on this page:
~ Active & Passive Policy, Lags, Expectations,
Phillips Curve
~
Federal Budget, Budget Deficits, Interest Rates
~ Trade, Gains,
Advantages, Trade Restrictions
~ Exchange Rate, BOP, Trade Balance, Current & Capital
Accounts
- private sector is unstable
- economic fluctuations happen because of the private sector (investment)
- natural forces can’t help the economy
- government should use discretionary policy
- prices and wages are not flexible
- economy does not quickly adjust to unemployment, etc. The longer it takes it to improve, the more output we have to sacrifice while we are waiting
- thus, we need to use a stabilization policy so that we can move AD in order to achieve the natural rate of output and price stability
Example.
· Contractionary gap: Economy is in recession, (below potential output). Government uses monetary or fiscal policy to move AD up, which sloes the contractionary gap. (However, in order to do this, you cause inflation, and it also worsens the budget deficit, and increases national debt).
· Expansionary gap: Short-run equilibrium is higher than economy’s potential. Government should reduce AD (move it downwards) ® close the gap through a decrease in aggregate demand. This avoids the increased costs that happen when you use passive policy
Problems:
- identifying the economy’s potential output level
- formulating an effective an effective policy requires detailed knowledge of current and future economic conditions (they must be able to predict what will happen with a passive policy)
- they must have tools necessary to achieve the desired results quickly
- must be able to forecast the effects of the economy on the economy’s key performance measures
- policy makers must work together: but congress, president and Fed often are not coordinated.
- Must be able to implement the appropriate policy, even if it involves short-term political costs
-
Must be able to deal with a variety of lags.
PASSIVE POLICY
- private sector is stable
- natural market forces (self-correction mechanism) move economy back to equilibrium
- government intervention just screws everything up (causes instability of the economy)
- economy will always naturally tend to move back to equilibrium (potential GDP)
- Self correction mechanism: wages and prices are flexible, so they will adjust:
Example.
· Contractionary Gap: If unemployment is high ® wages decrease ® production costs decrease ® AS shifts right ® economy will move to potential level of output.
· Expansionary gap: economy above it’s potential. Government should wait for market forces to prompt firms and workers to negotiate higher wages. ® higher production costs ® AS curve moves up and to the left ® higher price level and output reduced to the level of the economy’s potential. So, although it does move the economy back in place, it also causes higher prices.
LAGS
- lags occur when using active policy:
- there is long, sometimes unpredictable lags at several stages in this process (between what government does and the time when the desired result happens). These lags reduce effectiveness and increase uncertainty of active policies.
· recognition lag: the time it takes to recognize a problem and determine how serious it is
· decision-making lag: policy makers usually take additional time deciding what the correct action is.
· Implementation lag: time to introduce new policy.
· Effectiveness lag: time before the full impact of the policy registers on the economy.
All these problems cause it very hard for active policy to be effective.
Passive approach avoids these problems. Proponents of the passive
approach argue that this just causes fluctuations at the price level and real
GDP, because it often doesn’t really happen until self-correcting market forces
have already returned the economy to its potential output level. These lags are
also reason enough NOT to use active policy.
- effectiveness of government policies depends on expectations of people
- rational expectations : people form expectations on the basis of available information, including information about the probable future actions of policy makers
- if Fed announced it would serve the money needs of an economy at potential level. The Fed could do this with a constant-price plan. This would work if wage increases wouldn’t exceed growth in labor productivity. If wages were to increase, this would cause inflation. So, if the Fed follows through with this, the price level will turn out as expected.
- However, if firms and workers agreed on nominal wages, public officials will become alarmed with prevailing level of unemployment, so the Fed might have to increase AD (use expansionary monetary policy).
- This action will then increase AD, which will stimulate output and unemployment, while boosting price level. This will temporarily boost output and reduce unemployment.
- However, since this now causes higher prices, workers will request higher wages, which will cause AS to move to the left. This restores potential GDP, but still increases the price level.
