Macroeconomics Policies


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Macroeconomics Policies

  1. 1. 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.
  2. 2. Warming up <ul><li>Q:Why did God create economists ? </li></ul><ul><li>A:In order to make weather forecasters look good. </li></ul><ul><li>Q. What does an economist do? </li></ul><ul><li>A. A lot in the short run, which amounts to nothing in the long run. </li></ul>
  3. 3. The Business Cycle Trough Peak Peak Peak Trough REAL GDP (units per time period) TIME Growth trend
  4. 4. Macro Equilibrium PRICE LEVEL (average price) REAL OUTPUT (quantity per year) D 1 S 1 Q E P E Aggregate demand Aggregate supply P 1 E
  5. 5. Macro Failures <ul><li>There are two potential problems with macro equilibrium: </li></ul><ul><ul><li>Undesirability - the price-output relationship at equilibrium may not satisfy our macroeconomic goals. </li></ul></ul><ul><ul><li>Instability – even if the designated macro equilibrium is optimal, it may be displaced by macro disturbances. </li></ul></ul>
  6. 6. An Undesired Equilibrium PRICE LEVEL (average price) Q E P E Aggregate demand Aggregate supply E Equilibrium output Full-employment output Q F P* F
  7. 7. Stable or Unstable? <ul><li>Prior to 1930s, macroeconomists thought there could never be a Great Depression </li></ul><ul><li>They believed that a market-driven economy was inherently stable and that government intervention was unnecessary. </li></ul>Adam Smith 1723 –1790
  8. 8. The Business Cycle in U.S. History Korean War World War II Vietnam War Great Depression Source: U.S. Bureau of the census, The Statistics of the U.S.A. Growth recession Long-term average growth (3%) Recession
  9. 9. Inflation and Unemployment: 1900-1940 Source: U.S. Bureau of the Census. 24 20 16 12 8 4 0 – 4 – 8 1900 1910 1920 1930 1940 Inflation Unemployment
  10. 10. Macro Disturbances AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) ( b ) Demand shifts AD 0 AD 0 AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) ( a ) Supply shifts F P* Q F AD 1 F P* Q F AS 1 G P 1 Q 1 P 2 Q 2 H
  11. 11. The Keynesian Revolution <ul><li>British economist, John Maynard Keynes developed an alternate view of the macro economy. </li></ul><ul><li>Keynes asserted that a market-driven economy is inherently unstable. </li></ul>1885 -1942
  12. 12. Government Intervention <ul><li>In Keynes’ view, the inherent instability of the marketplace required government intervention. </li></ul>
  13. 13. Fiscal Stimulus Package <ul><li>1960s, a tax cut in 1964 to stimulate economic growth and reduce unemployment </li></ul><ul><li>$168 billion fiscal stimulus package - the largest legislative initiative ever designed to ease an economic slowdown. </li></ul><ul><li>According to the Congressional Budget Office (CBO), the goal of a fiscal stimulus is to boost economic activity by increasing short-term aggregate demand. </li></ul>
  14. 14. The Multiplier <ul><li>The cumulative decease in total spending is equal to the gap multiplied by the multiplier. </li></ul><ul><li>A recessionary gap of $100 billion per year would decrease total spending by $400 billion per year (If MPC = 0.75) . </li></ul>
  15. 15. 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 billion 6. 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
  16. 16. Fiscal Policy <ul><li>Fiscal policy is an integral part of modern economic policy. </li></ul><ul><li>Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes. </li></ul>
  17. 17. The Multiplier Cycles
  18. 18. The Multiplier
  19. 19. Monetary Theories <ul><li>Money and credit affect the ability and willingness of people to buy goods and services. </li></ul><ul><li>If credit isn’t available or is too expensive, consumers curtail the credit purchases and businesses might curtail investment. </li></ul>Milton Friedman 1912 –2006)
  20. 20. Monetary Stimulus <ul><li>The goal of monetary stimulus is to increase aggregate demand. </li></ul><ul><ul><li>Aggregate Demand – The total quantity of output demanded at alternative price levels in a given time period, ceteris paribus. </li></ul></ul>
  21. 21. Investment <ul><li>Lowering interest rates lowers the cost of borrowing which encourages investment. </li></ul><ul><li>Increased investment injects new spending into the circular flow. </li></ul><ul><li>The multiplier effect result in an even larger increase in aggregate demand. </li></ul>
