(A prelude to aggregate models and policy decisions)
Classical School Also called
neo-classical, supply-side
Major Thinkers
Adam Smith (Wealth of Nations)
David Ricardo
Thomas Malthus
Alfred Marshall
Jean-Baptiste Say
Basic Paradigm: competition is good
forces firms to improve.
Causes them to lower prices to earn market share
Invisible hand - pushes the market forward
For the consumer: better product at lower prices over time
Forces bad firms to improve or get out
New companies must be more efficient to compete
Say's law: Supply creates its own demand in the long run.
economy will not only improve but balance itself.
If suppliers overproduce, they create a surplus, they cut production and lower prices. You will recover once you flush out the surplus. Real wealth is in balance.
Shortage? Increase production. Raise prices. Hire more people. Raise wages. Real wealth stays the same.
Governments role = limited
Ensure competition occurs. - forms cartels, trusts. Businesses can cheat.
Monopolies stop completion
Unions - anti competitive. Stops firms from being able to adjust to wage changes. They can break down the fundamental Competitive process. Firms need to be flexible with wages at times.
Modern Policy Examples:
Trickle Down tax policies. Lower taxes on the rich. They control industry and when they profit more, they will build more industries. More workers will be hired. Everyone will benefit.
Lower taxes on businesses and individuals. This will help production and consumption and make industry more efficient.
Reduce power of groups like inefficient unions that block wage adjustments and
flexibility. Create more “Right to Work” laws.
Support more free trade like the EU, NAFTA, CAFTA, and the WTO
Get rid of socialistic, anti-competition parts of the economy.
Lower tax revenues that the government can collect in order to minimize the way government can afford to interfere in the economic markets.
Sum: in the long run, the economy will balance.
Riccardo adds international trade to this.
Free trade.
The more you trade the more competitive the world market becomes
the more interlinked it will become, the more efficient it becomes.
Then what happened? Great Depression
Keynesian economics
Demand-side
John Maynard Keynes
Neo-Keynesian,
Fiscal Policy
Modern guy is Krugman.
Basic Paradigm: Competition is good but flawed.
It's never going to balance itself.
Gov. Has to balance it.
The invisible hand is inefficient.
Says says law is a myth. There is no natural balance.
Businesses can't really lower prices at will. - sticky prices.
Paradox of thrift. - people will always save some of their income. Says its a leak.
Prices can increase but not decrease. - the ratchet effect
Inefficiencies will bring you down eventually.
Recessions will be the norm and government must step in.
Government Role
must now step in and correct the missing Aggregate demand
Congress will represent the interests of the people and will use the tools of taxes and spending.
Fiscal Policy
When recessions occur, governments spend. (also a ratchet effect)
Increase taxes and cut spending. - affect Aggregate demand
Automatic stabilizers - progressive tax, social security, unemployment insurance.
In the long run we're all dead.
Modern Policy Examples
Countercyclical Fiscal Policies like tax cuts during recessions.
Social Security programs to help form a safety net for the elderly.
Unemployment insurance benefits to help soften the blow of unemployment.
Then what happened? Stagflation of the 1970s
Monetary policy also refereed to as
Federal reserve policy
Central bank policy
Basic Paradigm: Completion is good will be encouraged but needs constant tuning
The more you do that the less problems you have.
Each recession has lasted about 14 months or less
Your stimulus hits about a year after the recession started, The recession is over, you create inflation
Even if you have good intentions you can't time it.
Congress jumps into raising taxes and lower spending. - politicians won't do it.
The best way to do this is through a central bank.
Central Bank Can
focus on inflation.
set realistic growth targets.
do this with interest rates and the money supply.
Lower interest rates in a recession Raise them when dealing with inflation. Modern Policy Examples
Bond sales and purchases as policy tools (The Open Market Committee)
Aggregate Models (All parts of the economy taken as a whole) Aggregate Demand (AD): Curve that shows the amount consumers are willing / able to buy at given price level.
Slopes down
Wealth Effect: as prices increase, income purchasing power falls
Foreign Purchases Effect: as prices rise, US goods are more expensive and therefore demanded less by foreign consumers.
Shifters: Consumption (C) of Goods and Services by the Private Sector
Future Expectations: How will the public react to fears of the future?
Indebtedness: Will, or can, the public keep borrowing into the future?
Net Income: How much money is left after paying taxes?
Gross Investment (Ig) Businesses must first use resources before selling.
What effect will interest rates have on business’ ability to borrow?
What kind of expectations will business have for future profits?
What kind of profits will exist after taxes and dividends are paid?
How quickly can new technology be applied to better construction?
Is there already excess capacity available for short term growth?
Government (G)
How much will government spend on goods and services?
Net Exports (Xn) or (X-M) (Export values minus Import values)
Net income being sent back to the US versus Remittances from the US
Value changes in the US Dollar and the effect on export/import prices
Aggregate demand is = ??
Aggregate Supply (AS): curve showing the relationship between the price level and the amount of real domestic output firms produce
Slopes up: as PL increases, GDPr increases.
Shifters The cost and availability of resources
The cost of paying for resources to build stuff
How much Land, Labor, Capital, Entrep., Foreign Resources, Tech.?
Market Power/Control and Competition
How much of the market (and pricing/profits) can this company control?
Productivity
How efficient and productive is the labor force and the technology applied?
Gov. Regulations / Legal Environment
What are the tax burdens on producers?
What subsidies are available?
What are the costs of dealing with governmental regulations?
