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I have take home exam of Introduction to Macroeconomics on Wednesday. Its 25 multi choice. very simple but it needs some one has good background of Macroeconomics. I attached the power point of the final exam. Later I’ll attach the exam when I get it. I have only a 12 hours to do it.
Government Budgets and the National Debt.ppt
Government Budgets and the National Debt
Three Paradigms for Evaluating Budgetary Policies
Government Budgets and the National Debt
Three are three general paradigms concerning government deficits and the national debt:
Deficit Hawk, Deficit Dove, and Functional Finance.
First, let’s keep in mind some basic definitions.
The government budget is the relation between government spending, G, and tax revenues, T, in one year.
If G = T then this is a balanced budget.
If G > T, there is a budget deficit.
If G < T, there is a budget surplus. The National Debt is the accumulation of all past deficits (and surpluses). Deficit Hawk View Deficit Hawks take the view that budget deficits and the national debt are almost always and everywhere bad for the economy. The deficit hawk argument usually includes some combination of the following five points. Deficit Hawks 1. Deficits cause inflation – Because most Hawks accept the basic neoclassical theory, they view the economy as tending to full employment. Since budget deficits increase aggregate demand, they will tend to set off inflationary pressures in a full employment—or near full employment—economy. Deficit Hawks 2. Deficits cause high interest rates – Accepting the neoclassical view of savings and investment and interest rate determination, Hawks view government spending that is financed by borrowing (i.e., deficits), to be coming out of a fixed ‘pool’ of savings. Government is thus competing with the private sector for savings, bidding up interest rates. Deficit Hawks 3. Deficits ‘crowd out’ private spending – Related to the previous points, if government and the private sector are competing for a fixed pool of savings to finance their spending, government spending financed by borrowing decreases the resources leftover for financing private expenditure. Thus any increase in deficit spending “crowds out” (is exactly offset by) decreases in private spending. And if the economy is at Yf, government can only employ resources if they are taken away from their employment in the private sector. Deficit Hawks 4. The national debt is a burden on future generations. They have to pay the debt. Deficit Hawks 5. Government deficits and debt are generally immoral. Hawks often make an analogy between government deficits and debt and household or business debt. Deficit Doves Take the view that deficits can be okay under certain circumstances—it depends on the economic context. But Doves also devote a lot of attention to issues of defining and measuring deficits and the debt, often arguing that they are not as big as they might appear. Deficit Doves 1. Are deficits being measured in constant or current dollars? Doves argue that it is wrong to compare deficits between years in current dollars, because the value of the dollar has changed. One way of correcting for this is to look at deficit/GDP ratios (and debt/GDP ratios). These ratios are also important for Doves, because they argue that a larger GDP means we can afford a bigger deficit or debt. Deficit Doves 2. The Federal Government doesn’t keep a capital account. So when there is a large capital expenditure it looks like a lot has been paid out in this period and the budget doesn’t reflect the services that will last for years. Deficit Doves 3. The Government owns assets. The Government may have a debt, but it also owns asset land, buildings, stocks, gold, water sewage treatment plants, hospitals, schools, etc. Deficit Doves 4. State and Local Budgets often not considered. Often the Federal budget is discussed, even though historically Federal deficits have been offset by surpluses at the State and local levels. Deficit Doves 5. Government agencies own government debt. It is argued that in this case, we really do “owe it to ourselves.” Deficit Doves 6. We should examine the “full employment deficit” Doves argue that much of the deficit is due to unemployment. When there is unemployment, income is lower, so tax revenues are lower, and government spending on various assistance for the unemployed is higher. Deficit Doves 7. Balance budget over the business cycle, rather than in one year. Doves argue that one year is an arbitrary amount of time. Instead, it makes more sense to run deficits during recessions and surpluses during booms, so that the budget is balanced over the cycle and debt is not growing. Deficit Doves 8. Debt is not a burden on future because we are also creating assets for the future. Doves also argue that the debt will be paid to those in the future as well. Deficit Doves 9. Doves argue that if deficits and high interest rates are correlated, the causality goes the opposite way—from high interest rates to big deficits. When interest rates are high, interest payments are high, pushing deficits higher. Deficit Doves 10. To the extent the analogy with households and firms is applicable, Doves think it supports their view. Well-managed, responsible debt is not a bad thing for households and firms—same with government. functional finance The Functional Finance view says both Hawks and the Doves are wrong. functional finance 1. In a Modern Money system, the purpose of taxation is to create a demand for—and give a value to—unbacked currency. functional finance 2. The Federal Government is the monopoly issuer of the currency. The government doesn’t need the public’s money; the government needs the public to need its money to give it value. functional finance 3. The purpose of bond sales is not to finance spending, but to drain excess reserves created by deficit spending. This is necessary to maintain positive short term interest rates. functional finance 4. In the functional finance view, the relation of G and T doesn’t matter – all that matters are the effects of any