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.