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Center for Policy Excellence: budget policy Workshop eleven and twelve The role of government: impact on macroeconomy (Based on Macroeconomics – Mankiw) Seminar notes for fellows Prepared by Diana Cook February 1999 CONTENTS 1. Introduction.................................................................................... 1 2. Production and growth ................................................................... 2 2.1 Productivity: its role and determinants ................................................. 2 2.2 Economic growth and public policy ...................................................... 3 2.3 Importance of long run growth ........................................................... 6 3. Government and saving.................................................................. 7 3.1 Taxes and savings .............................................................................. 7 3.2 Taxes and investment......................................................................... 8 3.3 Government budget deficits ................................................................ 8 4. Money and prices in the long run .................................................11 4.1 The causes of inflation ....................................................................... 11 4.2 Costs of inflation ............................................................................... 14 5. Short run economic flucatations ..................................................18 5.1 Three key facts about economic fluctuations ....................................... 18 5.2 Explaining short run fluctuations ........................................................ 18 5.3 The aggregate demand curve ............................................................ 19 5.4 The aggregate supply curve ............................................................... 20 5.5 Two causes of recession .................................................................... 22 6. Influence of monetary and fiscal policy on aggregate demand...26 6.1 How monetary policy influences aggregate demand ............................ 26 6.2 How fiscal policy influences aggregate demand ................................... 29 6.3 Using policy to stabilize the economy.................................................. 32 6.4 The economy in the long-run and the short-run .................................. 33 7. The short-run tradeoff between inflation and unemployment ....35 CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE II 7.1 The Phillips curve .............................................................................. 35 7.2 Shifts in the Phillips curve: the role of expectations ............................. 36 7.3 Shifts in the Phillips curve: the role of supply shocks ........................... 38 7.4 The costs of reducing inflation ........................................................... 38 8. Homework ....................................................................................41 CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE III 1. INTRODUCTION In these course notes we look at the short term and long term determinants of growth and how public policy can influence the economy. We start by looking at the drivers of growth in the long run. This analysis illustrates that in the long term public policy can only enhance growth by encouraging the efficient use of a country’s labor and capital inputs. As an example, we look at the impact of some government polices on incentives to save and invest. We also examine why inflation is harmful to a country’s long-term growth prospects. These notes do not examine in detail the impact of taxes on the economy. This will be covered in future course notes. However, in the short term, changes in aggregate demand can impact on the economy’s growth rate. What are the implications for policy makers? We examine this issue and then reconcile our short and long term perspectives of the economy. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 1 2. PRODUCTION AND GROWTH When you travel around the world, you see tremendous variation in the standard of living. What explains these diverse experiences? What policies should countries adopt to promote more rapid growth? A country’s gross domestic product (GDP) measures both the total income in the economy and the total expenditure on the economy’s output of goods and services. The level of real GDP is a good gauge of economic prosperity, and the growth in real GDP is a good gauge of economic progress. In this section we focus on the long run determinants of the level and growth of GDP. 2.1 Productivity: its role and determinants Definition: Productivity: the amount of goods and services produced from each hour of a worker’s time. The variation in living standards across the world is explained by productivity. The term productivity refers to the quantity of goods and services a worker can produce for each hour of work. Recall that a country’s GDP measures both the total income earned by everyone on the economy and the total expenditure on the economy’s output of goods and services. These two things must be equal: an economy’s income is the economy’s output. A nation can enjoy a high standard of living only if it can produce a large quantity of goods and services. 2.1.1 Determinants of productivity Definitions: Physical capital: the stock of equipment and structures that are used to produce goods and services. Human capital: the knowledge and skills that workers acquire through education, training and experience. Natural resources: the inputs into the production of goods and services that are provided by nature, such as lands, rivers and mineral deposits. Technological knowledge: society’s understanding of the best ways to produce goods and services. Productivity depends on: Physical capital or the stock of equipment and structures that are used to produce goods and services. Workers are more productive if they have tools with which to work. Note that capital is an input into the production process that in the past was an output from the production process. Human capital or the knowledge and skills that workers acquire through education, training and experience. Human capital is also a produced factor of production, as producing human capital requires inputs. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 2 Natural resources or inputs into production that are provided by nature, such as lands, rivers and mineral deposits. Natural resources take two forms: renewable and nonrenewable. Although natural resources are important, they are not necessary for an economy to be highly productive in producing goods and services. Technological knowledge or society’s understanding of the best ways to produce goods and services. Technological knowledge can be common knowledge – after one person uses it, everyone becomes aware of it. Or it can be proprietary – only the company that discovers it knows it. There is an important distinction between technological knowledge and human capital. Technological knowledge refers to society’s understanding about how the world works. Human capital refers to resources expanded transmitting this understanding to the labor force. 2.2 Economic growth and public policy What can government do to raise productivity and living standards? 2.2.1 Importance of savings and investment Because capital is a produced factor of production, a society can change the amount of capital it has. One way to raise future productivity is to invest more current resources in the production of capital. Society faces a trade-off between current and future consumption. Devoting more resources to producing capital requires devoting fewer resources to current consumption. To invest more in capital, society must consume less and save more of its current income. Encouraging savings and investment is one way that a government can encourage growth and, in the long run, raise the economy’s standard of living. In section 3 we look at the impact of some government policies on savings and investment. 2.2.2 Diminishing returns and the catch up effect Diminishing returns: The property whereby the benefit from an extra unit of input declines as the quantity of the input increases. Catch-up effect: the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich. Increasing the capital stock will lead to increases in productivity and economic growth. However, capital is subject to diminishing returns. As the stock of capital rises, the extra output produced from an additional unit of capital falls. In other words, when workers already have a large quantity of capital to use in producing goods and services, giving them an additional unit of capital increases their productivity only slightly. Because of diminishing returns, an increase in the savings rate leads to higher growth only for a while. In the long run the higher savings rate leads to a higher level of productivity and income, but not to higher growth in these variables. The diminishing returns to capital have another important implication: other things being equal, it is easier for a country to grow fast if it starts out relatively poor. This is sometimes called the catch-up effect. In poor countries, workers lack even the most rudimentary tools and, as a result, CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 3 have low productivity. Small amounts of capital investment can substantially raise their productivity. 2.2.3 Investment from abroad Savings by domestic residents are not the only way for a country to invest in new capital. The other way is investment by foreigners. Investment from abroad takes several forms: Foreign direct investment is a capital investment that is owned and operated by a foreign entity. Foreign portfolio investment is an investment that is financed with foreign money but operated by domestic residents. When foreigners invest in a country, they do so because they expect to earn a return on their investment. Therefore, investment from abroad affects GDP and GNP differently. GDP is the income earned within a country by both residents and nonresidents, whereas GNP is the income earned by residents of a country both at income and abroad. Foreign investment will raise GDP more than GNP. Investment from abroad is one way for a country to grow. Even though some of the benefits from the investment flow back to the foreign owners, this investment does increase the economy’s stock of capital, leading to higher productivity and higher wages. It is also a way to learn the stateof –the-art technologies developed and used in richer countries. Therefore, government can support economic activity through policies that encourage investment from abroad. Often this means removing restrictions that governments have imposed on foreign ownership of domestic capital. 