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.

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.

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 Peak Peak Trough REAL GDP (units per time period) TIME Growth trend

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

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.

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 Equilibrium PRICE LEVEL (average price) Q E P E Aggregate demand Aggregate supply E Equilibrium output Full-employment output Q F 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 Smith 1723 –1790

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.

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

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

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

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

British economist, John Maynard Keynes developed an alternate view of the macro economy.

Keynes asserted that a market-driven economy is inherently unstable.

Government Intervention In Keynes’ view, the inherent instability of the marketplace required 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.

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 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 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

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.

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)

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.

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.

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.

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

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.

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

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.

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 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

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

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.

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.

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.

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 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

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

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.

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

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

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 Treatment Jumpstart 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.

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.

A $300 billion fiscal stimulus will lead to a $1 trillion economic impact.