THREE ECONOMIC THEORIES

THREE ECONOMIC THEORIES

1) CLASSICAL

• an economy will always move towards equilibrium at full capacity and full employment

• Aggregate demand will adjust to full potential GDP, assisted by flexible wages and prices (wage contracts and resource price agreements can be renegotiated)

• Market clearing: an assumption that pricesare flexible and adjust to equate supply anddemand; Market is SELF-CORRECTING!!!!

• In long run, all prices are variable (if price level increases, wages increase thus profit-maximizing firms will not change production; price increase, quantity doesn’t change thus a vertical LRAS)

2) KEYNESIAN

• British economist John Maynard Keynes took the viewpoint that spending induces businesses to supply goods and services.

•  If consumers become pessimistic about their futures and cut down on their spending, then business will reduce their production. 

• He rejected the classical viewpoint that unemployment would be resolved by flexible wage rates; instead, wages are viewed as being "sticky”

• In the short run, many prices are sticky (fixed); they adjust only sluggishly in response to supply/demand imbalances; wages are fixed in SR, then as price increases, total revenue increases and profit-maximizing firms will increase production (price increase, quantity increase thus an upward sloping SRAS curve)

Downward Price Inflexibility (why prices do not change during recessions) – “sticky” wages/prices

• Fear of price wars

• Menu costs

• Wage contracts

• Morale, effort, and productivity (cutting wages reduces productivity)

• Minimum wage

3) SUPPLY SIDE ECONOMICS

FISCAL POLICY

What is Fiscal Policy?

• Changes in federal taxes and federal government spending designed to affect the level of aggregate demand in the economy

• Conducted by President, Congress, and Council of Economic Advisers (CEA)

• DISCRETIONARY SPENDING: when government stabilizes the economy by passing a law or taking some other specific action to change its tax and/or spending policies

EXPANSIONARY FISCAL POLICY

• During recessions, AD is usually too low to bring about full employment of resources.

• Government can:

• Increase government spending

• Cut taxes• Results in budget deficits because government spends more

than it collects in taxes• Increased government spending without increasing taxes OR

decreasing taxes without decreasing government spending should increase AD, increasing employment, the price level, or both.

• If increase in government spending…

• If there is a GDP gap of $20 billion and MPC is .75 (multiplier 4), then the government can inject $5 billion into the economy ( 5 multiplied 4 times which equals $20 billion)

• Will shift AD curve to the right

• Economy moves back to full employment

• If decrease in taxes…• must be somewhat larger than the

proposed increase in government spending if it is to achieve the same amount of rightward shift in AD curve

• If MPC is .75 and you want to increase new consumption by $5B, must cut taxes by $6.67B because $1.67 B is saved

Combined government spending and tax cuts…

• If economy has a $20B gap (below full employment), the government could increase its spending by $1.25 B and cut taxes by $5 B

Government Spending Financed by Tax Increases

• Suppose government spending rises by $100 billion and that this expenditure is financed by a tax increase of $100 billion…such a “BALANCED BUDGET” change in fiscal policy will cause REAL GDP TO RISE (AD INCREASE)

• Example…if taxes increase by $100, consumers will not cut their spending by $100 but will cut it by some fraction, say 9/10, of the increase; if consumers spend 90% of a change in their disposable income, then a tax increase of $100 would lower consumption by $90.

• So…the net effect of raising government spending and taxes by the same amount is an increase in AD (assuming AS is not affected)• AS may also be affected by increase in taxes• When taxes increase, workers have less incentive to work because their after-

tax income is lower• The cost of taking a day off or extending a vacation for few extra days is less

than it is when taxes are lower and after-tax income is higher• When taxes go up, then, output can fall, causing AS to shift to left

(justification of supply-side economics/Laffer Curve)

Government Spending Financed by Borrowing

• Borrowing to finance government spending can also limit the increase in aggregate demand

• Government borrows funds by selling bonds to public • debt that must be repaid back at a future date which

means taxes will have to be higher in the future in order to provide the government with funds to pay off debt

• This can limit expansionary effect of increased government spending (if taxes increase in future)…households and businesses will begin to save more today so they will be able to pay taxes in the future)

CONTRACTIONARY FISCAL POLICY

• If AD is too high, creating inflationary pressure, government can:• Reduce it spending

• Increase taxes

• both

• Economy will experience less employment, lower price level, or both

• These actions result in larger budget surplus or smaller budget deficit

If decrease government spending…

• Increases in AD expand output beyond full employment, increasing price level but declines in AD rarely decrease price level back to previous level.