  22. 22. Monetary Tools <ul><li>The Federal Reserve controls the money supply using the following three policy instruments: </li></ul><ul><ul><li>Reserve requirements </li></ul></ul><ul><ul><li>Discount rates </li></ul></ul><ul><ul><li>Open-market operations </li></ul></ul>
  23. 23. Monetary Policy - Last Two Recessions <ul><li>1991 and 2001, the Fed lowered rates, and the impact was evident about nine months after the rate cuts started.  </li></ul><ul><li>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. </li></ul><ul><li>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. </li></ul>
  24. 24. List of the rate cuts and a rebound in GDP growth: from the start of the rate cut cycle to a rebound <ul><li>1991: Six rate cuts totaling 200 basis points - to 6.0% in GDP in nine months </li></ul><ul><li>2001: Eight rate cuts totaling 350 basis points -to 3.0% in GDP in nine months </li></ul><ul><li>2007-08: Five rate cuts totaling 225 basis points - to 3.0% in GDP in five months </li></ul>
  25. 25. Limits on Monetary Restraint <ul><li>Two factors make it harder for the Fed to restrain aggregate demand: </li></ul><ul><ul><li>Expectations. </li></ul></ul><ul><ul><li>Global money. </li></ul></ul>
  26. 26. Constraints on Monetary Stimulus Inelastic demand Investment demand Rate Of Investment 7 6 0 Interest Rate Inelastic investment demand can also impede monetary policy A liquidity trap can stop interest rates from falling The liquidity trap Interest Rate E 1 E 2 g 1 g 2 Quantity Of Money Demand for money
  27. 27. Shifts of Aggregate Supply AS 2 E 2 Rightward AS shifts reduce unemployment and inflation AS 1 E 1 Output (real GDP per period) 0 Price Level (average price per unit of output) AD
  28. 28. Instability <ul><li>The aggregate supply curve shifts to the left when there is an increase in production costs. </li></ul><ul><li>The aggregate demand curve shifts when volatility in currencies cause significant changes in import and export prices. </li></ul>
  29. 32. Aggregate Supply <ul><li>The macro economy experienced stagflation in the 1970s. </li></ul><ul><li>Stagflation is the simultaneous occurrence of substantial unemployment and inflation. </li></ul>
  30. 33. Supply-Side Theories <ul><li>Decreases in aggregate supply cause inflation and higher unemployment. </li></ul><ul><li>Increases in aggregate supply move us closer to both our price stability and full employment goals. </li></ul>
  31. 34. Supply-Side Theories AD 0 AS 0 REAL OUTPUT (quantity per year) PRICE LEVEL (average price) Q 3 P 3 Q F E 0 P 0 AS 1 E 3
  32. 35. Supply-Side Policy <ul><li>Supply-side policy seeks to shift aggregate supply curve. </li></ul><ul><li>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. </li></ul>Jean-Baptiste Say 1767-1832
  33. 36. Changes in Marginal Tax Rates Since 1915
  34. 40. Consumer Confidence
  35. 43. Financial Crisis <ul><li>Financial Crisis : banking crisis, exchange rate crisis, or a combination of the two </li></ul><ul><ul><li>Banking crisis : banking system’s becoming unable to perform its normal lending functions </li></ul></ul><ul><ul><ul><li>Disintermediation : banks becoming unable to serve as intermediaries between savers and investors </li></ul></ul></ul><ul><ul><ul><li>Exchange rate crisis : sudden and unexpected collapse in the value of a nation’s currency </li></ul></ul></ul>
  36. 44. Domestic Issues in Crisis Avoidance <ul><li>Problem in financial sector regulation </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>Moral hazard problems are exacerbated by governments’ providing incentives or threatening banks to make bad loans for political ends </li></ul></ul><ul><ul><ul><li>In East Asian crisis, such loans gave rise to the term crony capitalism </li></ul></ul></ul>
  37. 45. New Deal - Shock Treatment Jumpstart the Economy <ul><li>Fiscal stimulus policies — public works projects, tax rebates. </li></ul><ul><li>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. </li></ul><ul><li>Example : $300 billion fiscal stimulus. </li></ul>
  38. 46. Example <ul><li>A $300 billion fiscal stimulus will lead to a $1 trillion economic impact. </li></ul>