Effects of Policy Changes in Multiple Markets Visual 5. 3 http//apeconomics. ncee. net Unit 5 : Macroeconomics National Council on Economic Education

The Effects of Policy Changes in Multiple Markets i 1 i AD 1 Visual 5. 3 http//apeconomics. ncee. net MD 1 Unit 5 : Macroeconomics National Council on Economic Education

The Effects of Policy Changes in Multiple Markets • What happens? – The aggregate demand curve should shift to the right. – As a result, the demand for loanable funds increases, shifting that curve to the right. • Rightward shift of loanable funds’ demand curve means a new, higher interest rate. – Increased demand for loanable funds causes an increase in the demand for money, meaning that curve shifts to the right as well, intersecting the MS curve at the new higher interest rate set by the changes in the loanable funds market.

In the previous scenario, what happened to the following variables, and why? • Output (real GDP): – Increased. Aggregate demand increased because of the increase in government spending. • Employment: – Increased. Aggregate demand increased because of the increase in government spending. • Price level: – Increased. Aggregate demand increased because of the increase in government spending. • Interest rates: – Increased. With the money supply held constant, the demand for money increased or the demand for loanable funds increased. • Investment: – Decreased because of the increase in interest rates

Crowding-Out • In the given scenario, how do we know crowding out has occurred? • Assuming there was no gov’t borrowing prior to their decision to increase spending, how does the loanable funds market graph indicate the quantity of gov’t borrowing?

What could the Fed have done to prevent crowding-out? • The Fed could use expansionary monetary policy; thus the government’s demand for funds would not result in an increase in interest rates.

Are there certain conditions when the Fed should or should not prevent crowding-out? • If the economy were experiencing a recession, the Fed would want to prevent crowding-out, but if the economy were at or near full employment and government spending increased, the Fed might not want to prevent crowding-out.

THE PHILLIPS CURVE

Unemployment and Inflation • Society faces a short-run tradeoff between unemployment and inflation. • If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. • If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment. • The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed. – Think MV = PQ

THE PHILLIPS CURVE • The Phillips curve illustrates the short-run relationship between inflation and unemployment.

The Phillips Curve Inflation Rate (percent per year) B 6 A 2 Phillips curve 0 4 7 Unemployment Rate (percent) Copyright © 2004 South-Western

Aggregate Demand, Aggregate Supply, and the Phillips Curve • The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the shortrun aggregate supply curve.

Aggregate Demand, Aggregate Supply, and the Phillips Curve • The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level. • A higher level of output results in a lower level of unemployment.

How the Phillips Curve is Related to Aggregate Demand Aggregate Supply (a) The Model of Aggregate Demand Aggregate Supply Price Level 102 Inflation Rate (percent per year) Short-run aggregate supply 6 B 106 B A High aggregate demand Low aggregate demand 0 (b) The Phillips Curve 7, 500 8, 000 (unemployment is 7%) is 4%) Quantity of Output A 2 Phillips curve 0 4 (output is 8, 000) Unemployment 7 (output is Rate (percent) 7, 500) Copyright © 2004 South-Western

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF EXPECTATIONS • The Phillips curve seems to offer policymakers a menu of possible inflation and unemployment outcomes.

The Long-Run Phillips Curve • In the 1960 s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run. – As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. – Monetary policy could be effective in the short run but not in the long run.

The Long-Run Phillips Curve Inflation Rate 1. When the Fed increases the growth rate of the money supply, the rate of inflation increases. . . High inflation Low inflation 0 Long-run Phillips curve B A Natural rate of unemployment 2. . but unemployment remains at its natural rate in the long run. Unemployment Rate Copyright © 2004 South-Western

How the Phillips Curve is Related to Aggregate Demand Aggregate Supply (a) The Model of Aggregate Demand Aggregate Supply Price Level P 2 2. . raises the price P level. . . Long-run aggregate supply 1. An increase in the money supply increases aggregate B demand. . . (b) The Phillips Curve Inflation Rate Long-run Phillips curve 3. . and increases the inflation rate. . . B A A AD 2 Aggregate demand, AD 0 Natural rate of output Quantity of Output 0 Natural rate of unemployment Unemployment Rate 4. . but leaves output and unemployment at their natural rates. Copyright © 2004 South-Western

Expectations and the Short-Run Phillips Curve • Expected inflation measures how much people expect the overall price level to change. • In the long run, expected inflation adjusts to changes in actual inflation. • The Fed’s ability to create unexpected inflation exists only in the short run. – Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate. • WHY? ? ?