policy. functional finance 5. “Printing money” can have no effect on the economy independently of the six different fiscal operations (taxing, spending, giving, taking, lending, and borrowing). To consider the effects of printing money and these six would be to double count. functional finance 6. The sound money, sound finance view of the Hawks treats the modern money system as if it were a gold standard. The gold standard is a fixed exchange rate system; modern money is (and must be) a flexible exchange rate system—not only no gold standard, but no currency board, no pegged currencies, no fixed exchange rates of any kind. functional finance 7. Doves are wrong because by saying that the deficit is not really as big as it seems, or that we can balance the budget over the cycle, they are giving in to the Hawk view that it matters whether we deficit spend, how big the deficit or debt is, and whether we balance or not! functional finance 8. The deficit is just accounting information – it tells us how much the public wants to ‘net save’. In a closed economy, (G – T) = (S – I), that is, the public deficit equals the private surplus. functional finance 9. The national debt is just accounting info. It is the record of government’s draining of excess reserves to maintain short term interest rates. It might be better called the “IRMA” (interest rate maintenance account) than the national debt. functional finance 10. The national debt is not a burden on the future, because there can be no financial burden on a state money monopolist. Macro Policy Debates1.ppt Macro Policy Debates neoclassical monetarists, Keynesians, and supply-side economics Quantity Equation MV = PY (sometimes MV = PQ or MV = PT) M = money supply V = velocity of circulation of money (how many times a dollar changes hands per year) P = price level Y = real output Quantity Equation MV = aggregate spending PY = total value of sales Since every purchase is a sale, must be true by definition Quantity Equation MV = PY It is actually an “identity”—meaning it is true by definition. Therefore, differences must come from the way the variables are interpreted, and the conclusions derived from the interpretations. Quantity Equation Suppose there is $20 in the economy. So M = 20. And I have it. I use it to buy some milk from you. I buy 5 gallons at $4 per gallon. Then, in the same time period, you buy one economics textbook from me for $20. Quantity Equation First Round Second Round M = 20 same M V = 1 V = 1 P = $4 P = $20 Y = 5 Y = 1 Quantity Equation M = $20 and there was a total of 2 transactions, so MV = $40. P in the first round was $4 and Y in the first round was 5, so PY in the first round was $20. In the second round, PY is 20 x 1 = $20. $20 + $20 = $40. Monetarists Monetarists claim that V is constant or stable (predictable). Therefore, if M increases PY increases, if M decreases PY decreases. But monetarists are neoclassicals, so they believe that output is at full employment in the long run, so Y is also fixed (natural rate of growth and self-adjusting to full-employment). Thus there is a direct relation between the money supply and the price level. And causality goes from M to P. So: If M increases, P increases. If M decreases, P decreases. Monetarism Since monetarists view V as constant, they hold the position that fiscal policy cannot result in any change in aggregate spending. Increases in government spending are offset by corresponding decreases in private expenditure. If the increase in government spending is financed by taxes, they argue that this will decrease disposable income and thus reduce spending. The drop in Yd will be divided between a drop in C and a drop in S. The drop in S will result in less I, so that the fall in C + I will exactly offset the rise in G—crowding out. Monetarism If the government expenditure is financed by borrowing, then this decreases the loanable funds available for private borrowing for investment and the purchase of consumer durables. This increased competition for a fixed pool of savings bids up the interest rate. So, for the monetarists, increased government expenditure necessarily means decreased private expenditure. ‘Crowding-out'. Monetarism So monetarist policy is for minimal government expenditures (police, military, etc.). Increase the money supply at 3% per year, since that is what they believe the natural rate of growth is- 3%. So if Y is growing at 3% per year, we increase the money supply by 3% per year so there will be just enough aggregate demand to buy the national output, but not out of control inflation. Velocity is supposed to be growing at a constant rate of 3% per year, so P will also be constant at 3% per year. Keynesians For Keynesians, things are much more variable. First, Y does not tend to Yf, so it is likely to be below Yf. There are two versions of the Keynesian story, with exogenous Ms and endogenous Ms. With exogenous Ms, fiscal policy either depends on V being variable, or must be accompanied by complementary monetary policy. As far as V, we can think about the multiplier. Keynesians believe that V is variable. The multiplier affect is not the result of an increase in the money supply; rather it depends on the changeability of V. The same dollar, so to speak, turns over more times in a given time period. The monetarists are right when they say that if V were constant, there could be no increase in aggregate spending without an increase in the money supply. It's just that the monetarists have been unable to prove that V is constant. They have conceded, in the face of empirical evidence, that V is variable in the short run. Keynesians Keynesians also disagree in their interpretation of Y. They of course say that Y will likely be at a below full-employment equilibrium. Therefore fiscal and monetary policy may affect Y, unless at Yf, then P will be affected. Obviously if we are at full-employment, then P will rise if aggregate spending rises. With an endogenous Ms, the increase in G increases Y, if Y is less than Yf, and the Ms increases endogenously. Keynesians But if we are at less than full employment, then an increase