2.2.4 Education Education – investment in human capital – is just as important as investment in physical capital for a country’s long run economic success. Thus, one way the government can enhance the standard of living is to provide good schools and to encourage the population to take advantage of them. Some economists have argued that human capital is particularly important for economic growth because it conveys positive externalities. An educated person, for instance, might generate new ideas about how best to produce goods and services. If these ideas enter society’s pool of knowledge, so everyone can use them, then the ideas are an external benefit of education. This argument would justify the large subsidies to human capital investment that we observe in the form of public education. 2.2.5 Property rights and political stability An important prerequisite for the market system to work is an economy-wide respect for property rights. Property rights refer to the ability of people to exercise authority over the resources they own. For example, businesses will only invest if they are confident that they will be able to benefit from the product of that investment. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 4 For this reason, courts play an important role of enforcing property rights in a market economy. Through the criminal justice system, the courts discourage direct theft. Through the civil justice system, courts ensure that buyers and sellers live up to their contracts. In many countries the system of justice does not work well. Contracts are hard to enforce and fraud often goes unpunished. Sometimes the government not only fails to enforce property rights but actually infringes upon them. To do business in some countries, firms are expected to bribe powerful officials. Such corruption impedes the coordinating power of markets. It also discourages domestic saving and investment from abroad. Political instability, such as revolutions and coups, are a particular threat to property rights. This underlines the importance of an efficient court system, honest government officials and a stable constitution to the country’s standard of living. 2.2.6 Free trade Some of the world’s poorest countries have tried to achieve more rapid economic growth by pursuing inward-orientated policies. Most economists today believe that poor countries are better off pursuing outward orientated policies that integrate these countries into the world economy. Trade is, in some ways, a type of technology. When a country exports wheat and imports steel, the country benefits in much the same way as if it has invented a technology for turning wheat into steel. A country that eliminates trade restrictions will, therefore, experience the same kind of economic growth that would occur after a major technological advance. 2.2.7 Control of population growth Countries with large populations have large labor forces and therefore tend to have greater GDP than smaller countries. However, for policy makers concerned about living standards. GDP per person is a better measure of economic well-being. It tells us about the quantity of goods and services available for the typical person in the economy. High population growth reduces GDP per person. When population growth is rapid, equipping each worker with a large quantity of capital is more difficult. This leads to lower productivity and lower GDP per worker. Reducing the rate of population growth can be one way to raise the standard of living of developing countries. Some countries do it directly via laws, others indirectly by increasing awareness of birth control techniques. Policies that foster equal treatment of woman can also reduce population growth. Woman with the opportunity to receive good education and desirable employment tend to want fewer children than those with fewer opportunities outside the home. 2.2.8 Research and development Although most technological advances come from private research by firms and individual inventors, there is also a public interest in promoting these efforts. To a large extent, knowledge is a public good. Once one person discovers an idea, it enters society’s pool of knowledge and other people can freely use it. Therefore, government has a role in encouraging the research and development of new technologies. As well as directly playing a role in the creation and dissemination of technological knowledge, government encourages research through the patent system. The patent gives the inventor a CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 5 property right over his invention, turning his new idea from a public good into a private good. This enhances the incentive for individuals and firms to engage in research. 2.3 Importance of long run growth A country’s standard of living depends on its ability to produce goods and services. Policymakers who want to encourage growth in standards of living must aim to increase their nation’s productive ability by encouraging the rapid accumulation of the factors of production and ensuring that these factors are employed as effectively as possible. Discussion: Most countries import substantial amounts of goods and services from other countries. Yet I have said that a nation can only enjoy a high standard of living if it can produce a large quantity of goods and services itself. Can you reconcile the two facts? What is the opportunity cost of investing in capital? Do you think a country can “over-invest” in capital? What is the opportunity cost of investing in human capital? Can a nation over invest in human capital? CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 6 3. GOVERNMENT AND SAVING In section 2.2.1 we discussed the importance of saving and investment for long run economic growth. In this section we look at some of the ways that government policy can impact on national savings and investment. 3.1 Taxes and savings Tax laws may impact on the incentive to save. For example, many countries collect revenue by taxing income, including income from interest and dividends. Some economists argue that taxing the return on savings substantially reduces the payoff from current saving, and, as a result, reduces the incentive for people to save. One way to change the tax law to encourage greater saving is to replace income taxes with a consumption tax. Under a consumption tax, income that is saved would not be taxed until that saving is spent. Other proposals have been to give tax exemptions to particular types of savings. What impact would this type of savings incentive have? We can think about it in terms of the supply and demand for loanable funds. As the tax change would alter the incentive for households to save at any given interest rate, the supply curve for loanable funds would shift out. This results in a lower interest rate, which encourages households and firms to borrow more to finance investment. Thus, if a change in tax laws encouraged greater saving, the result would be lower interest rates and greater investment. Figure 1 An increase in the supply of loanable funds Supply1 Interest rate Supply2 I1 I2 Demand Q1 Q2 Loanable funds However, this analysis depends on tax changes actually leading to an increase in national saving. Many economists are skeptical about whether they would have much effect on private saving. Also, remember that government saving is part of national savings. A cut in taxes may reduce government saving, offsetting any increase in private saving. Skeptics also often doubt the equity of tax incentives. They argue that, in many cases, the benefits of the tax changes would accrue primarily to the wealthy, who are least in need of tax relief. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 7 3.2 Taxes and investment Imagine that the government decided to give a tax exemption to any firm building a new factory. What would be the impact of a tax investment credit on saving and investment? The tax credit would alter the incentive of firms to borrow and invest in new capital – it would increase the demand for loanable funds. Therefore, it would shift the demand curve for loanable funds to the right. The result would be higher interest rates and greater savings. Figure 2 An increase in the demand for loanable funds Interest rate Supply I2 I1 Demand2 Demand1 Q1 Q2 Loanable funds 1 However, note that the tax credit increasesQinterest rates. For those firms wishing to invest in equipment or industries to which the tax credit does not apply, the cost of capital has increased. Therefore, tax exemptions can change investment decisions away from the market outcome. If we assume that the market is the most efficient allocator of resources, then tax exemptions for particular types of investment may not be desirable. It may be better to design policies that encourage investment by decreasing overall business tax rates. 3.3 Government budget deficits Crowding out: A decrease in investment that results from government borrowing. Discussion: How does the budget deficit affect interest rates, investment and economic growth? What are the impacts of budget deficits on private savings and investment? Recall that national savings represent the supply of loananble funds. This is composed of private and public saving. An increase in the budget deficit represents a decrease in public saving and, thereby, in the supply of loanable funds. When the government borrows to finance its budget deficit, it reduces the supply of loanable funds to finance investment by households and firms. As a result, the interest rate increases. The higher interest rate reduces the demand of the private sector for loanable funds. Fewer families buy new homes and fewer firms build new factories. The fall in investment because of government borrowing is called crowding out. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 8 Therefore, when the government reduces national savings by running a budget deficit, interest rates rise and investment falls. As investment is important for long-rune economic growth, government budget deficits reduce the economy’s growth rate. Figure 3 The effect of a government budget deficit Supply2 Interest rate Supply1 I2 I1 Demand Q2 Q1 Loanable funds Ricardian equivalence Although most economists accept the view that government budget deficits reduce national savings and crowd out investment, a small group questions this conclusion. They advance a theory called Ricardian equivalence. According to the theory of Ricardian equivalence when households see government running a budget deficit, they understand that government will need to raise their taxes in the future in order to pay off the debt that is now accumulating. Therefore, they increase their saving to offset the government dis-saving. However, this theory does not seem to hold empirically. For example, the big public deficits in the early 1980s in the US were not accompanied by a rise in private savings. In fact, US private saving actually fell. But a rise in government debt does mean higher taxes in the future. Why don’t households save in anticipation of those taxes? Perhaps they are too short sighted to see this future ramification of government policies. Or perhaps they expect these tax increases to fall not on themselves but on future generations of taxpayers. Discussion: These notes have suggested that investment can be increased both by reducing taxes on private saving and by reducing the government deficit. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 9 A Why is it difficult to implement both of these policies at the same time? B What would you need to know about private saving in order to judge which of these two policies would be a more effective way to raise investment? CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 10 4. MONEY AND PRICES IN THE LONG RUN Inflation: the increase in the overall level of prices. Hyperinflation: an extraordinarily high rate of inflation. 4.1 The causes of inflation The economy’s overall price level can be viewed in two ways. We can view the price level as the price of a basket of goods and services. When the price level rises, people have to pay more for the goods and services they buy. Alternatively, we can view the price level as a measure of the value of money. A rise in the price level means a lower value of money, because each hyrinvia now buys a smaller quantity of goods and services. 4.1.1 Money supply, demand and equilibrium What determines the value of money? Supply and demand. The central bank, together with the banking system, determines the supply of money. Through open-market operations the central bank can change the quantity of reserves available to banks which, in turn, influences the quantity of money that banks can create. There are many determinants of the demand for money. However, the most important variable is the average level of prices in the economy. People hold money because it is the medium of exchange. How much money people hold for this purpose depends on the prices of those goods and services. The higher prices are, the more money people will chose to hold in their wallets or checking accounts. Figure 4 Supply and demand for money and price level Money supply Price level Value of money High Low Equilibrium value of money Equilibrium price level Money demand Low High Quantity fixed by the central bank Quantity of money What ensures that the quantity of money the central bank supplies equals the quantity of money people demand? It depends on the time horizon being considered. Later in these course notes, we CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 11 will see that interest rates play a key role in the short term. However, in the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply. If the price level is above the equilibrium level, people will want to hold more money than the central bank has created, so the price level must fall to balance supply and demand. This is shown in Figure 4. The horizontal axis shows the quantity of money. The left-hand vertical axis shows the value of money and the right hand vertical axis shows the price level. Note that the price level axis is inverted: when the value of money is high, the price level is low. The equilibrium of money supply and demand determines the value of money and the price level. 4.1.2 Effects of a monetary injection Quantity theory of money: a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate. Money neutrality: the proposition that changes in the money supply do not effect real variables. What happens if the central bank increases the money supply? Let’s assume that the central bank injects money into the economy by buying some government bonds from the public in openmarket operations. Figure 5 An increase in the money supply MS1 MS2 Price level Value of money High Low V1 P1 V2 P2 Low MD M1 M2 High Quantity of money The money injection shifts the supply curve to the right. As a result, the value of money decreases and the equilibrium price level increases. In other words, when an increase in the money supply makes money more plentiful, the result is an increase in the price level that makes each dollar less valuable. How does this adjustment occur? The immediate effect of the monetary injection is to create an excess supply of money. People now have more dollars in their wallets than they want. The quantity of money supplied now exceeds the quantity demanded. People get rid of this excess supply of money in various ways. They might buy goods and services with their excess holdings of money. Or they might use this excess money to make loans to others by buying bonds or by depositing the money in a bank savings account. These loans allow other people to buy goods and services. In either case, the injection of money increases the demand for goods and services. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 12 However, the economy’s ability to produce goods and services has not changed. So the greater demand for goods and services causes the prices of goods and services to increase. The increase in the price level, in turn, increases the quantity of money demanded. Eventually the economy reaches a new equilibrium. The explanation of how the price level is determined and why it might change over time is called the quantity theory of money. According to the quantity theory, the quantity of money available in the economy determines the value of money, and growth in the quantity of money is the primary cause of inflation. This theory is based on the assumption that money is neutral. That is, changes in the money supply do not affect the economy’s ability to produce goods and services. The economy’s production depends on productivity and factor supplies. An increase in the money supply will change nominal GDP, through prices, but have no impact on real GDP. This is a valid description of what happens in the long term. However, money can have important effects on real variables in the short term. This is discussed in section 5. 4.1.3 Quantity equation Velocity of money: the rate at which money changes hands. Quantity equation: the equation M x V = P x Y, which relates the quantity of money, the velocity of money and the dollar value of the economy’s output of goods and services. The quantity theory of money can be expressed in the equation: MxV=PxY The equation states that the quantity of money (M) times the velocity of money (V) equals the price of output (P) times the amount of output (Y). It is called the quantity of money because it relates the quantity of money (M) to the nominal value of output (P x Y). In summary the quantity theory argues: 1 The velocity of money is relatively stable over time. 2 Because velocity is stable, when the central bank changes the quantity of money (M), it creates proportional changes in the nominal value of output (P x Y). 3 The economy’s output of goods and services (Y) is primarily determined by factor supplies and the available technology. As money is neutral, it does not affect output. 4 With output (Y) determined by factor supplies and technology, when the money supply changes (M), the parallel changes in the nominal value of output (P x Y) are reflected in the price level (P). 5 Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation. 4.1.4 The inflation tax Inflation tax: the revenue the government raises by creating money. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 13 If inflation is so easy to explain why do countries experience hyperinflation? That is, why do central banks sometimes print so much money that its value is certain to fall rapidly over time? The answer is that the governments in these countries use money creation as a way to pay for their spending. Normally the government does this by levying taxes and borrowing by selling government bonds. But the government can also pay for spending by simply printing the money it needs. In this sense, inflation acts like a tax. When the government prints money, the price level rises, and the money in your wallet is less valuable. Thus, the inflation tax is like a tax on everyone who holds money. 4.1.5 The Fisher effect Fisher effect: the one-for-one adjustment of the nominal interest rate to the inflation rate. The principle of money neutrality requires that an increase in the rate of money growth does not affect any real variable. This implies that an increase in the money supply must not affect real interest rates. The real interest rate is the nominal rate adjusted for inflation. If you have a savings account the real rate would tell you how fast the purchasing power of your savings account will rise over time. The real interest rate is the nominal rate minus the inflation rate: Real interest rate = Nominal interest rate – inflation rate. We can rewrite this equation to show that the nominal interest rate is the sum of the real interest rate and the inflation rate: Nominal interest rate = Real interest rate + inflation rate. Different economic forces determine each of the two terms on the right hand side of the equation. The real interest rate is determined by the supply and demand for loanable funds. According to the quantity theory of money, growth in the money supply determines the inflation rate. For an increase in the money supply not to impact on the real interest rate, the nominal interest rate must adjust one-for-one to changes in the inflation rate. Thus, when the central bank increases the rate of money growth, the result is both a higher inflation rate and a higher nominal interest rate. This is called the Fischer effect. 4.2 Costs of inflation 4.2.1 A fall in purchasing power? The inflation fallacy Inflation does not in itself reduce people’s real purchasing power. When prices rise, buyers of goods and services do pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. As most people earn incomes by selling their services, such as their labor, inflation in income goes hand-in-hand with inflation in prices. This is because real variables are determined by other real variables, such as physical capital, human capital, natural resources and the available production technology. Nominal incomes are determined by those factors and the overall price level. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 14 In Ukraine recent increases in inflation have been associated with decreases in purchasing power. Real wages have been falling. However, this is not a direct consequence of inflation but a consequence of a fall in labor productivity or in the ability of the economy to produce goods and services that people want to buy. This means that real wages needed to fall. This was achieved through inflation. In the absence of inflation, nominal wages would have had to fall or unemployment would have increased even further. Inflation may have indirectly contributed to this problem by imposing the economic costs discussed below. 4.2.2 Shoeleather costs Shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings. Inflation is like a tax on the holders of money. The tax itself is not a cost to society: it is only a transfer of resources from households to government. However, most taxes give people an incentive to alter their behavior to avoid paying the tax. This distortion of incentives can cause deadweight losses for society as a whole. Like other taxes, the inflation tax also creates deadweight losses, as people waste scare resources trying to avoid it. Because inflation erodes the real value of the money in your wallet, you can avoid the inflation tax by holding less money. One way to do this is to go to the bank more often. By making more frequent trips to the bank, you can keep more of your wealth in your interest-bearing savings account and less in your wallet, where inflation erodes its value. This is called the shoeleather cost of inflation. Of course it is not really the wear and tear of your shoeleather from frequent trips to the bank, but the time and convenience you must sacrifice to keep less money on hand because of inflation. The shoeleather costs are trivial in the case of mild inflation. But the cost is magnified in countries experiencing hyperinflation. In this situation people are forced to convert their currency into another as a store of value. 4.2.3 Menu costs Menu costs: the costs of changing prices. Firms change prices infrequently because there are costs in changing prices. These are called menu costs. They include the cost of printing new price lists and catalogues, the cost of sending these new price lists and catalogues to dealers and customers, the cost of deciding on new prices, and even the cost of dealing with customer annoyance over price changes. Inflation increases menu costs. During hyperinflations, firms must change their prices daily, or even more often, just to keep up with all the other prices in the economy. 4.2.4 Relative prices and the misallocation of resources The relative price of a good is the price of that good relative to all other goods in the economy. Inflation can mask changes in relative prices by making it difficult for producers and consumers to identify whether a price change is inflation or a relative price increase. Also if, due to menu costs, producers delay changing their price in the face of inflation, relative prices will change. This relative price change would not reflect any change in the supply and demand for that good. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 15 Why does this matter? The reason is that market economies rely on relative prices to allocate scarce resources. Consumers decide what to buy by comparing the quality and prices of various goods and services. Through these decisions, they decide how the scarce factors of production will be allocated among industries and firms. When inflation distorts relative prices, consumer decisions are distorted, and markets are less able to allocate resources to their best use. 4.2.5 Inflation-induced tax distortions Almost all taxes distort incentives, cause people to alter their behavior, and lead to a less efficient allocation of the economy’s resources. Many taxes, however, become even more problematic in the presence of inflation. The reason is that lawmakers often fail to take inflation into account when writing the tax laws. Some economists argue that inflation tends to raise the tax burden on income earned from savings. One example is the tax treatment on capital gains. Capital gains are the profits you make from selling an asset for more than its purchase price. However, capital gains taxes typically don’t take into account inflation when assessing your tax liability. If there has been inflation between the time you purchased and sold the asset, then your real gain, or increase in your purchasing power, is less than your nominal gain. Inflation exaggerates the size of capital gains and inadvertentently increases the tax burden on this type of income. The same problem arises from the taxation of nominal interest income – part of the nominal interest rate merely compensates for inflation. There are many other ways in which tax codes interact with inflation. As a result, higher inflation tends to discourage people from saving. This could depress long run economic growth. However, there is no consensus among economists about the size of this effect. One solution to this problem is to index the tax system. That is, tax laws could be rewritten to take into account the effects of inflation. However, indexation would also complicate the tax code. 4.2.6 Confusion and inconvenience Money, as the economy’s unit of account, is what we use to quote prices and record debts. It is the yardstick with which we measure economic transactions. Inflation makes it more difficult to use money as a unit of account. It is difficult to judge the costs of confusion and inconvenience that arise from inflation. As discussed above, the tax code incorrectly measures real incomes in the presence of inflation. Similarly, accountants incorrectly measure firms’ profits when prices are rising over time. As inflation causes money to have different values at different times, computing a firms profit is more difficult in an economy with inflation. Therefore, to some extent, inflation makes investors less able to sort out successful from unsuccessful firms, which in turn impedes financial markets in their role of allocating the economy’s saving to alternative types of investment. 4.2.7 Arbitrary redistributions of wealth Unexpected inflation redistributes wealth amongst the population in a way that has nothing to do with merit or need. These redistributions occur because most of the loans in the economy are specified in terms of money. Let’s assume you take a loan for 10 years at a fixed interest rate. If there is high inflation it will erode the value of your debt and it will be easier for you to repay it. However, deflation would CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 16 increase the real value of your debt. If inflation were predictable, it can be taken into account when the nominal interest rate is set. But when it is unpredictable it imposes a risk on the borrower and lender. We should also note that inflation is especially volatile and uncertain when the average rate of inflation is high. This suggests that if a country pursues a high-inflation monetary policy, it will have to bear not only the costs of high expected inflation but also the arbitrary redistribution of wealth associated with unexpected inflation. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 17 5. SHORT RUN ECONOMIC FLUCATATIONS Recession: a period of declining growth in real incomes and rising unemployment. Depression: a severe recession. Due to increases in the labor force, increases in the capital stock, and advances in technological knowledge, economies can usually produce more and more over time. However, sometimes economies grow at less than their normal rate. Firms are unable to sell all of their goods and services so they cut back on production. Workers are laid off, unemployment rises, and factories are left idle. With the economy producing fewer goods and services, real GDP and other measures of income fall. Such a period of falling incomes and rising unemployment is called a recession if it is relatively mild and a depression if it is more severe. While our focus in the previous sections has been on the long term, we now turn our attention to the short term. What causes short run fluctuations in economic activity? What can public policy do about them? 5.1 Three key facts about economic fluctuations Some important properties of economic fluctuations are: Economic fluctuations are irregular and unpredictable. Most macroeconomic quantities fluctuate together. As recessions are economy-wide phenomena, they show up in many macroeconomic indicators. When GDP falls in a recession, so does personal income, corporate profits, consumer spending, investment spending and so on. However, variables do fluctuate by different amounts. For example, investment tends to fluctuate more than GDP. As output falls, unemployment rises. When firms produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed. 5.2 Explaining short run fluctuations In the previous sections, we argued that money is neutral. According to classical macroeconomic theory, changes in the money supply affect nominal variables but not real variables. Most economists believe that this classical theory describes the economy in the long run but not in the short run. Our model of economic fluctuations is based on two variables: Economy’s output of goods and services as measured by real GDP. Overall price level, as measured by the CPI or GDP deflator. We analyze fluctuations in the economy as a whole with the model of aggregate demand and aggregate supply. The aggregate demand curve shows the quantity of goods and services that CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 18 households, firms and the government want to buy at any price level. The aggregate supply curve shows the quantity of goods and services that firm produce and sell at any price. Figure 6 Aggregate demand and supply Aggregate supply Price level Equilibrium price level Aggregate demand Equilibrium output Quantity of output However, this model is quite different from the model of supply and demand in individual markets. When we consider demand and supply in a particular market, the behavior of sellers and buyers depends on the ability of resources to move from one market to another. This microeconomic substitution is impossible when we are analyzing the economy as a whole. The quantity in our model, real GDP, includes the quantities produced in all markets. To explain why the aggregate demand curve is downward sloping and the aggregate supply curve upward sloping; we need a macroeconomic theory. 