This Summary of Macroeconomics - Krugman & Wells is written in 2016 and donated to JoHo WorldSupporter
At the core of economics lies the notion of individual choice, meaning that economics assumes that all individuals make decisions on what to do and what not to do. Additionally, we can find four principles that build up this notion:
People must make choices because resources are scarce
The first principle assumes that resources—anything that can be used to produce something else—are always scarce, as there are simply not enough resources to satisfy all of the world’s demands. The most important resources are land, labor, capital, and human capital; nevertheless, there are many more to name, such as clean air, which has been made a scarce resource due to pollution. It could be that an individual wants to buy a house close to his/her work (time); however, the only affordable house (money) in the area is next to a factory (clean air). The individual will have to make a choice on what s/he finds most important, due to the scarcity of resources. Sometimes we can find decisions that are better not left at the choices individuals make, which will be discussed in the later chapters.
The opportunity cost of an item is its true cost
The opportunity cost is what we give up in order to get an item we want. This can be money, such as in situations where you ‘give up’ money in order to buy a new car, but this can also be time or something else. It can be helpful to think of an opportunity cost as an addition to the monetary cost of an item, as it entails everything that is given up in order to acquire a specific item. If in the aforementioned situation, the individual had to choose between going on holiday and buying a new car, the opportunity cost would be not going on holiday.
“How much” decisions require making trade-offs at the margin
As resources are scarce, decisions on how much of a specific resource to use have to be made. A trade-off is a comparison of costs and benefits of using a specific resource, and the decision made after the comparison is called a marginal decision—a decision at the margin.
People usually respond to incentives—opportunities to make themselves better off
The final principle is one of the main assumptions made by economists; in fact, it underlies all analyses made by them. It is assumed, that if given the chance, people will always choose for the better option, no matter what. This also means that economists assume that if there is no change in incentive, people’s behavior will not change either.
Choices made by individuals both depend, and affect choices made by other individuals and therefore have consequences on a larger scale than just for one individual. This notion also has several principles that underlie it:
There are gains from trade
Economists assume that in order for everyone to become better off, trade—providing goods and services to others and receiving goods and services in return—is necessary. This is because in order to trade, people need to divide tasks; in turn, dividing tasks allows for specialization in those tasks that they can do best. If everyone does what they do best the economy as a whole can produce more, in effect increasing everyone’s standards of life. As there will always be people with different specializations, we can assume that we will have access to all goods and services necessary.
Because people respond to incentives, markets move toward equilibrium
When people respond to incentives to get the best opportunity they can get, there will be a point when there are no more gains to be had. This particular point is called equilibrium—an economic situation when no individual would be better off doing something different. Usually equilibrium is reached through a change in prices, which can either rise or fall and as a result, eliminating individuals’ opportunities as they all have achieved the best they can get.
Resources should be used as efficiently as possible to achieve society’s goals
This principle entails that full efficiency can only be reached if it makes everyone better off and no one worse off. Economies can only be fully efficient when all resources are used in such a way that there are no more opportunities to be gained and everyone is better off. However, there are cases where efficiency conflicts with other goals societies have made: most societies are also concerned with issues of equity, and policies that promote equity usually lead to a loss of efficiency. Examples of this are policies such as minimum wage and rent ceilings, which will be discussed in later chapters.
Because people usually exploit gains from trade, markets usually lead to efficiency
At the heart of this principle is the assumption that when people gain from trade they will not choose to do something from which they will not gain. If an individual can specialize, and therefore gain, the individual will not attempt to undermine this gain. As a result s/he will his his/her resources in such a manner that will lead to the best opportunities s/he can get. Finally, through looking at principle seven, this would mean that everyone would become better off and market efficiency will be reached.
When markets don’t achieve efficiency, government intervention can improve society’s welfare
There are three main ways on why markets fail: side effects of individual’s decisions (air pollution), one party preventing mutual benefits (monopolistic behavior), and the nature of some goods being inefficient for market control (national defense). Governments usually intervene by changing incentives, because incentives are what usually change an individual’s decision.
Besides interaction between economies it is also important to see the bigger picture of how the economy behaves. This leads us to the final three principles:
One person’s spending is another person’s income
A market economy assumes a type of domino effect: when one person buys a house this money would go to the agency selling the house; however, before this, the agency bought the house from a contractor who in turn hired builders, plumbers, and maybe even an architect. In a market economy everything is commodified; everything has a price and as a result every penny spend or not spend, leads to either an increase or decrease of another’s income.
Overall spending sometimes gets out of line with the economy’s productive capacity
The economy is never stagnant. There are always, and always will be, periods when overall spending increases or decreases. When overall spending is too high an economy experiences inflation: this happens when there are many people spending, however there is not enough being produced and therefore producers will raise their prizes if there are still customers willing to buy. This can also happen the other way around causing deflation.
Government policies can change spending
As discussed before, government policies can change incentives that influence individuals’ decisions. Furthermore, government’s themselves can also choose to spend, which they usually do on things such as education, military equipment, and infrastructure to name a few. Finally, the government also controls the money supply—the total amount of money in circulation— that also influences total spending.
As real-life situations can be very complicated, we can use model—simplified representations of reality—to better understand these situations. Models are used because it allows economists to look at one input at a time and better see what causes changes in the economy. The most important assumption within these economic models is the ceteris paribus, or the other things equal assumption—which means that all other relevant factors remain unchanged.
To better understand how trade-offs work within any given economy, the production possibility frontier (PPF)(Page 28: Figure 2-1) is used. It illustrates the trade-offs facing an economy that produces only two goods, and shows the maximum quantity of one good that can be produced for any given quantity produced of the other. When the economy produces goods that are on the PPF, the economy is efficient. While if it’s producing inside the PPF, but not on it, it is inefficient. Note that an economy cannot produce outside the PPF, as it does not have the capacity to do so. There are three main economic aspects that the PPF shows:
Opportunity cost: the PPF works as a reminder that the true cost of a good or service is its opportunity cost, which are usually increasing the more of a good is produced (the more you produce of something the more you give up of another thing); and
Efficiency: the PPF only shows us whether an economy is efficient in production. There is however another component necessary for an economy to be efficient as a whole; namely, efficiency in allocation. Therefore the PPF does not show the efficiency of the whole economy, but rather only of one component of the economy;
Economic growth: the PPF also shows economic growth, which is shown by a shift of the PPF to the right. Economic growth is usually achieved through an increase in factors of production—resources used to produce goods and services, or technological progress—progress in the technical means for producing goods and services.
In order to model how gains from trade work, the model for comparative advantage is used. It works on the idea that if two countries both produce two of the same goods, and even with one of these countries producing less of both goods, there will still be gains from trade.
As a result, economists argue that a country has a comparative advantage (Page 35: Figure 2-5) in producing a good or service of its opportunity cost of producing the good or service is lower than other countries’. This principle also holds for individuals’ comparative advantage. In order to better understand this model it can be helpful to think again about the principle of specialization: if two countries both specialize in the good they are comparatively better in than the other country, they will gain from trade. Additionally, the model shows that everyone always has a comparative advantage in something.
As comparative advantage can be a somewhat difficult concept to grasp, many often misunderstand it, or confuse it with absolute advantage—when a country can produce more of a good or service, because it has more output per worker than other countries. It is very important to understand that in reality, countries can still benefit from trade, even when they do not have an absolute advantage.
The main issue with the models discussed before is that they do not involve monetary transactions, which is actually how most of the economy works. The circular-flow diagram (Page 38: Figure 2-6) represents the transactions in an economy by flows around a circle. The simplest version shows the money flow between households—a person or a group of people that share their income—and firms—an organization that produces goods and services for sale. In addition, there are only two markets were trade happens: markets for goods and services—where goods and services are sold to households—and factor markets—where firms buy the resources they need to produce goods and services.
Just as in most research fields, there are several ways economic models, and the knowledge acquired from these, can be used. In economics we make one important division between the type of analysis, which can be made; namely, between positive economics—descriptive: tries to answer questions about the way the world works—and normative economics—prescriptive: involves saying the way the world should work. Positive economics, thus, entails answering ‘what if’ questions. These are often asked by firms and governments to see what would happen if they would carry out a specific policy. This analysis by economists simply gives the government or firm information and knowledge, and the outcome of such a policy; however, it does not give an opinion on whether this outcome is right or wrong. When economists do give their opinion they engage in normative economics.
In order to understand the economy, it is necessary to look at behavior of actors on a grander scale. In doing so economists usually look at competitive markets—markets in which there are many buyers and sellers of the same good or service, none of which can influence the price at which the good or service is sold. This chapter will focus on the specifics of these types of markets, and how we can understand them. The main model that is used to see how competitive markets behave is the supply and demand model, which exists out of five key elements, which will be discussed in this chapter.
In order to see the quantity demanded of a good or service we can use the demand schedule—a table showing how much of a good or service consumers will want to buy at different prices—and, most importantly, the demand curve which shows the demand schedule in a graph. The supply and demand model also uses the ceteris paribus, which are called ‘laws’. The first law we will introduce is the Law of Demand:
The higher the price of a good, other things equal, the lower the quantity demanded of that good |
The law of demand accounts for movements along the demand curve (Page 70: Figure 3-3)—changes in the quantity demand of a good arising from a change in the good’s price. Shifts of the demand curve are also possible. These happen when anything but the price changes, and result in either a leftward, or rightward shift of the demand curve, denoted by a new demand curve. Therefore, a rightward shift of the demand curve indicates that the quantity demanded increases, but the price stays the same. This also works the other way around: a leftward shift means that the quantity demanded decreases, but the price remains the same.
There are five principle ways in which the demand curve can shift (Page 75: table 3-1):
Changes in the number of consumers
Every individual has a demand curve, the so-called individual demand curve. So far we have been discussing the market demand curve, which is the sum of all individual demand curves within a given economy. Some events, such as s a baby-boom or an ageing population, can lead to either an increase or decrease in the amount of consumers (individuals), leading to a shift of the demand curve.
Changes in income
When consumers start earning more money, they usually have more to spend, which usually leads to an increase of quantity demanded (and vice versa). However, this does not hold for all goods. Normal goods are goods of which the quantity demanded increases when consumer income rises, while inferior goods
Changes in tastes
Sometimes people just simply change their taste. If less people like a specific good or service due to a change in taste, less people will demand for it therefore decreasing the quantity demanded, and vice versa.
Changes in the prices of related goods or services
The related goods and services here are substitutes, and complements. Two goods are substitutes if a rise in the price of one good leads to an increase in the demand of another good. Goods are complements when an increase of the price of one good, decreases the quantity demanded for the other good.
are goods of which quantity demanded decreases when consumer income rises. Inferior goods are usually cheap versions of goods (junk food).
Changes in expectations
This mostly has to do with expectations of future rises or falls in prices. When people know that sales are coming up they might wait before they buy twenty new T-shirts. This also holds when people expect a rise or fall in their future income. If you know you will be without a job in two months, you might want to cut some of your spending now, to have more money when you really need it.
In a way the supply is quite similar to demand, however, the quantity supplied is from the viewpoint of the sellers; it entails the actual supply people would want to sell at a specific price. Just as a demand schedule and curve, there is also a supply schedule and corresponding supply curve, the former is a table and the latter a curve, which show the quantity supplied at any given price. Finally, the Law of Supply states:
The higher the price of a good, all other things equal, the higher the quantity supplied |
Therefore, a movement along the supply curve (Page 78: Figure 3-8) and the corresponding change in quantity supplied is influenced by a change in prices.