in G will not crowd out private expenditures, because the increased expenditure is in effect utilizing unused resources, not taking them away from the private sector. Same with an increase in M- it can result in an increase in Y. Keynesians If the increase in G is financed by taxes, the monetarists say that it will be crowded out due to the decrease in disposable income. But this misses the whole point of the balanced budget multiplier. If it is financed by borrowing, the monetarists argue that this reduces the loanable funds available for borrowing. But Keynesians don't believe that investment is financed out of a pool of savings, nor that the interest rate is determined by S and I (modern forms of credit, etc.). So i won't be bid up, either. Keynesians Fiscal policy works because either: 1) Y increases by V increasing; 2) Y increases leading to M increasing, either: a) because coordinated with monetary policy; b) M increases by fiscal policy; c) causality runs from Y to M (endogenous money) Stagflation simultaneous recession and inflation 1970s Keynesians criticized because they were accused of not being able to explain stagflation, supposed to be a trade-off between unemployment and inflation; not supposed to be able to have both stagflation The reason that Keynesians were supposedly unable to explain stagflation is because, traditionally, unemployment was due to insufficient aggregate demand and inflation was due to excess aggregate demand. How can you have too much and too little of something at the same time? stagflation We can use the aggregate supply-aggregate demand (AS-AD) analysis to look at the stagflation issue. We will assume for now a textbook aggregate demand curve (with real balance effects and so downward sloping to the right). The aggregate supply curve in the following graph is a Keynesian one, horizontal up to full employment and then vertical. AD-AS Analysis P Y AS AD1 P*1 Ye*2 Yf P*3 0 AD2 AD3 stagflation Start at Yf, with the price level at P*1. Insufficient aggregate demand would shift the AD curve in from AS1 to AS2, and output, income, and employment would drop to Ye*2. Excess aggregate demand would shift the AD curve out from AD1 to AD3, causing prices to rise from P*1 to P*3. So there can be either unemployment or inflation, but not both. Stagflation The Keynesian reply was simple. If the inflation was due, not to excess demand but to supply-side factors, in other words if it was cost-push rather than demand-pull inflation, then stagflation is easy to explain. In that case, rising costs, such as due to the OPEC oil crisis, shifts the AS curve up, causing a recession with rising prices. AD-AS Analysis P Y P*1 Ye*1 P*2 0 AS1 AS2 Ye*2 The Decline of Keynesianism and the Rise of Supply-Side Economics But it was too late for Keynesian economics. Stagflation was just the straw that broke the paradigm’s back. With the election of Ronald Reagan as President in 1980, supply-side economics would be given a chance. MONEY.ppt MONEY Monetary History, Theory, and Policy What is Money? Many definitions At the end of the day, money is anything that functions as money What are the functions of money? functions of money Unit of account – means of measuring the comparable worth of goods and services; standard of value Medium of exchange – a. means of purchase (money exchanges directly for goods and services); b. means of payment (means of settling debt) Store of value – means of accumulating wealth; money as an end-in-itself fractional reserve banking In a fractional reserve banking system, banks keep some fraction of total deposits on reserve to meet the normal demand of depositors The fraction of deposits kept on reserve are required reserves, the remaining portion of deposits are excess reserves and are available for lending and investing characteristics of fractional reserve banking system Banks are private, profit-seeking enterprises; Through lending, spending, and redepositing, banks affect the money supply; Banks are susceptible to a run on the bank Tension between #1 and #3: banks want to earn profits, and so want to lend reserves, but don’t want to be vulnerable to a run, so don’t want to lend too much Central banks In U.S., the Federal Reserve, or “Fed” A central bank is like a bank for private banks: 1. lend reserves to private banks – they charge interest on loans, called the discount rate 2. hold private banks’ reserves demand for money Transactions demand – stable, determined by mpc and convention Precautionary demand - stable, determined by mpc and convention Speculative demand – determined by relation between two rates of interest: 1. current actual rate (ic) 2. expected future rate (ie) speculative demand To understand how the speculative demand for cash is determined by the relation of the two rates of interest, must understand: 1. investor motto: buy low and sell high 2. inverse relation between bond prices and interest rates speculative demand If ic < ie then people think that interest rates are going to go up, so they think that bond prices are going to go down, so they sell bonds and hold cash (speculative demand for cash is high) If ic > ie then people think that interest rates are going to go down, so they think that bond prices are going to go up, so they buy bonds with all available cash (speculative demand for cash is low)
Money Demand
Interest Rate
Quantity of Money
MD
i
0
three ways central bank can attempt to affect the money supply
Set reserve requirement ratio – % of deposits banks must keep on reserve (least used method; money supply is too sensitive to changes in rrr)
Set discount rate – rate of interest charged for borrowing reserves (intermediate method – 5-7 times per year)
Open market operations – buying and selling bonds (used most often; daily)
methods of attempting to control the money supply
To try to increase the money supply:
decrease rrr; decrease d.r.; buy bonds
To try to decrease the money supply:
increase rrr; increase d.r.; sell bonds
money supply
If the central bank is able to control the money supply, the money supply is “exogenous,” and the money supply curve is vertical.
