the plan for the future

The Power of Macroeconomics: Economic Principles in the Real World

21 April 2014 - 7 June 2014

Lecturer: Professor Peter Navarro


This document contains course notes of the course The Power of Macroeconomics: Economic Principles in the Real World by Peter Navarro, Professor of Economics and Public Policy at the Paul Merage School of Business, University of California, Irvine in the United States that is available on This course focuses on basic macroeconomic concepts and uses a historical perspective to explain the schools of thought.




1. An Overview of Modern Macroeconomics
1.1. A short introduction into modern macroeconomics
1.2. The big four macroeconomic issues
1.3. Major macroeconomic policy tools
1.4. The major schools of macroeconomics
1.5. Demand-pull inflation versus cost-push inflation: the Keynesian dilemma and the rise of Monetarism
1.6. From supply side economics and the new classicals back to Keynesianism

2. The Aggregate Supply-Aggregate Demand Model and the Classical-Keynesian Debate
2.1. Intoduction to the Keynesian model
2.2. The two pillars of classical economics
2.3. Why classical economics failed
2.4. The AS-AD framework
2.5. Why the AS and AD curves shift
2.6. The three ranges of the economy

3. The Keynesian Model and Fiscal Policy
3.1. Intoduction to the Keynesian model
3.2. Analysis of the Keynesian model
3.3. The Keynesian expenditures functions
3.4. The Keynesian multiplier and closing recessionary or inflationary gaps
3.5. Strengths and weaknesses of Keynesian model

4. The Federal Reserve and Monetary Policy
4.1. Introduction
4.2. All about money
4.3. All about interest rates
4.4. Determinants of money demand
4.5. How paper money is created and the money multiplier

5. Unemployment, Inflation, and Stagflation
5.1. Some basic unemployment concepts
5.2. Unemployment defined and measured
5.3. Okun's law
5.4. Demand-pull versus cost-pust inflation and the Keynesian dilemma
5.5. Inflation, inflationary expectations and the Phillips curve
5.6. The natural rate of unemployment and inflationary spirals
5.7. Monetarist versus Keynesian cures for inflation
5.8. Supply-side economics and the Laffer curve

6. The Warring Schools of Macroeconomics
6.1. New classical economics and rational versus adaptive expectations
6.2. The Great Recession of 2007 and quantitative easing
6.3. How to forecast the business cycles and structural trade imbalances
6.4. What causes macroeconomic instability and is the economy self-correcting?
6.5. Rules versus discretion
6.6. A balanced budget rule, crowding out, and where the warring schools converge

7. Economic Growth and Productivity
7.1. Overview of the four wheels of growth
7.2. The four wheels of growth in detail
7.3. The growth models of Adam Smith and Thomas Malthus
7.4. Solow's neoclassical growth model
7.5. The pros and cons of growth and how to stimulate growth

8. Budget Deficits and the Public Debt
8.1. Budget deficits and the public debt defined
8.2. The Debt-to-GDP Ratio; Real versus nominal deficit; Structural versus cyclical deficit
8.3. Calculating the structural and cyclical parts of the budget deficit
8.4. Financing budget deficits and associated problems; The balanced budget multiplier
8.5. Budget deficit pros and cons
8.6. Impacts of budget deficits and debt on investment and productivity

9. International Trade and Protectionism
9.1. Absolute versus comparative advantage
9.2. The nuts and bolts of comparative advantage and the gains from trade
9.3. Tariffs, quotas, trade barriers, protectionism, and the deadweight loss
9.4. The pros and cons of protectionism
9.5. The limitations of Ricardian free trade in the real world and the case of China

10. Exchange Rates, The Balance of Payments, and Trade Deficits
10.1. Are trade deficits a problem?
10.2. Some balance of payments accounting
10.3. Exchange rates defined and why they move
10.4. Floating versus fixed exchange rates, the gold standard, and Hume's gold specie flow adjustment mechanism
10.5. The dollar standard and its collapse
10.6. Today's hybrid exchange rate system, currency blocs, and fixed pegs
10.7. How chronic trade deficits can persist, the multiplier link and global coordination of fiscal and monetary policies
10.8. The European Monetary System, Germany as a case study, and the benefits of policy coordination

11. The Economics of Developing Countries
11.1. The four elements of development
11.2. Human resources, natural resources, and land ownership patterns
11.3. The importance of capital formation and technological change
11.4. Why some countries prosper, the cycle of poverty, and nine policies to promote growth


1. An Overview of Modern Macroeconomics

1.1. A short introduction into modern macroeconomics

At a personal level macro economics can answer questions like should I switch jobs or ask for a raise, should I buy house now or wait until next year or should I get a variable or fixed rate mortgage? At a business and professional level, macroeconomics can also help answer questions like how much should I manufacture this month and how much inventory should I maintain? Should I invest in new plant and equipment, expand into foreign markets, or downsize my firm?

Macroeconomics can help answer these questions because it arms us with a new way of thinking about the world we live and work in. It helps us filter and sort and process all of the information we are bombarded with every day in the media: an interest rate hike here, a fallen consumer confidence there, coffee shortage in Brazil or a drop in the Japanese yen. From the macroeconomic perspective, all of these seemingly unrelated bits of information reveal to us first patterns and trends, and ultimately courses of action.

A couple of stories about two fictional people in very real situations can demonstrate the use of macroeconomics. Jim Wells used to own a small high tech manufacturing business that made precision components for computer games. Every July, Jim had to decide how many components to produce for the upcoming holiday season, and every year he had simply doubled his production. Since he never had any trouble moving the inventory, Jim decided to do the same thing again, even though it meant taking out a big short term loan to finance the expansion.

Unfortunately Jim's college studies in engineering never included a course in macroeconomics. So in making his decision, he missed some rather significant danger signs. For example, he had read in the Wall Street Journal that the Federal Reserve recently raised the bank discount rate, and sold bonds in the open market. But Jim didn't see this as contractionary monetary policy that might trigger a recession. Instead he just grumbled about the higher interest rate on his business loan. Nor did Jim see the recessionary implications of several stories on CNN reporting a fall in consumer confidence and a slight uptick in the unemployment rate.

And even though Jim had noted a small blurb in Business Week about Japan's shift towards a more expansionary monetary policy, Jim didn't have a clue that this would cause the value of the yen to fall relative to the dollar. This gave his Japanese competitors a big leg up. By October, the Japanese had taken over half of a market that was already shrinking fast from the onset of a recession. By Thanksgiving, Jim found himself sitting on a huge inventory. By December, he was unable to repay the huge loan. By June, he was bankrupt. Today, Jim works as a consultant for one of his old Japanese competitors during the day, and studies macroeconomics in the evenings at a nearby college.

He sits in the front row of class right next to Teresa Watson. Unlike Jim, Teresa didn't go bankrupt but she came very close. Teresa is a single working mother whose big dream in life is to own her own home. As the marketing director for a major corporation, Teresa earns a good salary and some years ago she had saved $25,000 for a house down payment. After months of looking, Teresa's choice had boiled down to either a modest two bedroom condo near her job in the city or her dream home, the more expensive single family house out in the valley.

After talking it over with a mortgage banker, Teresa decided that the only way she could afford her dream home was to take out a variable rate mortgage. It was available at a full two percentage points below the fixed rate mortgage, and her monthly mortgage payment would be several hundred dollars less, but only if interest rate stayed low. Sure, Teresa felt a little nervous about choosing the variable rate, but the mortgage banker told her not to worry. Rates of been stable for over three years now and it shouldn't be any problem.

Teresa failed to see numerous warning signs of growing inflationary pressures. On the demand-pull side the unemployment rate had just reached an eight year low. On the cost push side, the news was full of stories about a bad cotton crop in Brazil, a worldwide drought and possible food shortages, renewed violence in the Middle East and rising oil prices and, a fall in the value of the dollar.

Within two years, interest rates had climbed into the double digits, and Teresa could no longer afford her skyrocketing mortgage payments. The climb in interest rates, the economy plunged into a recession taking the real estate market down with it. For six months, Teresa tried to sell her house at the original price. But finally, facing the humiliation of foreclosure, she unloaded it for $25,000 less than she bought it for, losing every cent of her equity.

The tragedy is that both Jim and Teresa could have avoided their hardships if they had only been armed with the power of macroeconomics. Anticipating increased competition and recession, Jim could have halved this production rather than doubling it and he would still be in business today. And Teresa could have either bought that less expensive condo with a fixed rate mortgage. Or better yet, waited until the real estate market went soft and bought her dream house at an affordable price.

History provides a real world context for the study of macroeconomics
The power of macroeconomics can best be seen from an historical perspective. First, history gives a real world context for an otherwise abstract and difficult subject. For our grandparents the hardships, pain, and uncertainty of the Great Depression were all too real and we as a nation don't ever want to repeat them. Nor do we want to repeat the economic stagnation of the 1950s, the stagflation of the 1970s, or the so-called jobless recovery of the early 1990s.

The second reason to put macroeconomics in an historical context, is to emphasise that it is very much an evolving policy science. Put simply, the Keynesian solutions which were used to lift us out of the Great Depression in the 1930s, or to wake us up from the economic doldrums of the 1960s, would be inappropriate in today's more sophisticated in global economy.

Macroeconomists around the world relied heavily upon Classical Economics from the late 1700s up until the Great Depression of the 1930s. Starting with the Great Depression, the problems facing macroeconomists have become progressively more complex over time, from unemployment and inflation to stagflation, stagnating income, and chronic budget and trade deficits. New macroeconomic theories have emerged in response to this increasing complexity at key turning points in the world's economic history, such as Keynesianism in the 1930s, monetarism in the 1970s, supply side economics in the 1980s and new Classical Economics in the the 1990s.

1.2. The big four macroeconomic issues

Macroeconomics focuses on the big economic picture, specifically on how the overall national economy performs. Microeconomics which deals with the behaviour of individual markets and businesses, consumers, investors and workers that make up the economy. The four most important policy problems in macroeconomics are inflation, unemployment, the rate of economic growth and movements in the business cycle.

Inflation is defined as an upward movement of prices from one year to the next. It is typically measured by the percentage change in price indices, such as the consumer price index, the producer price index, or the so called GDP deflator. The producer price index is based on a number of important raw materials. The most widely used measure of inflation, the consumer price index or CPI, is calculated by pricing a market basket of goods and services purchased by a typical household. This basket includes prices of food, clothing, shelter, fuel, transportation, medical care, college tuition, and other goods and services purchased for day-to-day living.

Inflation eats away our savings and at our paychecks. For example, if the rate of inflation exceeds the rate of growth in our paycheck that means our real income or purchasing power is declining even though our wages are going up. Not everyone loses from inflation. Unanticipated inflation can benefit borrowers at the expense of lenders. Suppose you borrow $1,000 from a bank and promise to repay it in two years. If, during that time, the price level doubles because of inflation, the $1000 will only have half the purchasing power of the $1000 originally borrowed.

Another macroeconomic problem is unemployment. The unemployment rate is measured as the number of unemployed persons divided by the number of people in the labour force. In talking about employment, economists distinguish between three kinds, frictional, cyclical and structural.

Frictional unemployment is the least of the macroeconomist's worries. It occurs as a natural part of the job seeking process as people quit their jobs just long enough to look for and find another one.

Cyclical unemployment is more serious and occurs when the economy dips into a recession and has traditionally been researched the most by economists.

In an increasingly technological age the third type of unemployment, structural unemployment, has begun to receive more attention. Structural unemployment occurs when a change in technology makes someone's job obsolete. Structural unemployment is one of the hardest kinds of unemployment to cure.

Approaches to calculating national income
The third major macroeconomic policy issue is the rate of economic growth, which is typically measured by the growth in the nation's gross domestic product or GDP. The GDP is defined as the market value of all the final goods and services produced in a country in a given year. And economists have two ways of measuring it. One is called the flow of cost or income approach. The other is called the flow of product or expenditures approach.

With the flow of product or expenditures approach the gross domestic product equals consumption plus investment plus government expenditures plus expenditures by foreigners or net exports. Net exports are defined as the difference between total imports and total exports. In contrast, the flow of cost, or income approach, simply adds up all the income people receive each year from producing the year's output. Under this approach the gross domestic product roughly equals wages earned by workers plus rents earned by property owners plus interest received by lenders plus profits earned by firms.

Approaches to calculating national income
In thinking about economic growth in the gross domestic product it is useful to distinguish between actual and potential GDP. Actual GDP, represents what we are producing, while potential GDP represents the maximum amount the economy can produce without causing inflation. When actual GDP is well below potential GDP, we are in the recessionary range of the economy.