Shifts of the supply curve can also occur and these are usually the result of a change in one of these five factors (Page 82: Table 3-2):
Changes in technology
Technology entails all the methods that can be used for production; therefore, a technological development that decreases the price for producing milk would cause a rightward shift of the supply curve: now suppliers can produce more milk for the same price.
Changes in the prices of related goods or service
Similar to changes in the prices of substitutes and complements for demand, there can also be changes in prices for substitutes in production and complements in production.
Changes in expectations
Usually when suppliers believe that in the future the price of a specific good or service increases they will reduce supply today, a leftward shift, and vice versa.
Changes in input prices
Inputs are any good or service that is used to produce another good or service. As everything has a price, input prices can also increase or decrease. Inputs can range from goods and services as simple as the price for hops to make beer to the price of oil or wages for workers.
Changes in the number of producers
An increase in the amount of suppliers would lead to an increase in the quantity supplied and vice versa.
The first chapter already established that markets must always move towards equilibrium, the same holds for a competitive market. A market such as this one is in market equilibrium when the quantity of a good or service demanded equals the quantity supplied (Page 84: Figure 3-11). This in turn establishes the equilibrium price and the equilibrium quantity. We can find both the equilibrium price and quantity by putting the supply and demand curve in the same graph: the place where the curves cross show the market equilibrium. When the market price is above the equilibrium price, less people will be motivated to buy this specific good or service enabling a surplus of supply (Page 86: Figure 3-12). Because the producers cannot find enough customers they will eventually lower their prices, which causes a movement down along the supply curve until the market reaches equilibrium again.
The same can occur when the market price is below the equilibrium price: producers now have too many customers willing to buy their products and they will find themselves in a shortage of supply (Page 87: Figure 3-13). This works as an incentive to producers to raise their prices, until it eventually reaches the equilibrium price.
Yes, they can. This is where it gets a little tricky: an increase or decrease of demand would cause the demand curve the shift rightward or leftward respectively. In this case a rightward shift of the demand curve, would cause an upward change along the supply curve and the equilibrium price and quantity would rise, and vice versa (Page 89: Figure 3-14).
The same happens when the supply curves shifts. An increase in input prices would cause the supply curve to shift rightward, as it now costs more to produce the same amount of goods or services. This causes a rise in the equilibrium price, but a fall in demand. Furthermore, we can see an upward movement along the demand curve (Page 90: Figure 3-15). The movement along the demand curve is due to the Law of Demand: all other things equal, when the price of a good or service rises, the quantity demanded will fall.
Finally, the demand and supply curve can also shift simultaneously. There are two things that are most important to remember about simultaneous shifts in opposite directions: (1) if demand increases and supply decreases, we can be sure that the equilibrium price rises, but we will not know the change in equilibrium quantity (Page 91: Figure 3-16); and, (2) if demand decreases and supply increases, there will be a decrease in equilibrium price, but it is unsure how the equilibrium quantity changes. There are also two possible scenarios for a simultaneous shift of the supply and demand curves towards each other: (1) when supply and demand both increase, the equilibrium quantity increase, but it is unknown what happens with equilibrium price; and, (2) when they both decrease, the equilibrium quantity will fall, but the change in equilibrium prices is unknown.
It is possible in markets that people lose their jobs because there is too little demand, or that their wages become so small that they don’t make enough money to sustain themselves anymore. In these cases governments can feel obliged to intervene in the market. It can do so in two ways: 1) by using price controls, or 2) by using a price ceiling/floor.
The most common price ceiling is rent control, however, they are also common during crises when there are resources that can suddenly become very scarce. However, there are problems with inefficiency when the government imposes a price ceiling on the market.
A price ceiling (Page 104: Figure 4-2) is always below the equilibrium, and we can imagine this as a horizontal line at the imposed price ceiling. Doing so would effectively reduce the quantity supplied; however, at this price there is a higher demand. This is because a lower price reduces the incentive to supply more, but at the same time the lower price increases demand. Eventually this will create a deadweight loss—the loss in total surplus that occurs whenever an action or policy reduces the quantity transacted below the efficient market equilibrium quantity. Additionally, deadweight loss is seen as a loss to everyone: it is not a loss that ends up as someone else’s gain. There are three main ways a price ceiling can cause inefficiency:
Inefficient low quality: due to a lack of incentives sellers are less stimulated to increase the quality of their goods, even though there might be customers who would want to buy better-quality goods at a higher price.
Inefficient allocation to consumers: this is due to the lower quantity supplied. It leads to a situation where people can get the resource through luck or personal connections; therefore, some who really want the resource and are willing to pay a higher price for it might not be able to access it and vice versa
Inefficient quantity: because the price are forcibly kept low, less producers will be willing to supply as they won’t gain as much, as when the price is higher
Wasted resources: in order to gain access to the resource, a lot of time and effort is made, which could better be used for something else
Black markets: these are usually caused because buyers and sellers want to evade the price ceiling
Price floors work similarly to price ceilings, however, they are established above the equilibrium (Page 110: Figure 4-5). A price floor leads to a decrease in quantity demanded, and therefore also to an overall loss to society.
The inefficiencies caused by price floors are similar to those caused by price ceilings:
Wasted resources
Inefficient allocation of sales among sellers
Inefficient high quality: this is the same as with a price ceiling, but the opposite now
Inefficiently low quantity: as mentioned before a price floor also leads to a deadweight loss, as the demand decreases with the increased prices
Illegal activity: an example for this would be ‘black labor’
Another type of government intervention can be a quantity control, or quota—an upper limit on the quantity of some good that can be bought or sold. The government decides on a quota limit, and issues licenses until it reaches the quota limit. In other words, a quota limits the amount supplied. Inevitably, this leads to a wedge—a situation where the price paid by buyers ends up being higher than that received by sellers. The new price level will be established at the quantity supplied of the supply curve meets the quota. While the price paid by buyers is established where the quota meets the demand curve. The difference between these prices is called the quota rent. Earnings from the quota rent go to the ‘original’ license-holder, due to its right to sell the good.
Just as price controls, quantity controls generate deadweight loss and lead to illegal activity.
The most important distinction between macro- and microeconomics lies in what the focus on. While microeconomics looks at individuals, macroeconomics looks at the whole picture: it analyzes all of the economy as a whole. Furthermore, macroeconomics tends to look at policies. The reason for this is the legacy of the Great Depression in the 1930s. Before the 1930s, economists believed in the invisible hand theory of trade; they believed that economies were self-regulating and therefore needed no government intervention. After the Great Depression, Milton Keynes developed a theory that argued that governments should intervene in order to help a depressed economy—Keynesian economics. Governments should do this through monetary policies—changing the quantity of money in the economy—and/or fiscal policies—changes in taxes or government spending to affect overall spending.
Economists now know that an economy has a business cycle—the short-run alternation between recessions and expansions (Page 171: Figure 6-3). There are four periods within a business cycle:
Recession | Expansion | Business-cycle peak | Business-cycle trough |
When output falls for a significant amount of time | When output increases for a long period | The point where output starts falling | The point where output starts increasing |
Modern macroeconomics favor policies that keep the economy stable, it advocates policies that both reduce the severity of recessions, but also tries to lessen any major economic expansion.
Furthermore, macroeconomics tries to understand the reasons behind long-run economic growth. Many models have been developed in order to understand the influences of sustained economic growth.
Economies generally experience some level of inflation—an overall increase in price level—or deflation—an overall decrease in price level. The business cycle is very influential in the short-run in changing overall price levels; however, in the long-run price levels are largely influenced by the money supply—the overall quantity of assets, which can be eased immediately to buy goods and services. The best situation for an economy to have is price stability—when overall price level is stable or changes very slowly.
Countries usually run either a trade deficit—when the value of their imports, exceeds the value of their exports—or a trade surplus—when the value of exports, exceeds the value of imports. The causes of trade deficits and surpluses lie in choices made in savings and investment spending.
Arguably there are no countries left in the world that are real autarkies—when a country doesn’t trade with any other country. Instead, all countries nowadays engage in some level of international trade, they can buy goods and services from another country, imports, or sell goods and services to another country, exports.
Comparative advantage (see Chapter 2) is a very important concept for understanding choices for imports and exports; it provides a reason to choose the production of one good or service over another. The PPF’s discussed in chapter 2 were straight lines, instead of the more realistic curved lines. Also as discussed in chapter 2 this indicates that opportunity costs are constant. The model for this type of analysis is the: Ricardian Model of International Trade and assumes constant opportunity costs. We can analyze this by imagining a situation where two countries trade with each other—Venezuela and North Korea—and can only produce two goods—pepper sauce and noodles:
| Opportunity cost of North Korea |
| Opportunity cost of Venezuela |
1 tube of pepper sauce | 2 batches of noodles | > | 0,5 batches of noodles |
1 batch of noodles | 0,5 tubes of pepper sauce | < | 2 tubes of pepper sauce |
By looking at this table it is clear that North Korea has a comparative advantage in producing noodles, as their opportunity cost is lower per batches: producing one batch of noodles ‘costs’ North Korea 0,5 tubes of pepper sauce, while it costs Venezuela 2 tubes of pepper sauce. On the other hand, Venezuela has a comparative advantage in producing pepper sauce. The table above shows the trade-offs between North Korea and Venezuela when they don't engage in trade, however, as discussed in Chapter 1 and 2, everyone is better off when trading. Economists, therefore, argue that countries should specialize in producing and export the good they have a comparative advantage over, while importing the goods the do not have a comparative advantage in.
Here we should not confuse comparative advantage with absolute advantage. Absolute advantage has to do with labor productivity, and it is possible for countries to have no absolute advantage in the production of any good or service. On the other hand, comparative advantage has to do with which good or service can be produces with the lowest opportunity cost. The Ricardian Model of International Trade deals with comparative advantage, and economists believe that in order to have mutual gains from trade, countries should specialize in the good they have a comparative advantage in, not an absolute advantage.
Comparative advantage could be formed in three ways: 1) technological knowledge; 2) climate differences; and, 3) factors (Heckscher-Ohlin Model)
This model argues that factor endowments are the most influential in determining a country’s comparative advantage by analyzing a country’s factors of production—inputs used for production. Important to know for this model is factor abundance—the scale of the supply of a factor of production—and factor intensity—a way of measuring what factor is used in relatively greater quantities than other factors.
In the third chapter we looked at supply and demand, and discussed the market equilibrium; however, there we only analyzed the market in an autarky and therefore used the domestic demand- and domestic supply curve. To analyze the effects of imports and exports in international trade, we need to add a new assumption; the simplest one is to assume that the price of a specific good is fixed, the so-called world price.
If the world price is below the domestic equilibrium price, it will be cheaper to import. This will increase the supply, and as a result prices will fall until the domestic price is equal to the world price. In this scenario consumer surplus will increase and producer surplus will decrease. However, consumer surplus increases more than producer surplus decreases; therefore, the total surplus increases and the economy as a whole gains (Page 140: Figure 5-7).
When the world price is above the domestic price, producers will be stimulated to export their products to other countries at the world price. Similarly this situation leads to an overall increase of the total surplus in the economy; however, in this situation producer surplus increases while consumer surplus decreases (page 141: Figure 5-9).