Exogenous Money Supply
Money Supply (Ms)
Interest Rate
Quantity of Money
i
M1
0
Shift inward of Money Supply (Exogenous Money Supply)
Ms1
Interest Rate
Quantity of Money
Ms2
M1
M2
0
Shift outward of Money Supply (Exogenous Money Supply)
Ms1
Interest Rate
Quantity of Money
Ms2
M1
M2
0
money supply
Since the mid-1980s, it has become widely argued that the central bank cannot control the money supply, and that the money supply is “endogenous,” so that the money supply curve is horizontal. In this case, the money supply is determined by market forces, in particular the demand for money or the demand for credit. In this case, it is the short-term interest rate that central banks control directly.
Endogenous Money Supply
Ms1
Interest Rate
Quantity of Money
i
0
endogenous money supply
In this view, when households and firms increase their demand for loans, the Fed and private banks are said to accommodate the demand for credit. Credit is extended and investment increases, increasing output and income. Higher income means higher savings, and these savings are redeposited in the banking system.
endogenous money supply
This depiction of the money supply process fits in very nicely with Keynes’s view of the investment-savings relationship and capitalism as a demand-led system. Just as Keynes turned the investment-savings relation on its head, likewise, in this view loans create deposits rather than the other way round.
Incorporating endogenous money into the Keynesian view of the investment-savings relation
Demand for credit↑ Fed and private banks accommodate the demand for credit credit is extended I↑ Y↑ S↑ savings are redeposited into banks, replenishing reserves depleted initially by the loans and even increasing reserves
Institutional mechanisms banks can use to try to extend their lending capacity
1. Fed Funds – member banks of the Federal Reserve system can borrow reserves from one another. These reserves are called “Fed Funds” and the rate of interest they pay is the Federal Funds rate, the inter-bank lending rate set by the Fed.
Institutional mechanisms banks can use to try to extend their lending capacity
2. Foreign banks – U.S. banks can borrow dollars from foreign banks, that are not regulated by the Fed and so have no reserve requirements in dollars. These reserves used to be called “Eurodollars” but it is no longer only European banks that lend and the creation of the “Euro” currency makes the terminology confusing (what would we call the Euros European banks borrow from abroad, “Euroeuros”?
Institutional mechanisms banks can use to try to extend their lending capacity
3. certificates of deposit (CDs) – these are savings accounts that must keep a minimum balance for a minimum length of time. The key to understanding how they are used to extend lending capacity is that the rrr on CDs is lower than on other types of accounts. Banks can use CDs to extend lending capacity in two ways:
Using CDs to Extend Lending Capacity
i. offer new, attractive CDs to attract new customers, increasing reserves;
ii. change current customers over from regular deposits, e.g., checking accounts, to CDs, decreasing the average rrr.
Institutional mechanisms banks can use to try to extend their lending capacity
4. Repos (repurchasing agreements) – a repo is, in general, an agreement between a buyer and a seller to reverse a transaction at a specified time in the future (often the next day) at a specified price. So a bank will sell $1 million worth of bonds today and agree to buy them back tomorrow for $1.01 mil. The first bank will get to “hold” $1 mil. Overnight, increasing its average reserve holdings over that period (banks do not have to meet their reserve requirements at every moment in time, just on average over a two-week period). The second bank will get to earn something on its excess reserves.
Institutional mechanisms banks can use to try to extend their lending capacity
5. open market operations – selling bonds to obtain reserves, with or without repos attached.
Institutional mechanisms banks can use to try to extend their lending capacity
6. Fed as “Lender of Last Resort” (LLR) – borrow reserves from the Fed, at the discount rate (rate of interest Fed charges banks to borrow reserves). This is called going to the “discount window”. Fed is LLR in the sense that it is the ultimate lender of dollars, and in the sense that banks use it as the last resort, because there can be penalties for repeatedly failing to meet reserve requirements.
money supply and demand, and the equilibrium rate of interest
The equilibrium rate of interest in Keynes is determined by the intersection of money supply and money demand curves.
Assume an exogenous money supply for the time being.
Exogenous Money Supply
Money Supply (Ms)
Interest Rate
Quantity of Money
Money Demand (MD)
M*
i*
0
Keynesian Monetary Policy
Monetary policy is the attempt to affect macroeconomic variables such as aggregate output, income, employment and the price level through changes in the money supply and interest rates.
Expansionary policy seeks to expand output and employment; anti-inflationary policy seeks to control inflation.
Assume exogenous money supply for now.
Keynesian Expansionary Monetary Policy (KEMP)
The Fed increases the money supply through its available mechanisms (rrr, dr, omo). This causes interest rates to fall, increasing investment, causing output, income, and employment to expand.
Ms↑ i↓ I↑ Y↑
Keynesian Expansionary Monetary Policy (KEMP)
Ms1
Interest Rate
Quantity of Money
MD
Ms2
i*1
i*2
M1
M2
0
Limits of KEMP
Keynesian Expansionary Monetary Policy has three limits.
Interest rates may be insensitive to changes in the money supply (liquidity trap)
Liquidity Trap – horizontal portion of the money demand function. When interest rates get so low that no one thinks they can get any lower, so no matter how much money the Fed throws into the system, people just hold onto it, waiting for interest rates to rise and bond prices to fall.