In contrast, when actual GDP is above potential GDP, we run the strong risk of inflation. The figure illustrates the relationship between actual and potential GDP and the unemployment rate. The difference between potential GDP and actual GDP is the GDP gap. This GDP gap measures the output the economy sacrifices because it fails to fully use its productive potential. A high unemployment rate means a large GDP gap.

It is also useful to distinguish between nominal GDP and real GDP. Nominal GDP is measured in actual market prices. Prices change over time so using nominal GDP to measure economic growth would be like using a rubber yardstick that stretches from day to day. To address this problem, macroeconomists use real GDP. This is nominal GDP adjusted for inflation, and it is calculated in constant prices for a particular year. Moreover when we divide nominal GDP by a Real GDP, we obtain the GDP Deflator, another valuable inflation index. Real GDP is the best widely available measure of the level and growth of output in the economy and movements in real GDP serve as the carefully monitored pulse of a nation's economy.

Phases of the business cycle
Closely related to the issue of economic growth and real GDP as a measure of such growth is the problem of business cycles. The term business cycle refers to the recurrent ups and downs in real GDP over several years. While individual business cycles vary substantially in length and intensity, all display common phases, as illustrated in this figure. There is a peak where business activity reaches a maximum, a trough which is brought about by a recessionary downturn in total output. And a recovery or upturn in which the economy expands towards full employment. Note that each of these phases of the cycle oscillate around a growth trend line.

A central concern of macro economists is to determine whether a recurring business cycle exists and to discover the forces behind it. More importantly, both macroeconomists and political leaders want to know what macroeconomic policies may be used to control or harness the business cycle. At the same time, a central concern of businesses is to determine whether the economy is going into a contraction or expansion. The right guess in business is often the difference between a big profit and a big loss. That is why many businesses rely on economic forecasting services to help them plan their production and marketing efforts.

1.3. Major macroeconomic policy tools

In dealing with economic problems such as inflation and unemployment, governments have a number of policy tools at their disposal. The two most important are the fiscal policy and monetary policy. Fiscal policies are the use of government expenditures or tax levels to influence economic growth. A fiscal policy can be increased government expenditures or tax cuts to stimulate or expand the economy. Fiscal policies can also be used to contract the economy and fight inflation by reducing government expenditures or raising taxes.

Monetary policies are the use of control over the money supply to achieve similar goals. Both monetary and fiscal policies are often used in conjunction with one another. Properly practiced, macro economic policies can help create a climate of prosperity and growth. However, improperly implied macroeconomic policies can inflict the greatest of miseries and harm.

This point can be demonstrated by outlining the historical evolution of macro economic thinking. Over time new theories like Keynesianism, monetarism and supply-side economics have emerged to try and cope with problems that the previous theories couldn't solve. Ultimately, it is only after we come to understand how macroeconomics has evolved, and how it keeps evolving over time that we will come to realise how important and relevant this subject is to everything we do.

AS-AD model
Before exploring macroeconomic history it is better to become acquainted with one of the most important tools in macroeconomics, aggregate supply and aggregate demand analysis. The AS-AD model has its roots in classical economics and is represented in this figure. The vertical axis measures the general price level for all goods and services. And the horizontal axis measures the level of real GDP.

The upward sloping curve labeled AS represents the economy's aggregate supply, or how much output the economy will produce at different price levels. It slopes upwards meaning that the higher the price level the more that businesses will produce. The downward sloping AD curve is the aggregate demand curve. It represents what everyone in the economy, consumers, businesses, foreigners and government, would buy at different aggregate price levels. The downwards slope means that as the general price level falls consumers and businesses will increase their demand for goods and services.

The AS And AD curves cross at point E which is a macroeconomic equilibrium. A macroeconomic equilibrium is a combination of overall price and quantity at which neither buyers nor sellers wish to change their purchases, sales, or prices. For example, at a price level of P equals 200, the economy is out of equilibrium because businesses want to sell quantity C, but purchasers only want to buy quantity B. At this price, goods will pile up on the shelves, and eventually firms will have to cut production and prices. This drives the economy back to equilibrium at point E. This aggregate supply and aggregate demand model can be used to interpret some important events in macroeconomic history.

1.4. The major schools of macroeconomics

Macroeconomic history starts with the classical model that dates from the late 1700s and has its roots in the laissez faire writings of free market economists like Adam Smith, David Ricardo, and most importantly Jean Baptist Say. These classical economists believe that the problem of unemployment was the natural part of the business cycle and that was self-correcting so there was no need for the government to interfere in the free market. Between the Civil War and the roaring 1920s, America sustained periodic booms and busts, recording no less than five official depressions. After every bust the economy always bounced back, exactly as the classical economists predicted.

That was true until the classical economists met their match in the Great Depression of the 1930's. After the stockmarket crash of 1929 the economy fell into first a recession and then a deep depression. The gross domestic product fell by almost a third, and by 1933, 25% of the work force was unemployed. At the same time, business investment virtually disappeared. It dropped from about $16 billion in 1929 to $1 billion by 1933. President Herbert Hoover kept promising that prosperity was just around the corner and the classical economists kept waiting for what they viewed as the inevitable recovery.

Two key figures walked on to the macroeconomic stage, economist John Maynard Keynes and Hoover's presidential successor, Franklin Delano Roosevelt. John Maynard Keynes flatly rejected the classical notion of a self correcting economy. He warned that patiently waiting for the eventual recovery was fruitless because in the long run we are all dead. Keynes believed that under certain circumstances, the economy would not naturally rebound, but simply stagnate, or even worse, fall into a death spiral. To Keynes, the only way to get the economy moving again, was to prime the economic pump with increased government expenditures. The idea of fiscal policy was born and a Keynesian prescription became the underlying philosophy of Franklin Delano Roosevelt's New Deal.

Roosevelt's ambitious public works programmes in the 1930s together with the 1940s boom of World War II were enough to lift the American economy out of the Great Depression and up to new heights. In the early 1950s the Keynesian prescription of large scale government expenditures worked again when the heavy spending associated with the Korean War helped pull the economy out of a slump. A decade later, pure Keynesianism reached its zenith with a much heralded Kennedy tax cut of 1964. President John F Kennedy's Chairman of Economic Advisors, Walter Heller, popularised the term fine tuning. Heller firmly believed that through the careful mechanistic application of Keynesian principles the nation's macroeconomy could be held very close to full employment with minimal inflation.

In 1962 Heller recommended to Kennedy to the President a large tax cut to stimulate the sluggish economy. Congress eventually agreed and this Keynesian tax cut helped make the 1960s one of the most prosperous decades in America. This fiscal stimulus also laid the foundation for the emergence of a new and ugly macroeconomic phenomenon known as stagflation, which is simultaneous high inflation and high unemployment. The stagflation problem had its roots in President Lyndon Johnson's stubbornness. In the late 1960s, against the strong advice of his economic advisors, Johnson increased his expenditures on the Vietnam War, but he refused to cut spending on his Great Society social welfare programmes. This refusal helped spawn the virulent demand pull inflation.

demand-pull inflation

1.5. Demand-pull inflation versus cost-push inflation: the Keynesian dilemma and the rise of Monetarism

The essence of demand-pull inflation is too much money chasing too few goods. That is exactly what happened when the U.S tried to finance both guns and butter or both the Vietnam War and the Great Society. During war time, increased defence spending moves aggregate demand from AD to AD'. And equilibrium output increases from E to E' as real GDP expands. However, when real output rises far above potential output, the price level moves up sharply as well, from P to P'. In 1972, President Richard Nixon impose price and wage controls and gained the nation a brief respite from the Johnson-era inflation.

However, once the controls were lifted in 1973, inflation jumped back up to double digits, helped in large part by a different kind of inflation then emerging, an inflation known as cost push or supply side inflation. Cost-push, or supply-side inflation occurs when factors such as rapid increases in raw material prices or wage increases drive up production costs. This can happen as a result of so-called supply shocks, such as those experienced in the early 1970s. During this period, such shock included crop failures, a worldwide drought, and a quadrupling of the world price of crude oil.

cost-push inflation
Sharply higher oil, commodity, and labour costs increased the cost of doing business. In the AS, AD framework the higher cost shift the AS curve up from AS to AS' and, equilibrium shifts from E to E'. Output declines from Q to Q' while prices rise. This leads to the phenomenon of stagflation, recession or stagnation combined with inflation. In this situation the economy suffers the double whammy of both lower output and higher prices. Prior to the 1970s, economists did not believe you could even have both high inflation and high unemployment at the same time. They thought that if one went up, the other had to go down.

The 1970s proved economists wrong on this point and likewise exposed Keynesian economics as being incapable of solving the new stagnation problem. The Keynesian dilemma was simply this, using expansionary policies to reduce unemployment simply created more inflation. While using contractionary policies to curb inflation, only deepened the recession. That meant that the traditional Keynesian tools could solve only half of the stagflation problem at any one time, and only by making the other half worse.

It was this inability of Keynesian economics to cope with stagflation that set the stage for Professor Milton Friedman's, monetarist challenge to what had become the Keynesian orthodoxy. Milton Friedman's monetarist school argued that the problems of both inflation and recession may be traced to one thing: the rate of growth of the money supply. To the monetarists, inflation happens when the government prints too much money, and recessions happen when it prints too little.

From this monetarist perspective, stagflation is the inevitable result of activist fiscal and monetary policies, that try to push the economy beyond its so-called natural rate of unemployment, also called its lowest sustainable unemployment rate (LSUR). This natural rate of unemployment, or LSUR, is the lowest level of unemployment that can be attained without upward pressure on inflation. Accordng to the monetarists expansionary attempts to go beyond this lowest sustainable unemployment rate may result in short run spurts of growth. However, after each growth spurt, prices and wages rise, and drag the economy back to its LSUR, albeit at a higher rate of inflation.

Over time these futile attempts to push the economy beyond it's lowest sustainable unemployment rate lead to an upward inflationary spiral. In this situation, monetarists believe that the only way to wring inflation and inflationary expectations out of the economy, is to have the actual unemployment rate rise above the LSUR. That means inducing a recession. This is at least one interpretation of what the federal reserve did beginning in 1979 under the monetarist banner of setting monetary growth targets.

Under Chairman Paul Volcker, the Fed adopted a sharply contractionary monetary policy, and interest rates soared to over 20%. Particularly hard hit were interest sensitive sectors of the economy like housing construction, automobile purchases and business investment while the Feds bitter medicine worked. Three years of hard economic times left a bitter taste in the mouths of the American people. Now hungry for a sweeter macroeconomic cure than either the Keynesians or monetarists could offer, the time was right for supply side economics to enter the stage.

1.6. From supply side economics and the new classicals back to Keynesianism

In the 1980 presidential election, Ronald Reagan ran on a supply-side platform that promised to simultaneously cut taxes, increase government tax revenues and, accelerate the rate of economic growth without inducing inflation, a very sweet macro-economic cure indeed. On the surface, the supply side approach looks very similar to the kind of Keynesian tax cut prescribed in the 1960s to stimulate a sluggish economy. However, the supply siders viewed such tax cuts from a very different behavioural perspective. Unlike the Keynesians, they did not agree that such a tax cut would necessarily cause inflation. Instead, the supply siders believed that the American people would actually work much harder and invest much more if they were allowed to keep more of the fruits of their labour.

The end result would be to increase the amount of goods and services our economy could actually produce by pushing out the economy's supply curve, which explains the name supply-side economics. The supply siders promised that by cutting taxes, and thereby spurring rapid growth, a loss in tax revenue from the tax cut would be more than offset by the increase in tax revenues from increased economic growth. Thus, under supply side economics, the budget deficit would actually be reduced. Unfortunately, that did not happen. While the economy boomed, so too did America's budget deficit as well as America's trade deficit.

The so called twin deficits deeply concerned Reagan's successor George Bush particularly after the budget deficit jumped over $ 200 billion at the midpoint of his term in 1990 and the economy began to slide into recession. To any red blooded Keynesian, this onset of recession would have been a clear signal to engage in expansionary policy. However, in the Bush White House, the supply side advisors had been suplanted by a new breed of macroeconomic thinkers, the so called new classicals.

New Classical economics is based on the controversial theory of rational expectations. This theory says that if you form your expectations rationally, you will take into account all available information, including the future effects of activist fiscal and monetary policies. The idea behind rational expectations is that such activist policies might be able to fool people for a while. However, after a while people will learn from their experiences and then you can't fool them at all. Central policy implication of this idea is of course profound. Rational expectations render activist fiscal and monetary policies completely ineffective, so this should be abandoned.