• Contractionary policies are to halt rise in price level (eliminates a continuing positive inflationary gap)

If increase taxes…

• Used to reduce consumption spending

• If there is an inflationary gap (demand-pull inflation) of $20B and MPC is .75, the government can increase taxes by $6.67B

Combined government spending decreases and tax increases…

• Can do both to reduce AD and control inflation

Policy Options: G or T?

• Depends largely on one’s view as to whether the government is too large or too small

AUTOMATIC/BUILT IN STABILIZERS

Definition

• economy stabilizing by itself as the economic situation changes due to things that are already built into the system such as…

• Transfer Payments• unemployment compensation (if laid off, you may qualify for

unemployment benefits which helps them buy necessities and helps AD from falling too much)• Food Stamps

• Tax Progressivity• When incomes are high, tax liabilities rise and eligibility for

government benefits falls, without any change in the tax code or other legislation. • When incomes slip, tax liabilities drop and more families become

eligible for government transfer programs, such as food stamps and unemployment insurance, that help buttress their income.• This process acts as an automatic stabilizer during inflationary

episodes because as income rises, tax collections rise even faster, accelerating withdrawals from the economy and dampening inflationary growth of nominal income (vice versa)

Problems of Fiscal Policy

• Problems of timing• Recognition lag – time of beginning of recession/inflation to

awareness that it is actually happening

• Administrative lag - time of need for fiscal policy action and time action is taken (think about DIVIDED GOVERNMENT)

• Operational lag – time fiscal action is taken and the time that action affects output, employment, or the price level (tax cuts immediate; government spending takes planning)

• Political considerations• It’s a human trait to rationalize actions/policies that are in

one’s self-interest• Decisions may be made according to reelection and not in

best interest of economy

• Future policy reversals• Fiscal policy actions may fail to achieve its intended

objectives if households expect future reversals of policy (example, tax cut…if people believe it is temporary, they may save a large portion of tax saving and vice versa)

• Offsetting state and local finance• Policies of state/local governments are frequently pro-

cyclical (they worsen rather than correct recession or inflation); many states face challenge of balancing the budget

• Crowding-out effect (MUST KNOW)• An expansionary fiscal policy (deficit spending) may increase the

interest rate and reduce private spending, thereby weakening or canceling the stimulus of the expansionary policy

• If in recession, government increases its spending, and money supply held constant…to finance its budget deficit, the government borrows funds in the money market, resulting in an increase in demand for money; this results raises the price paid for borrowing money (the interest rate); this increased interest rate will crowd out investments

• Most economists will agree that budget deficit is inappropriate when economy has achieved full employment (will crowd out private investment); some economists disagree if this exists under all circumstances

STOP!!!!!!!!!!!!!

The National/Public Debt

• Define: total accumulation of the deficits (minus the surpluses) the Federal government has incurred through time

• Deficits occur due to: war financing, recessions, and fiscal policy (and lack of political will)

• Who owns?• Public owns 49% of debt (individuals, foreign nations, banks, local/state

governments)• Federal government/agencies 51% (Federal Reserve, U.S. government

agencies)• Represents how much Federal government owes to holders of U.S.

securities (financial instruments issued by the Federal government to borrow money to finance expenditures that exceed tax revenues)• Treasury bills (short-term securities)• Treasury notes (medium-term securities)• Treasury bond (long-term securities)• U.S. saving bonds (long-term, nonmarketable bonds)

Concerns of Public Debt

• Will it bankrupt nation or place tremendous burden on your children/grandchildren? FALSE CONCERNS

• Does not threaten to bankrupt Federal government. There are two reasons why:• Refinancing : public debt easily refinanced by selling new

bonds (high demand…no risk of default by government)

• Taxation: government has authority to levy and collect taxes; can increase taxes

Burdening Future Generations

• Public debt doesn’t impose as much burden on future generations as commonly thought

• Repaying public debt owned by Americans would not change purchasing power (from Americans to Americans)

• only repaying 25% of public debt owned by foreigners would negatively impact U.S. purchasing power

Public Debt Concerns• Distribution of ownership of government securities is highly uneven

• Debt necessitates annual interest payments of $184 billion• Interest charge must be paid out of tax revenues

• Higher taxes may dampen incentives to bear risk, innovate, invest, work

• May impair economic growth

• 25% of U.S. debt held by citizens of foreign countries • An economic burden to Americans

• Enables foreigners to buy some of our output

• U.S. transfers goods/services to foreign lenders

• Crowding-Out Effect• Passes on to future generations a smaller stock of capital goods

• Drives up interest rates, which reduces private investment spending

• Future generations may inherit economy with smaller production capacity and lower standard of living