Liquidity Trap
Interest Rate
Quantity of Money
MD
Ms2
iLT
M2
M3
Ms3
0
Liquidity Trap
Limits of KEMP
Keynesian Expansionary Monetary Policy has three limits.
2. Investment may be insensitive to changes in interest rates (recall all of Keynes’s’ warnings about inverse, mechanistic relation between interest rates and investment).
Limits of KEMP
Keynesian Expansionary Monetary Policy has three limits.
3. Output may be insensitive to changes in investment. (either if the economy is at full employment—in which case why pursue expansionary monetary policy—or, if the mpc is falling faster than investment is increasing.
Keynesian Anti-Inflationary Monetary Policy (KAIMP)
Fed decreases money supply, causing interest rates to rise, causing investment to slow, decreasing inflation.
Ms↓ i↑ I↓ P↓
(here P↓ is usually a slowing of inflation rather than deflation)
Keynesian Anti-Inflationary Monetary Policy (KAIMP)
Ms1
Interest Rate
Quantity of Money
MD
Ms2
i*1
i*2
M1
M2
0
Limits of KAIMP
Keynesian Anti-Inflationary Monetary Policy has two limits.
1. It is only effective for “demand-pull” inflation—inflation due to excess demand. If there is “cost-push” (or supply-side) inflation, it may not be effective and could even exacerbate it (though higher finance costs, for example).
Limits of KAIMP
Keynesian Anti-Inflationary Monetary Policy has two limits.
2. The Fed can overshoot its mark and the fall in investment may cause output and employment to fall, which can even cause a recession.
Keynesian Fiscal and Monetary Policies
In general, fiscal policy is seen as more direct, stronger, and more effective, and monetary policy is seen as more indirect, weaker, and less effective.
In the Post-War “golden age” of U.S. capitalism (approximately 1946-1971), a combination of fiscal and monetary policies were used, called “fine-tuning” the macroeconomy.
Supply-Side Economics.ppt
Supply-Side Economics
“Reaganomics,” Monetarism, and Military Keynesianism
Cornerstones of Supply-Side Economics in the 1980s
1) supply-side tax cuts for business to provide incentives for firms to produce, and tax cuts for households to promote the incentive to work in the labor market
Cornerstones of Supply-Side Economics in the 1980s
2) Shift in the composition of government spending away from social programs (including job training and education) to military spending—but no net decrease in government spending
Cornerstones of Supply-Side Economics in the 1980s
3) Contraction of the money supply to fight inflation—supply-siders in the early 1980s accepted the monetarist view of the quantity theory insofar as there being a direct relation between M and P.
Cornerstones of Supply-Side Economics in the 1980s
4) Deregulation of industry and financial institutions—to cut costs, promote efficiency, and remove cumbersome laws and regulations.
Cornerstones of Supply-Side Economics in the 1980s
5) Don’t worry about demand, Say’s Law holds.
Say’s Law—
“supply creates its own demand”
SUPPLY-SIDE ECONOMICS
year GNP deficit tax cuts trade deficit notes
1981 (Ms contracted to fight inflation; i rise 23.5%)
1982 -2.5% $128b 5% $ 38.4 U x 2 to 9.5%
1983 +3.6% $208 10% $ 64.2 9.5% unempl.
1984 +6.0% $185 10% $122.4
1985 +3.3% $212 $133.6
1986 +2.7% $221 $155.1
1987 +3.4% $150 $170.3
1988 +4.4% $155 $137.1
1989 +2.5% $153 $129.4
1990 +1.0% $220 $123.4
1991 -. 7% $269 $ 86.3
supply-side in the 80s
1981: Reagan entered office in 1981- first attacked inflation: anti-inflationary measures are policies that favor creditors over those in debt
money supply was sharply contracted- Supply siders are monetarists when it comes to monetary policy; both monetarists and supply-siders are neoclassicals- did bring inflation under control – monetarist would say because of direct relation between M and P; but what would Keynes say happens when M supply is contracted? Interest rates should go up? In fact, interest rates shot up 23.5%!
supply-side in the 80s
1982: GNP fell 2.5% as unemployment nearly doubled until 12 million officially out of work. Reagan tax cuts begin (5%), and deficits increase by over 64% or $50b to over $128b. Biggest recession since before WWII (up to that time).
supply-side in the 80s
1983: GNP rises 3.6%, but that is just 1.1% increase in output from two years previous- deficit expands 62.5% to a whopping $208 billion (almost triple from when Reagan entered office) as more tax cuts (10%) and trade deficit rises 67% from $38.4b to 64.2b. No improvement in unemployment- still 9.5% unemployed.
supply-side in the 80s
1984: so-called ‘recovery’ GNP rises by 6%, but another $185b deficit; and trade deficit up 90% to $122.4b. Another 10% tax cut leading to another $433b in deficits in next two years.
Supply-Side Economics
Logic of Supply-Side Tax Cuts:
-Tax cuts for workers give them an incentive to work, work harder and work more hours.