Whether this theory is good economics or not is discussed in a later lesson, but it was clearly bad politics for President Bush. Indeed, Bush's new classical advisors flatly rejected any Keynsesian quick fix to the deepening recession. Instead they called for more stable and systematic policies based on long term goals, rather than a continued reliance on short sided discretionary reactions. Bush took this new classical advice. The economy limped into the 1992 presidential election, and like Richard Nixon in 1960, Bush lost to a Democrat promising to get the economy moving again.

What is perhaps most interesting about this transition of power is that Bill Clinton actually did very little to stimulate the economy. The mere fact however, that Clinton promised a more activist approach helped restore business and consumer confidence. The same time congressional passage of Clinton's deficit reduction legislation in 1993 sent Wall Street a clear signal that his administration was serious about budget balance. Together these factors helped accelerate a recovery that had already begun by the end of Bush's term. These factors also set the stage for Clinton's remarkably easy re-election in 1996, as well as the longest economic recovery in peace-time history.

However, the next decade would not be anywhere near as kind or prosperous as the 1990s. Shortly after George W. Bush took office in 2001, the US economy would fall into recession while by years end, America would be hit by a 9/11 terrorist attack that would catapult the country into two expensive wars in Iraq and Afghanistan. In that same year of 2001, China joined the World Trade Organisation and began flooding America with illegally subsidised exports. Over the next ten years, the US would shutdown over 50,000 factories, lose more than $5 million manufacturing jobs and see it's historical annual rate of GDP growth cut by a full two thirds.

On top of two wars in a burgeoning trade deficit, the US economy would also be hit in 2007 with a massive collapse of a housing bubble and soon find itself in the worst recession since the great depression of the 1930s. To pull a nation out of recession in slow growth, the White House and Congress would orchestrate the biggest fiscal stimulus in history. While the Federal Reserve would use new monetary policy tools like quantitative easing to likewise break the record for a huge monetary stimulus.

All these fiscal and monetary stimuli would be to little avail however, and in the 2010s macro-economists would once again find themselves in a rapidly changing global economy where traditional fiscal and monetary policy solutions were no longer working very well and where countries around the globe face deeper seated structural issues seemingly resistant to Keynesian solutions. Of course the major purpose of this introductory course in macroeconomics, is to help all of us better understand the incredibly complex global economic forces now effecting both our personal and professional lives.

2. The Aggregate Supply-Aggregate Demand Model and the Classical-Keynesian Debate

2.1. Intoduction to the Keynesian model

The debate between classical economists and Keynesians ranks as one of the most important in macroeconomics. It is a debate that goes back to the Great Depression. It remains a very important debate, even today. This is because many of the macroeconomic policies now favoured by conservatives, have their roots in classical economics. While those on the other side of the ideological spectrum, are generally much more supportive of the Keynesian approach. The classical versus Keynesian controversy is primarily a dispute over how an economy adjusts during a recession and finds its way back to full employment.

Classical economists believe that a price adjustment mechanism would cure the economy. They believe that in the event of unemployment, prices, wages and interest rates would all fall. This would in turn increase consumption, production and investment, and quickly return the economy back to its full employment equilibrium. The Keynesian school argues that before the price adjustment mechanism had time to work, it would be overpowered by a more deadly income adjustment mechanism. When an economy sinks into a recession people's incomes fall. This fall in income causes them to both spend less and save less, while businesses respond by investing and producing less. This reduction in consumption, savings, investment, and output in turn drives the economy deeper into recession rather than back to full employment.

This debate is important. The classical approach believes that the best cure for a recession is to leave the free market alone. This approach is also known as laissez faire. Laissez faire economists are those who believe that most government policies will probably make things worse, so the best policy is relatively little government. On the other hand, Keynesians prescribe large-scale government expenditures to prime the economic pump. Keynesians typically are activist economists who believe that the government can create and implement policies that will positively affect the economy.

Classical economics has its roots in the free market writings of eighteenth century economists like Adam Smith, David Ricardo, and most importantly, Jean Baptiste Say. These classical economists believe that the problem of unemployment was a natural part of the business cycle. That it was self-correcting, and most importantly, that there was no need for the government to intervene in the free market to correct it. They blamed unemployment on wages that were too high and believed that in the event of a recesion, unemployed workers would be willing to work for less.

Wages would then fall back down to levels where it once again made it profitable for firms to hire the workers and the recession would end. Classical economists agreed that frictional and structural unemployment could exist, but they did not agree that cyclical unemployment could be caused by a shortage of aggregate demand. Between the Civil War and the roaring 1920s, America sustained periodic booms and busts recording no less than five official depressions. However, after ever bust the economy always bounced back exactly as the classical economists predicted.

That was true until the classic economists met their match in the Great Depression of the 1930s. While President Herbert Hoover kept promising that prosperity was just around the corner, and the classical economists kept waiting for what they viewed as the inevitable recovery, a towering figure walked on to the macroeconomic stage. Economist John Maynard Keynes. John Maynard Keynes was born in 1883, the son of a British economist famous in his own right, John Neville Keynes. John Maynard Keynes was by all accounts a genius who made millions as a stock market speculator. He was also a distinguished patron of the arts, a faculty member at Cambridge University, and a key appointee to the British Treasury.

In 1936, with the global economy flat on its back, Keynes published the general theory of employment, interest, and money. In that book Keynes flatly rejected the classical notion of a self-correcting economy that would solve unemployment through adjustments in wages and prices. Keynes argued that patiently waiting for the eventual recovery was fruitless. Because in the long run we're all dead. And Keynes believed that under certain circumstances a recessionary economy would only not naturally rebound, but even worse, fall into a deep spiral.

To Keynes, the only way to get the economy moving again was to prime the economic pump with massive government expenditures. From an historical perspective, it is important to emphasise that, at the time Keynes' approach was economic heresy. Indeed, the Keynesian prescription was initially rejected by the entire economics profession. Keynes and his followers were branded as socialists or even communists for advocating such an activist role for the central government. To his credit, Keynes stuck to his guns and, as the Depression wore on, his teachings gained both adherents and disciples.

2.2. The two pillars of classical economics

To understand why Keynesian economics triumphed, it is important to understand how the two major pillars of classical economics crumbled under the weight of Keynes' argument. These two pillars are Say's law and the quantity theory of money. Say's Law was formulated in the 1800s by the French businessman Jean Baptiste Say, and popularised by British stockbroker David Ricardo. Say's Law states that supply creates its own demand, which means that when people work to produce goods and services, they earn income for doing so. Say's Law states that the total income generated by this work, must equal the value of the goods and services. Thus if the workers spend this income, it must be enough to pay for all the goods and services they produce.

There is a problem with Say's Law. Suppose that the income earners do not spend all their money and instead save some of it. That is exactly the problem that Thomas Malthus raised in this critique of Say's Law. Malthus said that if people did not spend all their money, there would be a general glut of goods, and people would be out of work. Malthus is famous for the Malthusian doctrine that population will grow faster than the production of food, and that this will lead to mass starvation. In fact, it was Malthus' dark vision that originally earned the economics profession its label as the dismal science.

Circular flow model
Jean-Baptiste Say and David Ricardo had an answer to Malthus' critique. According to them it does not matter if people save some of their money, because all of these savings will in turn be invested in the economy. Therefore, aggregate demand, which equals consumption plus investment, will always equal aggregate supply. We can follow the logic of Say's Law, by looking at the circular flow diagram. The employee compensation paid to workers, the rents paid to landowners, the interest paid to money lenders and the profit earned by business owners together represent the total income earned by all the people producing aggregate supply.

This flow of income moves from right to left at the top of the figure from business firms to house holds represents aggregate supply in Say's Law. On the demand side, there are several arrows at the bottom of the figure. One arrow moves from left to right, and represents consumer purchases of goods and services from businesses. A second arrow shows consumer savings moving first into the banking and finance sector, and then emerging as investment by businesses. Together, consumption plus investment equals aggregate demand in Say's Law. Say's Law became a tenant of classical economics. It didn't state that unemployment couldn't exist but it did state that if wages and prices and interest rates were allowed to adjust, unemployment would go away on its own.

Classical economists buttress their Say's Law analysis with the quantity theory of money. The quantity theory of money determines the price level while Say's Law analysis determines real output. The quantity theory of money is based on the so-called equation of exchange. This equation may be written as M times V equals P times Q:

M * V = P * Q

M equals the money supply. V is the velocity of money, or, the amount of income generated each year by a dollar of money. P is the general price level, as measured by an index, such as the consumer price index, and Q is the quantity of real output sold. While P times Q, on the right side of the equation, equals the nominal or inflation adjusted output of the economy, as measured by the gross domestic product.

In its simplest terms, the quantity theory of money states that the price level varies in response to changes in the quantity of money. If the money supply goes up 20%, prices go up 20%. If the money supply goes down 5%, prices go down 5%. To better understand this point, we have to understand two important classical assumptions about the quantity theory of money. The first is that velocity is constant. The second, known as the veil of money assumption, is that real output is not influenced by the money supply. That is, it doesn't matter how much money the government prints, it will not increase the amount of goods and services that the economy can actually produce. If the velocity V is constant on the left side of the equation, and output Q on the right side of the equation is unaffected by the money supply, the only thing that can change if the money M changes, is the price level P.

2.3. Why classical economics failed

While the Classical Economists made a powerful theoretical argument, as to why a recessionary economy should always adjust back to full employment. The reality of the Great Depression in the 1930s resulted in a search by the world's political leaders for an alternative economic solution. That solution turned out the be Kenynesian economics. To John Maynard Keynes, the problem with classical economics was not the price adjustment mechanism that it relied on per say. Rather Keynes believed that before such a mechanism had time to work, it could be dwarfed by a much more powerful and deadly income adjustment mechanism.

Key difference in price assumptions
To Keynes, when an economy sinks into recession, peoples' incomes fall. This fall in income causes them to both spend less and save less, while businesses respond by investing and producing less. This reduction in consumption, savings, investment and output in turn drives the economy deeper into recession rather than back to full employment. While eventually income will fall far enough so that savings and investment return to equilibrium. The economy will be at a level well below full employment with no way to get out stuck in a rut with a glut of goods, just like Thomas Malthus predicted in his original critique of the classical model.

Out of this classical economics versus Keynesian economics debate have emerged two important models that are frequently used in macro economic analysis. One model, the aggregate supply aggregate demand framework, has its roots in classical economics. It allows for price adjustments in it's framework. The second model, the Keynesian model, assumes that prices are fixed. Keynes believed that price adjustments take more time than income adjustments. Both models are very helpful in understanding how modern economies function.

2.4. The AS-AD framework

The AS-AD framework
In the aggregate supply-aggregate demand model, the price level is represented on the vertical axis, while real domestic output or GDP is represented on the horizontal axis. Aggregate demand slopes downward while aggregate supply slopes upward. Equilibrium in the model occurs at point E, where the AS and AD curves cross. This is because at this point the price and output combination is compatible with the intentions of both buyers and sellers. Finally, equilibrium in this model does not necessarily have to occur at the full employment potential output GDP of Q sub c. It can also be at a recessionary level such as Q sub u, where actual GDP is below potential GDP.

The downward sloping aggregate demand curve is also known as the aggregate equilibrium demand curve. Aggregate demand is a schedule, which is graphically represented as a curve. It shows the various amounts of real output that domestic consumers, businesses, and government, along with foreign buyers, collectively desire to purchase as each possible price level, holding other things constant. Holding other things constant or the ceteris paribus assumption, is crucial in understanding shifts in the aggregate demand curve. The downward slope of the aggregate demand curve means that, as the general price level falls, consumers and businesses will increase their demand for goods and services. This will happen for three reasons.

First there is a real balance or wealth effect. As the price level falls, the purchasing power of consumers increases and the demand more goods and services. This is because the real value of money is measured by how many goods and services each dollar will buy. Accordingly, a lower price level increases the real value, or purchasing power, of accumulated financial assets, such as savings accounts and bonds, that have fixed money values. For example, a household may not buy a new car or a sailboat if the purchasing power of its assets is only $30,000. However, if there is deflation, and the price level falls, the household's real purchasing power may increase to, say, $50,000. So the new purchase is more likely to be made.