- Thus, even though in the short-run it causes increase in output and employment, in the long-run, it causes higher prices and higher inflation
Time inconsistency problem: when policy makers announce one policy to influence expectations, but then pursue a different policy once those expectations have been formed and acted on.
Anticipation: So, people can learn to predict and anticipate these actions of the government, so as to not get fooled. They can learn to correctly anticipate these actions. If the economy is producing at potential output, an expansionary monetary policy, if correctly anticipated, will have no effect on output or employment. If the changes are unanticipated, the policy can temporarily influence output and employment.
In other words: monetary policy is usually fully anticipated by workers and firms, so it has no effect on the level of output. It effects only price level. So, only unexpected changes in policy can bring about short-run changes in output.
Policy credibility: For the Fed to pursue a policy consistent with a constant price level, its announcements must be credible (believable). The Fed could, for example, offer insurance policies, or promise to resign if they don’t purse the announced course.
Cold turkey: a popular (and efficient) anti inflation policy: the Fed announces and executes tough measures (such as decreasing money supply).
PHILLIPS CURVE
- The Phillips curve says that there is a direct trade-off between inflation and unemployment:
¯ inflation ® unemployment
¯ unemployment ® inflation
- for the most part, this held true, until the 1970s. Then it showed it didn’t hold true: a decrease in AS cause both higher inflation and higher unemployment
inflation + unemployment = stagflation.
this stagflation was at odds with the Phillips curve.
- long-run Phillips curve takes this into account: when employers and workers have the time and ability to adjust fully to unexpected changes in DC, the Phillips Curve is a vertical line drawn at the economy’s natural rate of unemployment. Thus, the rate of unemployment is independent of the rate of inflation.
This means that there is NOT a trade-off between unemployment and inflation, and you can make policy that doesn’t cause either of them.
Federal Budget, Budget Deficits, Interest Rates
- plan for government outlays and revenues for a year.
- Outlays: government purchases and transfer payments
- social security, medicare, welfare payments (50%), national defense (16%), interest payments (14%).
- Fiscal year: period covered by the federal budget. Oct 1- Sept 30.
Presidential role: each agency prepared a budget request, president submits The Budget to the US Government (president’s proposal), then submits Economic Report of the President to Congress.
Congressional role: after president submits proposal, budget committees in House and Senate rework it and make an outline. Then the outline is approved by Congress as a budget resolution.
Problems with the budget process:
· continuing resolutions instead of budget decisions
· overlapping committee authority
· lengthy budget process
· uncontrollable budget items (about ¾ of the budget outlays are determined by existing laws, can’t be changed – such as interest on the national debt)
· overly detailed budget
- if government purchases + transfer payments exceed government revenue = budget deficit. (since 1960, US has had a deficit
- deficits usually occur during wars and severe recessions, but in the US deficits remained large during the economic expansion of the 1980s. That deficit occurred because of tax cuts (early 80s) and growth in federal spending.
- Rationale: it is used for economy’s productivity (highways, dams etc). the cost of these projects should be paid by future taxpayers, who will also benefit from the investments (so, it is ok to borrow to finance these projects).
- before Depression: deficits happened only during wartime, and these were mostly self-correcting.
-
after Depression: John Keynes argued that government spending
can actually compensate for any drop in investment spending.
The federal deficit increases during recessions because, as economic activity
slows --> unemployment increases --> increases government outlays for
unemployment benefits and other transfer payments. Then, as business activity
expands, so do jobs, income etc, which will cause federal revenue to grown,
transfer payments to decline, so the deficit shrinks back to where it should be.
Philosophies concerning deficits:
· annually balanced budget – (before Depression) aims at equating revenues with outlays
· cyclically balanced budget – budget deficits during recessions should be financed by budget surpluses during expansions
· functional finance – fiscal policy should achieve potential GDP, rather than balancing budget annually or over the business cycle.
Deficit can arise from different things. A deficit that arises from discretionary fiscal policy à higher real output à higher price level à higher interest rate.
Outcome of deficits:
There is no clear and consistent relationship between deficits and other measures of performance such as output, price level, and interest rates.