A country’s industries usually exist out of both exporting industries and import-competing industries. When engaging in international trade exporting industries will increase production, while import-competing industries will decrease production. For the former this will lead to a rise in the prices of its factors of production, as the demand for those factors increase. The latter type of industry will see a drop in the prices of its factors of production, due to a fall in demand for those factors. Furthermore, a country tends to export the goods that it has a comparative advantage in—goods, which are intensive in its abundant factors—which will ultimately lead to a rise in the prices of abundant factors and a fall in the prices of scarce factors.
Most economists are pro-free trade—when a government does not intervene in the economy. However, governments usually do intervene in trade, one of the most common policies is trade protection—government intervention that limits imports. The most favored method for this is tariff, which are taxes put on imports. Tariffs raise the price level of a specific good, but in the process decreases domestic demand (page 146: Figure 5-11). As a result of a tariff, domestic production will increase, but domestic demand will decrease, compared to the free trade situation. Finally, the government will also generate some income. Tariffs are seen as ‘bad’ for the economy as the overall loss in consumer surplus is bigger than the gains for producers and the government. Therefore, total surplus decreases, and deadweight loss is created. Another form of trade protection is an import quota, which limits the quantity of goods that can be imported. The effects are the same is with a tariff, however now the government revenue becomes the quota rent (Chapter 5).
According to all models and theories there can only be gains from free trade; however, governments still choose to intervene. This is due to issues such as national security, job creation, and the protection of infant industries. However, in most cases of trade protection, specific policies are used because of the influences of producers (political lobbying).
Although the influence of domestic producers on economic policies is usually quite large, trade protection in some countries is still limited. This is due to International Trade Agreements (ITA). Because countries know that they loose when they engage in trade protection, they usually enter ITAs. As such, they promise each other to lessen trade protection, in return for similar policies of the other countries in the agreements. Some of the biggest ones are the North American Free Trade Agreement (NAFTA), the European Union (EU), and the World Trade Organization (WTO).
Due to globalization there are some new issues however. Globalization has severely increased inequality between countries, but also within countries. Furthermore, outsourcing, and in particular offshore outsourcing, have also raised many concerns.
Most countries measure their economy; the basic set of numbers they calculate is called the national income and product accounts and accounts are the basis for government policies and decisions.
A helpful way of understanding how money spreads through the economy is by using the circular flow diagram (Page 189: Figure 7-1). The assumption here is that inflow of money equals outflow of money in each sector. The circular flow diagram shows the four sectors of an economy (government, households, firms, and the rest of the world), and connects these to the three types of markets (markets for goods and services, factor markets, and financial markets).
| Markets for goods and services | Factor markets | Financial Markets | Others |
Government | Government spending | - | Governments borrow here | Governments transfers to households |
Households | Consumer spending | Income: wages, profit, interest, and rent | Consumer savings | Consumers taxes to government |
Firms | Investment spending | Payment: wages, profit, interest, and rent | Borrowing and stock issues | - |
Rest of the world | Exports and imports | - | Foreign lending/ borrowing and purchases/ sales of stock | - |
When adding up consumer spending, investment spending, government spending, and exports minus imports (net exports) we get a country’s gross domestic product (GDP), which is the value of a country’s total output. However, a country’s GDP only concerns output of its final goods and services—those goods and services, which are sold to the end user. A country’s intermediate goods and services—are not used in the calculation for GDP, because it would lead to counting some items double. Instead only the value added is counted, which is the value of its sales minus the value of its purchases of intermediate goods and services.
In total, there are three ways of calculating GDP: the first one is adding up all spending on domestically produced final goods and services (aggregate spending) as mentioned above. The other way is to add up the total value of final goods and services produced. Finally, we can add up total income earned in the economy. All three ways of calculating GDP are used by the government.
GDP is mostly used to understand the size of the economy, and for comparison other economies.
The number for GDP is usually not very useful for measuring economic growth over time as GDP can go up, even when output doesn’t change due to inflation. Instead, economists measure aggregate output—the total quantity of final goods and services produced in an economy. By looking at production quantities, the numbers won’t be influenced by price changes. Finally, to understand the real growth of the economy, economists use the measure of Real GDP—the total value of final goods and services produced in the economy during a year, calculated using the prices of a selected base year. The GDP discussed before is called the nominal GDP—the total value of final goods and services produced in the economy during a given year, calculated using the prices current in the year in which the output is produced. When analyzing economic growth real GDP is used, because than you can solely focus on changes in quantity, without inflationary or deflationary influences.
Because GDP, both nominal and real, only measure a country’s aggregate output, a country with a larger population will naturally have a higher GDP. To eliminate such differences GDP per capita is often used. GDP per capita is often used to compare different country’s living standards; however, because it is just an average it does not tell us anything about inequality within a specific country.
Economists also use a single number to look at overall level of prices, the aggregate price level. Aggregate price level is calculated by using a price index, which measures the cost of purchasing a given market basket in a given year, where that cost is normalized so that it is equal to 100 in the selected base year:
Price index in a given year = | Cost of market basket in a given year |
x 100 |
Cost of market basket in base year |
A market basket is a hypothetical set of consumer purchases of goods and services; the most common measure is the consumer price index (CPI), which looks at the costs of the market basket of a typical urban family. Usually the inflation rate—percent change per year in a price index—is calculated using the CPI; however, this is not necessarily so.
Inflation rate = | Price index in year 2 – Price index in year 1 |
x 100 |
Price index in year 1 |
Another common measure of changes in price level is the producer price index (PPI). Due to bigger fluctuations in goods and services purchased by producer, the PPI tends to change more quickly. The final measure is the GDP deflator, which is the ration of nominal GDP to real GDP times hundred in that year ((nominal GDP: Real GDP)*100).
Although, all three ways of calculating changes in the price level give different levels of inflation, they usually stick and move together.
Macroeconomic policies mainly try to fight unemployment and inflation. Firstly, we will take a look at unemployment.
Although it seems like you can be either employed or unemployed, this is not entirely true. Employment is the total amount of people who have a job; however, unemployment is the total amount of people who are actively looking for a job, but are not employed at the moment. By adding up those employed and unemployed, we get to a country’s labor force. To calculate the unemployment rate, which is the percentage of the total number of people in the labor force who are unemployed we can use this calculation:
Unemployment Rate = | Number of unemployed workers |
x 100 |
Labor force |
Finally, another important concept is the labor force participation rate, which is the percentage of the population aged 16 or older that is in the labor force.
Although the unemployment rate is a trustworthy indicator of unemployment in a given economy, there are chances of either overstating or understating the true level of unemployment. The unemployment rate includes people who are pretty sure that they can find a job, or are just thinking of accepting a specific job also as unemployed. Even though they might find a job very soon. On the other hand, when someone has stopped looking for a job, because they believe that there are no jobs out there, they are called discouraged workers and not counted as unemployed. As such, they fall in the larger category of marginally attached workers who are unemployed, have looked for a job in the past, but for some reason are not looking for a job now. Finally, there is those who are underemployed—part-time workers who want to work full-time, but can’t find a full-time job. Still, the unemployment rate indicates economic fluctuations and has a strong relation with economic changes.
Generally speaking when an economy is experiencing an expansion the unemployment rate falls. While, if an economy experiences a recession the unemployment rate increases. However, if a recession hits particularly hard and the recovering period is characterized by real GDP growing at a below-average rate, unemployment can sometimes continue to rise—a jobless recovery.
Still, when an economy grows unemployment rates tend to fall. However, it is not possible for the unemployment rate to drop to zero. The lowest point the employment rate can fall to is called the natural rate of unemployment and it arises from the effects of frictional plus structural employment.
Frictional unemployment is caused by the time it takes that workers spend in finding a job. Structural unemployment refers to an actual shortage of jobs. There are five common causes for structural unemployment:
Side Effects of Government Policies
Labor Unions: labor unions usually push wages above the equilibrium wage, which causes an incentive for more workers to supply their labor at the new higher price.
Minimum Wages: these generate the same effect as labor unions do
Mismatches between Employees and Employers
Efficiency wages: wages that the employers set above the equilibrium to incentivize workers to perform better
Besides natural unemployment, there is also cyclical unemployment, which is the deviation of the actual rate of unemployment from the natural rate due to downturns in the business cycle. Therefore, adding up natural unemployment and cyclical unemployment leads to actual unemployment. The three most common ways for the natural rate of unemployment to change is, because of a change in the labor force (i.e. baby boom coming of age, increases in female labor force participation), changes in intuitions that govern the labor market, and changes in government policies.
Although inflation indicates a rise in overall price levels, this does not necessarily mean that everyone becomes poorer in the process. This is because all prices change the same way. What is important for people’s income is the real wage—the wage rate divided by the price level. Similarly, real income is income divided by the price level. What matters is the percentage change, not the overall level of prices. While inflation is not that important, the inflation rate is.
High rates of inflation can cause severe economic problems, and increase economic costs. The three most significant ones are:
Shoe-Leather Costs
These refer to the increased costs of transaction caused by inflation. This is due to using up resources such as time and labor; while these could be spend more efficiently somewhere else.
Menu Costs
Menu costs are quite literally the costs of changing the prices listed on ‘menus.’ Whenever a price increases in restaurants, supermarkets and other places that have their prices printed, they will need to reprint all the prices. These costs can become quite big when a country experiences high inflation or hyperinflation
Unit-of-Account Costs
These types of costs come from the way inflation makes money a less reliable unit of measurement.
Inflation causes both winners and losers: this is mainly because of the interest rate on loans, which is a long-term economic transaction. Economists distinguish between the nominal interest rate—the interest rate in dollars—and the real interest rate—the nominal interest rate minus the inflation rate. When the actual inflation rate is higher than what was expected, borrowers gain and lenders lose; due to the decrease in the value of money and vice versa. Deflation—when the inflation rate drops—also produces winners and losers. Deflation causes debts to increase in value, and sudden large deflation can cause extreme problems.
While a slow rise of inflation is not harmful to the economy, governments usually try to keep, or bring back down if its higher, inflation rates around 2-3%. This is because lowering the inflation rate—disinflation—is notoriously more difficult once a high inflation rate stabilizes.
The main statistic to measure long-run economic growth is GDP per capita. Although, there are some problems with using GDP per capita, economists argue it is still a good indicator of a country’s standard of living. A common calculation used to give a rough indication on a country’s long-run economic growth is the Rule of 70—it tells how long it will take for GDP per capita, or another gradually changing (positive!) variable, to double. The number of years for a variable to double can be found by dividing 70 by the annual growth rate of the variable.
Long-run economic growth depends mostly on rising labor productivity; in order for an economy to sustain its growth in the long run, it also has to sustain a long-run increase in average output per worker. Labor productivity can increase by an increase in any of these three factors:
Human Capital
When workers become more educated, or more specialized their productivity also increases
Physical capital
This refers to manufactured resources (i.e. buildings, tools).
Technological Process
Arguably the most important one for economic growth in the long run, is advancements in technical means of the production of goods and services.
To analyze the effects of an increase in any of these factors we can use the aggregate production function (APF). The APF has diminishing returns to physical capital, which means that when human capital and technology per worker are kept fixed, each successive increase in physical capital will lead to a smaller increase in output per worker (Page 249: Figure 9-4). It is important to remember that this is another “other things equal” assumption. In reality, all factors rise in times of economic growth. To keep apart the different influences per factor growth accounting—an estimation of each major factor in the aggregate production function to economic growth—can be used. It can be used to calculate the effects of physical and human capital on economic growth and what is left over of ‘the’ economic growth attributed to technological process. The total factor productivity indicates the maximum amount of output that can be reached with a given amount of factor inputs. Natural resources are not used for calculations, because most economies are not very dependent on it and are much more influenced by human capital, physical capital, and technological progress.