A second reason why the aggregate demand curve slopes downward is an interest rate effect. As the price level falls, so too do interest rates. Falling interest rates, in turn, increase investment spending by businesses, as well as certain kinds of consumer spending, on items such as automobiles and housing. Third, there is a foreign purchases, foreign trade, or net export effect. As the domestic price level falls, the relative price of foreign goods increases. This reduces the demand for the now more expensive foreign imports. Increases the demand for exports, and thereby also increases the aggregate quantity demanded.

2.5. Why the AS and AD curves shift

Aggregate demand is defined as the graph showing the various amounts of real output that would be purchased at each possible price level, holding other things constant. What are these other things? These other things are grouped by the four major categories of real GDP, which are consumption, investment, government spending, and net exports. These factors are referred to as the determinants of aggregate demand because they determine the location of the aggregate demand curve. A change in one or more of these determinants will shift aggregate demand.

Factors shifting the AD curve
An increase in aggregate demand is shown as a rightward or outward shift of the AD curve, from AD1 to AD2. Similarly, a decrease in aggregate demand is shown as a leftward or inward shift, from AD1 to AD3. Now let's talk briefly about each of these determinants of aggregate demand. For example, in the consumption category, an increase in consumer wealth or a rise in consumer confidence will shift the AD curve out. However, consumers with a high level of debt may be forced to cut spending to pay off the debt, while an increase in taxes on consumers will likewise reduce expenditures and shift the AD curve inward.

Similarly, investment spending will rise with a fall in interest rates, an increase in profit expectations, or a reduction in business taxes, and the AD curve will shift out. This will also be true if an improvement in technology stimulates investment spending. For example, recent advances in biotechnology and electronics have spawned new labs and production facilities to exploit the new technologies. However, a rise in excess capacity has the opposite effect, because when there is unused capital equipment, demand for new capital equipment falls, and so too does aggregate demand.

As for government spending, we shall soon see that expansionary fiscal or monetary policy can shift the AD curve out, while contractionary policy has the opposite effect. Finally, rising national income in a foreign country can stimulate foreign demand for US goods, and shift out the AD curve. In contrast, if the dollar's exchange rate changes, so that the dollar is stronger relative to other currencies, domestic aggregate demand will fall. This is because foreigners will buy less of our exports, and American consumers will buy more foreign goods.

Now let's see if you can guess what will happen to the AD curve under some different circumstances. Suppose, then, that the Dow Jones stock market average plunges 2000 points in a week. Which item in the table will this affect and which way will the AD curve shift? In such a case, consumer wealth will fall and the AD curve will shift in. Now, how might news about a possible recession affect consumer and profit expectations in the AD curve? Well, if consumers expect a recession, they may save more and consume less. This will shift the AD curve inward. At the same time, lower profit expectations may cause businesses to invest less and likewise shift the AD curve in. Ironically, these actions by business and consumers may well increase the likelihood of a recession.

Factors shifting the AS curve
The upward sloping aggregate supply curve shows the level of real GDP, or domestic output, that will be produced at each price level, holding other things constant. The curve slopes upward because higher price levels create an incentive for businesses to produce and sell additional output, while lower price levels reduce output. The major determinants of aggregate supply include changes in factor input prices like land, labour and capital which affect production costs, changes in technology, efficiency and productivity which affect the economy's potential output, and changes in the legal and institutional environment that businesses operate in.

The aggregate supply curve will shift to the left if the cost of an imported resource like oil rises as it did during the oil embargo of 1973 and 74. While equilibrium output falls, the price level goes up. This is an example of cost push inflation. Productivity is defined as total output divided by total inputs. An increase in productivity means the economy can obtain more real output from its inputs. If productivity increases, the average production cost of a unit of output will fall, and this will cause the aggregate supply curve to shift outward or to the right. This is because increases in productivity increase the potential output of an economy.

A decrease of the sales tax, the payroll tax, or excise taxes will decrease production costs and thereby increase aggregate supply. The AS curve will shift out to the right. Any increase in government regulation on businesses, such as tougher clean air or clean water requirements, will make the cost of production rise and the AS curve would shift in to the left.

Keynesian range

2.6. The three ranges of the economy

It is useful to identify three distinct ranges in the curve. The horizontal, or Keynesian range, represents a range where increasing output will not lead to any inflation. In this range, the economy is likely to be either in a severe recession or a full-blown depression. Thus, large amounts of unused machinery and equipment, and unemployed workers are available for production. In such a case, putting these idle resources back to work, can be done with little or no upward pressure on the price level.

Classical range
It follows that in this Keynesian range, prices are for all practical purposes, fixed. Hence the flat portion of the curve, and fiscal policies such as increased government expenditures, can be used to stimulate the economy without any fear of inflation. For example, an increase in aggregate demand caused by expansionary government policies may shift output from Q1 to Q2, but the price level remains the same.

In the vertical or classical range the economy has reached its absolute full capacity level of real output at Qc. In this range any attempt to increase production further will not increase real output, but only cause a rise in the price level like the classical economists' quantity theory of money predicts.

Intermediate range
In this classical range expansionary fiscal and monetary policies will not be effective. Here, an increase in aggregate demand, from AD5 to AD6 does not increase Qc, but only the price level from P5 to P6. This is demand pull inflation because shifts in aggregate demand pull up the price level.

There is an intermediate range between Qu and Qc, where any expansion of real output is accompanied by a rising price level. The economy is comprised of different product and resource markets, and as it moves to full employment, movements in all these markets may not occur simultaneously.

Classical adjustment mechanism step 1
For example, as the economy expands in the intermediate range, auto and steel workers may still be unemployed, but the high-tech computer industry may begin to experience shortages in skilled workers. At the same time, raw material shortages, or bottlenecks in production, may begin to appear in other industries.

In this range real GDP may begin at Q3, but it is below the full employment output of Q4. In this case, stimulating aggregate demand through expansionary fiscal policies, will move the economy to Q4. It will also result in demand-pull inflation, as the price level rises, from P3 to P4.

Classical adjustment mechanism step 2
The aggregate supply aggregate demand framework can be used to illustrate how an economy is supposed to recover from a recession under classical assumptions.

In step one the economy is at full employment, Q1 where AS1 intersects a AD1 at a price of P1.

In step two the economy suffers a demand shock, shifting the aggregate demand back to a D2, for example a threat of war in the Middle East may cause consumers to reduce there spending and businesses to reduce there investment.

Classical adjustment mechanism step 3
The new equilibrium is a recessionary output of Q2 at a price of P1, and the result is a recessionary gap equal to Q1 minus Q2.

Now, in step three, wages, prices and interest rates fall, as a result of the recession.

This causes aggregate demand to move downward, along the aggregate demand curve, through the wealth, interest rate and net export effects.

Classical adjustment mechanism step 3
At the same time, the supply curve shifts out to AS2, as firms hire more workers, and expand output.

Together, these price and wage adjustments drive the economy back to full employment at Q1, and close the recessionary gap, but at a new and lower price, of P2.

This classical price adjustment mechanism did not work to lift the economy out of the Great Depression.

According to John Maynard Keynes the problem was that the price adjustments necessarily to bring about this recovery would be overwhelmed by a much more powerful and deadly income adjustment mechanism.

His theory led to the Keynesian multiplier model, that shows how it can be used to illustrate a recovery from a recession or depression.

3. The Keynesian Model and Fiscal Policy

3.1. Intoduction to the Keynesian model

In macroeconomics the basic Keynesian model goes by many names. Some economists refer to it as the multiplier model. Others call it the aggregate production aggregate expenditures model. The development and application of the basic Keynesian model gave birth to fiscal policy. Fiscal policy involves the use of government expenditures or tax changes to stimulate or contract an economy. The basic Keynesian Model provides a very straight-forward approach to using fiscal policy to close a recessionary gap. At least in theory, this model may be used to calculate very precisely how much government expenditures must be increased, or alternatively, how much taxes must be cut to stimulate an economy back to full employment.

Even though this model is presented in the very mechanical way that it was taught at universities in the 1960s, macroeconomics is hardly as simple as the Keynesian model would suggest. Harsh reality, that economists learned in the 1970s with the emergence of a virulent stagflation. We'll talk much more about stagflation and the complexities of macroeconomics later. For now, let's try to master the simple Keynesian model and the use of fiscal policy. If you were to sit down tonight and read John Maynard Keynes's famous little book, the General Theory of Employment, Interest and Money. You would find little in that book resembling today's basic textbook Keynesian model.

How Keynes's arcane prose was transformed into an easily-understood algebraic and graphical model is a story in and of itself. Involving two key figures, professors Alvin Hansen and Paul Samuelson. Alvin Hansen was a textbook writer and classical economist who, in the mid nineteen thirties left the University of Wisconsin to take a post at Harvard. As the story goes, somewhere on the train between Madison and Cambridge, Hansen converted to the Keynesian faith. At Harvard, Hansen led a seminar that became an important cauldron of ideas for the Keynesian doctrine. And Hansen also took regular trips to Washington D.C. to spread the Keynesian gospel to the nations policymakers.

The Keynesian model
Perhaps most importantly, Hansen wrote A Guide to Keynes, which became the bible for economic students in the 1950s. While Hansen's star pupil, Paul Samuelson began writing what would become the definitive macroeconomic textbook for more than three decades. Out of these writings has emerged the basic Keynesian model. The most important assumption underlying this model is that prices are fixed. Keynes himself didn't believe this believe this, but Keynes did believe that when an economy is in the recessionary range, prices and wages were sufficiently inflexible to make income adjust much faster than prices. Therefore, for simplicity, price changes could be assumed away.

The fixed price assumption allowed Hansen and Samuelson to develop a Keynesian aggregate production-aggregate expenditures model that was distinguishable from the aggregate supply aggregate demand model. The vertical axis measures total spending or aggregate expenditures. The horizontal axis measures real GDP or output. There is a 45 degree line that measures aggregate production. In addition there is an aggregate expenditures curb that is calculated by totaling consumption plus investment plus government spending plus net exports.

The Keynesian model
Equilibrium in this model will occur where the aggregate expenditure and aggregate production curves cross. This equilibrium does not necessarily have to occur at the economy's full potential output, Qp. For example, if equilibrium occurs at, say, Qr, actual output is below potential output Qp. And the economy is experiencing a recessionary gap. If however the economy is at Qi actual out put exceeds potential out put and there is an inflationary gap. One useful way of thinking about these recessionary and inflationary gaps is through the concept of leakages versus injections.

Leakages and injections
This can be done using the circular flow diagram. In this diagram the flow of income moves from right to left at the top of the figure and represents aggregate supply. A leakage is income not directly spent on domestic output but rather is diverted from the circular flow. One important leakage occurs when consumers save a portion of their income. That this savings leakage can be offset by an investment injection. An injection is an addition of income to the circular flow.

There are various leakages and injections in the macro economy. Any particular macroeconomic equilibrium will depend on the balance between these injections and leakages. Consumer savings and business investment are the primary sources of imbalances in a totally private and closed economy. In an economy with a government sector, taxes represent an important leakage while government spending is a crucial injection. In an open economy where trading occurs, import leakages and export injections are likewise very important in determining actual output.

3.2. Analysis of the Keynesian model

Aggregate production
Aggregate production is defined as the total amount of goods and services produced in the economy. By definition such production creates an equal amount of income, so that the aggregate production curve can be represented by a 45 degree line. This is illustrated in this figure, where production in dollars is represented on the vertical axis. Real income or GDP is represented on the horizontal axis, and the vertical line at QP represents the economy's potential full employment income or GDP. The upward-sloping, 45 degree line, representing the aggregate production curve, means that at any point along this curve, production equals income.

For example, at point A where the 45 degree line crosses the full employment vertical line production and income both QP. In contrast at point E both production and income are at Q. The economy's so-called recessionary gap is equal to the difference between QP and Q. In the Keynesian model, total spending or aggregate expenditures may be represented algebraically by the equation that we first introduced in lesson one. When we discussed the use of the flow of product or expenditures method, to calculate income or gross domestic product. Specifically aggregate expenditures AE equals consumption C plus investment I plus government expenditures G plus net exports X - M (exports minus imports):

AE = C + I + G + (X - M)

Aggregate expenditures
The aggregate expenditures curve is simply the vertical summation of these four components. These aggregate expenditures appear as a curve in the basic Keynesian multiplier model. Expenditures are measured on the vertical axis. Real income, or GDP, is measured on the horizontal axis. The aggregate expenditures curve slopes upward but it has a flatter slope than the 45 degree line that represents the aggregate production curve. That the aggregate expenditures curve intersects the vertical axis at a level above zero. This means that, even if income is zero, people will still spend a certain amount of money on consumption. Those expenditures are called autonomous consumption because they happen independently of the level of income.