5.3 The aggregate demand curve 5.3.1 Why the aggregate demand curve is downward sloping What lies behind the negative relationship between the price level and the quantity of goods and services demanded? There are three distinct but related reasons: Pigou’s wealth effect. When prices fall, the money consumers are holding becomes more valuable because it can be used to purchase more goods and services. Thus, a decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services are demanded. Keyne’s interest rate effect. The lower the price level the less money households need to hold to buy the goods and services they want. When the price level falls, therefore, households try to reduce their holdings of money by lending some of it out. Thus, a lower price level reduces the interest rate, encourages greater spending on investment goods and thereby increases the quantity of goods and services demanded. Mundell-Fleming’s exchange rate effect. When a fall in a country’s price level causes interest rates to fall, the real exchange rate depreciates. The depreciation is caused by investors CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 19 seeking higher returns abroad. This depreciation stimulates net exports and increases the quantity of goods and services demanded. Note: the aggregate demand curve is drawn for a given quantity of money. 5.3.2 Why the aggregate demand curve may shift When factors other than prices change, the aggregate demand curve shifts. Events that would shift the curve include: Ukrainians become more concerned about saving for retirement so reduce their consumption. The computer industry introduces a new line of computers, and many firms decide to invest in new computer systems. The government decides it will reduce purchases of military equipment. The central bank increases the money supply. 5.4 The aggregate supply curve In the long run the aggregate supply curve is vertical, whereas in the short run the aggregate supply curve is downward sloping. 5.4.1 Why the aggregate supply curve is vertical in the long run In the long run an economy’s supply of goods and services depends on its supplies of capital and labor and on the available production technology used to turn capital and labor into goods and services. As the price level does not affect these long run determinants of GDP, the long-run aggregate supply curve is vertical. Note that supply curves for individual products are upward sloping: they depend on relative prices or the price of those goods and services compared to other prices in the economy. When the price of one good increases relative to others, resources are transferred to the production of that good. Figure 7 Long run aggregate supply curve Price level 1 A change in the price level… Long run aggregate supply P1 2. …does not affect the quantity of goods and services CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE supplied in the long run 20 P2 Natural rate of output Quantity of output 5.4.2 Why the long run aggregate supply curve may shift The long run supply curve shows the natural rate of output. It shows what the economy produces when unemployment is at its natural or normal rate. This is the rate of production towards which the economy gravitates in the long run. Any change in the economy that alters the natural rate of output shifts the long-run supply curve. For example, if an increase in the economy’s capital stock increases the productivity of labor. Many factors influence the long run growth, including policies towards savings, investment, education, technology and so on. Whenever a change in one of these factors alters the ability of the economy to produce goods and services, it shifts the long run supply curve. The position of the long run aggregate supply curve also depends on the natural rate of unemployment. For example, an increase in minimum wages would increase the natural rate of unemployment and shift the aggregate supply curve to the left. 5.4.3 Why the aggregate supply curve is upward sloping in the short run The key difference between the short-run and the long-run is aggregate supply. In the short-run the aggregate supply curve is upward sloping. That is, over a period of a year or two, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied and vice versa. There are three alternative explanations for the upward slope of the supply curve in the short-run. However, each theory share a common theme: a specific market imperfection causes the supply side of the economy to behave differently in the short run than in the long-run. This happens when the price level deviates from the price level that people expected. When the price level rises above the expected level, output rises above its natural rate, and when the price level falls below its expected level, output falls below its natural rate. The three theories are: The new classical misperceptions theory. According to this theory, changes in the overall price level can temporarily mis-lead suppliers about what is happening in the markets in which they sell their output. For example, suppliers may misperceive a lower price level as a reduction in their relative price, and these misperceptions could induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied. The Keynesian sticky wage theory. This theory is based on the idea that nominal wages are “sticky” or slow to adjust. This may be due to long-term contracts or social norms in wage setting. Imagine that a firm has agreed to pay its workers a nominal wage based on their CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 21 expectations of the price level. If the price level turns out to be lower, the real wage will rise above the level the firm intended to pay. This makes employment and production less profitable, which induces firms to reduce the quantity of goods and services supplied. The new Keynesian sticky price theory. As not all prices adjust instantly to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices. This depresses sales and induces firms to reduce the quantity of goods and services they produce. Note that under each of these theories, the problem is only temporary. Eventually as people adjust their expectations, misperceptions are corrected and nominal wages and prices adjust. Thus, in the long-run the aggregate supply curve is vertical. 5.4.4 Why the short-run supply curve may shift Many events that shift the long-run supply curve will also shift the short run supply curve. However, the short-run supply curve is also affected by people’s expectation of the price level. For example, when people expect the price level to be high, they will tend to set wages high. High wages rise firms’ costs and, for any given actual price level, reduce the quantity of goods and services the firm will supply. Thus, a higher expected price level decreases the quantity of goods and services supplied. A lower expected price level increases the quantity of goods and services supplied. The influence of expectations on the position of the short-run supply curve reconciles the economy’s behavior in the long run with the short run. In the short-run expectations are fixed. But in the long-run expectations adjust, shifting the short-run supply curve. This ensures that the economy eventually finds itself at the intersection of the aggregate demand curve and long run supply curve. 5.5 Two causes of recession Figure 8 shows an economy in long-run equilibrium. Equilibrium output is determined by the intersection of the aggregate demand and long-run aggregate supply curve. The short-run aggregate supply curve also passes through this point, indicating that perceptions, wages and prices have fully adjusted to this long-run equilibrium. Figure 8 Long run equilibrium Long run aggregate supply Price level Short-run aggregate supply Equilibrium price level Aggregate demand Natural rate of Quantity of output output CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 22 5.5.1 Effects of a shift in aggregate demand Suppose for some reason, perhaps a fall in the stockmarket, that pessimism overtakes the economy and aggregate demand falls. Households cut back on their spending and businesses cut back on investment. Figure 9 A contraction in aggregate demand Long run aggregate supply Short-run AS1 Price level Short-run AS2 A P1 B P2 P3 C AD2 Y2 Y1 AD1 Quantity of output In the short run the economy moves along the initial short-run supply curve, going from point A to point B. Output falls from Y1 to Y2 and the price level falls from P1 to P2. The falling levels of output indicate that the economy is in recession. Firms would respond by lowering employment. Thus, the pessimism that caused the shift in demand is to some extent self-fulfilling: it leads to falling incomes and rising unemployment. What could policy makers do? They could increase aggregate demand by increasing spending or increasing the money supply. If policy makers can act with sufficient speed and precision, they could return the economy to point A. However, even without action by policy makers the recession will remedy itself. As expectations about the price level fall, the short run aggregate supply curve shifts to the right. In the long run the economy approaches point C where the new aggregate demand curve crosses the long-run supply curve. At point C output is back to its natural rate. Prices have fallen sufficiently to offset the shift in the aggregate demand curve. Thus, in the long run the shift in the demand curve is reflected fully in prices and not in output. 5.5.2 Effects of a shift in aggregate supply Stagflation: a period of falling output and rising prices. Imagine once again an economy in long-run equilibrium. Now suppose that suddenly some firms experience an increase in their costs of production. This will shift the aggregate supply curve to the right. Depending on the event, the long run supply curve may also shift but, to keep things simple, we will assume it does not. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 23 Figure 10 An adverse shift in aggregate supply Long run aggregate supply Price level Short-run AS2 Short-run AS1 B P2 P1 A AD1 Y2 Y1 Quantity of output The economy moves along the existing demand curve to point B. Output falls and prices rise. This is stagflation: the economy experiences both stagnation (falling output) and inflation (rising prices). What should policy makers do with stagflation? There are no easy answers. One possibility is to do nothing. Eventually the recession will remedy itself as wages and prices adjust to the higher production costs. For example, a period of low output will put downward pressure on workers’ wages. Over time the aggregate supply curve will shift back to AS1, the price level falls and output returns to its natural rate. Alternatively, policy makers may want to offset some of the shift in the short-run aggregate supply curve by boosting aggregate demand. This is shown in Figure 11. In this case, changes in policy shift the aggregate demand curve just enough to prevent the shift in aggregate supply affecting output. However, the price level increase to P3. Policy makers are said to accommodate the shift in aggregate supply because they allow the price level to increase permanently. Figure 11 Accommodating an adverse shift in aggregate supply Long run aggregate supply Price level P3 P2 P1 C Short-run AS2 Short-run AS1 B A AD2 AD1 Y2 Y1 Quantity of output Thus, policy makers can not use aggregate demand to offset both the price and output impacts of a supply shock. Discussion: CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 24 1 What type of recession is Ukraine in? 2 Will the recession cure itself? CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 25 6. INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND In this section we look in more detail how the government’s tools of monetary and fiscal policy can influence aggregate demand and short-term economic fluctuations. 