Long Run Aggregate supply (LRAS): Measure of supply in the long run, with all resources variable.
no relationship between PL and Q of output in the long run.
Investment decisions = marginal analysis. marginal benefit = expected rate of return marginal cost = interest rate (paid for borrowed $) Firms will invest if: expected rate of return >= interest rate Rate of Return
Net expected revenue - cost = profit
profit / cost = rate of return
Example Nice Tool Manufacturing Possible investment: New Okuma CNC Mill Cost: $100,000 Next Expected Revenue: $110,000 Expected Profit: ? $10,000
Expected RoR: ? .1 (10%) Must also consider the interest rate interest cost = principal x interest rate (i) Let's say i = 5% Interest cost = $5,000 Net Profit (including interest costs) = $5,000
Let's say i = 15% Interest cost = $15,000 Interest rate > expected RoR (15% > 10%)
Investment will be undertaken if expected rate of return (r) => the real interest rate (i)
Investment demand graph.
total investment demand in biz. sector (nominal interest)
Slopes down.
As interest lowers, demand for investment funds increases.
Interest is a cost of doing business.
component of GDP (Ig)
(i = normal interest rate)
Who is demanding this investment (three big ones)
Businesses
Mortgages
Student loans / education
Investment will be undertaken if expected rate of return (r) => the real interest rate (i)
Shifts of the investment Demand Curve
1)Cost of acquiring, maintaining, and operating capital goods.
When these costs rise, expected RoR shrinks
Investment demand falls
ID curve shifts to the left.
If these costs lower / curve shifts right
2)business taxes
firms looks at returns after taxes
tax hike = lower expected RoR
lower investment demand / curve shifts left
tax cut = higher expected RoR
higher investment demand / curve shifts right
3)Technological Changes
new tech stimulates investment
more efficiency lowers production costs
new tech means new demand
rapid increase in technology shifts the curve to the right
4)stock of capital goods on hand
if an economy is overstocked with capital goods and finished products, expected RoR declines
investment demand declines. (what's the point of investing?)
curve shifts left
if an economy is understocked with capital and finished goods,
firms selling as fast as they can, expected RoR increces
FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks) HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture) APPAREL (men's shirts and sweaters, women's dresses, jewelry) TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance) MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services) RECREATION (televisions, toys, pets and pet products, sports equipment, admissions); EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories); OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses). From Bureau of Labor Statistics
used to adjust gov. policies (social security, tax brackets, etc.)
How does it work?
"market basket" of 300 goods and services consumed by the average urban citizen in the US
Measured against a standard (1982-1984)
Index = 100
CPI = most recent market basket / market basket index x 100 Rate of inflation = % growth of CPI from year to year. RI = later year CPI - earlier year CPI / earlier year CPI x 100 Types of Inflation Demand-Pull Inflation
Too many consumers chasing too few goods (can be normal)
Excessive spending out of fear of future inflation
Too few unemployed and wage inflation due to competition
step-by-step scenario
Producer's resources are fully employed
Can't meet excess demand by producing more
Excess demand then bids-up prices of limited goods
Demand is "pulling-up" inflation.
Cost-Push Inflation
Natural disasters cut supply (supply shocks)
Political actions like boycotts cut the supply (OPEC 1973, 1979)
Natural reduction of resources with no new discoveries
step-by-step scenario
Rise in per-unit production costs
Squeeze profits
Firms less willing and able to supply at given prices
goods and services decline
prices rise
costs are "pushing up" inflation
Political Inflation
Governments printing too much currency to cover debts…
Central Bank interventions in the economy
Examples:
Continental Dollars of the 1770’s and 1780’s
Germany of the early 1920’s
Zimbabwe Civil War 2008 to 2011
Effects of Inflation Redistribution of real income
Nominal v. Real income
Nominal income: number of dollars received (wages, etc.)
Real income: measure of the amount of goods and services that can be purchased with nominal income. (purchasing power)
Real income = nominal income / price index inflation affects different people's real income differently. Inflation “Helps”:
Those who pay back loans at a fixed interest rate
Inflation “Hurts”:
Those who lend money at a fixed interest rate (banks)
Those saving money at fixed rate interest rate returns (consumers)
Those on any long term fixed level of income (retired, disabled)
Those trying to hire workers and keep costs under control (business, workers)
Those trying to plan future business projects and project costs (business)
Economic Norms:
Unemployment = 4 to 5 % (post 1980 in the USA)
Inflation = 2 to 3 % per year (“Anticipated Inflation”)
Misery Index = Unemployment and Inflation Rates Together:
Acceptable Misery: 6 to 8
Excessive Misery: Any double digit number
Why is Unemployment Bad?
Not enough Consumption (GDP)
Too much poverty...
Too much government assistance needed.
Why is Unemployment Good?
More workers available for future expansions.
Less pressure to raise wages.
Why is Inflation Bad?
Loss of real wages
Loss of real wealth
Loss of the value of savings
Loss of the value of fixed income
Panic buying
Loss of the value of currencies
Loss of the incentive to take financial risks
Loss of the incentive to hire
Why is Inflation Good?
If you owe money, you pay back cheaper money
BECAUSE Unemployment hurts the unemployed, but Inflation hurts everyone, always assume that government policies should focus on controlling inflation FIRST.
Governments role = limited
Great Depression 
Says says law is a myth. There is no natural balance. 
Modern Policy Examples
Basic Paradigm: Completion is good will be encouraged but needs constant tuning 
Central Bank Can 