To fully understand how the Keynesian multiplier model works, not only autonomous consumption must be understood, but also why the aggregate expenditures curve is flatter than the aggregate production curve. The best way to do this is to examine the major components of the Keynesian expenditure function discussed above. Consumption, investment, government expenditures and net exports. The largest component of aggregate expenditures is consumption. It accounts for almost 70% of total aggregate expenditures in the US economy. This table divides consumption into three catagories. Durable goods like autos and household equipment. Non durable goods like food and clothing, and services like transportation and medical care.

Haynes sought to explain consumption expenditures in the following way. First he posited that there is a level of consumption that will occur, even if a person's income falls to zero. This zero income condition might happen, for example, if a person loses his or her job. Nonetheless, despite being unemployed, this person will still be able to consume by dipping into his or her savings. The level of consumption, that occurs regardless of changes in one's income, is called autonomous consumption.

Second, Keynes said that there is a level of induced consumption that will depend on the individual's disposable income, where disposable income is simply the amount of money left after paying taxes. Keynes further described this consumption behaviour in terms of a person's marginal propensity to consume, or, as it is also referred to as, the marginal propensity to expend. This is the extra amount that people consume when they receive an extra dollar of disposable income. By the same token, there is a marginal propensity to save, or marginal propensity to withdraw, and it measures the extra amount people save when they receive an extra dollar of disposable income, so:

MPS = 1 - MPC

Consumption function
Some people may only spend 75 cents of every dollar of their disposable income, and save 25 cents. In this case, the MPC will be 0.75, while the MPS will be 0.25. In another situation people may spend as much as 90 cents, and save only 10 cents of every dollar. In this case, the MPC is 0.90 and the MPS is 0.10. The marginal propensity to consume, or MPC, equals the slope of the consumption function and that the MPS is the slope of the savings function. The aggregate expenditures curve is flatter than the 45 degree line in the Keynesian model precisely because the MPC is less than one.

Now let's turn to a discussion of what the Keynesian consumption function actually looks like. In fact it can be expressed in an equation, a table or a graph. Algebraically we can represent the Keynesian consumption function simply as follows. Total consumption C equals autonomous consumption C0 plus induced consumption. Where induced consumption equals the marginal propensity to consume, MPC, times disposable income, Yd, or:

C = C0 + MPC + Yd

The consumption function intersects the vertical axis at the level of autonomous consumption at $50 or point A. While the slope of the consumption function is simply the MPC or 0.75. This consumption function relates back to the problem that Thomas Malthus originally identified with Say's Law and the classical model, namely that people will not necessarily spend everything they earn, and aggregate expenditures therefore need not equal aggregate production.

3.3. The Keynesian expenditures functions

The second major component of the aggregate expenditures curve is investment. Investment expenditures include purchases of residential structures, investment in business plant and equipment, and additions to a company's inventory. Investment in plant and equipment is by far the biggest category, averaging a full 70% of total investment annually. While total investment expenditures account for roughly 15% of total aggregate expenditures.

Investment function
In the Keynesian model, investment expenditures are assumed to occur independently of the level of income. Algebraically, this means that investment I is simply equal to autonomous investment I0. The advantage of this assumption, is that it allows economists to draw the investment function as a horizontal line. This is illustrated in this figure. The curve I1 shows annual business investment in 1929, just prior to the stock market crash, at $16 billion. The curve I2 shows investment after it has fallen to $1 billion by 1933.

If investment is not determined by the level of income, it is useful to ask here, what are the determinants of investment? To Keynes himself, there were at least two important factors. First, he believed that investment was sensitive to changes to the interest rate. When that rate falls, investment rises, when the interest rate rises, the investment falls. Note however, that while Keynes believed the interest rate was important in determining investment he did not believe that falling interest rates and increased investment would necessarily lead to a full employment equilibrium like the classical economists did.

This is because Keynes believed that investment was in large part driven by a second important determinant, namely the expectations or business confidence that businesses had regarding potential sales and profits. Keynes referred to these expectations as animal spirits, and basically said that, if businesses believe the economy was about to go bad, it could become a self-fulfilling prophecy. Businesses would cut back on investment and production and thereby help trigger a recessionary spiral.

The third component of aggregate expenditures in the Keynesian model is government spending. This includes purchases of goods like tanks or road building equipment as well as the services of judges and public school teachers. Unlike private consumption and investment, this component of aggregate demand is determined directly by the government's spending decisions. When the Pentagon buys a new fighter aircraft this output immediately adds to the GDP. Such government expenditures account for almost 20% of total aggregate expenditures in the US

As with investment, the Keynesian model assumes government expenditures to be autonomous, that is, determined outside the model. This means algebraically that government expenditures G simply equal autonomous government expenditures G0. And as with the investment function, the government expenditure function can be graphically portrayed as a horizontal line. In general, government expenditures exhibit much less volatility than investment, although episodic events such as wars and natural disasters can lead to large fluctuations.

In the Keynesian model, increased or decreased government expenditures, together with tax cuts or tax increases, serve as the primary tools of fiscal policy that are used to counterbalance changes in investment and consumption spending. Specifically, expansion fiscal policy involves increased government expenditures, tax cuts or some combination of the two to stimulate a recessionary economy and close a recessionary gap. In contrast, contractionary fiscal policy involves reduced government expenditures, tax hikes or some combination of the two to cool down and overheated economy.

In addition to discretionary changes in government spending and taxes, there are also important non-discretionary government expenditures. That act as built-in macroeconomic stabilisers. These non-discretionary expenditures are called transfer payments, and they include such things as unemployment compensation to workers, welfare payments, and subsidies to farmers. These transfer payments, help stabilise the macro economy, because they automatically rise during recessions, and fall during expansion. This is because during recessions, as more and more people become unemployed, they become eligible for these programmes, and as the economy expands, there is less need for these programmes so there are fewer payments.

The fourth component of aggregate expenditures, is net exports. This component equals the value of exports, minus the value of imports. US exports include such things as the sale of airplanes to China, beef and oranges to Europe, an medical equipment to Canada, US imports include such things as Japanese made automobiles, Korean made running shoes, and oil from the Middle East. Because exports create domestic production, income, and employment for an economy, they must be added to aggregate expenditures. However, when we purchase imports from a foreign country, no such production, income, and employment is created, so that imports must be subtracted from aggregate expenditures.

While net exports are a very important part of a global or open economy, they were not central to the development of the Keynesian multiplier model. Economists often make a simplifying assumption of a closed economy, in which there is no international trade, and drop net exports from the model. This makes it possible to focus solely on the role of government spending in fiscal policy. International trade and trade deficits however can be dealt with in a subsequent stage.

3.4. The Keynesian multiplier and closing recessionary or inflationary gaps

Recession multiplier effect
In the Keynesian model expansionary fiscal policy can be used to close a $100 billion recessionary gap. To demonstrate this, one more concept is needed, the so called Keynesian expenditure multiplier. The Keynesian expenditure multiplier, is the number by which a change in aggregate expenditures, must be multiplied in order to determine the resulting change in total output. This multiplier is greater than 1 and the reason is that income is re-spent, not just once but many times after the initial increase. The multiplier process can deepen a recession. In step one there is an aggregate demand shock, which leads to $100 billion in unsold goods from a reduction in aggregate demand.

In step two, this leads to a cutback in employment and wages. While in step three, this leads to a reduction in income. Assuming a marginal propensity to consume of 0.75, there is a reduction in consumption of $75 billion in step four. This triggers a cutback in sales and further cutbacks in employment, and the process continues. The ultimate impact of this demand shock on total spending can be determined by computing the change in income and consumption at each cycle of the circular flow. In the Keynesian model it can be easily shown mathematically that the multiplier is simple the reciprocal of the marginal propensity to save. That is the multiplier is one divided by the MPS, or put another way, one divided by one minus the MPC:

Keynesian multiplier = 1 / MPS = 1 / (1 - MPC)

Recession multiplier effect
Suppose that the US permanently increases defence spending by $100 billion in response to a threat to the oil fields in the Middle East. What will be the effect of this increase in G on the GDP? The increase in G shifts upward the C + I + G line by $100 billion to C + I + G'. The new equilibrium level of GDP is thus read off the 45 degree line at E', rather than at E. Because the MPC is two thirds, the multiplier is three, and the new level of output is $300 billion higher.

This example shows why the analogy of using government expenditures to prime the economic pump is particularly apt. The expenditures trigger increased investment and consumption, and the total expansionary effect is far larger than the initial stimulus. It should also be clear from this example how important the role of the multiplier is in the conduct of fiscal policy.

If there is a recessionary gap of $100 billion and a marginal propensity to consume of 0.8, then it is possible to calculate the amount government expenditures must be increased to close this gap. To answer this question, the multiplier must be calculated. It is simply 1 divided by 0.2, which results in a multiplier of 5. Therefore, to close the $100 billion recessionary gap, government spending must be increased by $20 billion, because 5 times 20 equals 100.

Alternatively, a tax cut can be used to close the same $100 billion recessionary gap. This is a fiscal policy move, much like was done in the 1960s with the Kennedy Tax Cut. The calculation for the appropriate size for the tax cut is a little more complicated than it is for government expenditures. This is because a dollar's worth of tax cuts has slightly less of an expansionary effect than a dollar's increase in government expenditures. The reason is that consumers will not increase their expenditures by the full amount of the tax cut. Instead they will save a portion of that tax cut based on their marginal propensity to save. From this insight we can calculate the Keynesian tax multiplier as simply the expenditure multiplier times the MPC:

Recessionary gap
Only part of a tax cut is used to increase consumption. This tax multiplier concept can be put to work. How much should taxes be cut to close a $100 billion recessionary gap if the marginal propensity to consume is 8 and the multiplier is 5? The answer is $25 billion or $5 billion more than the increase in government expenditures needed to achieve the same result. We arrive at this total by first multiplying the expenditure multiplier of five times the MPC, yielding a tax multiplier of four. Then, four times the $25 billion tax cut yields the desired $100 billion expansion. Well we now know how to use expansionary fiscal policy to close a recessionary gap.

Keynesian tax multiplier = expenditure multiplier * MPC

Inflationary gap
Suppose there is an inflationary gap instead. A gap, such as the one in the late 1960's, caused by demand-pull inflation from the Vietnam War, and Great Society expenditures. The economy is in equilibrium at point a where aggregate expenditures crossed the 45 degree line of aggregate production and income is at $960 billion. But this is $60 billion above the full employment output of $900 billion. In such a case, we know that there will be strong upward pressures on prices, even though such pressures are not visible in the Keynesian model.

In the light of these inflationary pressures, fiscal policy can be used to close the inflationary gap. To close the inflationary gap, contractionary fiscal policy must be used, where contractionary fiscal policy involves reduced government expenditures, tax hikes, or some combination of the two, to cool inflationary pressures. If the slope of the aggregate expenditures curve is .75, then the multiplier is four. Thus to close this inflation area gap, government expenditures must be reduced by $15 billion or alternatively taxes must be raised by $20 billion. At a multiplier of four either fiscal policy tool will lead to the desired economic contraction of $60 billion.

Whether it is more preferable to increase government spending or to cut taxes to eliminate recessionary gaps depends more on one's views of the appropriate size of the government than pure economics. At one end of the ideological spectrum, the liberals who think that there are many unmet social and infrastructural needs, usually recommend increased government spending during recessions and tax increases to fight demand-pull inflation. These actions either expand or preserve the absolute size of government. On the other hand, there are conservatives who seek to shrink the size of government. They will generally favour tax cuts during recessions and cuts in government spending to fight demand pull inflation.

3.5. Strengths and weaknesses of Keynesian model

The Keynesian model was useful in explaining the economy's plunge into and recovery from the Great Depression. In 1929, the economy was booming and at full employment, but the stock market crash sent the business community into a panic. The business communities animal spirits went from the full embodiment of a robust bull, to that of a bleak bear market. Reacting to the crash, businesses cut back sharply on investment and production. At the same time, frightened consumers cut back dramatically on consumption while attempting to save more, effectively increasing their marginal propensity to save as a response to the crisis.