6.1 How monetary policy influences aggregate demand The aggregate demand curve shows the quantity of goods and services demanded for any price level. Remember that the aggregate demand curve slopes downwards for three reasons: Pigou’s wealth effect. A lower price level raises the real value of households’ money holdings and higher real wealth stimulates consumer spending. Keyne’s interest rate effect. A lower price level lowers the interest rate as people try to lend out their excess money holdings and the lower interest rate stimulates investment spending. Mundell-Fleming’s exchange rate effect. When a lower price level lowers the interest rate, investors move some of their funds overseas and cause the domestic currency to depreciate relative to the foreign currencies. This depreciation makes domestic goods cheaper compared to foreign goods and, therefore, stimulates net exports. These three effects occur simultaneously to increase the demand for goods and services when the price level falls. However, they are not of equal importance. As money holdings are a small part of household wealth, the Pigou wealth effect is the least important. The importance of the Mundell-Flemming effect depends on the share of trade in a country’s GDP. In large economies the most important reason for the downward slope of the aggregate demand curve is the Keyne’s interest rate effect. Therefore, to understand how policy influences aggregate demand, we examine Keyne’s interest rate effect in more detail. 6.1.1 The theory of liquidity preference Theory of liquidity preference: Keyne’s theory that the interest rate adjusts to bring money supply and money demand into balance. According to Keynes, interest rates adjust to balance the supply and demand for money. Let’s look at the determinants of the supply and demand for money: Money supply. The money supply is controlled by the central bank. Therefore, it does not depend on other economic variables, including the interest rate. Therefore, the money supply curve is vertical (see Figure 12). Money demand. The liquidity of money explains the demand for it. People chose to hold money instead of other assets that offer a higher rate of return because money can be used to buy goods and services. Therefore, one of the most important determinants of money demand is the interest rate. The interest rate is the opportunity cost of holding money. An CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 26 increase in the interest rate raises the cost of holding money, compared to investing it in an interest-bearing bond, and reduces the quantity of money demanded. Figure 12 Equilibrium in the money market Money supply Interest rate Equilibrium interest rate Money demand Quantity fixed by the central bank Quantity of money The interest rate adjusts to balance the supply and demand for money. If the interest rate is not at the equilibrium level, people will try to adjust their portfolios of assets and, as a result, will drive the interest rate towards equilibrium. 6.1.2 The downward slope of the aggregate demand curve We now use the liquidity theory to explain the downward slope of the aggregate demand curve. The price level is one determinant of the quantity of money demanded (see section 4.1.1). A higher price level will increase the amount of money people want to hold and shift the demand curve to the right. Yet the quantity of money supplied is unchanged, so the interest rate must rise to discourage the extra demand. This increase has ramifications not only for the money market but also for the quantity of goods and services demanded. At a higher interest rate, the cost of borrowing and the return to saving are greater. Therefore, the quantity of goods and services demanded fall. Keynes’s interest rate effect can be summarized in three steps: A higher price level reduces money demand. Higher money demand leads to higher interest rates. A higher interest rate reduces the quantity of goods and services demanded. Figure 13 The money market and the slope of the aggregate demand curve Money supply CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 27 Interest rate r2 3. ...which increases the equilibrium interest rate… 2. …increases the demand for money… r1 Money demand at price level P2, MD2 Money demand at price level P1, MD1 Quantity fixed by the central bank Quantity of money Price level P2 1. An increase in the price level… P1 Aggregate demand Y2 Y1 Quantity of output 4. …which in turn reduces the quantity of goods and services demanded. The end result is a negative relationship between the price level and the quantity of goods and services demanded. 6.1.3 Changes in the money supply The liquidity theory also sheds light on how the central bank shifts aggregate demand when it changes monetary policy. Suppose the central bank increases the money supply. And suppose that the price level does not, in the short run, respond to this monetary injection. How does it affect the equilibrium interest rate and aggregate demand curve? Figure 14 A monetary injection Interest rate Money supply, MS1 MS2 1. When the central bank increases the money supply… r1 2. …the equilibrium interest rate falls CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 28 r2 Money demand at price level P Quantity of money Price level P1 AD2 Aggregate demand, AD1 Y1 Y2 Quantity of output 3. …which increases the quantity of goods and services demanded at a given price level The increase in the money supply reduces the interest rate to induce people to hold the additional money. The lower interest rate reduces the cost to borrowing and the return to saving, increasing the quantity of goods and services demanded. 6.1.4 Interest rate targets Sometimes central banks will target interest rates rather than the money supply. This would not fundamentally change our analysis of monetary policy. Monetary policy can be described in terms of the money supply or in terms of the interest rate. When the central bank sets an interest rate target, it commits itself to adjusting the money supply in order to make the equilibrium in the money market hit the target. Thus a change in monetary policy that aims to expand aggregate demand can be described as either increasing the money supply or raising the interest rate. 6.2 How fiscal policy influences aggregate demand Government can also influence the economy thorough fiscal policy. Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes. In the long run, fiscal policy can influence growth through its impact on savings and investment. In the short run, however, the primary effect of fiscal policy is on the aggregate demand for goods and services. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 29 6.2.1 Changes in government purchases When government changes its own purchases of goods and services it shifts the demand curve directly. However, the increase in aggregate demand will be different from the increase in spending. There are two offsetting effects: The multiplier effect suggests that the increase in aggregate demand could be larger than the increase in spending. The crowding out effect suggests that the shift in aggregate demand could be smaller than the increase in spending. 6.2.2 The multiplier effect Multiplier effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. When the government increase its spending on goods and services that increase leads to higher employment and profits in the firms from which the government purchases. As workers see higher earnings and firm owners see higher profits, they rise their own spending on consumer goods. Therefore, the government purchases raises the demand for the products of many other firms in the economy. Because each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar, government purchases are said to have a multiplier effect on aggregate demand. The multiplier We can derive a formula for the size of the multiplier effect that arises from consumer spending. An important number is the marginal propensity to consume: the fraction of extra income that a household consumes rather than saves. Multiplier = 1/(1-MPC) For example, if the MPC is 0.75, the government purchases multiplier is 1/(1-0.75), which is 4. If the government increases spending by $20 billion, it generates $80 billion worth of demand for goods and services. However, note that using multiplier analysis is very dangerous. It depends crucially on the assumption about the marginal propensity of consumption, which is very difficult to determine. This multiplier effect continues even after the first round. Higher demand leads to higher incomes, which leads to higher demand and so on. Once all these effects are added together, the total impact on the quantity of goods and services demanded can be much larger than the initial impact from higher government spending. The effect can also be strengthened by higher investment in response to higher levels of demand. 6.2.3 The crowding-out effect Crowding out effect: the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 30 There is an effect that offsets the multiplier effect. While an increase in government purchases stimulates the demand for goods and services, it also increases the demand for money. As incomes rise from increased government spending, households plan to buy more goods and services and, as a result, chose to hold more of their wealth in a liquid form. Figure 15 The crowding-out effect Money supply Interest rate r2 3. ...which increases the equilibrium interest rate… 2. …the increase in spending increases money demand… r1 MD2 Money demand, MD1 Quantity fixed by the central bank Price level 1. When an increase in government purchases increases aggregate demand… Quantity of money 4. …which in turn partly offsets the initial increase in aggregate demand AD2 AD3 Aggregate demand, AD1 Quantity of output A higher interest rate tends to choke off the demand for goods and services. In particular, because borrowing is more expensive, the demand for residential and business investment goods declines. This is called the crowding-out effect. The crowding out effect partially offsets the impact of government purchases on aggregate demand. When the government increases its purchases by $20 billion, for example, the increase in aggregate demand could be more or less than $20 billion, depending on whether the multiplier effect or the crowding out effect is larger. 