How Expected Inflation Shifts the Short-Run Phillips Curve Inflation Rate 2. . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. Long-run Phillips curve C B Short-run Phillips curve with high expected inflation A 1. Expansionary policy moves the economy up along the short-run Phillips curve. . . 0 Short-run Phillips curve with low expected inflation Natural rate of unemployment Unemployment Rate Copyright © 2004 South-Western

The Natural Experiment for the Natural-Rate Hypothesis • The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the naturalrate hypothesis. • Historical observations support the natural-rate hypothesis.

The Natural Experiment for the Natural Rate Hypothesis • The concept of a stable Phillips curve broke down in the early ’ 70 s. – Stagflation • During the ’ 70 s and ’ 80 s, the economy experienced high inflation and high unemployment simultaneously.

The Phillips Curve in the 1960 s Inflation Rate (percent per year) 10 8 6 1968 4 1967 2 0 1966 1962 1965 1964 1963 1 2 3 4 5 6 1961 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The Breakdown of the Phillips Curve Inflation Rate (percent per year) 10 8 6 1973 1971 1969 1968 4 1970 1967 2 0 1972 1966 1962 1965 1964 1963 1 2 3 4 5 6 1961 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS • The short-run Phillips curve can shift due to changes in expectations. • The short-run Phillips curve also shifts because of shocks to aggregate supply. – Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation. – An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS • A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge. • This shifts the economy’s aggregate supply curve. . . • . . . and as a result, the Phillips curve.

An Adverse Shock to Aggregate Supply (a) The Model of Aggregate Demand Aggregate Supply Price Level 3. . and raises the price level. . . AS 2 P 2 B A P Aggregate supply, AS (b) The Phillips Curve Inflation Rate 1. An adverse shift in aggregate supply. . . 4. . giving policymakers a less favorable tradeoff between unemployment and inflation. B A PC 2 Aggregate demand 0 Y 2. . lowers output. . . Quantity of Output Phillips curve, P C 0 Unemployment Rate Copyright © 2004 South-Western

SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS • In the 1970 s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum. – Fight the unemployment battle by expanding aggregate demand accelerate inflation. – Fight inflation by contracting aggregate demand endure even higher unemployment.

The Supply Shocks of the 1970 s Inflation Rate (percent per year) 10 1980 1974 8 1981 1975 1979 1978 6 1977 1973 4 1976 1972 2 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

THE COST OF REDUCING INFLATION • To reduce inflation, the Fed has to pursue contractionary monetary policy • When the Fed slows the rate of money growth, it contracts aggregate demand. • This reduces the quantity of goods and services that firms produce. • This leads to a rise in unemployment.

Disinflationary Monetary Policy in the Short Run and the Long Run Inflation Rate Long-run Phillips curve 1. Contractionary policy moves the economy down along the short-run Phillips curve. . . A Short-run Phillips curve with high expected inflation C B Short-run Phillips curve with low expected inflation 0 Natural rate of unemployment Unemployment 2. . but in the long run, expected Rate inflation falls, and the short-run Phillips curve shifts to the left. Copyright © 2004 South-Western

THE COST OF REDUCING INFLATION • To reduce inflation, an economy must endure a period of high unemployment and low output. – When the Fed combats inflation, the economy moves down the short -run Phillips curve. – The economy experiences lower inflation but at the cost of higher unemployment.

THE COST OF REDUCING INFLATION • The sacrifice ratio is the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point. – An estimate of the sacrifice ratio is five. – To reduce inflation from about 10% in 1979 -1981 to 4% would have required an estimated sacrifice of 30% of annual output!

Rational Expectations and the Possibility of Costless Disinflation • The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future.

Rational Expectations and the Possibility of Costless Disinflation • Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run. • How quickly the short-run tradeoff disappears depends on how quickly expectations adjust.

Rational Expectations and the Possibility of Costless Disinflation • The theory of rational expectations suggests that the sacrificeratio could be much smaller than estimated.

The Volcker Disinflation • When Paul Volcker was Fed chairman in the 1970 s, inflation was widely viewed as one of the nation’s foremost problems. • Volcker succeeded in reducing inflation (from 10 percent to 4 percent), but at the cost of high employment (about 10 percent in 1983).

Figure 11 The Volcker Disinflation Inflation Rate (percent per year) 10 A 1980 1981 1979 8 1982 6 1984 4 1987 C 2 0 1 2 3 4 5 6 B 1983 1985 1986 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

The Greenspan Era • Alan Greenspan’s term as Fed chairman began with a favorable supply shock. – In 1986, OPEC members abandoned their agreement to restrict supply. – This led to falling inflation and falling unemployment.