· if AD decreases and we have a recession, deficits increase because of automatic stabilizers, but output, inflation rate, and interest rates decline.
· if AD increases, deficits increase, so do output, price level and interest rates.
Example:
Deficit can arise from different things. A deficit that arises from discretionary fiscal policy --> higher real output --> higher price level --> higher interest rate.
It is very important to notice what deficits do to interest rates, because interest rates are directly related to investment, and investment is crucial to economic growth.
- government operating above its potential:
-
federal government makes a deficit: sells securities. This increases
government’s demand for credits à
rises interest rates à discourages (crowds
out) private investment à
reduces the deficit expansionary effect.
- It is not proven what this exactly does. Maybe:
· government borrowing displaces some private-sector borrowing, but this discretionary fiscal policy will result in a net increase in DC
· crowding out is extensive, so borrowing from the public could results in little or no increase in AD.
Problem of crowding out: deficits crowd out private capital formation, which decreases private investment à reduces economy’s ability to grow.
- if economy operating below its potential:
- additional fiscal stimulus provided by deficit -->encourages firms to invest more à higher level of investment.
(business expectations largely cause firms to be encouraged to invest more, because a government deficit could stimulate a weak economy, increasing AD, and boosting employment – making business expectations positive.
- as firms have higher expectations, they are more willing to invest, so this is crowding in (= stimulating private investment)
National debt = the accumulation of federal budget deficits.
Gross debt – US Treasury securities (ex. Social security). This is government owing to itself, so it is often ignored.
Debt held by the public – debt by households, firms, bank, and foreign entities.
- As a percentage of GDP, our national debt has doubled since 1980.
Measure of debt:
· Total debt = all outstanding liabilities of federal, state, and local governments
· Net debt = subtracts the government’s’ financial assets (loans to students and farmers, foreign exchange on reserve, etc)
Problems of debt to foreigners: future payments to service this debt are paid to foreigners and are thus not available to US citizens – so the deficits of one generation can reduce the standard of living of the next.
Current situation: US budget deficit peaked in 1992 ($290 billion), but turned into a surplus in 1998 (because of higher tax rates, reduced outlays especially for defense, declining interest rates, and a strengthening economy).
Trade, Gains,
Advantages, Trade Restrictions
Gains from trade – each country concentrates on producing those goods which involved the lowest opportunity cost.
- gains from trade exist whenever there is a difference between opportunity costs of two goods
Autarky – situation of national self-sufficiency in which there is no economic interaction with foreigners.
Absolute advantage – the country that can produce the good with less opportunity cost than the other country
Comparative advantage – even when a country has a higher opportunity cost, it will still benefit from international trade, as long as it specializes in that good with the lower opportunity cost.
- This means that even if one country has an absolute advantage in both goods, because of the differences in opportunity cost, BOTH countries will benefit from trading.
- This means that comparative, not absolute advantage, is the source of gains in trading.
Terms of trade – how much of one good is exchange for a unit of another good.
Consumption possibilities frontier – shows a nation’s alternative combinations of goods available as a result of production and foreign trade.
The only constraint on trade is that total world production must equal total world consumption
§ Resource differences – countries have different quantities and qualities of resources. Each country should export those products that they can produce more cheaply in return for those that are unavailable domestically or are more costly to produce than to buy from other countries.
§ Economies of scale – when cost ¯ as production . Countries gain from trade if each nation specializes – they can then produce at a greater output rate which ¯ output costs.
§ Taste differences – even if all countries had same resources with equal efficiency, they would *still* benefit from trade, if they had different trades and preferences.
TRADE RESTRICTIONS
Trade restrictions are placed to protect domestic industries. They usually benefit domestic producers but harm domestic consumers.
Consumer and producer surplus
- consumer surplus – the bonus consumers get from market exchange
- producer surplus – the bonus producers get from market exchange
- taxes on imports. Can be ad valorem (percentage of price of imports) or specific (with exact predetermined amounts)
- world price – price at which good is traded internationally. It is determined by the world supply and demand for the good.