There are several reasons why countries’ growth rates differ. Policies that promote high rates of investment spending stimulate rapid increases in physical capital. Investment spending can increase through high savings or inflow from foreign capital. Furthermore, human capital can increase through better education. Generally, when the average level of education increases, human capital increases too. Finally, spending on research and development (R&D) generates new technologies, and as a result causes technological progress.
Governments policies can stimulate economic growth through: 1) subsidizing R&D, 2) subsidizing education (by ensuring access to education), 3) ensuring that the economy’s financial system is well-regulated and well-functioning, and finally 4) subsidizing infrastructure (i.e. roads, power lines).
Secondly, governments can enforce protection of property rights. This is usually achieved through handing out patents for new innovations made by the innovator. Patents protect the intellectual property right, and stimulate innovations. However, patents are only temporary as it is also in society’s interests to stimulate competition.
Finally, maintaining political stability also increases economic growth.
The ‘miraculous’ growth in East Asia in the latter half of the twentieth century has puzzled many economists. One of the main arguments given for economists is that East Asia was able to develop this rapidly because they were catching up to other countries. This is known as the convergence hypothesis, which argues that international differences in real GDP per capita tend to narrow over time. However, this is not necessarily so, both Latin America and Africa have not experienced the same growth, even though they had a relatively low level of real GDP per capita too.
In the early 1900s, Latin America was quite similar to other economically advanced countries; however, this changed in the 1920s. The region has been severely setback by irresponsible government policies, political instability, and neo-liberalist pressures from the US. Furthermore, public education has not been a high priority in many of the region’s countries.
Sub-Saharan Africa meanwhile has been ravaged by civil wars, political instability, and government corruption (largely caused by de-colonization). However, the WHO has emphasized the role of health issues in sub-Saharan Africa. Still, slowly some sub-Saharan African economies are picking up.
One of the current issues that economists are dealing with is the possibility of sustainable long-run economic growth. They are trying to find out whether economic growth can continue when natural resources are decreasing, and environmental pressures are increasing.
Economists tend to look quite positively to the dilemma of limited natural resources. This is due to the demand and supply principle, which means that if the quantity supplied decreases, the price would increase, and demand would fall. As a result suppliers and consumers would start looking for substitutes.
Probably the most serious issue the world is facing now is environmental degradation. However, this can only be curbed by government intervention, as environmental degradation does not provide a ‘natural incentive’ such as limited natural resources. Economists believe that the best way to reach this would be to use market-based incentives: through a tax, or a type of quota (a cap and trade system). Furthermore, rich and poor countries should cooperate and share the costs of emissions.
Although economists are positive about these types of measures, it is important to remember that these policies so far have had little effect. Many rich nations have agreed to share the economic costs of emission reductions; however, these agreements are non-binding, and tend to be empty promises.
The two main ways to realize long-term economic growth is either through increasing human capital (public education) or physical capital. An increase in physical capital can be achieved through private investment spending done by firms, which in turn raise money to invest by borrowing. This money is borrowed from savings. As a result, savings and investment are always equal for the economy as a whole. This principle is called the savings-investment spending identity.
GDP is equal to total spending on domestically produced final goods and services: GDP = C + I + G + X - IM
Where C = spending by consumers; I = investment spending; G = government spending; X = exports; IM = imports
Now income can either be spent in consumption (consumer spending C + government purchases G) or it can be saved (S), resulting in the equation: GDP = C + G + S
meaning Total income = Consumption spending + Savings
Total spending consists of either consumption spending (C+G) or investment spending (I), resulting in the equation: GDP = C + G + I meaning Total Income = Consumption spending + Investment spending
Putting the equations together: C +G + S = C + G + I
extracting the C and G on both sides results in: S = I, so savings equals investment spending in the economy as a whole.
Both households and the government can do savings. The latter does this in the years where it spends less than it receives; in other words, in the years that the government runs a budget surplus—total savings by the government. On the other hand when the government spends more money than it receives it runs a budget deficit, which is a negative budget surplus. The money received by the government are tax revenues, and the difference between the tax revenues and government spending is what is called the budget balance. In order to calculate the total savings of an economy, national savings, you need to sum private savings (households) and government savings. However, this only counts for the savings-investment spending identity in a closed economy. In an open economy, money and goods do not necessarily stay within one country, and this also affects the savings-investment spending identity.
The net capital flow represents the money going in and out of the country and is calculated by subtracting the total outflow of funds from the total inflow of funds.
NCI = IM - X
Similar to the budget balance, this can be positive or negative. Still, as the interests paid over the loans have to be paid to a foreigner, this eventually costs the economy more, because the interests paid is domestically earned money leaving the domestic economy. When a country spends more on imports than it exports it has to borrow money in order to pay for the extra imports and vice versa. The amount it borrows (or lends) is the same as the net capital flow. Therefore, the net capital flow can also be calculated by subtracting exports from imports.
We have established now that savings and investment spending are equal to one another. While in a closed economy [savings = national savings] in an open economy this is [savings = national savings + capital inflow]. The place where those who want to loan in order to engage in investment spending is called the loanable funds market. It is very similar to the market for supply and demand, only that instead of goods or services, we now have funds being traded. Therefore, the market of loanable funds exists out of the demand for funds (by borrowers) and the supply of funds (by lenders). The equilibrium price that is decided through this market is the interest rate: r, and is indicated on the vertical axis, while the horizontal axis shows the quantity of loanable funds. Finally, this interest rate is the nominal interest rate, as it is not adjusted for inflation.
The demand curve in this market is downward sloping due to expected returns in the future from current investments. This can be exemplified by imaging setting up a new shop. In order to open a new shop one needs to engage in investment spending, however, if there is no guarantee that in the future this will pay off and make a profit, there is no reason to open up the shop. This can be calculated by using the present value of X—the amount of money needed today in order to receive X at a future date given the interest rate. This is where the interest rate becomes important, as the value of a unit of money is worth less in the future than it is now (due to inflation). This is magnified if the interest rate is also high. So if one wants to make an investment now, but the investment rate is high, it will be more difficult to earn the invested money back. The supply curve is upward sloping, because a high interest rate makes it more profitable to save than to spend. It works the same as the logic of the demand curve: when the interest rate is high, it is more profitable for people to save their money, and therefore, the quantity supplied will increase when the interest rate goes up.
There are two causes of a shift of the demand curve:
Changes in government borrowing: the government’s spending policies have a very large influence on the overall demand for loanable funds due to the size of funds demanded. In the years it runs a budget deficit, it will have to loan money in order to make ends meet; and, in years when it runs a surplus, this demand suddenly drops.
When a government runs a deficit for subsequent years, the demand curve will continuously shift rightward, causing a continuous increase in the interest rate. As an increase in the interest rate leads to businesses engaging in less investment spending, this can be very troublesome for economies in the long run. The effect on businesses by government borrowing is called crowding out. However, crowding out does not hold when an economy experiences a depression, as government spending in this case can lead to higher incomes and eventually higher savings; thus, increasing the quantity of loanable funds and stabilizing the interest rates.
Changes in perceived business opportunities: when many businesses perceive a increase (or decrease) in payoff of investment spending, the rush for new (or diminishing) business possibilities can cause a shift of the demand curve
There are also two causes for a shift in the supply curve:
Changes in net capital inflows: this happens when investors’ notions about a country change. When there’s an increase in net capital inflow the supply curve will shift to the right and vice versa.
Changes in private savings behavior
Arguably the biggest influence for changes in the nominal interest rate is expected future inflation. A change in the expected future inflation will cause the whole schedule to either move up (increasing the interest rate) or to move down (decreasing the interest rate). A rise in expected inflation reduces the real interest rate that prospective borrowers face. They may pay the same nominal interest rate, but the financial burden is smaller, due to the inflationary expectations (loans become cheaper). So inflationary expectations shift the demand curve rightward. Also the supply curve will be affected. Due to an increase in expected inflation, lenders have a tendency to increase current spending (because money becomes worth less and less in the long-run), which reduces the available funds: causing a leftward shift of the supply curve. This is called the Fisher effect, and says that an increase in expected future inflation rate does not have an effect on the real interest rate.
Households can invest their savings (wealth) in financial assets—a paper claim that entitles the buyer to future income from the seller. Additionally, households can choose to invest their wealth in physical assets—tangible objects that can be used to generate future income. Typically, these transactions happen on the financial market. There are four types of financial assets: loans, stocks, bonds, and bank deposits. It is important to remember that because a financial asset is a claim on someone’s future income, this also means that someone bears the liability—a requirement to pay income in the future.
A stable financial system makes sure that the flow of funds between lenders and borrows run smoothly. As such, it has three main tasks: enabling liquidity, and reducing transactions costs and risks.
Enabling liquidity: when an asset is liquid this means that it can be quickly changed into cash. It is important to have liquid assets in case an emergency comes up where cash is quickly needed. Banks ensure that investors can have liquid assets, while still being to engage in investment spending in illiquid assets
Reducing transaction costs: transaction costs are the costs of making a deal, these can be time spend on making the deal, but also finding information on how to get the best deal possible. If a company would have to go to all the individual lenders in the market it would incur transaction costs with every lender and these will add up. However, banks reduce these costs significantly as the bring together all lenders and borrowers together
Reducing risk: because we can never know what the future brings, investing can be tricky business. By selling shares, companies can share the risk, as it spreads out a risky investment over an X amount of people.
As mentioned before there are four main types of financial assets; however, there are also loan-backed securities:
Bonds: usually the seller of the bond would pay the buyer a fixed amount of interest a year and repay the full value of the bond at an agreed upon time. However, there is always the possibility that the seller cannot pay back the buyer and default. Bonds, therefore, also have a default risk and once this is established they can be traded with relative ease on the market
Loans: an agreement between a lender and a borrower on how/what to lend
Stocks: from the owner’s point of view a stock is an asset; however, for the company this stock is a liability.
Loan-backed securities: these are a type of asset that is created by adding a couple of loans together, and then selling shares from these loans as a whole. This process is called securitization and is also what happened prior to the burst of the 2008 housing bubble.
In order to decrease risk, but also gain higher returns the financial market makes use of financial intermediaries—institutions that transform funds pooled from a lot of people into financial assets.
Banks: banks usually lend out the money that individuals put into their bank account. When you decide to put money into the bank you’re actually lending out your money to the bank. Banks in turn lend this money out to companies
Mutual funds: investors often have a diversified portfolio, meaning that their investments are spread out over many different stocks and shares, which decreases the risk of losing everything when one investment goes bad. However, not everyone has enough money to create a diversified portfolio; instead, one can invest in mutual funds—financial intermediaries that create stock portfolio by buying and holding shares in companies and then selling shares of the stock portfolio to individual investors.
Pension funds and life insurance companies: although these type of companies, and especially pension funds, have specific rules as how they have to operate, they are function almost the same mutual funds
The asset market also works according to supply and demand: an increase in the price for stocks, will lead to a decrease in the demand for stocks. Similarly, as bonds are a substitute for stocks an increase in the price for stocks will lead to an increase of the demand for bonds. These rules apply to all types of assets, both financial and physical.