– Tax cuts for businesses means firms will invest and produce more.
Supply-Side Tax Cuts—Workers
Problems: After-tax income is important to workers. But it is only one — a very important one, but nevertheless only one — part of total job satisfaction. Job security, work environment, many other factors are also important, as numerous studies have shown. What is happening to the job security index when unemployment shoots up to double digits in the Reagan recession? What is happening to the work environment index when deregulation kicks in? Moreover, to enjoy the incentive of take home pay, you have to have some pay to take home, and so these incentives mean nothing for the unemployed.
Supply-Side Tax Cuts—Firms
As far as businesses, again we go back to Keynes’s emphasis on expected profitability. It doesn’t matter if taxes are smaller, if expectations are dimmed because of a recession and unemployment, firms aren’t going to be increasing productive capacity. They aren’t able to sell all they can produce now. A capital gains tax cut does nothing to guarantee investment. An investment tax credit may help a little more, at least then there is some incentive to invest.
Supply-Siders and Say’s Law
For both these cases, supply doesn’t create its own demand. Supply-siders are adherents to Say’s Law, but Say’s law means production generates income sufficient to purchase that output—the national income accounting identity—but does not guarantee that all production will in fact be purchased.
costs and revenues
Lower costs for one is lower income for others—in this case with the tax cuts, much of that lower income resulted in lower tax revenues for government—look at what happened to the budget deficit following the tax cuts.
Reaganomics—the legacy
But then what about the Reagan recovery? From 1982-84 there were over $520b in deficits—that’s fiscal stimulus. The so-called recovery was demand side, not supply side. One indicator that this is so is the fact that there was inflation in this period. See this with AS-AD analysis.
Reagan Recovery—supply or demand side expansion?
P
Y
P*1
Ye*1
0
AD1
AS1
AS2
P*2
Ye*s
Reagan Recovery—supply or demand side expansion?
If the recovery was supply-driven, then there should be an increase in output with steady or falling prices. If the expansion was demand-driven, output and prices would both rise.
Reagan Recovery—supply or demand side expansion?
P
Y
P*1
Ye*1
0
AD1
AS1
P*2
Ye*s
AD2
Reagan Recovery:
why didn’t it last?
1) This was military Keynesianism- the tax cuts combined with no decrease in G but a shift in the composition of spending to military expenditures gives us a multiplier effect but a low one—there is no inner growth dynamic to military spending.
Reagan Recovery:
Why didn’t it last?
2) redistribution of income from poor to rich meant redistribution from those with a higher mpc to those with a lower mpc—and so a lower multiplier.
Reagan Recovery:
why didn’t it last
3) booming trade deficit—without a full employment policy, this becomes a problem, because reverse multiplier effect—declining competitiveness in US manufacturing, refusal to try to limit capital flight, protect domestic industry
Reaganomics: why didn’t it last?
4) deregulation of the banking system—led to S&L crisis; $500 billion + taxpayer bailout
Reaganomics: problems
5) contrary fiscal and monetary policy—expansionary fiscal, anti-inflationary monetary…
Reaganomics: problems
6) decline in infrastructure and
education/skill level of the labor force
Reaganomics: problems
1990-91—Worst recession since WWII up to that time.
End of supply-side
End of the supply-side era: $4.2 trillion debt run-up (from $1.1t $5.3t
unstable banking system
over official 7.5% unemployment
Clintonomics
With the run-up of the national debt, Democrats took a political strategy of trying to call the Republicans fiscally irresponsible. The Democrats were very upset about deficit dove positions that said deficits and the debt were ok. They didn’t want to hear that deficits weren’t a problem and maybe they were even good sometimes and we shouldn’t fret over the debt. So that by the end of the eighties, the two parties are both claiming to be the ‘really’ fiscally responsible one, against those terrible deficits and the national debt, and any common sense that had been represented in the mainstream policy debate vanishes into thin air.
Reaganomics and “Big Government”
Several Reagan advisors reveal that the Reagan administration purposely ran up deficits and the debt to try to bankrupt big government—tax cuts leading to big deficits were the only path to “downsizing” big government.
“It’s the Economy, Stupid!”
A key part of “It’s the Economy Stupid!” Economics is budget balancing, deficit reduction. The deficit did fall; the budget even moved into surplus. But that was not the cause of the Clinton expansion, it was the result of rising incomes and the automatic stabilizers. By the turn of the century we have Al Gore running on paying down the debt, surplus uber alles, and putting money in a “lock-box.” The private sector is racked with debt, and the U.S. circa 2000-2001 looked more and more like Japan in the early 90s, where interest rates at zero for years did nothing to stimulate the economy.
Tweedle-dee and Tweedle-dum
Debates over issues like social security are fraught with fallacies and misunderstandings concerning the modern money system and budgetary and employment policy. Republicrats and Demublicans alike do not understand modern money or functional finance.
