Basics of Macroeconomic Policies Sy Sarkarat, Ph. D. United States Fulbright Scholar for Azerbaijan State Economics University , Baku, Azerbaijan. Fall 2008 Copy Rights: This lecture was prepared to CRRC and it is designed for educational purpose not for profit.
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Basics of MacroeconomicPolicies
Sy Sarkarat, Ph. D.United States Fulbright Scholar for Azerbaijan State Economics University , Baku, Azerbaijan.
Fall 2008
Copy Rights: This lecture was prepared to CRRC and it is designed for educational purpose not for profit.
Warming up
• Q:Why did God create economists ?• A:In order to make weather forecasters look
good. • Q. What does an economist do?• A. A lot in the short run, which amounts to
nothing in the long run.
The Business Cycle
Trough
Peak
REAL
GD
P (u
nits
per
tim
e pe
riod)
TIME
Growth trendPeak
Peak
Trough
Macro EquilibriumPR
ICE
LEVE
L (a
vera
ge p
rice)
REAL OUTPUT (quantity per year)
D1 S1QE
PE
Aggregatedemand
Aggregatesupply
P1
E
Macro Failures
• There are two potential problems with macro equilibrium:– Undesirability - the price-output relationship at
equilibrium may not satisfy our macroeconomic goals.
– Instability – even if the designated macro equilibrium is optimal, it may be displaced by macro disturbances.
An Undesired EquilibriumPR
ICE
LEVE
L (a
vera
ge p
rice)
QE
PE
Aggregatedemand
Aggregatesupply
E
Equilibriumoutput Full-employment output
QF
P*F
Stable or Unstable?
• Prior to 1930s, macroeconomists thought there could never be a Great Depression
• They believed that a market-driven economy was inherently stable and that government intervention was unnecessary.
Adam Smith1723 –1790
The Business Cycle in U.S. History
Growth recession
Long-term average growth (3%)
RecessionKorean War
World War II
Vietnam War
Great Depression
Source: U.S. Bureau of the census, The Statistics of the U.S.A.
Inflation and Unemployment: 1900-1940
24
20
16
12
8
4
0
– 4
– 8
1900 1910 1920 1930 1940
Inflation
Unemployment
Source: U.S. Bureau of the Census.
Macro Disturbances
FP*
QF
AS0
PRIC
E LE
VEL
(ave
rage
pric
e)
REAL OUTPUT (quantity per year)
(b) Demand shifts
AD0
AD1
FP*
QF
AD0
AS0
PRIC
E LE
VEL
(ave
rage
pric
e)
REAL OUTPUT (quantity per year)
(a) Supply shiftsAS1
GP1
Q1
P2
Q2
H
The Keynesian Revolution
• British economist, John Maynard Keynes developed an alternate view of the macro economy.
• Keynes asserted that a market-driven economy is inherently unstable.
1885 -1942
Government Intervention
• In Keynes’ view, the inherent instability of the marketplace required government intervention.
Fiscal Stimulus Package • 1960s, a tax cut in 1964 to stimulate economic
growth and reduce unemployment
• $168 billion fiscal stimulus package - the largest legislative initiative ever designed to ease an economic slowdown.
• According to the Congressional Budget Office (CBO), the goal of a fiscal stimulus is to boost economic activity by increasing short-term aggregate demand.
The Multiplier
• The cumulative decease in total spending is equal to the gap multiplied by the multiplier.
• A recessionary gap of $100 billion per year would decrease total spending by $400 billion per year (If MPC = 0.75).
The Multiplier Process
1. $100 billion in unsold goods appear
3. Income reduced by $100 billion 4. Consumption reduced by $75 billion
5. Sales fall $75 billion6. Further cutbacks in employment or wages
7. Income reduced by $75 billion more
8. Consumption reduced by $56.25 billion more
Factor markets
Product markets
Business firms
Households
9. And so on
2. Cutbacks in employment or wages
Fiscal Policy
• Fiscal policy is an integral part of modern economic policy.
• Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes.
The Multiplier Cycles
The Multiplier
Monetary Theories
• Money and credit affect the ability and willingness of people to buy goods and services.
• If credit isn’t available or is too expensive, consumers curtail the credit purchases and businesses might curtail investment.