There is a big debate between economists on how asset price expectations are established. Simply put we can say that economists can be divided into two camps: one that emphasizes rationality, and one that emphasizes irrationality. The efficient markets hypothesis: holds that asset prices always embody all publicly available information. Therefore, changes in asset prices can only happen when new information is ‘discovered’. As this new information is always unpredictable, changes in asset prices cannot be known beforehand. Asset prices, thus, follow a random walk—a movement of an unpredictable variable. Other economists, however, challenge this hypothesis due to evidence that individual investors don’t actually behave as the theory says they do. The efficient market hypothesis cannot account for instances as the housing bubble, and why people think that in the future asset prices will continue to increase, because they are increasing now.
An initial rise or fall in aggregate spending is not an isolated event; instead, it often acts similar to a drop of water falling into a pond generating consecutive waves. When an initial extra investment is made, for example a house is build, this generates someone else’s income, who in turn can spend that extra income on commissioning another house to be build etcetera. In order to calculate the effects of a change in spending, economists use the Marginal Propensity to Consume (MPC)—the increase in consumer spending when disposable income rises by $1. This can be calculated by dividing the change in consumer spending with the change in disposable income. As consumers don't spend all their money, but also save part of this the is also the Marginal Propensity to Save (MPS) which is MPC-1 and gives us the part of the dollar that is not spend, but saved. In order to use these calculations we have to make four simplifying assumptions:
There are no exports and imports (equal to zero)
The interest rate is a given
Producers are willing to supply additional output at a fixed price
There is no government spending and taxation
Due to the assumption of there being no taxes and international trade, each extra dollar spent leads to an increase of $1 of both real GDP and disposable income. An investment of $100 million would therefore increase real GDP and disposable income by $100 million, and would set off multiple rounds of increased real GDP and disposable income:
Total increase in real GDP = (1+ MPC + MPC² + MPC³ + MPC4 +etc.) x $100 million |
= 1 / (1-MPC) x $100 million |
The aforementioned increase in investment spending of $100 million is actually an autonomous change in aggregate spending (AAS)—an initial change in the desired level of spending. In order to get the ratio of the total change in real GDP caused by an AAS the multiplier is calculated:
Total increase in real GDP = 1 / (1-MPC) x AAS |
Multiplier = change in equilibrium Y /change in autonomous spending = 1 / (1-MPC) |
Consumer spending is mainly determined by disposable income, which is the income consumers have left after taxes are paid and all government transfers received. To better understand the relationship between consumer spending and disposable income economists use the consumption function. In a graph it is mapped with household consumer spending on the x-axis and current disposable income on the y- axis. The slope of the curve is the MPC. The aggregate consumption function (CF) shows us this relationship for the economy as a whole; in this case household consumer spending becomes ‘consumer spending’, while current disposable income becomes ‘disposable income’. The CF can shift either up—indicating an increase in spending at any given level of current disposable income—or down—indicating a decrease in spending at any given level of current disposable income. Shifts of the CF can be caused by firstly, changes in expected future disposable income. This is because consumers tend to spend more when they know their disposable income will go up in the future, and less when they know it will go down. Secondly, changes in aggregate wealth can also cause a shift of the CF. According to the life-cycle hypothesis, consumers plan their spending over a lifetime, and don’t base their decisions only on current disposable income.
Changes in investment spending tend to drive the business cycle as they are much more dramatic than changes in consumer spending. In addition many economists believe that due to the multiplier process changes in consumer spending are usually the result of a process that begins with changes in investment spending. Investment spending is driven by the interest rate and expected future real GDP. Spending on residential construction are most effected by the interest rate, still, interest rates also affect other types of investment spending and the relationship between interest rate and investment spending is a negative one: when interest rates rise, investment spending will fall. The same holds for expected future real GDP: when firms expect their future sales to increase, they are more inclined to raise their investment spending. However, if a firm does not need to increase its production capacity, because they already have enough machines to produce the desired level of products, they will be less likely to increase their investment spending. Therefore, the production capacity of firms is also important to investment spending.
To capture all these different effects on investment spending economists use the accelerator principle. This principle argues that a higher growth rate of real GDP leads to higher planned investments spending, but a lower growth rate of real GDP leads to lower planned investment spending. The accelerator principle helps us understand and explain investment spending slumps. So far, we have mainly discussed planned investment spending, however, firms also engage in unplanned investment spending through spending on a firm’s inventory. This is called unplanned inventory investment and occurs when sales of a firm are higher or lower than expected. The sum of planned investment spending and unplanned inventory investment is the actual investment spending of a firm.
From the next chapters on the assumption that the aggregate price level is fixed will be dropped. Still, we continue to assume that countries do not have a government (spending and taxing) and no foreign trade. As a result there are only two types of aggregate spending: consumer spending C and investment spending I. Additionally, because of being in a situation without any taxes or transfers, aggregate disposable income is equal to real GDP (as here price level is still fixed). In order to model income and expenditure we will further assume that planned investment spending is fixed.
Finally, one more concept is important: planned aggregate spending—the total amount of planned spending in the economy, which is equal to consumer spending added to planned investment spending. As mentioned earlier in this chapter the aggregate consumption function (CF) shows us consumer spending. Therefore, planned aggregate spending in a graph is a diagonal line that runs at the same slope as the CF but slight above, as planned investment spending is added. Planned aggregate spending always moves towards real GDP, until it reaches the income-expenditure equilibrium, where planned aggregate spending is equal to aggregate output/ real GDP. In order to find the point where income-expenditure equilibrium is reached we use the Keynesian cross diagram. It identifies the equilibrium as the point where the planned aggregate spending line crosses the 45-degree line.
We have discussed the demand and supply curve before, however, when one discusses the economy as a whole the demand and supply curve indicate the aggregate demand and aggregate supply. In turn they establish the aggregate price level.
The aggregate demand curve (AD curve) is downward sloping, indicating a negative relationship between aggregate price level and the quantity demanded. There are two main reasons for why the AD curve slopes downward:
The wealth effect of a change in the aggregate price level: means that consumer-spending changes due to a change in the aggregate price level. This is also called a change in the purchasing power. When the aggregate price level rises, the purchasing power of consumers falls, leading to a downward sloping AD curve
The interest rate effect of a change in the aggregate price level: indicates that due to a change in the aggregate price level, both consumer-spending and investment-spending will be affected, because of the affect on the purchasing power of consumers and firms.
The income expenditure model assumes that the aggregate price level is fixed; however, this is not the case. When you drop this assumption we can use the model to find out what aggregate spending is at any given aggregate price level, which is what the AD curve shows. There are five main causes (two of them are government policies) of a shift of the AD curve:
Size of the existing stock of physical capital: the incentive to spend depends on how much physical capital one has. When you have your house filled with chairs, you are a lot less inclined to buy more chairs, because you have enough, but when you have the feeling you don’t have enough chairs you might buy extra.
Changes in expectations: changes in expected future income will change consumer behavior now, influencing both consumer spending and investment spending
Changes in wealth: when the value of assets rises, those who hold the assets will experience an increase in their purchasing power and vice versa.
Monetary policy: can be used to influence interest rates, and as a result, will increase or decrease consumer spending and investment spending
Fiscal policy: there are two ways in which the government can use fiscal policy to influence AD. Either directly by increasing their own spending (as part of the AD), or indirectly through changing taxes and government transfers influencing consumers’ disposable income.
There aggregate supply curve shows the relationship between the quantity of aggregate output supplied and the aggregate price level in an economy. There are two types of aggregate supply curves: the short-run aggregate supply (when production costs can be taken as fixed) curve, and the long-run aggregate supply (when all prices are fully flexible) curve.
In the short-run we assume that all production costs are fixed, because it is very difficult to change the prices for production costs. The most stable production cost is wages. Nominal wages, the amount of money of wage paid, is often an agreed upon amount for a longer period of time. When the economy is experiencing bad times, it is unlikely that employers will decrease wages and vice versa. This effect is called sticky wages—nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages. In the short-run a change in the aggregate price level will lead to a change in the aggregate output. However, shifts of the SRAS are also possible, and are commonly caused by changes that affect producers’ profit per unit/ production costs:
Changes in nominal wages: although nominal wages are fixed, still, after some time passes they can change, leading to a right- or leftward shift of the SRAS
Changes in commodity prices: commodities are not a final good; therefore, their prices are also not included in the calculation of the aggregate price level. However they do represent a large production cost to producers. As a result, changes in commodity prices can greatly affect production costs.
Changes in productivity: when productivity increases workers now produce more output with the same amount of inputs.
In the long-run all production costs are fully flexible, which also means the in the long run the aggregate price level does not have any effect on the quantity of aggregate output supplied. The LRAS is a vertical line, and touches the horizontal axis at the potential output of an economy—the level of real GDP when all prices are fully flexible. Although the actual real GDP is usually a bit below or above the potential output, it gives us a good indication of an economy’s output. The economy of a country is always on the SRAS and sometimes on both the SRAS and LRAS. This is because the SRAS signifies the actual output, while LRAS signifies the potential output. Some years the actual output is equal to potential output, but this does not necessarily have to be the case. When actual output is higher than potential output this will eventually cause a shift of the SRAS leftwards and vice versa, due to a rise or fall of nominal wages.
We can analyze economic fluctuations by combining AD and AS into a model, conveniently named the AD-AS model. When the AD and SRAS cross the economy is at a short-run macroeconomic equilibrium, and the actual output supplied is equal to the quantity demanded. Before we discussed the causes of a shift of the AD curve: such shifts are called demand shocks (27-12) and can be either positive—shifting the AD curve rightward—or negative—shifting the AD curve leftward. The same holds for the SRAS curve, only these are called supply shocks. It is important to understand that a negative supply shock leads to stagflation, namely the combination of a decrease in output, but an increase in the price level.
The long-run macroeconomic equilibrium can be found at the point where the AD, SRAS, and the LRAS meet (27-14). When the economy is in a long-term macroeconomic equilibrium it’s produced at its potential output; however, when the short-run macroeconomic equilibrium is below potential output the economy experiences a recessionary gap. When the economy is producing above its potential output, there is an inflationary gap. Finally, in the long run the economy is self-correcting as demand shocks only have a temporary effect. When there is a recessionary gap and actual output is below potential output, all prices will slowly fall and this will ‘push’ the SRAS curve leftward; as due to lower production costs, producers can increase their output again and the new equilibrium aggregate price level drops. On the other hand, when the economy faces an inflationary gap due to a positive demand shock, the AD curve’s shift initially causes output to rise above potential output, and the aggregate price level to rise too. However, over time nominal wages and other production costs will rise and the SRAS curve will slowly shift leftwards, until it crosses both the LRAS and AD again at a higher aggregate price level then it started.
According to Keynes the economy was not self-correcting in the long run. Instead, he argued that governments should step after a demand shock, and engage in monetary in fiscal policies. This is also the same argument behind stabilization policy—when the government uses policies to smoothen out the business cycle. Governments respond to demand shocks because falls in aggregate output are associated with unemployment, and it’s more profitable when the economy has price stability. Still, responding to these shocks does not always work out as planned: there may be long term costs in terms of lower long run growth and the effects of policies are not always predictable. Governments have a lot less tools to respond to supply shocks, and when there is a supply shock there are two undesirable events co-occurring: both a rise in unemployment (due to a fall in output), and a rise in the aggregate price level. If the government were to shift the AD curve in response to a supply shock it could either decrease unemployment (but raise the price level), or lower the price level (but increase unemployment).