Together, the reactions of business and consumers lead to a sharp and sudden downward shift of the aggregate expenditures curve. Business people in turn, responded by decreasing output further. This depressed income and consumption, the economy continued its downward spiral And eventually, unemployment reached a staggering 25% of the workforce. One of the ironies of this result, of course, was that in their attempt to save more. Many individual households actually wound up saving less because their incomes were plummeting as aggregate expenditures fell. This result is known in macroeconomics as the paradox of thrift, and it can be an important contributor to recessionary events.

In this particular case, with the economy in a depressed state, consumers not only tried unsuccessfully to boost their savings, but businesses also became unwilling to invest no matter how low interest rates fell. At this point the government stepped in with a massive dose of expansionary fiscal policies. The public works projects of Franklin Delano Roosevelt's new deal followed by the dramatic spurt of defence expenditures of world war II triggered both increased consumption and investment, and the economy roared back to full employment.

The textbook Keynesian multiplier model provides a very mechanistic approach to curing the economy of a recession. Specifically, if the actual GDP and the full employment GDP are known, then the size of the recessionary or inflationary gap can be calculated. And if you know the marginal propensity to consume, and therefor the multiplier. You also know how much you have to increase or decrease government expenditures or taxes, to close the gap. Now if only life were this simple, none of us would have to worry about ever being unemployed again. After mastering this simple lesson anyone would be qualified to serve as the President's top economic advisor. This is not the case, even if many economists at the height of the 1960's Keynesian Era naively thought it was.

There are many problems with this mechanistic Keynesian view and one specific one has to do with an important issue known as crowding out. Crowding out refers to the reduction in private sector investment that can be caused by increased government spending. And it can happen when the government borrows money to finance these expenditures. Such borrowing or deficit spending can drive up interest rates. As we have discussed earlier in this lecture, higher interest rates can in turn reduce private sector investment. Why should this concern us? Because it means that any fiscal policy stimulus may be partly, or fully offset, by a reduction in private sector demand. This, in turn means, that the net expansionary effect of Keynesian fiscal policies might wind up being smaller, and indeed in some cases, much smaller than was intended.

Beyond this specific problem of crowding out, a much broader problem with a mechanistic Keynesian approach is that it relies on a model that is not a complete model of the economy, particularly with respect to the monetary and financial sector. Despite its limitations the Keynesian model is a powerful tool for illustrating two particular situations. The first is when the economy is in the Keynesian recessionary or depressionary range. In this range with fixed price assumption mirrors reality because increased output brought about by increased aggregate demand does not put upward pressure on prices. The second situation were the Keynesian model is useful analytically is for illustrating how a small imbalance between leakages and injections can multiply into a much larger unemployment or inflation problem.

Inflationary gap
It is clear that the Keynesian model assumes away one of the most important problems in economics, namely inflation. In doing so, it neglects the crucial influence of monetary factors on interest rates, and interest-sensitive components of output, such as investment. That's one good reason, why in macro-economics, we also like to use the aggregate supply aggregate demand model. It illustrates both price levels and real output. There is a relationship between the Keynesian aggregate expenditures-aggregate production model and the classical aggregate supply-aggregate demand model. The top panel shows the output expenditure equilibrium in the Keynesian model. At point E, the spending line just cuts the 45 degree line. This leads to an equilibrium output of Q and a recessionary gap of QP minus Q.

This same equilibrium can also be seen in the bottom panel, where the AD curve cuts the AS curve at point E. So both approaches lead to the same equilibrium output q. But note that in this case the economy is assumed to be operating in the intermediate range. So that if fiscal policy were to be used to close the recessionary gap, some inflation would likely result. Moreover if fiscal policy were to try to push the economy beyond QP into the classical range, the primary result would be inflation. In this case, the Keynesian model is not helpful, while a deeper understanding of the monetary sector of the economy is crucial. It will be to the monetary sector we will turn to in the next lecture.

4. The Federal Reserve and Monetary Policy

4.1. Introduction

Monetary policy may be used to fight recessions and inflation. Whether to use monetary or fiscal policy, monetarism or Keynesianism, became the macro economic question in the 1970s as the nation found itself fighting a soaring inflation and then a virulent stagflation. Monetarism emerged in the 1970s to challenge the Keynesian orthodoxy. Monetary policy involves the use of changes in the money supply to contract or expand the economy.

Between the Great Depression, and the height of the Vietnam War, monetary policy largely played second fiddle to fiscal policy. Fiscal policy had been a resounding success in lifting the US out of the Great Depression in the 1930s as well as ending a more mild but nonetheless significant recession in 1949 and 1950. Moreover, the astonishing success of the Kennedy tax cut of 1964 seemed to provide incontrovertible proof that Keynesian economics could be used to fine tune the economy and keep it at or close to full employment with minimum inflation.

Even during these four decades of Keynesian triumphs, monetary policy played an important supporting role. Particularly in the 1950s, the Eisenhower administration relied heavily on a tight monetary policy to keep inflation in check. In fact, many critics now believe that an overly conservative monetary policy led to a stagnating economy in the late 1950s a nd set up the defeat of Eisenhower's would-be successor, Republican Richard Nixon, in the 1960 presidential election. Nixon lost to democrat and Keynesian disciple John F. Kennedy who ran on slogan of getting the country moving again.

Moving again is actually what the democratic administrations of first John F. Kennedy and then Lyndon Johnson did to the economy. By the end of the 1960s the economy was moving so fast that inflation began to rear its ugly head. By 1969, inflation had crept over 5%, high for those good old days. And by the early 1970s it had jumped to almost double digits. And it was at this point as a new phenomenon known as stagflation began to emerge that monetarism began to challenge the Keynesian orthodoxy.

4.2. All about money

The measure of money
For most people money is cash. Money has a much broader definition. It is anything that can be widely used, and accepted, in exchange for other goods and services. In practice, there are three kinds of money. Commodity money, like gold nuggets, represents the preferred money of centuries past. Today, in virtually all countries, commodity money has been replaced by the two other kinds of money, bank money and paper or fiat money. An example of bank money is the checkbook that can be used to pay bills. Fiat money or paper money consists of the dollar bills in the United States and the yen in Japan.

Money is the most liquid asset, meaning that it is the most readily spendable. Money has three major functions. First it is a medium of exchange. Without money people would have to conduct their transactions by barter, which involves the direct exchange of one good or service for another. Second, money serves as a unit of account or standard of value. It states the rate at which goods and services can be exchanged. For example if a loaf of bread costs $1 and a pound of butter costs $2, the butter will exchange for two loaves of bread.

The definition of money
Third, money serves as a store of value. This is because people can hold onto money and then spend it later. It is this function that money performs least because most methods of holding money do not yield the same kind of monetary returns that you get by storing wealth in the form of less liquid assets such as stocks and bonds. In the presence of inflation money can rapidly lose its value.

In talking about monetary policy, macro economists distinguish between four kinds of money. M1, M2, M3 and L. These different kinds of money reflect variations in the liquidity and the accessibility of assets. Macroeconomists concern themselves the most with M1 and M2. M1 is known as transactions money because it consists of items that are actually used for transactions. These items include, most imporantly, paper currency and coins, plus checking accounts and demand deposits.

M2 is known as broad money. It includes M1, plus so called near moneys, such as savings accounts, small time deposits, and money market mutual fund shares. Finally, M3 and L are the broadest definitions of money, and include almost all short-term assets. Monetary policy uses changes in the supply of money to contract or expand the economy. In order to conduct monetary policy effectively policy makers must have a very good idea of what they are changing when they change the money supply.

4.3. All about interest rates

The interest rate is the amount of interest paid per unit of time, expressed as a percentage of the amount borrowed. Interest is the payment made for the use of money, and it is often called the price of money. For example, you may deposit $2,000 in a savings account at your local bank, where the rate of interest is 4% per year. At the end of the year, the bank will have paid $80 in interest into the account, the deposit will be worth $2,080. Textbooks often speak of the interest rate, but in today's complex financial system, there is a vast array of interest rates. There are three major reasons why interest rates differ.

First, there is the term or maturity of the loan. This refers to the length of time until it must be paid off. This can range from overnight loans to up to 30 years or more for a home mortgage. In general, longer term loans command a higher interest rate because lenders are willing to sacrifice quick access to their funds. Only if they can increase their return or yield.

Second, there is the degree of risk. Some loans, such as the securities of the US government, are virtually riskless. In fact, the interest rate on US government securities is often called the riskless rate. In contrast, very risky investments, which bare a significant chance of default or non-payment might include the securities of businesses close to bankruptcy. Cities with shrinking tax bases, or countries with large overseas debt, and unstable political systems. These riskier investments might pay 1, 2, or even 5% or more per year above the risk less rate.

Third, there is the issue of liquidity. An asset is said to be liquid if it can be converted into cash quickly with little loss in value. In contrast, because of the higher risk and difficulty of extracting a borrowers investment, illiquid assets, or loans usually command higher interest rates.

The nominal interest rate measures the yield in dollars per year per dollar investment. But as with nominal GDP, inflation can make the dollar a rubbery and distorted yardstick. That's why economists also compute the real interest rate. It corrects for inflation and is simply calculated as the nominal interest rate minus the rate of inflation. Thus, if the nominal interest rate is 8% per year, and the inflation rate is 3% per year, the real interest rateis 5%. For an investor it is important to focus on real returns, not on nominal returns.

4.4. Determinants of money demand

The two major determinants of money demand are known as the transactions demand and the asset demand. The transactions demand for money arises because people and firm use it as a medium of exchange. For example, households need money to buy groceries and firms need money to pay for materials and labour. The average money holdings of a family that earns a 3,000 dollar paycheck per month that keeps it only in money, and spends the money during the month, holds $1,500 on average in money balances.

The basic determinant of the amount of money demanded for transactions, is the level of nominal GDP. The larger the total money value of all goods and services that are exchanged in the economy, the larger amount of money need, to negotiate these transactions. So, what do you think will happen to the transactions demand for money if prices and nominal GDP double? If prices and nominal GDP double, the transactions demand for money will double.

The asset demand or, speculative motive for holding money, arises because people use money as a store of value. An example of the asset demand for money is when someone is interested in buying some stocks or bonds but think that the present prices are too high. In this case, he or she might want to hold some money, in order to be ready to buy the stocks or bonds when the price becomes more attractive. Essentially then, someone is speculating that a better financial opportunity will appear soon.

While money is an asset, it provides no rate of return or interest, like other assets, such as stocks and savings accounts do. Moreover, its value can depreciate because of inflation. There is an opportunity cost of holding money that includes the interest or rate of return that could have been earned by lending or investing the money as well as the loss in value from holding money during inflation. The asset demand for money decreases, if interest rates rise or the expectation of inflation increases, because the opportunity cost of holding money increases.

4.5. How paper money is created and the money multiplier

To understand how money is created, the best way is to go back several hundred years to England, when commodity money such as gold was the prevailing medium of exchange and goldsmiths emerged as the first commercial bankers. In this earlier era people did not like to carry around their gold or leave it in the house because it was cumbersome and could be stolen. People asked their goldsmith to store it. The Goldsmiths in turn, would give the gold depositors a paper receipt, and when a depositor needed to get some gold to make a purchase, he or she would use that receipt to redeem the gold.

Over time, three important things happened. First the depositors figured out that they could trade their gold receipts for goods rather than go back to the goldsmith to redeem the paper every time they needed to make a transaction. These receipts started to function as the first paper money. Second, the gold depositors soon figured out that they did not have to leave their gold with the goldsmith for free. In fact, it wasn't long before goldsmiths began competing for depositor's gold. In those good old days, they didn't offer people free toasters or rebates to open an account. They did offer them interest on their gold deposits.

The origin of bank reserves
Finally, the goldsmiths figured out that they could operate under what is today called the system of fractional reserves. For example, they might take in a $1000 of gold deposits and issue receipts for that amount to the depositors. However, they then might issue another thousand dollars in gold receipts as loans to other people, even though they did not have enough gold deposits to redeem all the receipts they issued. The goldsmiths could operate this way because it was highly unlikely that everyone who held the receipts would come in at the same time to demand their gold.

In this particular example the implicit fractional reserve is 50% or 5. At this level the goldsmiths would issue twice as many receipts as they had gold deposits for and such a system allowed the goldsmiths to expand the supply of money Over and above the amount of gold reserves they held in their vaults. Today's modern banks function much like the goldsmith's of old. And you can see now how such banks can create money. Suppose for example that a person deposits a thousand dollars in bank one. This table shows the balance sheet for bank one in this initial position where both reserves and deposits are $1000.