6.2.4 Changes in taxes The other important instrument of fiscal policy is taxation. When the government cuts taxes, it increases households’ take home pay. Households will save some of this additional income, but they will also spend some of it. Therefore, the tax cut increases aggregate demand. Similarly, a tax increase decreases aggregate demand. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 31 The multiplier and crowding-out effects also affect the size of the shift in aggregate demand resulting from a tax change. In addition to these effects, there is another important determinant of the size of the shift in aggregate demand that results from a tax change: households' perceptions about whether the tax cut is temporary or permanent. In deciding how much of the extra income to spend, households will ask themselves how long the extra income will last. Tax cuts that are perceived as being temporary with only have a little impact on aggregate demand. Fiscal policy and aggregate supply Most economists believe that the short-run macroeconomic effects of fiscal policy work primarily though aggregate demand. Yet fiscal policy can also potentially influence the quantity of goods and services supplied. For example, when government cuts tax rates, workers get to keep more of every hyrniva they earn and therefore have a greater incentive to work and to produce goods and services. As a result, the quantity of goods and services supplied is greater at any price level. Some economists, called supply-siders, have argued that the influence of tax cuts on aggregate supply is very large. Some claim that a cut in tax rates may actually increase tax revenue by increasing worker effort (see attached article). Changes in government purchases can also potentially affect aggregate supply. For example, government spending on economic infrastructure can boost the productivity of private sector enterprises, leading to increases in aggregate supply. However, this effect is probably more important in the long run than in the short-run. 6.3 Using policy to stabilize the economy Should policymakers use fiscal and monetary policy to control aggregate demand and stabilize the economy? If so, when? If not, why not? 6.3.1 The case for an active stabilization policy At the least, government should avoid being the cause of economic fluctuations. Most economists argue against large and sudden changes in monetary and fiscal policy. Moreover, when large changes do occur, it is important that monetary and fiscal policy makers be aware and respond to the other’s actions. Some economists argue that the government should respond to changes in the private economy to stabilize aggregate demand. These arguments are based on Keynes’ theory that aggregate demand fluctuates largely because of irrational waves of pessimism and optimism. In principle, government can adjust monetary and fiscal policy in response to these waves and thereby stabilize aggregate demand. For example, when people are excessively pessimistic, the central bank can expand the money supply and vice versa. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 32 6.3.2 The case against stabilization policy Some economists argue that the government should avoid using monetary and fiscal policy to try to stabilize the economy. They claim that these policy instruments should be set to achieve long run goals, such as economic growth and low inflation, and that the economy should be left to deal with short-term fluctuations on its own. Although monetary and fiscal policy may be able to stabilize the economy in theory, these economists doubt whether it can in practice. One problem is that these policies affect the economy with a substantial lag. Changes in monetary policy are thought to take at least six months to have much effect on output and employment and these effects can last for several years. Therefore, central banks often react too late to changing economic fluctuations and, as a result, end up being a cause rather than a cure of economic fluctuations. Lags in fiscal policy are largely attributable to the political process. By the time policies are ready to implement, the economy may well have changed. 6.3.3 Automatic stabilizers Automatic stabilizers: 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 help policymakers avoid the problem of lags. 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. The most important automatic stabilizer is the tax system. When the economy goes into a recession, the amount of taxes collected by the government falls automatically because almost all taxes are tied to economic activity. The automatic tax cut stimulates aggregate demand and reduces the magnitude of economic fluctuations. Government spending also acts as a stabilizer. For example, spending on unemployment benefits and other welfare support automatically increases in a recession. The automatic increase in government spending stimulates aggregate demand at exactly the time when aggregate demand is insufficient to maintain full employment. The role of automatic stabilizers suggests that government shouldn’t always aim to balance its budget. If the economy goes into a recession taxes fall and government spending rises. To balance the budget, the government would have to look for ways to increase taxes or cut spending in a recession – this could exacerbate the economic cycle. A strict budget balance rule would eliminate the impact of automatic stabilizers. However, government should aim to balance the budget over the economic cycle. 6.4 The economy in the long-run and the short-run It may appear that we have two theories for how interest rates are determined. In section 3 we said that the interest rate adjusts to balance the supply and demand of loanable funds. By contrast, this chapter said that interest rates adjust to balance the supply and demand for money. Which of these theories is right? The answer is both. This reflects the difference between the long-run and the short-run behavior of the economy. In the long run: CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 33 1 Output is determined by the supplies of capital and labor and the available production technology for turning capital and labor into output. 2 For any given level of output, the interest rate adjusts to balance the supply and demand for loanable funds. 3 The price level adjusts to balance the supply and demand for money. Changes in the supply of money lead to proportionate changes in the price level. However, these propositions do not hold in the short-run. Many prices are slow to adjust to changes in the money supply. As a result, the overall price level cannot, by itself, balance the supply and demand for money in the short run. This price inflexibility forces the interest rate to move in order to bring the monetary market into equilibrium. These changes in the interest rate, in turn, affect the aggregate demand for goods and services. As aggregate demand fluctuates, the economy’s output of goods and services moves away from the level determined by the factor supplies and technology. In the short run: 1 The price level is stuck at some level and, in the short run, is relatively unresponsive to changing economic conditions. 2 For any given price level, the interest rate adjusts to balance the supply and demand for money. 3 The level of output responds to changes in the aggregate demand for goods and services, which is in part determined by the interest rate that balances the money market. Discussion: Suppose the central bank decides to expand the money supply. A What is the effect of this policy on the interest rate in the short term? Diagram. B What is the effect in the long run? C What characteristic of an economy makes the short run effect of monetary policy on the interest rate different from the long-term effect? CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 34 7. THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT Society faces a short run trade-off between inflation and unemployment. If monetary and fiscal policymakers expand aggregate demand, they can lower unemployment in the short run, but only at the cost of higher inflation. If they contract aggregate demand they can lower inflation but only at the cost of temporarily higher unemployment. 7.1 The Phillips curve Phillips curve: a curve that shows the short-run tradeoff between inflation and unemployment. The short-run trade-off between inflation and unemployment is often called the Phillips curve. The rationale for this correlation is that low unemployment is associated with high aggregate demand and high aggregate demand puts upward pressure on wages and prices throughout the economy. This suggests that while policy makers might prefer low unemployment and low inflation this combination is impossible. Figure 16 The Phillips curve Inflation rate (percent per year) B The Phillips curve illustrates a negative relationship between the inflation rate and the unemployment rate. At point A, inflation is low and employment is high. At point B, inflation is high and unemployment is low A Phillips curve Unemployment rate (percent) This fits in with our model of aggregate demand and supply. The Phillips curve simply shows the combinations of inflation and unemployment that arise in the short term as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. The greater the aggregate demand for goods and services, the greater the economy’s output and the higher the overall price level. Higher output translates into higher employment and lower unemployment. Therefore, by shifting the aggregate demand curve, monetary and fiscal policy can shift the economy along the Phillips curve. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 35 7.2 Shifts in the Phillips curve: the role of expectations 7.2.1 The long run Phillips curve In the long run most economists accept that the rate of inflation is not related to unemployment. This means that monetary policy makers face a long-run Phillips curve that is vertical. If the central bank increases the money supply slowly, the inflation rate is low and the economy finds itself at point A in Figure 17. If the central bank increase the money supply quickly, the inflation rate is high and the economy finds itself at point B. In either case the unemployment rate tends towards its normal level called the natural rate of unemployment. Figure 17 The long run Phillips Curve Inflation rate (percent per year) High inflation 1. When the central bank increases the growth rate of the money supply, the rate Low inflation of inflation increases… Long run Phillips curve B 2. …but unemployment remains at its natural rate in the long run A Natural rate of unemployment Unemployment rate (percent) This is consistent with the idea of a vertical long run supply curve. Note that the natural rate of unemployment is not necessarily the socially desirable rate of unemployment. Nor is the natural rate of unemployment constant over time. The unemployment rate is “natural” not because it is good but because it is beyond the influence of monetary policy. However, while monetary policy can not influence the natural rate of unemployment, other types of policies can. To reduce the natural rate of unemployment, policy makers should look to policies that improve the functioning of the labor market. Labor market policies such as minimum wage laws, collective-bargaining laws, unemployment insurance and job training affect the natural rate of unemployment. 7.2.2 Expectations and the short-run Phillips curve Policy makers can pursue expansionary monetary policy to achieve lower unemployment for a while but eventually it returns to its natural rate. The short run trade-off comes because of inflation expectations. Expected inflation measures how much people expect the overall price level to change. The expected price level affects the perceptions of relative prices that people form and the wages and prices they set. As a result, expected inflation is one factor that sets the position of the short run supply curve. If expected inflation is set in the short term, then monetary changes can lead to unexpected fluctuations in output, prices, unemployment and inflation. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 36 However, perceptions, wages and prices will eventually adjust to the inflation rate so output will return towards the natural rate. This can be summarized in the equation: Unemployment rate = Natural rate of unemployment – a (Actual inflation – expected inflation) In the short-run expected inflation is set. Higher actual inflation is associated with lower unemployment. In the long run, however, people come to expect whatever inflation the central bank produces. Thus, actual inflation equals expected inflation and unemployment is at its natural rate. Note that policy makers can not continue to exploit this short run trade-off. Let’s assume policy makers use fiscal or monetary policy to expand aggregate demand. In the short run the economy goes from point A to point B in Figure 18. Unemployment falls below its natural rate and inflation rises above expected inflation. Figure 18 Expected inflation and the short run Phillips curve Inflation rate (percent per year) Long run Phillips curve C B Short-run Phillips curve with high expected inflation A Short-run Phillips curve with low expected inflation Natural rate of unemployment Unemployment rate (percent) Over time, people get used to the higher inflation rate and they revise their expectations of inflation. When expected inflation rises, the short run trade-off between inflation and unemployment shifts upward. The economy ends up at point C with higher inflation than at point A but with the same level of unemployment. So if policy makers use this trade-off they lose it. People begin to expect the higher inflation and policy makers have to rack up inflation higher and higher to get any short-term boost to output. This is highlighted by the experience of the US in the late 1960s and 1970s. Beginning in the late 1960s the US government followed both fiscal and monetary policies that expanded aggregate demand. As a result inflation stayed high – around 5% to 6% per year compared to 1% to 2% per year in the early 1960s. However, unemployment did not stay low. As inflation remained high in the early 1970s, people expectations caught up with reality and the unemployment rate reverted to the 5% to 6% rate that had prevailed in the early 1960s. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 37 7.3 Shifts in the Phillips curve: the role of supply shocks Shocks to aggregate supply will also shift the Phillips curve. One example, for the US and many countries in the mid-1970s, was sharp increases in the price of oil as the Organization of Petroleum Exporting Countries (OPEC) exerted its market power as a cartel in the oil market. Ukraine faced a similar shock with the increase in energy prices with the break up of the Soviet Union. The increase in the price of oil raised the price of producing many goods and services so reduced the quantity of goods and services provided at any given price level. The shift in aggregate supply is associated with a similar shift in the short-run Phillips curve. As firms need fewer workers, employment falls and unemployment rises. The inflation rate is also higher. Confronted with an adverse shift in aggregate supply, policy makers face a difficult choice. If they contract aggregate demand to fight inflation, they will raise unemployment further. If they expand aggregate demand to fight unemployment, they will raise inflation further. In other words, policy makers face a less favorable tradeoff between unemployment and inflation than they did before the shift in aggregate supply. An important question is whether the adverse shift in the Philips curve is permanent or temporary. If people view the event as a temporary aberration, expected inflation does not change and the Phillips curve will revert to its former position. But if people view the shock as leading to a new era of higher inflation, then expected inflation rises and the Phillips curve remains at it new, less desirable, position. 7.4 The costs of reducing inflation When the central bank slows the rate of money growth, it contracts aggregate demand. The economy moves from point A on the Phillips curve (see Figure 19) to point B, which has lower inflation and higher unemployment. Over time, expected inflation falls and the short-run Phillips curve shifts downwards. The economy moves from point B to C. Inflation is lower and unemployment is back to its natural rate. Thus, if an economy is to reduce inflation, it must endure a period of high unemployment and low output. The size of this cost depends on the slope of the Phillips curve and how quickly expectations of inflation adjust to the new monetary policy. Figure 19 Deflationary monetary policy Inflation rate (percent per year) Long run Phillips curve A B Short-run Phillips curve with high expected inflation CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 38 C C Natural rate of unemployment Short-run Phillips curve with low expected inflation Unemployment rate (percent) 7.4.1 Rational expectations and the possibility of costless disinflation Rational expectations: the theory according to which people use all the information they have, including information about government policies, when forecasting the future. Expected inflation is an important variable that explains why there is a trade-off between inflation and unemployment in the short run but not in the long-run. How quickly the short-run trade-off disappears depends on how quickly expectations adjust. The theory of rational expectations argues that people take into account economic policies when forming their expectations of inflation. Therefore, if the government makes a credible commitment to reducing inflation, the output costs of reducing inflation will be much lower. In this case, people would lower their expectations of inflation much more quickly. The short-run Phillips curve would move downwards and the economy would reach low inflation quickly without the cost of temporarily high unemployment and low output. However, policy makers can not count on people immediately believing them when they announce a policy of disinflation. Discussion: 1 Show the effects of the following events on the short run and long run Phillips curve: A A rise in the natural rate of unemployment. B A decline in the price of imported oil. C A rise in government spending. D A decline in expected inflation. 2 A Suppose the economy is in long-run equilibrium. Draw the economy’s short-run and long run Phillips curves. B Suppose a wave of business pessimism reduces aggregate demand. Show the effect of this shock on the Phillips curve. If the government undertakes expansionary monetary policy can it return the economy to its original inflation and unemployment rate? C Now suppose the economy is back in long-run equilibrium and the price of imported oil rises. Show this on Phillips curve. If the central bank undertakes expansionary monetary policy can it return the economy to its original inflation and unemployment rate? If the bank undertakes contractionary monetary policy can it return the economy to its original inflation and unemployment rate? CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 39 3 Given the unpopularity of inflation, why don’t elected leaders always support efforts to reduce inflation? Economists believe that countries can reduce the cost of disinflation by letting their central banks make decisions about monetary policy without interference from politicians. Why? CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 40 8. HOMEWORK In these course notes we looked at the impact of government policy on the economy in the shortrun and the long-run. Using the tools from this analysis, think about the alternatives you have identified in your solution analysis. See if you can use these tools to help explain the different impact these policies may have on the economy in the short and long-run. We will discuss this in the first half on the next workshop. Also, expand your glossary to include: Productivity. Physical capital. Human capital. Natural resources. Technological knowledge. Diminishing returns. Catch-up effect. Ricardian equivalence. Inflation. Hyperinflation. Quantity theory of money. Money neutrality. Velocity of money. Quantity equation. Inflation tax. Fisher effect. Shoeleather costs. Recession. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 41 Depression. Theory of liquidity preference. Stagflation. Multiplier effect Crowding out effect. Automatic stabilizers. Phillips curve. Rational expectations. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP ELEVEN AND TWELVE 42