The Greenspan Era Inflation Rate (percent per year) 10 8 6 1990 1991 1989 1984 1988 1985 1987 2001 1995 1992 2000 1986 1997 1994 1993 1999 2002 1998 1996 4 2 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent) Copyright © 2004 South-Western

Misery Index •

Misery Index POTUS Misery Index Harry Truman 7. 88 Dwight Eisenhower 9. 26 JFK 7. 14 LBJ 6. 77 Nixon 10. 57 Gerald Ford 16. 00 Jimmy Carter 16. 26 Reagan 12. 19 Bill Clinton 7. 80 Dubya 8. 11 Obama 9. 41

Chapters 16 and 17 ECONOMIC GROWTH AND DISPUTES OVER MACRO THEORY AND POLICY

Long-Term Economic Growth • Avg. growth rate of per capita real GDP has been above 2 percent a year for the last four decades. • However, the annual rate of growth has varied considerably during this same period. – Real GDP growth rate averaged 3. 27% from 1947 to 2014 • All-time high of 16. 9% in Q 1 1950 • Record low of -10% Q 1 1958 • Increased at annual rate of 3. 9% in Q 3 of this year • The increase in the average standard of living represented by the increase in per capita real GDP is important. • The distribution of the increase in real GDP is also important

Long-Term Economic Growth • For growth to occur, economic agents – producers and consumers – must have the appropriate incentives. • Growth accounting focuses on three sources of long-run economic growth: – Quantity and quality of labor – Quantity and quality of capital – level of technology.

Long-Term Economic Growth • Increases in any one of these elements (quantity/quality of labor, quantity/quality of capital, level of technology) will increase real GDP. – The growth in the quantity of labor is primarily the result of population growth. – The quality of labor is affected by improvements in education, training, and health of workers. – Investment and research and development result in improvements in capital and technological advances. – Increases in capital or technological advances increase productivity and thus increase real GDP.

Levers of Growth • When the increases in the supply of labor, in the supply of capital stock, or in technological capabilities occur, these three sources act as levers of growth.

How do we stimulate the levers of growth? • Increasing savings will increase the supply of loanable funds, decrease interest rates and spur investment or increases in the capital stock. • In the United States, tax incentives are the principal method to increase savings. • IRAs and Roth IRAs are examples. – During the 1970 s and 1980 s, stockholders in gas and electric utility companies received a tax break if they reinvested their dividends in the companies.

How do we stimulate the levers of growth? • Increasing government support for basic research will stimulate research and development. – National Science Foundation grants are one mechanism used in the United States.

How do we stimulate the levers of growth? • Getting the most from comparative advantage by encouraging international trade will also stimulate growth throughout the world.

How do we stimulate the levers of growth? • Growth can also be stimulated by improving the quality and capabilities of the labor force so workers can be more productive with a given level of capital and technology. • Improving the quality of education is the primary tool used here. • The United States has focused on improving the quality of public education and, using education IRAs, provides incentives for people to obtain more education.

• How do changes in the labor force and in technological capabilities affect LRAS? • How do changes in LRAS impact the production possibilities curve?

Contemporary disagreements in macroeconomics • Economists today disagree mainly on the following three interrelated questions: 1. What causes instability in the economy? 2. Is the economy self-correcting? 3. Should government adhere to rules or use discretion in setting economic policy?

Differing Macroeconomic Philosophies • Classical: Believes that the government SHOULD NOT interfere in the economy, allow for selfcorrection of economic problems. Modern classical economists are called “monetarists”. – F. A. Hayek – Milton Friedman (CHICAGO SCHOOL) • Keynesian: Believes that GOVERNMENT SHOULD interfere in the economy (taxes, government spending). Most “mainstream” economists are Keynesians. – John Maynard Keynes

Some history of both schools of thought… • The classical viewpoint dominated economics from the time of Adam Smith until the 1930 s – They maintained that full employment was normal and gov’t should stick to laissez-faire policies • Keynes observed in the 1930 s that laissez-faire capitalism is subject to recurring recessions and depressions with widespread unemployment, and contended that active government stabilization policies are necessary to avoid wasting idle resources

Differences • Mainstream – Focuses on aggregate demand its components – Main equation of import is C+I+G+NX – AD is unstable from quarter to quarter due to changes in variability of components • Monetarists – Money underlies aggregate demand. If money supply is controlled, aggregate demand will remain stable. – Changes in money supply shift the AD curve. – Equation of exchange (MV=PQ) is fundamental equation for monetarists.

The Chicago School • Read “The Chicago School”, excerpted from Commanding Heights by Daniel Yergin and Joseph Stanislaw • Let’s discuss – – According to Becker, what was the Chicago school's contribution to economic science? How was the Chicago school in direct conflict with the Keynesian school of economic thought? According to the Chicago economists, what should government’s role in the economy be? According to Friedman, what produced the best results for economic freedom?

“Fear the Boom and Bust” • How would Keynes have handled the Great Recession of the late 2000 s? What about Hayek? • Part 1: http: //youtu. be/d 0 n. ERTFo-Sk • Part 2: http: //youtu. be/GTQnarzm. TOc