How banks create money
Now, suppose further that the banks board of directors decides that they're going to maintain a fractional reserve or reserve requirement of 10%. This means that the board of directors is betting that no more than ten percent of their depositors will come in and demand their money at any one time. This in turn means they can safely lend out at least $900 of the new $1000 demand deposit. This table shows bank one's balance sheet after making such a loan. Deposits remain at $1,000, but reserves fall to $100 while loans and investments go to $900.

At this point, the borrower from bank one deposits the money in bank two. And this is reflected in bank 2's initial balance sheet in this table. But since bank 2 also has a 10% reserve requirement, it can lend out funds, $810 to be precise, as indicated by bank 2's final balance sheet. In this table. When $810 is deposited in bank three, bank three lends out $729, bank four lends out $656, and so on. The final equilibrium is reached when every new dollar of original bank reserves supports ten dollars of demand deposits.

Fractional reserve money supply expansion
Through the expansion the original $1000 demand deposit creates an additional $9000 of new loans and investments and a total of $10,000 in new deposits. There is a money supply multiplier operating on bank reserves that is very different from the Keynesian expenditure multiplier. The money supply multiplier is simply one divided by the bank's required reserve ratio. In the example above, if the reserve requirement is 0.10 or 10%, the money multiplier is ten, and, 10 times the original $1,000 increase in demand deposits, is $10,000.

The obvious question is where the one thousand dollars of paper money that was deposited in bank one originally came from? This money comes from the nation's central bank, which is the Federal Reserve in the United States. Through its control of bank reserves, the Federal Reserve sets the level of interest rates, and has a major impact on economic output and employment. The Fed, as it is called, was created in 1913 following the financial panic of 1907. During this panic, numerous banks collapsed because of so-called runs on the banks. A bank run occurs when too many of the bank's depositors demand their money at the same time.

To see the problem of a bank run, imagine what would have happened to the goldsmith in the example above if everybody had showed up all at once demanding their $2,000 in gold, and the goldsmith had had only $1,000 of gold in his vault. Bank runs usually happened because, for one reason or another, people suddenly believed that they may not be able to get all their money out of their bank. The irony of course, is that when everybody tried to do that at once, the fear becomes reality. For that reason a central bank can serve as the lender of last resort, so if a bank needs to pay off its depositors, it can always borrow from the Fed, which is a banker's bank.

5. Unemployment, Inflation, and Stagflation

5.1. Some basic unemployment concepts

Unemployment and inflation are two of the most important problems in macroeconomics. In most cases, macroeconomists can solve at least one of them, but only by worsening the other. For example, expansionary fiscal or monetary policy can usually pull an economy out of a recession, but such actions may cause inflation. On the other hand, contractionary policies typically can be used to fight inflation, but often at the cost of more unemployment and recession. But what happens when an economy faces both high unemployment and soaring inflation as many nations of the globe did during the turbulent 1970s? Are traditional, Keynesian style monetary and fiscal policies still effective in fighting such stagflation?

In order to answer this question, it is important to understand what the causes of unemployment and inflation are. One of the great debates in macroeconomic theory is whether or not there is a clear trade off between unemployment and inflation as advocates of the so called Phillips Curve suggest? Others argue that the Phillips Curve is a concept of a failed Keynesianism. In this lesson we're also going to compare and contrast the Keynesian and monetarist views of stagflation. And then illustrate why the doctrine of supply side economics emerged in the 1980s as a viable political alternative to these two competing economic camps.

In thinking about the unemployment problem, economists identify three different kinds. Frictional, structural, and cyclical. Frictional unemployment is the least of the economist's worries. It arises because of the incessant movement of people between regions and jobs or through different stages of their life cycle. For example, even when an economy is at full employment there is still some turnover as students search for jobs when they graduate from school and when women reenter the labour force after having children. Cyclical unemployment is a much more serious problem. It occurs when the economy dips into a recession, and it is this type of unemployment that macroeconomists have historically spent most of their time trying to solve.

In an increasingly technological age, the third type of unemployment, structural unemployment, has begun receiving more attention. Structural unemployment occurs when there is a mismatch between the available jobs and the skills workers have to perform them. It often results when technological change makes someone's job obsolete. The highly skilled glassblower thrown out of work by the invention of bottle making machines or the specialised autoworker replaced by a robot.

A second source of structural unemployment results from a mismatch between the location of workers and the location of job openings. For example, in the 1980s when the price of oil plunged, many oil field workers in the oil producing states found themselves structurally unemployed when widespread layoffs occurred, even though unemployment was low in other parts of the country.

The distinction between cyclical, frictional, and structural unemployment is important. Because it helps economists diagnose the general health of the labour market and craft appropriate policy responses. For example, in the presence of cyclical unemployment due to recession, expansionary fiscal or monetary policies may be quite appropriate. However, structural unemployment often requires more targeted policies, such as job retraining.

5.2. Unemployment defined and measured

Statistics on unemployment and the labour force are among the most carefully designed and comprehensive economic data the United States collects. The data are gathered monthly in a procedure known as random sampling of the population. Each month, about 60,000 households are interviewed about their recent work history. The survey divides the population 16 years and older into different groups.

People without jobs, who are not looking for work are categorised as not in the labour force. This includes homemakers, students, retirees, voluntarily idle and the non-working disabled. This category also includes all persons incapable of working, such as inmates in institutions and people under 16 years of age. People with jobs are categorised as employed. People without jobs who are looking for work are said to be unemployed. The labour force is equal to the number of people who are employed plus people who are not employed.

The unemployment rate is the number of unemployed divided by the labour force times 100. For example, if the total unemployed is 8 million and the labour force stands at 130 million, then the unemployment rate is 6.2%. This is simply 8 million divided by 130 million which equals 0.062 and this times 100 equals 6.2%.

The unemployment rate steadily falls as education increases. High school drop outs suffering the highest rate of unemployment. Teenagers generally have the highest unemployment rate of any demographic group while black teenagers have experienced unemployment rates between 30 and 50%.

Recent evidence indicates that, particularly for whites, teenage unemployment has a large frictional component. Teenagers move in and out of the labour force very frequently. They get jobs quickly and change jobs often. Moreover, in most years half the unemployed teenagers are new entrants who have never had a paying job before. All these factors suggest that teenage unemployment is largely frictional. That is, it represents the job search and turnover necessary for young people to discover their personal skills and to learn what working is all about.

Black teenagers have by far the highest unemployment rate. One possible reason is racial discrimination. Another theory holds that a high minimum wage tends to drive low-productivity black teenagers into unemployment. Still another theory advanced by some conservative critics of the modern welfare state, blame high unemployment of blacks on the culture of dependency that is nurtured by government welfare to the poor. Unfortunately, there is insufficient empirical data to resolve the issue, and the controversy over black teen unemployment is ongoing.

5.3. Okun's law

Unemployment is a problem that results not only in a waste of valuable labour resources, but also the loss of potential output. The opportunity cost of unemployment is measured as the cumulative difference in potential versus actual output. The largest economic loss occurred during the Great Depression, and amounted to 4.4 trillion dollar between 1930 and 1939. The oil and inflation crises of the 1970s and 1980s also generated several trillion additional dollars of lost output. In calculating these numbers, economists make use of Okun's Law.

Okun's Law was first identified by economist Arthur Okun. By studying macroeconomic data, he found an important relationship between output and unemployment. Unemployment changes are well predicted by the rate of GDP growth and, according to Okun's Law, for every 2% actual GDP falls relative to potential GDP, the unemployment rate rises by about one percentage point.

In 1979 the employment rate was 5.8%, but over the next three years actual real GDP did not grow at all as the economy stagnated. By contrast, potential GDP grew at 3% per year increasing a total of 9% over the three year period. The unemployment rate in 1982 can be calculated using Okun's Law. A 9% shortfall in GDP should have led to a rise of 4.5 percentage points in the unemployment rate. Starting with an unemployment rate of 5.8% in 1979, Okun's Law would predict a 10.3% unemployment rate by 1982. The actual rate was very close, 9.7%.

One important consequence of Okun's Law is that actual GDP must grow as rapidly as potential GDP just to keep the unemployment rate from rising. In a sense, as our population grows and technology changes, GDP has to keep growing just to keep unemployment in the same place. Moreover, if you want to bring the unemployment rate down, actual GDP must be growing faster than potential GDP.

5.4. Demand-pull versus cost-pust inflation and the Keynesian dilemma

Demand-pull inflation
Inflation has often been described as the cruelest tax because it eats away savings and paychecks. For example, if the rate of inflation exceeds the rate of growth in our paycheck, that means our real income or purchasing power is declining, even though our wages are going up. But not everyone loses from inflation. For example, as we learned in lecture one, inflation that is unanticipated can benefit borrowers at the expense of lenders. There are two very different types of inflation, demand-pull inflation and cost-push inflation.

The essence of demand-pull inflation is, too much money chasing too few goods. That happened when the US tried to finance both guns and butter, both the Vietnam War and the Great Society. Increased government expenditures on both guns and butter drive aggregate demand from AD to AD'. Equilibrium output increases from E to E' as real GDP expands. However, when real output rises far above potential output, the price level moves up sharply as well from P to P'.

In 1972, President Richard Nixon imposed price and wage controls and gained the nation a brief respite from the Johnson era inflation. However, once the controls were lifted in 1973, inflation jumped back up to double digits, helped in large part by a different kind of inflation then emerging, an inflation known as cost-push or supply side inflation.

Cost-push inflation
Cost-push or supply side inflation occurs when external shocks such as rapid increases in raw material prices or wage increases drive up production costs. In the early 1970s, such supply shocks included crop failures, a worldwide drought, and a quadrupling of the world price of crude oil. Sharply higher oil, commodity, and labour costs increased the cost of doing business. The higher costs shift the AS curve up from AS to AS' and the equilibrium shifts from E to E'. Output declines from Q to Q', while prices rise. This leads to stagflation, the double whammy of both lower output and higher prices.

Prior to the 1970s economists didn't believe you could even have both high inflation and high unemployment at the same time. If one went up, the other had to go down. But the 1970s proved economists wrong on this point, and likewise exposed Keynesian economics as being incapable of solving the new stagflation problem. The Keynesian dilemma that expansionary policies to reduce unemployment simply created more inflation while contractionary policies to curb inflation only deepened the recession. That meant that the traditional Keynesian tools could solve only half of the stagflation problem at any one time, and only by making the other half worse.

This dilemma was well illustrated by the ill fated initial Keynesian responses to the emerging stagflation crisis. During 1973 and 1974, inflation was labeled public enemy number one by policy makers even though there were clear signs of an accompanying recession. During both of these years, the Federal Reserve under Chairman Arthur Burns ordered sharp increases in the discount rate as a form of contractionary monetary policy. In addition, in 1974, President Gerald Ford responded to the crisis with a Whip Inflation Now campaign that included Keynesian calls for contractionary fiscal policy in the form of fiscal restraint and a tax surcharge.

The result of these discretionary policies was to drive the economy deeper into recession even as oil price shocks in particular helped drive the inflation rate ever higher. Then, in 1975, alarmed by the deepening recession, the nation's policymakers switched their Keynesian strategy as they replaced inflation with recession as their number one policy worry. As Congress passed a $23 billion Keynesian tax cut to fight recession, the Federal Reserve switched to an expansionary Keynesian monetary policy.

The result was a disaster. Stagflation poses a seemingly unreconcilable dilemma for traditional Keynesianism. High inflation remained, even as the economy failed to recover from recession. It was this inability of the Keynesian economics to cope with stagflation that set the stage first for professor Milton Friedman's monetarist challenge to what had become the Keynesian orthodoxy and then later for the emergence of supply-side economics.

5.5. Inflation, inflationary expectations and the Phillips curve

In modern industrial nations like the United States, most economists believe that there is a core or inertial rate of inflation that tends to persist at the same rate until some kind of demand or supply side shock comes along to change things. At the heart of this idea of inertial or core inflation, is the concept of inflationary expectations, and a behavioural model known as adaptive expectations. Inflationary expectations are important because the expectation of inflation can significantly contribute to actual inflation. The reason is that inflationary expectations strongly influence the behaviour of businesses, investors, workers, and consumers.

The assumption of adaptive expectations, means that people believe that next year's rate of inflation will be the same as the current or last year's rate. For example, during the 1990s prices in the US rose steadily at around 3% annually and most people came to expect that inflation rate. This expected rate of inflation was, in turn, built into a core rate of inflation for the economy through institutional arrangements such as negotiated labour contracts.