Government spending and tax revenue represent a large portion of a country’s GDP; therefore, changes in government spending or taxation can be of major influence to a country’s economy, because they effect total aggregate spending. Most tax revenues come from personal income taxes, social insurance taxes, and corporate profit taxes. Government spending is mostly done on national defense, education, social security, and Medicare and Medicaid.
The government can stimulate (or discourage) consumer spending by raising (or decreasing) taxes; furthermore, the government itself is also part of the economy and by making choices on what to spend on it can shift the aggregate demand curve. Policies that affect a country’s economy are called fiscal policies. They exist out of:
Expansionary fiscal policy: increases aggregate demand (rightward shift of AD) through increasing government transfers, government purchases, and cutting taxes
Contractionary fiscal policy: reduces aggregate demand (leftward shift of AD) through increasing taxes, reducing government purchases and reducing government transfers.
During the 2008 crisis and the recession afterwards many voices called for expansionary fiscal policies to help stimulate spending. However, these claims were seem by just as many voices as extremely controversial. In general, we can find 3 main arguments against the use of expansionary fiscal policy:
Government borrowing always crowds out private investment spending (not necessarily)
Government spending always crowds out private spending (wrong)
Government budget deficits lead to reduced private spending (not necessarily)
The extent to which expansionary fiscal policy works depends on the context: while it can be very helpful during a recessionary gap, when the economy experiences full employment, it can lead to disastrous consequences. However, it is important to note that just as any government policy, fiscal policies experience time lags: it can take months before the government decides on its stimulus package, and by the time it has been approved it could be that the stimulus is not necessary anymore, which could lead to a destabilization of the economy of the wrong stimulus is given.
As mentioned before there are two main ways in which the government can affect the AD curve: either by increasing/decreasing government purchases of goods and services, or by increasing/decreasing government transfers and taxes. The former is usually more effective in shifting the AD curve as it has a direct effect on demand. The latter, however, does not, due to the dependence on the size of the MPS. As discussed in chapter 11, an initial change in aggregate spending is not an isolated event, but rather works as a type of ‘trickle down’ effect due to the multiplier. Therefore, the effectiveness of fiscal policies depends on the size of the multiplier.
Tax cuts tend to be problematic in this regard, as they usually change the size of the multiplier. Although rarely imposed, lump-sum taxes—taxes that do not depend on the taxpayer’s income—are the only type of tax that do not influence the multiplier. This is because of the cost of ‘basic needs’: people who have a lower income tend to have a higher MPC, the proportion of their income that they have to spend on housing, insurance and food is a lot higher compared to people who have a high income. Therefore, tax-cuts that affect low-income households tend to have a greater effect.
Some fiscal policies are ‘automatic’, and these are called automatic stabilizers. It functions as a set of rules (policies) that will automatically be expansionary when the economy is contractionary and vice versa. However, taxes aren’t the only type of automatic stabilizers; government transfers play an important role in stabilizing the economy too. Finally, fiscal policies can also be discretionary: in this case the policy is a choice made by the policy makers, and not automatic.
Although it is possible to quickly calculate whether a government is executing an expansionary or contractionary fiscal policy by looking at changes in the budget balance, there are two things that economists keep in mind when they calculate it this way. Firstly, as discussed before, some fiscal policies have a bigger effect on real GDP than others due to the multiplier effect. Secondly, fluctuations in the economy often cause fluctuations in the budget balance, instead of the other way around. This effect is largely explained by the work of automatic stabilizers. When the economy expands, tax revenue tends to increase and some government transfers decrease; in other words, the budget moves toward a surplus during expansionary periods. On the other hand, during a contractionary period government tax revenue tends to fall while government transfers increase resulting in a move toward a budget deficit. Therefore, when analyzing budget policy it is imperative to divide automatic stabilizers that are influenced by the business cycle, and are temporarily, from changes caused by discretionary fiscal policy changes, which are usually long-term. By separating the effects from the business cycle from discretionary fiscal policies, economists can get a better estimate of the budget balance. In doing so, they use the cyclically adjusted budget balance to calculate the size of the budget balance when real GDP equals potential output.
In order to understand what the consequences of fiscal policies are in the long-run we first need to know some of the basics of government accounting. Usually, the governments do not do their bookkeeping in calendar years; instead, they use fiscal years that start at the 1st of October and go until the 30th of September the next year. Furthermore, it is important to fully understand the difference between deficit and debt. While the first is about the difference between spending and receiving, the latter are about actually owing someone something. They are connected to each other, however, but just not the same thing. Finally, there is public debt: these are debts the government owes to individuals and institutions outside the government. We have already discussed the risk of the government’s borrowing activities crowding out the market; additionally, when a government runs persistent budget deficits this will put pressure on future budgets, and increasingly put stress on the government’s ability to repay debts. In the summer of 2015 this led to a renewed crisis situation in Greece, where the government was unable to repay its debts and had to borrow again, to make sure it wouldn’t default on its debts. The debt-GDP ratio is a helpful too for better understanding whether a government is able to repay its debts: when the debt is a large percentage of the GDP this becomes increasingly difficult, and usually encourages governments to take action. However, the calculations of government debt do not take into account its implicit liabilities, which are spending promises made by the government, such as social insurance. Especially in ageing countries these liabilities will put further pressure on the budget in the years to come.
In economics the term money is used for any asset that can be used for the purchasing of goods and services easily and quickly. The specification of –any asset- also means that money is more than just cash: currency in circulation is the cash held by the public, but checkable bank deposits, bank accounts on which people can write checks, are also seen as money. The total value of all the money in an economy is called the money supply.
Generally speaking, money has three functions in an economy. Firstly, it is a medium of exchange; it is an asset that is used for trading goods and services instead of consuming. Secondly it is also a store of value, meaning that it holds value over time and not expires. Finally, money is also a unit of account. It can be used to set prices and make economic calculations.
Besides having different functions, there are also different types of money. Commodity money is a good that can be used as a medium of exchange, but also has intrinsic value in other uses (e.g. gold: both coins and jewelry). There is also commodity-backed money, which is money that does not hold any intrinsic value; instead, it derives its value from the promise that it can be converted into valuable goods, such as gold. Still, this is different from the paper money we use nowadays. Most contemporary societies use flat money instead, which derives its value entirely from its official status as a means of payment.
The U.S. Federal Reserve uses in its calculations two different monetary aggregates—the overall measure of the money supply. They differ in the diverging definitions of ‘money’ and are called M1, and M2. The former only looks at currency in calculation, checkable bank deposits, and traveler’s checks. The latter also includes near-moneys, which are assets that can’t be used directly as a medium of exchange, but it isn’t too difficult to convert them into such a medium.
In Chapter 10 we discussed the roles of banks as financial intermediaries, and their function as lenders. However, banks cannot lend out all the money that depositors put into them. The money that banks do not lend out is called bank reserves, and the public does not hold these; therefore, they are also not part of currency in circulation. To analyze the financial situation of a bank the T-account is used, which shows in one table on the left sides the bank’s assets and on the right side the bank’s liabilities. Banks are by law supposed to hold more assets than liabilities, the reserve ratio shows the fraction of deposits (assets) the bank has more than liabilities. As banks always have some liabilities, a bank run usually leads to bank failure. This is because if when everyone starts withdrawing funds from the bank at the same time, the bank will not be able to hand out these funds, as part of it is loaned out to others. In order to prevent bank runs many governments have some forms of regulation.
A common method is deposit insurance, which insures depositors’ funds in case of a bank run. In the situation where a bank fails, depositors will get their funds back. Capital requirements are installed to make sure that banks do not engage in excessive risk taking. Because banks know that their depositors will get their funds in case of bank failure, they tend to engage in risky behavior. Capital requirements make sure that banks have to hold more assets than the value of the bank deposits, in this case losses due to risky behavior will be accrued against the bank’s own assets. Reserve requirements are similar to capital requirements, but these rules set the minimum reserve ratio instead. Finally there is the discount window, which allows banks to borrow money to pay off its depositors.
Banks influence the money supply in two ways: by decreasing currency in circulation, and the have the ability to ‘create money’. There are several steps that lead to the creation of money by banks. Firstly, once meeting the minimum reserve requirements banks will always lend out any excess reserves they have. If they suddenly find themselves with an excess reserve of $10,000 they will lend out that money, which in turn ends up as a checkable bank deposit somewhere else. In a situation where the required reserve ratio is 10% this means that the bank will keep 10% of that $10,000 ($1,000), and in turn will lend out the remaining 90% ($9,000). Consequently, that $9,000 will end up as checkable bank deposit somewhere else again, the bank will keep 10% ($900) and lend out the remainder $8,100 etc.
However, determining the actual money supply is a bit more complicated as there are more factors at play than just reserve requirements. To fully be able to determine the money multiplier we need one last factor: the monetary base is the sum of currency in circulation and reserves held by the banks. It differs from the monetary supply in that it includes bank reserves but excludes checkable bank deposits. As a result, the monetary base is typically much smaller than the monetary supply. Finally, the money multiplier is the ratio of the monetary supply to the monetary base and tells us the effect described in the preceding paragraph.
Central banks are the main institution that oversees and regulates the banking system and controls the monetary base. In the U.S. this is called the Federal Reserve (Fed), and the EU also has a central bank, the European Central Bank (ECB). Central banks usually carry out monetary policies that can be divided into three main policy tools. Firstly, they can set the discount rate, which is the interest rate that is charged on loans to banks that use the discount window. Secondly, they set the reserve requirements. Finally, they participate in open-market operations, which are purchases (or sales) of government debt by the central bank. Although it is sometimes casually said that the central bank controls the money supply, strictly speaking the control the monetary base.
The Fed was created in 1913 in response ‘The Panic of 1907’ in the U.S. The burst of the ‘trust’ asset bubble led to bank runs and massive losses to the American economy. Although, it ended in merely a week, The Panic caused a four-year recession, falling production, and an increase in unemployment.
The creation of the Fed led to a standardization and centralization of the holding of bank reserves. During the Great Depression in the 30s the government realized that this was still not enough: banks were still not protected against bank runs, as there were no reserve requirements for banks. As a result of the Depression the Glass-Steagall Act was enacted in 1933 that separated banks into two categories: commercial banks, which were covered by deposit insurance, and investment banks, which were not covered as their activities were much more risky.
This worked out for a while until the savings and loan crisis of the 1980s. The banking industry also existed out of so-called savings and loans (thrifts) institutions that accepted savings and turned them into long-term mortgages. When the U.S. experienced a period of high inflation during the 1970s this eroded the value of the assets these institutions held. As a result, the government allowed these institutions to partake in more risky investments, insured by the state, without adding any regulation. In the end this created a bubble, which burst in the 1980s and the liabilities paid by the state.
The 2008 crisis shares some similarity to the previous crises as it involved badly regulated institutions and a slow reaction by the government. However, important to this crisis was the role of technology. Hedge funds went largely unregulated in the U.S., and these were both extremely risky, and extremely profitable. However, LTCM (one of the largest hedge funds) was not able to survive the crises in Asia and Russia in the 90s unscathed. When it tried to sell of its assets it inadvertently pushed the prices down of what it was trying to sell due to its size. Eventually this lead to falling asset prices all over the world in a vicious cycle of deleveraging and the financial markets panicked. Although the Fed was able to stabilize the markets, the failure of LTCM did set the stage for the next crisis. The effects of the Fed’s policy (and the large inflow of FDI from China) caused the interest rate of the U.S. to be historically low. This helped cause a housing boom, which in turn increased subprime lending—loans made to home-buyers who don’t meet the ‘normal’ criteria for borrowing. These loans were possible because of the process of securitization, where loans are pooled together and shares of the total loan are sold to investors. Investors considered this to be safe practice due to the unlikeliness of a wide-spread default on the payments of the loans. However, by late 2006 the housing bubble burst and many subprime borrowers were not able to fulfill their payments. Eventually this led to a combination of a collapse of trust in the financial system and extreme losses by financial firms, causing, once again, a vicious cycle of deleveraging and a credit crunch. In response to this the U.S. government started bailing out banks, which led to a relative stabilization of the markets by 2010. However, the economy did not necessarily improve; while it did manage to end the recession, unemployment did not decrease.