- legal limits on the quantity of particular commodity that can be imported
- in order for it to be effective, it must restrict imports to less than the amount imported with free trade.
- An effective quota will limit imports so that the domestic price is higher than the world price and the domestic quantity is lower than the free-trade level.
- other restrictions include export subsidies (encouraging firms to export), low-interest loans (to foreigners, to promote exports of large capital goods) and domestic content requirements (to make it so that foreign firms have to make a certain percentage of the final good in the US)
Advantages/disadvantages of trade restrictions:
- infant industries – new domestic firms need to be protected from foreign competitors until they are strong enough to be competitive, so we need restrictions.
- anti-dumping – (dumping = selling a commodity abroad at a price hat is below its cost of production in the home market) – we should allow dumping to happen, because there is no reason why consumers should no t be allowed to buy imports for a persistently lower price.
- jobs and income – tariffs protect US jobs and wage levels. If a foreign firm comes in and forces a US firm out of business, US workers will lose jobs. (However, this might hurt international trade, which will make everyone in the US worse off).
- declining industries – when domestic firms are in jeopardy of being displaced by lower-priced imports, we should introduce temporary restrictions to allow for adjustment of domestic industry.
Exchange Rate, BOP, Trade Balance, Current & Capital Accounts
Exchange rate is the price of one currency in terms of the other. It is the means by which the price of a good produced in one country gets translated into the price to the buyer in another country.
GDP – measures the flow of economic activity that occurs within that country during a given period.
BOP – Balance of Payments – summarizes all economic transactions that occur during a given time period time period between residents of that country and residents of other countries. (residents = individuals, firms and governments)
- measures economic transactions between countries (goods, services, transfer payments etc)
- measures a flow – volume of transactions.
- Accounts are maintained according to the principle of double-entry bookkeeping. The ones on the left are debits, the ones on the right are credits (so, a deficit ion part can be offset by a surplus in the other)
- The total debits must be equal to the total credits.
Merchandise trade balance
· merchandise X – merchandise M
· reflects trade in tangible products (trade balance)
· US merchandise exports are listed as credit (US residents must be paid off for imported goods)
· US merchandise imports are listed as debit (US residents pay for imported goods)
If X>M, there is a trade surplus
If M>X, there is a trade deficit
- X of goods and services – M of goods and services
- reflects trade in services
- services = transportation, insurance, banking, consulting, and tourist expenditures. Also sometimes called “invisible”.
- usually just subtract imports from exports to get net exports.
- GDP = total expenditures for consumption, investment, government purchases, and net exports.
- government transfers to foreign residents, foreign aid, personal gifts to friends and relatives aboard, personal and institutional charitable donations, etc.
- net unilateral transfers = transferred received from abroad by US residents minus transfer sent to foreign residents.
- Balance on current account – the section in the BOP account that measures the sum of the country’s net unilateral transfers and its balance on goods and services
balance on current account = net unilateral transfers + balance on goods and services
- Record of a country’s international transactions involving flow or sales of financial and real assets
- The US is now the world’s largest net debtor nation
- Official reserve transactions account = net amount of international serves that shift among central banks to settle international transactions.
- section of BOP that reflects flow of international reserves.
- international reserves = gold, dollars, euros, Special Drawing Rights, currencies among central banks, etc.
- to ensure that the two sides of the BOP are in balance, statistical discrepancy is created
- statistical discrepancy = offsets excess of credits or debits in all other accounts by an equivalent debit or credit in the discrepancy account
- provides annalists with a measure of the net error in the BOP
· Current transactions – income and expenditures from exports, imports, and unilateral transfers
· Capital transactions – international investments and borrowing
Ø debit entries in current & capital accounts ® in demand for foreign exchange ® depreciation of the dollar
Ø credit entries in current & capital accounts ® in supply of foreign exchange ® appreciation of the dollar
Copyright © 2004 by TP. All rights reserved.
Revised:
05/15/07 14:35:10 -0700.