The Neoclassical-Keynesian Synthesis.ppt
The Neoclassical-Keynesian Synthesis
Real Balance Effects and the Neoclassical Response to Keynes
The Neoclassical Response to the Keynesian Critique
Some neoclassical economists became Keynesians
Some tried to ignore Keynes
Some misinterpreted Keynes as arguing that sticky wages and prices could cause unemployment in the long run (this result was already in neoclassical economics—if that is all that Keynes was arguing, then Keynes was not making a new contribution).
Neoclassical Response to Keynes
4. This next response was the most interesting: it said, “Keynes is making some real contributions and we should recognize that. His theory of the multiplier, his argument that we should conduct aggregate analysis and that money should play a central, determining role, even his liquidity preference theory, are all real contributions and should be incorporated into the analysis.”
Response to Keynes
“But,” this response continued, “if Keynes is saying he is refuting neoclassical theory he is going too far.” “Because,” they said, “it can be shown that all of these contributions can be incorporated into the broader neoclassical framework and it can still be demonstrated that the central proposition of neoclassical macro theory still holds.”
Central Proposition of Neoclassical Macro
They argued: “It can still be shown that if wages, prices, and interest rates are perfectly flexible that the economy will tend to full employment in the long run.”
The argument will look a little different, it won’t be simply the old neoclassical labor and loanable funds markets story.
Grand Neoclassical-Keynesian Synthesis
This argument, which came to be known as the neoclassical synthesis, used the real balance effects arguments to demonstrate their proposition.
The real balance effects has two parts: the direct real balance effect, or Pigou effect, and the indirect real balance effect, or Keynes effect, or interest rate effect.
Real Balance Effects
The real balance effect argument begins by noting that in Keynes if there is unemployment, or aggregate supply is greater than aggregate demand, firms will cut back production, income will fall, and employment will fall.
But, they ask, what if instead of cutting output, firms cut prices in response to insufficient demand? And if this occurred throughout the economy, the price level would fall (there would be deflation). Deflation means that the real value of money would rise.
Direct Real Balance
(or Pigou) Effect
AS>AD P ↓ real value of $ ↑ (C + I)↑ mult effects Y↑ Yf
When AS>AD, the price level falls, increasing the real value of money. Consumers and investors holding cash would feel richer, and consumption and investment would rise. This would set off multiplier effects, increasing output and income. As long as AS>AD, this would continue, until full employment.
Indirect Real Balance (or Keynes or Interest Rate) Effect
AS>AD P ↓ real value of $ ↑ amount of $ necessary to satisfy transactions demand for $↓ amount of $ available for speculative demand↑ demand for securities↑ bond prices↑ interest rates↓ (C + I)↑ mult Y↑ Yf
Demand for Money in Keynes
Keynes asked the question: “Why would anyone hold any of their wealth in the form of cash rather than in higher interest-earning or profit-bearing assets?”
He gave three reasons in The General Theory: transactions demand for cash, precautionary demand for cash and the speculative demand for cash.
Demand for Money
Transactions demand – wealth people keep in the form of cash to make normal daily, weekly, and monthly transactions.
Precautionary demand – in case of emergencies (flat tire, broken arm, etc.)
Speculative demand – in case an unexpected financial opportunity should arise, to earn higher than normal profits.
inverse relation between bond prices and interest rates
Suppose a bond that sells for $1000 earns $50 per year interest. So the interest rate is 5%. Then suppose the interest rate rises to 10%. The bond is locked in to a return of $50 per year, so the price falls to $500. (think of the alternative of putting $1000 in the bank at 10%, it would earn $100, so no one would buy the bond for $1000 when the return is $50 if the interest rate is 10%.).
Real balance effects and neoclassical synthesis
Notice that the RBE incorporate aggregate analysis, money as a central determining variable, the multiplier, and liquidity preference theory all from Keynes.
Yet the central proposition of neoclassical macro still holds—if wages, prices, and interest rates are perfectly flexible, the economy tends to full employment in the long run, no government intervention.
Keynesian reply to RBE
1. yes, if price level falls, real value of $ rises, but what about the real value of non-cash assets? So, whether you feel richer or poorer when there is deflation depends on whether households and businesses keep their wealth in cash or non-cash assets.
Keynesian reply to RBE
2. yes, if price level falls, real value of $ rises, but what about the real value of debt? Debt is denominated in cash, so real value goes up when price level falls. Whether households and businesses feel richer or poorer when there is deflation depends on the importance of debt (consumer debt, corporate debt, and government debt as well).
Keynesian reply to RBE
3. Consideration of expectations complicates the RBE stories. If consumers and investors do not know if prices and interest rates will continue to fall, they may not buy (and borrow to buy), but wait and see if they fall more. And if they do not buy (and borrow), then prices and interest rates continue to fall. How high will the real value of debt inflate before they think prices and interest rates have hit rock bottom?
Keynesian reply to RBE
4. Lower prices may be good for buyers, but are they good for sellers? It depends. If you are thinking about investing in producing widgets because interest rates are down, and you see the prices of widgets falling, there is a limit to how low prices can go before it is a dis-incentive for you to expand output in that market.
Keynesian reply to RBE
5. Indirect real balance effect reintroduces the mechanistic inverse relation between interest rates and investment that Keynes criticized. (this applies only to the indirect real balance effect).