Holding money generally comes with an opportunity cost: on the one hand it can be really convenient to have actual cash in your wallet, on the other hand by not storing your money on the bank, there is a ‘loss’ of the interest you could have received if you would have stored your money in the bank. The trade-off that is made here typically depends on the (nominal) interest rate.
Short-term interest rates, which are the interest rates of financial assets that expire within a year, are a lot more volatile compared to long-term interest rates, and tend to be the ones that affect the money demand. For these interest rates the rule follows that the higher the short-term interest rate, the higher the opportunity cost of holding money and vice versa. This is because if you decide to hold large amounts of cash while the interest rate is high, the opportunity cost incurred will be higher when the interest rate is low. There are also long-term interest rates, which apply to financial assets that expire in more than a year. Although it sometimes is more practical to divide between these two types of interest rates, for now it will be assumed that there is just one interest rate.
In order to graph the demand and supply of money, we put the interest rate, r, on the x- axis, and the quantity of money on the y-axis. The reason for choosing the interest rate for the x-axis is due to the easy convertibility of the assets it is applied to.
The money demand curve shows the aforementioned relationship between the interest rate and the quantity of money demanded. Movements along the demand curve work according to the ceteris paribus concept. Still, shifts of the demand curve can also occur.
Changes in real GDP: as money is a means for buying goods and services, and change in the amount of these purchases will also affect the amount of money households/ firms want to hold: an increase in real GDP causes a rightward shift and vice versa.
Changes in institutions: only recently it has been allowed to pay interest over regular checking accounts. This caused an increase of quantity demand + a right-ward shift
Changes in Credit Markets and Banking Technology
Changes in the Aggregate Price Level: the rule behind this relationship is that ‘other things equal, the demand for money is proportional to the price level’. This means that if the price level rises, people would automatically demand more money
In order to understand how the interest rate is decided upon we can use the liquidity preference model of the interest rate, which combines the money demand curve, the money supply curve. The interest rate is then determined at the point of intersection of both curves (the equilibrium). It is usually the central bank that increases or decreases the money supply by choosing the amount of money supply they think is necessary to hit a specific interest rate target. This results in a vertical money supply line, as determined by the central banks. The U.S. Fed generally meets every six weeks to decide on a specific interest rate to follow until the next meeting six weeks later. The ability to affect the money supply means that if the money supply increases this will generally decrease the interest rate and increase the quantity of money demanded, and vice versa. The money supply is usually controlled through selling or purchasing Treasury bills, while other tools of monetary policy are less commonly used.
Monetary policy generally influences aggregate demand by changing the money supply, which in turn changes the interest rate. Just as with fiscal policy, we can divide monetary policy into expansionary policy, aimed at increasing the aggregate demand, or contractionary, aimed at decreasing aggregate demand. The goals of monetary policy are to ensure price stability, keep inflation low, and fight recessions.
According to the economist John Taylor, monetary policy should try to keep the interest rate at the same level as the inflation rate, the output gap, and/or the unemployment rate. The Taylor-rule encourages policy makers to ‘learn from the past’ and set policies based on past inflation rates. However, in 2012 this type of focus changed, and the Fed focused mainly on using monetary policy to hit a particular inflation target. This is called inflation targeting and combines different tools in order to keep to that inflation goal. Those who prefer this policy usually argue that the central bank becomes more transparent and accountable. Nevertheless, this way of doing policy can also lead to a destabilization of the economy, due to frantic attempts to keep to the inflation target. Finally, it is good to remember that inflation rates can never drop below zero, otherwise known as the zero lower bound for interest rates.
We discussed in the 12th Chapter that the economy is self-correcting in the long-run. When monetary policy is misused it can lead to disastrous consequences for an economy. As a rule we can say that ‘in the long-run, changes in the quantity of money only affect the aggregate price level and nothing else’. This effect is also called money neutrality, which holds that changing the money supply is useless, as it does not have any long-term effect on the economy. In fact, a change in the money supply will result in an equal change of the aggregate price level. However, monetary policy does have a big effect on the economy in the short-run and is therefore quite useful in times of crises.
While there can be many causes for low to moderate inflation, high inflation is closely related to huge increases of the money supply. To better understand this economists use the classical model of the price level, which assumes that the real quantity of money is always at its long-run equilibrium. This is different from what was discussed in chapter 15, where the importance to make a distinction between the short-run and long-run was emphasized; however, in cases of high inflation this particular model can be very useful. The main reason for this is the ‘stickiness’ of prices and wages. In periods of low to moderate inflation, workers and business will be slow to respond to changes in the money supply; however, when experiencing high inflation, these workers and business become used to the continuous rising inflation and respond much quicker. As a result, the stickiness of wages and prices disappears, and the main difference between the short- and long-run does too.
The quick responses to changes in the money supply are extremely problematic for countries experiencing high inflation as it diminishes the effects of monetary policy. Part of the reason when governments themselves cause in an increase in inflation has to do with the government budget. Most governments have the authority to use the central bank to increase the money supply (by printing more money) to pay of government debts, in doing so they won’t have to legitimize an increase in taxes to their voters. The right to do so, and the ‘revenue’ that governments can create in doing so is called seignorage. However, as we know increasing the money supply also increases inflation. The reduction in the value of money held by the public caused by inflation is called the inflation tax. Furthermore, the reduction in the value of money will cause people to reduce their real money holdings (such as paper money), as these become worth less and less, which reduces the real money supply. It is therefore wrong to think that by printing extra money to decrease a government budget deficit has no consequences at all. Still, governments sometimes decide to take these measures anyways. If the government finds itself in a situation where it has to pay off a large debt, and can only do so through raising the money supply (to earn a given amount of real seignorage), this in turn increases the interest rate, and decreases the real money supply. As money is now ‘worth less’, the government needs to collect even more money thus increasing the money supply more, causing the interest rate to increase more too, and the real money supply to decrease. This could spiral out of control and eventually cause hyperinflation, where people don’t want to hold any real money at all and the government has to shut down its money-printing presses.
Expansionary policies can sometimes lead to inflation due to the relationship between the output gap and the unemployment rate. There are two rules at the core of this relationship. Firstly, if there is a positive output gap (inflationary gap), the unemployment rate is below the natural rate and vice versa. Secondly, when the actual aggregate output is the same as the potential output, the unemployment rate will also be equal to the natural rate. Therefore, fluctuations of the aggregate output around the potential output, are equal to fluctuations of the unemployment rate around the natural rate. This negative relationship between the unemployment rate and the output gap is called Okun’s Law.
As we know, expansionary policies lead to a decrease in the unemployment rate; at the same time, this would also increase the output gap (increase the inflationary gap) and vice versa. The negative short-run relationship between the unemployment rate and the inflation rate is shown through the short-run Phillips curve (SRPC); additionally, as the relationship is negative the curve naturally also slopes downwards (Page 485: Figure 16-6). While supply shocks, and thus the unemployment rate, impact the SRPC, it is commonly accepted that the expected inflation rate has a much larger influence. This is because if people expect the inflation rate to rise or fall in the future, they will adjust their behavior to that change in the present. Therefore, an increase in expected inflation would cause an upward shift of the SRPC, and vice versa. The actual expected inflation rate is usually decided by past experiences, thus, if people have experienced long-term inflation of 2,5% they will expect the same rate in the future. The long-run Phillips curve (LRPC) shows the relationship between unemployment and the inflation rate after expectations of inflation have had time to adjust to experience (Page 490: Figure 16-11). It is vertical due to the NAIRU, or the nonaccelerating inflation rate of unemployment, which indicates the unemployment rate at which inflation does not change over time. The rule holds that maintaining an unemployment rate below the NAIRU would lead to a continuous acceleration of inflation. On the other hand, keeping the unemployment rate above the NAIRU would lead to a decelerating inflation. In other words, the NAIRU is equal to the natural rate of unemployment
Reducing the expectations in increasing inflation can come at a high cost for policy makers. The process itself is called disinflation and includes policies that increase the unemployment rate and decrease aggregate output. However, to combat accelerating inflation, these policies are sometimes worth it anyways.
Deflation works the opposite way of inflation: the value of real money increases over time, so people want to hold more real money. However, for borrowers the effect can be detrimental: the value of their debts will increase over time; as a result, they often cut back on their spending. On the other hand, for lenders the value of the loans they’d made increases over time; however, this does not coincide with an increase of spending. Therefore, deflation can lead to a decrease in aggregate demand, because of the increase in the real debt burden for borrowers, also called debt deflation. When economies experience deflation, this also affects the expected deflation for people. However, the nominal interest rate cannot fall below zero (it is zero bound). This is problematic because it decreases the effectiveness of monetary policies. In a situation of decreasing aggregate demand, the government would normally decrease interest rates; but if the interest rate is already zero (or close to) there is nothing the government can do. In these cases it would have fallen into a liquidity trap.
Banks are important as the works as an intermediary by transforming short-term liabilities into long-term assets, called maturity transformation. In other words, banks borrow consumer’s deposits in the short-term, and then lend those deposits in the long-term. This increases a saver’s welfare, because it allows them immediate access to their funds and it allows them to receive interest on those funds. However, not all banks use deposits for maturity transformation. Shadow banks tend to borrow from short-term credit funds, and invest these funds in long-term risky projects. Although this gives lenders higher returns, it tends to be a lot more risky and less regulated. Still, banks are at a danger of bank runs. When there is a mass panic and many consumers want to withdraw money at the same time from the bank, there is a danger that the bank does not have enough funds at that moment as they have lend out too much funds themselves. This typically results in a bank failure, and was seen in the 2008 economic crises.
Although banking crises almost never happen, when they do this often leads to disastrous results for the economy as a whole. There are two main causes for bank crises: the burst of an asset bubble, and financial contagion. Asset bubbles are usually generated, because many believe that investing in that specific asset will lead to future returns, and higher gains. In an asset bubble this would push the price of the asset up to ridiculous heights, until it becomes unsustainable and the bubble bursts. This causes a crash of the price, and often a (massive) loss of capital and trust. If severe enough it can lead to a type of downward spiral called a financial contagion. Financial contagion can be seen as a domino effect of banks failing one after the other due to loss of confidence and bank runs.
When the burst of an asset bubble, financial contagion, and a large shadow banking sector are combined this often leads to a financial panic: a situation where people out of nowhere lose trust in the liquidity of financial institutions and markets.
When banking crises hit they often have long-term effects to an economy and can cause long and deep recessions. The biggest problems with a banking-crisis recession are:
Debt overhang: caused by the deleveraging of assets and leaves the borrower with no funds to pay back his/her debts.
Credit crunch: potential borrowers are unable to borrow any new funds are they must pay extremely high interest rates
Both these effects cause spending to fall, as consumers and businesses work on re-paying their debts and increasing the value of their assets.