Milton Friedman 1912 –2006)
Monetary Stimulus
• The goal of monetary stimulus is to increase aggregate demand.– Aggregate Demand – The total quantity of output
demanded at alternative price levels in a given time period, ceteris paribus.
Investment
• Lowering interest rates lowers the cost of borrowing which encourages investment.
• Increased investment injects new spending into the circular flow.
• The multiplier effect result in an even larger increase in aggregate demand.
Monetary Tools
• The Federal Reserve controls the money supply using the following three policy instruments:– Reserve requirements– Discount rates– Open-market operations
Monetary Policy - Last Two Recessions
• 1991 and 2001, the Fed lowered rates, and the impact was evident about nine months after the rate cuts started.
• In 1990, the Fed started cutting rates on July 13. The rate cuts were slow and small, but ten months later real GDP rose at a 2.6% annual rate starting in the second quarter of 1991.
• In 2001, the Fed started cutting rates Jan. 3. Nine months later, real GDP rose at a 1.6% annual rate in the fourth quarter, and was followed by a 2.7% growth rate in the first quarter of 2002.
List of the rate cuts and a rebound in GDP growth: from the start of the rate cut cycle to a rebound
• 1991: Six rate cuts totaling 200 basis points - to 6.0% in GDP in nine months
• 2001: Eight rate cuts totaling 350 basis points -to 3.0% in GDP in nine months
• 2007-08: Five rate cuts totaling 225 basis points - to 3.0% in GDP in five months
Limits on Monetary Restraint
• Two factors make it harder for the Fed to restrain aggregate demand:– Expectations.– Global money.
Constraints on Monetary Stimulus
Inelastic demand
Investment demand
Rate Of Investment
7
6
0
Inte
rest
Rat
e
Inelastic investment demand can also impede monetary policy
A liquidity trap can stop interest rates from falling
The liquidity trap
Inte
rest
Rat
e
E1 E2
g1 g2
Quantity Of Money
Demand for money
Shifts of Aggregate Supply
AS1
E1
Output (real GDP per period) 0
Pric
e Le
vel
(ave
rage
pric
e pe
r uni
t of o
utpu
t)
AD
AS2
E2
Rightward AS shifts reduce unemployment and inflation
Instability
• The aggregate supply curve shifts to the left when there is an increase in production costs.
• The aggregate demand curve shifts when volatility in currencies cause significant changes in import and export prices.
Aggregate Supply
• The macro economy experienced stagflation in the 1970s.
• Stagflation is the simultaneous occurrence of substantial unemployment and inflation.
Supply-Side Theories
• Decreases in aggregate supply cause inflation and higher unemployment.
• Increases in aggregate supply move us closer to both our price stability and full employment goals.
Supply-Side Theories
AD0
Q3
P3
QF
E0
AS0
REAL OUTPUT (quantity per year)
PRIC
E LE
VEL
(ave
rage
pric
e)
P0
AS1
E3
Supply-Side Policy
• Supply-side policy seeks to shift aggregate supply curve.
• Supply-side policy is the use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services.
Jean-Baptiste Say 1767-1832
Changes in Marginal Tax Rates Since 1915
Consumer Confidence
Financial Crisis
• Financial Crisis: banking crisis, exchange rate crisis, or a combination of the two
– Banking crisis: banking system’s becoming unable to perform its normal lending functions
• Disintermediation: banks becoming unable to serve as intermediaries between savers and investors
• Exchange rate crisis: sudden and unexpected collapse in the value of a nation’s currency
Domestic Issues in Crisis Avoidance
• Problem in financial sector regulation– Moral hazard: incentive to act in a manner that creates
personal benefits at the expense of the common good: e.g., banks have an incentive to make riskier investments when they know they will be bailed out
– Moral hazard problems are exacerbated by governments’ providing incentives or threatening banks to make bad loans for political ends
• In East Asian crisis, such loans gave rise to the term crony capitalism
New Deal - Shock TreatmentJumpstart the Economy
• Fiscal stimulus policies — public works projects, tax rebates.
• Policies that put money directly into the hands of those who were most likely to spend it are what pulled us out of the Great Depression.
• Example : $300 billion fiscal stimulus.
Example
• A $300 billion fiscal stimulus will lead to a $1 trillion economic impact.
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