Keynesian reply to RBE
6. Historical experience and empirical record
a. Great Depression – deflation, but no real balance effects. Interest rates zero, no investment.
b. Post WWII experience of industrialized nations. Many periods of unemployment, but virtually no deflation. (slowing of inflation not the same as deflation)
Macroeconomics 20
1
Answer all 25 multiple choice questions.
1. Which is not a function of money?
a) unit of account; b) medium of exchange; c) means of measure; d) store of value
2. Since the 1980s, it has generally been the view that the money supply:
a) is completely controlled by the central bank;
b) cannot be controlled by the central bank;
c) is completely controlled by the Treasury;
d) cannot be controlled by the Treasury
3) Which of the following is not one of the three kinds of demand for money in Keynes?
a) speculative;
b) precautionary; c) administrative;
d) transactions
4) Which of the following is not one of the ways the Fed can use to try to affect the money supply?
a) change the discount rate;
b) change the fed funds rate;
c) change the reserve requirement ratio;
d) open market operations
5) Expansionary policy is used to:
a) try to fight inflation;
b) try to decrease output, income, and employment;
c) try to increase output, income, and employment;
d) try to increase deflation
6) There is a tension between these two characteristics of banks in a fractional reserve banking system:
a) private profit seeking enterprises and susceptible to runs;
b) private profit seeking enterprises and engage in money creation;
c) engage in money creation and susceptible to runs;
d) engage in runs and susceptible to money creation
7) The liquidity trap is:
a) the horizontal portion of the money demand function;
b) when interest rates are so low people do not think they can go any lower;
c) when interest rates are insensitive to changes in the Money supply;
d) all of the above
8) The limits to KEMP are:
a) I may be insensitive to changes in i, i may insensitive to changes in Ms, Y may be insensitive to changes in I;
b) I may be insensitive to changes in Y, I may be insensitive to changes in i, i may be insensitive to changes in Ms;
c) I may be insensitive to changes in i, i may be insensitive to changes in Ms, Y may be insensitive to changes in i;
d) I may be insensitive to changes in i; Ms may be insensitive to changes in i, Y may be insensitive to changes in I
9) The limits to KAIMP are:
a) only works for demand-pull inflation, Fed may overshoot its mark and cause a recession;
b) only works for cost-push inflation, Fed may overshoot its mark and cause a recession; c) only works for demand-push inflation, Fed may overshoot its mark and cause a recession;
d) only works for cost-pull inflation, Fed may undershoot its mark and cause a recession
10) In the endogenous view of the money supply:
a) the Ms curve is vertical;
b) the Ms curve is horizontal;
c) the Md curve is vertical;
d) the Md curve is horizontal
11) Deficit Hawks view deficits as causing:
a) high investment rates; b) deflation; c) high interest rates; d) all of the above
12) Deficit Doves believe that:
a) deficits cause high interest rates;
b) high interest rates cause bigger deficits;
c) deficits are always good;
d) all of the above
13) In the functional finance view, bond sales:
a) finance deficit spending;
b) add to bank reserves depleted by deficit spending;
c) drain excess reserves to maintain short term interest rates;
d) none of the above
14) In the functional finance view, taxes:
a) finance government spending;
b) create a demand for government bonds;
c) create a demand for government currency;
d) all of the above
15) In the functional finance view:
a) the government needs the public’s money to spend;
b) the public needs the government to accept its money;
c) the government needs the public to need its currency;
d) both b and c
16) The view that the national debt is a burden on future generations is held by:
a) deficit hawks; b) deficits doves; c) functional finance; d) a and b
17) The view that the government is the monopoly issuer of the currency is held by:
a) deficit hawks; b) deficit doves; c) functional finance; d) b and c
18) Which describes KEMP:
a) Ms↑ ( i↑ ( I↑ ( Y↑;
b) Ms↑ ( i↓ ( I ↓– Y↑;
c) Ms↑ ( i↓ ( I↑( Y↑;
d) Ms↑ ( i↓ (I↑ ( P↓
19) In the endogenous money view:
a) deposits create loans;
b) reserves create loans;
c) loans create deposits;
d) deposits create reserves
20) The most common method the Fed uses to try to affect the money supply is:
a) reserve requirement ratio; b) discount rate; c) open market operations; d) fed funds rate
21) What are the tools of monetary policy?
a) government spending and taxes;
b) money supply and interest rates;
c) money demand and interest rates;
d) government supply and tax rates
22) In the endogenous view of the money supply, everything begins with:
a) the supply of credit;
b) the demand for credit;
c) the supply of loanable funds;
d) none of the above
23) The Fed can try to increase the money supply by:
a) selling discount rates;
b) buying discount rates;
c) selling bonds;
d) buying bonds
24) The Fed can try to decrease the money supply by:
a) raising the discount rate;
b) lowering the discount rate;
c) lowering the reserve requirement ratio;
d) raising the money supply
25) When money is used to settle debt it is functioning as:
a) a means of purchase;
b) a means of value;
c) a means of payment;
d) a medium of account
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