Loss of monetary policy effectiveness: is the most dangerous consequence, as monetary policy is often used in order to help the economy out of a recession
When a country experiences a crisis the central bank and the government often step in to reduce the effects of such a banking crisis. Typically they:
Act as a lender of last resort: providing funds to financial institutions
Offer guarantees to depositors and others with claims on banks
Only when the crisis is extreme enough the central bank will step in and provide financing to private credit markets
The damage caused by the 2008 crises was enormous, and long-term. In fact, in 2016 we are still noticing some of the after effects. The persistence of the after effects led to debates about the right policy responses and created two camps: those calling for more fiscal stimulus—increasing government spending and reducing unemployment—versus those calling for fiscal austerity—spending cuts and (possibly) tax increases to reduce budget deficits. The 2008 crisis initially began as the shadow-banking sector suffered severe losses with the burst of the housing market bubble. As a consequence of the crisis, governments have enacted new bills (US: Dodd-Frank bill) in order to prevent new crises. These new reforms often include an increase in consumer protection, more regulation of derivatives and shadow banking, and resolution authority—nationalizing through the bailing out of financial institutions.
Macroeconomics as a concept only came to be used after the Great Depression of the 1930s. However, before this event there was already some macroeconomics analysis going on: ‘classical macroeconomics’, which generally ignores any short-run effects on the aggregate output; instead, analyses focused only on long-run effects of monetary policy. Additionally, the role of business cycles was already well known; however, their had not been any theory developed that explained why the business cycle happened.
The Great Depression showed that the short-run could not be ignored. In his analysis of the Great Depression, Milton Keynes managed to develop theories regarding both the short-term and the business cycle. He argued that changes in aggregate demand affect aggregate output, prices, and employment; and, changes in business confidence cause the business cycles. Through this a better understanding of the short-run was developed and it became now accepted that the SRAS curve was upward sloping, instead of it being vertical. Additionally, it was accepted that changes in business confidence caused changes in the AD curve, and through this created the business cycle. Finally, these theories legitimized macroeconomic policy activism.
Early Keynesian economics emphasized the effectiveness of fiscal policy, and somewhat disregarded the effects of monetary policy. However, through time economists realized that monetary policy was effective (except in the case of a liquidity trap). This new ‘movement’, led by Milton Friedman, was called monetarism. Monetarists asserted that GDP would grow steadily if the money supply also grew steadily. While they agreed upon most of the Keynesian principles, they also argued that most of the policies that tried to smooth out the business cycle would only make things worse. Instead, they proposed the use of discretionary monetary policy, which uses change in the interest rate or money supply to stabilize the economy, and asserted that this suffered less from the time lag experienced by discretionary fiscal policy.
In the 1970s and 1980s there were some economists that contested the traditional arguments about the slope of the SRAS based on the idea of rationality; additionally, there were some economists that changes in productivity could also cause economic fluctuations (called real business cycle theory). This eventually caused an approach that was called new classical macroeconomics, which emphasized that the AD curve only affects the aggregate price level, not the aggregate output.
The economists that challenged the idea of rationality disagreed with the view that everyone makes decisions optimally using all available information. The model developed from this view, the rational expectations model, assumed that expected changes in monetary policy would only affect the price level. However, the new Keynesians argued that markets are almost never in perfect competition, and that this causes price stickiness. They then went on to theorize an upward sloping supply curve, modeling that changes in aggregate demand affected both aggregate output and employment. Economists who developed the real business cycle theory claimed that the rate of growth of total factor productivity caused the business cycle. This undermined the idea that technology would somehow regress during deep recessions.
The period form 1985 to 2007 was a relatively calm economic period for the U.S., and was nicknamed the Great Moderation. From this period the Great Moderation consensus was developed, which combined the use of monetary policy for stabilization, and retained skepticism towards using fiscal policy. Furthermore, it acknowledged policy constraints caused by the natural rate of unemployment and the business cycle. However, this consensus was challenged due to the Great Recession. Fiscal policy became a favored tool again; however, it did not decrease unemployment significantly. Concurrently, critics argued that fiscal policy was useless, and that crowding out would occur. This however, never happened.
In order to keep track of all international transactions economists use the balance of payments accounts, which summarize international transactions between countries. The balance of payment can be split up into two parts, the current account and the financial account, which show both payments from foreigners and payments to foreigners.
The current account exists out of three different types of transactions. Firstly, there are the sales and purchases of goods and services. This is regarded as the most important aspect of the current account, and more generally called the balance of payments on goods and services. Secondly, there is the factor income, which shows the income countries pay for the use of factors of production owned by residents of other countries. On the Dutch balance of payments account this would entail profits made abroad by the Dutch-owned Royal Dutch Shell, but it would also include a Dutch expat temporarily working abroad. Finally, there is the transaction of transfers, which includes donations, and other unilateral transfers. To summarize, the current account (or fully: balance of payments on current account) includes all transactions that do not create liabilities. The financial account exists out of official asset sales and purchases, and private sales and purchases of assets. While the former entails purchases and sales by governments and central banks, the latter consists mainly out of private investors. As this account involves purchases and sales of assets, it does create liabilities. The current account and the financial account always add up to 0. This is because a country can only spend as much as it receives. Therefore, the sources of payments, the financial account, must be equal to the uses of payments, the current account.
Sometimes economists use the merchandise trade balance, which simply states the difference between exports and imports, as the data is more accurate and easier to retrieve.
Because the financial account measure the net purchases and sales of assets, it is also possible to view these purchases and sales as foreign savings, available to finance domestic spending; in other words, capital inflows. By simplifying the loanable funds model it becomes possible to understand motivations behind these capital flows.
The first simplification economists make, is the assumption that all capital flows are in the form of loans. The second simplification is the dismissal of the effects of expected changes in exchange rates. We can analyze capital flows similarly like goods and services; capital circulates from cheap places to expensive places to establish a new international equilibrium rate. However, this model only shows the net capital flows and is therefore shows as being ‘one-directional’; it only shows the surplus of outflows versus inflows, or vice versa. Gross capital flows show that capital flows are actually ‘multi-directional’; countries typically engage in both purchasing and selling of assets, in order to decrease their risks.
The reason why the current and the financial account balance is the exchange rate, which is determined in the foreign exchange market. Exchange rates are the prices at which currencies are traded and can either appreciate, when the value of the currency goes up compared to other currencies, or depreciate, when the value of a currency goes down compared to other currencies. The foreign exchange market exists out of a demand for a currency and a supply of a currency. Foreigners wanting to buy domestic goods, services, and assets determine the demand; on the other hand, domestic residents wanting to buy foreign stuff determine the supply side. The effect of the exchange rate in balancing the current and financial account can be explained by imaging a (hypothetical) situation where there would be a sudden increase in investments from The Netherlands to Malaysia. This would cause the demand for the Malaysian currency to increase (the Malaysian ringgit would then appreciate). The number of Euros then needed compared to Ringgits would increase, leading to the Dutch buying less Malaysian products, as they are now more expensive; however, it would also make it cheaper for Malaysians to buy Dutch products. In other words, there would be an increase in Malaysia’s financial account due to the increase of capital inflows; however, Malaysia would also experience a decrease in the current account, due to a decrease in exports combined with an increase in imports.
However, as we know inflation can affect the aggregate price levels of countries. To include these changes economists distinguish between the real exchange rate (exchange rate adjusted for international differences in price levels), and nominal exchange rates (unadjusted exchange rates). As a rule, only real exchange rates affect the current account. To better understand why, imagine wanting to buy a pair of Nikes in the U.S. as a European. The pair of Nikes initially costs $100, which is €10 (exchange rate is $10 per €1); however, you decide to wait a few years before you buy the shoes. By now both U.S. prices and the supply of dollars have risen by a 100%, and the shoes are therefore $200. Still, the pair of Nikes would cost just as much as several years ago: as the supply of dollars also rose by 100% to $20 per €1, the Nikes now cost $200/$20, or €10 euros.
By using the concept of purchasing power parity (PPP) economists calculate the nominal exchange rate that would equalize the price of a specific market basket between two countries. Although this is usually different from the ‘actual’ nominal exchange rate, the PPP still provides a pretty good indication of changes in the nominal exchange rate.
Just as any other price, supply and demand determine the nominal exchange rate; however, this exchange rate is actually the price of a country’s money. As the quantity of this money is determined by government policy, governments can exert and influence the exchange rate significantly; these policies are called exchange rate regimes. The two main types of regimes are keeping a floating exchange rate—when the exchange rate is determined only by supply and demand—and a fixed exchange rate—when the government consciously keeps the exchange rate against another currency that is close to or the same as a particular target.
In order to keep the exchange rate fixed governments typically buy or sell (their own) currency in the foreign exchange market, a policy called exchange market intervention. But to be able to do so, they also need other currency to buy their own currency: these stocks of foreign currency are the foreign exchange reserves, and most countries maintain them. A second way governments can affect the exchange rates is by using domestic policies (usually monetary policy) to change the interest rate. When interest rates in a country go up, capital inflows (demand) will increase and capital outflows (supply) will decrease. In other words, when a country raises its interest rates its currency also appreciates, and vice versa. Finally, the government can set up foreign exchange controls, which limit the right of individuals to buy foreign currency and therefore appreciates a country’s currency.
It is not that easy for governments to choose an exchange rate regime. While on the one hand having a stable exchange rate is generally good for business, holding large foreign exchange reserves is pretty costly. Also, when using domestic policy to influence the exchange rates it takes away funding from other objectives. Finally, foreign exchange controls change incentives for imports and exports towards more ineffectiveness.
Although it might seem so, maintaining fixed exchange rates doesn’t mean that they have to stay the same permanently. It is quite common for countries to either devaluate their currency—reducing the target value—or revaluate—increasing the target value. There are two reasons for devaluation and/or revaluation. The first is devaluating the currency to stimulate exports while reducing exports, increasing the balance of payments on current account (or vice versa). The second reason is as a macroeconomic tool for affecting aggregate demand. Devaluation typically increases aggregate demand, and as such can be used to reduce a recessionary gap. This also works with a revaluation, which decreases aggregate demand, and could reduce an inflationary gap.
Domestic monetary policy typically affects the exchange rate too. When the interest rate in a country rises, residents are less inclined to save their money; instead, they will be more motivated to invest their funds abroad. This causes an increase in the supply of that particular currency, while at the same time the demand for that currency decreases. As a result, the currency depreciates as the equilibrium exchange rate drops.
Finally, there is the ‘international business cycle’ that affects the exchange rates. A recession in a country would normally decrease imports in that country and therefore also decrease exports in another country, and vice versa. This is why business cycles internationally seem to be, and can be, quite similar to one another. A good example of this would be the slowdown of China’s economic growth, which is reducing imports in China and causing fears to countries that export to China. However, this effect is much less strong when a country keeps a floating exchange rate regime. To better explain this we could look at Europe and China. The economic slowdown of China is decreasing demand from China for Europe’s products; therefore, it is decreasing Europe’s exports. However, this also means that it is decreasing the demand for Euros. A decrease in demand for Euros leads to a depreciation of the Euro, making European products cheaper for China, and somewhat lessening the decrease in exports. At the same time, the depreciation of the Euro makes it more expensive for Europeans to import products, causing a decrease in imports. Therefore, the combination of these effects would somewhat lessen the decrease in aggregate demand.
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