To see how this may work, suppose the chief negotiator for the United Auto Workers Union believes that workers will achieve a 1% increase in productivity annually. Because increases in real wages are tied to labour productivity, he also believes that auto workers deserve at least the 1% increase in their real inflation adjusted wages. Assuming he has adaptive expectations, and last years inflation rate was 3%, the percentage increase in nominal wages he demands at the bargaining table will be a minimum 4% increase in the nominal wages. Of this demand is 1% to get the real increase based on productivity gains and 3% to adjust for the expected inflation.

Inflationary spiral
When Ford, General Motors, and Chrysler all agree to this 4% wage demand, the increase in wages caused by the union's inflationary expectations will lead to an actual increase in the auto industry's labour costs. This in turn will put upward pressure on auto prices so that the expectation of inflation becomes a self-fulfilling prophecy and the inertial or core rate of inflation is maintained.

To explain how adaptive expectations lead to an inertial inflation rate, it is good to start off at point E where the aggregate supply and demand curves cross at potential output QP. At this point, the core rate of inflation is 3%. Because of their adaptive expectations, everyone expects average costs and prices to rise at 3% this year, because that is what they did last year. Consequently, workers demand and receive higher nominal wages. This pushes up the aggregate supply curve even as their increased spending pushes up the aggregate demand curve. Over time, the aggregate supply and demand curves continue to rise by 3% a year as the macroeconomic equilibrium moves from E, E' to E''. In this case, the core, or inertial rate of inflation, is maintained.

Output increases as well as price level
What might cause the core or inertial rate to change and more importantly, how might inflation start to spiral out of control such as it did in the 1970s? To answer these questions, it is inportant to introduce one of the most important concepts in macroeconomics, namely the Phillips curve. The Phillips curve was developed by the English economist A.W. Phillips after a study of more than a century's worth of data on unemployment and money wages in the United Kingdom. Phillips found that wages tended to rise when unemployment was low, but fall when unemployment was high. The reason for this is that workers press less strongly for wage hikes when fewer jobs are available, and businesses fight harder against wage demands when profits are low.

Phillips curve
To convey the idea of the Phillips curve, the aggregate supply, aggregate demand model can be used. Holding the aggregate supply curve steady, we start at AD0. An increase in aggregate demand, shifts the AD curve upwards from AD1 to AD2, and eventually to AD3. The result is that the price level rises from P0 to P3, while output increases from Q0 to Q3. Unless robots are doing all the work, the increase in real output is almost certainly accompanied by a fall in the unemployment rate while the price level is rising. This is the essence of the Phillips Curve relationship.

The Phillips Curve is a theoretical inverse relationship between inflation and unemployment. But what is most interesting is that the employment and inflation data of the 1960s appears to provide strong empirical evidence that the Phillips Curve actually exists. Co-movements of the inflation and unemployment rates between 1961 and 1969 are plotted on the graph, and the points do indeed suggest a downward sloping Phillips Curve. On the basis of this and earlier historial evidence, most economists came to believe that a stable, predictable tradeoff exists between unemployment and inflation. The important policy implication is that fiscal or monetary policy can be used to expand the economy a bit more to reduce unemployment. The only price is a bit more inflation.

Phillips curve
Something very significant happened in the 1970s to shake economists' faith in the Phillips curve as the data points for the years 1971 to 1979 show. Connecting the data points starting in 1970 and ending in 1979 do not create the typical downward sloping Phillips Curve but rather a much more chaotic Phillips Curl. The curl is produced by connecting the data points of subsequent years, which is clearly a wrong method to apply on the data, but nevertheless there is no Phillips Curve to be found in the data of the 1970s.

There are various explanations for the emergence of the Phillips Curl based on the strong theoretical differences that exist between the various schools of macro economics, such Keynesians, monetarists to supply-siders and new classical economists. The standard explanation of the breakdown of the Phillips Curve is that a series of supply shocks in the 1970s shifted the short run aggregate supply curve leftward. This moved the Phillips curve rightward and upward from the green curve to the blue curve. The red curve is a supply shock process in reverse. Oil prices feell back down in the 1980s. This and other positive supply side effects shifted the Phillip's curve back towards the red line.

From a macro policy perspective, the virtue of this standard explanation is that it preserves the Phillip's Curve relationship. This means that in stable times, and absent supply-side shocks, policy makers can still engage in discretionary fiscal and monetary policies to expand or contract the economy as they see fit. The only price paid is a little more inflation for a little more unemployment. This may be acceptable from a Keynesian perspective, but the Monetarists have a very different explanation of stagflation and the events of the 1970s that calls into question the very existence of the Phillips curve. According to the monetarists, this disappearance of the Phillips Curve in the 1970's may best be explained through the concept of the natural rate of unemployment, and by distinguishing between a short run and long run Phillips Curve.

5.6. The natural rate of unemployment and inflationary spirals

The Modified Phillips Curve theory of the monetarists grew out of the work of Edmund Phelps and Milton Friedman. The theory asserts that there is a minimum unemployment rate that is consistent with steady inflation. This rate is what classical economists and monetarists typically refer to as the natural rate of unemployment. Some textbooks refer to it as the lowest sustainable rate of unemployment (LSUR). The monetarists' major point that it is impossible to drive unemployment below the natural or lowest sustainable rate in the long run. This assertion clearly implies that the long run Phillips Curve is vertical rather than downward sloping.

This is important because the policy implications of the monetarist natural rate theory strike to the very heart of Keynesian activism. Indeed, while the theory allows that a nation can use expansionary fiscal or monetary policy to drive unemployment below the natural rate temporarily, such a Keynesian joyride along the short run Phillips Curve must inevitably come at the price of rising inflation. If a nation repeatedly uses Keynesian policies to try and keep unemployment below the natural rate, the only result over the longer run, will be a deadly upwards spiral of wages and prices, precisely like the one in the 1970s.

Inflationary spiral
How exactly might this happen? One important point about the natural rate of unemployment is that it is not a constant rate. Rather it can change as the structure of an economy changes. For example, in the prosperous decade of the 1960s, the natural rate of unemployment was somewhere between 4% and 5%. However, in the 1970s the natural rate of unemployment actually climbed into the 5% to 6% range. This increase in the natural rate came about because the supply side shocks of the 1970s. Particularly the energy price shocks raised the real costs of production in the economy. These higher costs in turn, lowered the economy's potential output, relative to what it would have been.

This monetarist perspective can be applied on the Phillips Curve to illustrate how inflation can begin to spiral out of control if macroeconomic policy makers attempt to expand the economy below its natural rate of unemployment. The discussion of this process brings together many of the elements of modern inflation theory. The situation starts at point a1, where the core rate of inflation is 3% and the natural rate of unemployment is 6% as indicated by the vertical curve. From a political perspective this 6% rate of unemployment is seen as unacceptably too high by a Congress and Keynesian president, who, in an earlier decade, have become accustomed to a 4% unemployment rate without inflation.

With voters growing restive over an apparent recession, they are going to engage in expansionary fiscal policy to reduce the unemployment rate to 4%. This is where the idea of adaptive expectations comes back in. In particular, because people are assuming inflation will remain at 3%, they do not immediately demand higher wages, even as inflation rises above the core rate to 6%. This lag in wage demands, allows the economy to move up the short run Phillips Curve to point b1, and the unemployment rate does indeed fall to 4%. Once people finally figure out that inflation has risen, and successfully demand higher wages to offset this rise in inflation, the short-run is over.

At this time the rise in nominal wages, brought about by successful wage demands, shifts the short run Phillips Curve, PC1, out to PC2 back to an unemployment rate of 6%, but at a higher inflation rate. Frustrated again by the apparent recession, the politicians once again try to drive the unemployment rate back down to 4%, well below the natural rate. This works again in the short run, as the economy moves back to point b2, but the Keynesian joy ride again doesn't last. With inflation now at 9%, people's adapted expectations eventually change, and there is another shift in the short-run Phillips Curve, to PC3, back to the natural unemployment rate of 6% with even more inflation, caught in a vicious inflationary spiral.

5.7. Monetarist versus Keynesian cures for inflation

Besides demonstrating how politics coupled with Keynsian activism can lead to an inflationary spiral, the monetarist story also raises the policy question of how to stop such an inflationary spiral. To the monetarists the solution is to stop using expansionary Keynesian policies and allow the economy to return to the natural or lowest sustainable rate of unemployment. The problem is that even if the upward spiral of inflation is stopped, there still is significant inflation because a higher core rate of inflation has been built into the economy. Specifically, in this case, even if inflation's upward spiral is stopped, the economy may be stuck at point a3, with a inertial rate of inflation of 9%.

Neither the traditional Keynseian or monetarist approaches to wringing this inflation out of the economy has any political appeal. The traditional Keynesian solution is a so-called incomes policy, which is imposing wage and price controls until inflation dissipates. One problem with this approach is that it may not work. This is a lesson President Nixon learned when his administration imposed temporary wage and price controls in 1971 and then watched helplessly as inflation jumped right back up into double digits once those controls were lifted in 1973.

The other problem with an incomes policy is that it runs contrary to the ideological of free market capitalism beliefs of the majority of Americans. Businesses don't want the heavy handed government holding down their prices and workers do not want that same government holding down their wages. Accordingly, there are very few advocates of wage and price controls today.

The monetarists' solution is equally unpalatable from a political point of view. Specifically, monetarists believe that the only way to wring inflation and inflationary expectations out of the economy, is to have the actual inflation rate below the expected inflation rate. To achieve this, the actual unemployment rate must be above the natural rate of unemployment, which means inducing a recession. This is at least one interpretation of what the Federal Reserve did beginning in 1979 under the banner of setting monetary growth target. In 1979 the Fed under chairman Paul Volcker adopted a sharply contractionary monetary policy and interest rates soared to over 20%.

The resulting recession was the worst since the Great Depression. And it probably cost President Jimmy Carter the 1980 election and a second term. Nonetheless, the Fed's bitter medicine worked. Between 1979 and 1984, inflation fell dramatically. But at great human and economic cost. This table estimates the economic cost of reducing the inertial rate of inflation in 1979 of 9%, to 4% by 1984.

Over this period, because of the recession induced by the Fed, the economy produced $1.5 trillion dollars less than its potential GDP. While this $1.5 trillion dollars may have been the economic price tag of the Fed's monetarist experiment, there was a perhaps even more profound political result. The hard economic times left a bitter taste in the mouths of the American people. Hungry for a sweeter macroeconomic cure than either the Keynesians or monetarists could offer, supply side economics entered the stage.

5.8. Supply-side economics and the Laffer curve

In the 1980 presidential election, after almost a decade of stagflation, candidate Ronald Reagan ran on a supply side platform that promised to simultaneously cut taxes, increase government tax revenues, and accelerate the rate of economic growth. Without inducing inflation, a very sweet macroeconomic cure indeed. On the surface, the supply side approach looks very similar to the kind of Keynesian tax cut prescribed in the 1960s to stimulate a sluggish economy. However, the supply siders viewed such tax cuts from a very different behavioural perspective.

Unlike the Keynesians, they did not agree that such a tax cut would necessarily cause inflation. Instead, the supply siders believed that the American people would actually work much harder and invest much more if they were allowed to keep more of the fruits of their labour. The end result would be to increase the amount of goods and services our economy could actually produce by pushing out the economy's supply curve, hence this recipe is called supply side economics.

Supply-side economics offers a very painless way to avoid both the Keynesian stagflation dilemma and the bitter monetarist cure. After a supply shock, inflation rises, while output and employment falls, but use supply side policies to push the aggregate supply curve back out and voila, the price level falls even as real output and employment is rising. This supply-side philosophy is embodied in one of the few formal theoretical constructs of supply-side economics, the Laffer Curve.

Laffer curve
The Laffer Curve, named after economist Arthur Laffer, is a relation between the marginal tax rate and total tax revenues. The Laffer Curve is backward bending, reflecting the behavioural notion that at some point, people will work less the more they are taxed. This backward bend means that above a certain tax rate, m in the figure, an increase in the tax rate will actually cause overall tax revenues to fall. Note also, for a supply side tax cut to actually increase tax revenues, the existing tax rate before the tax cut must be above m. Say, at a rate associated with point n on the curve.

This is an important point because, in the early 1980s the Reagan Administration simply assumed that the economy was on the backward bending portion of the Laffer curve, and that a tax cut would increase total tax revenues. Based on this assumption, it moved forward with one of the largest tax cuts in American history. As the corporate tax rate was cut by 25% over three years, the top marginal tax rate on the wealthy fell from 50 to 38%. As part of its Reaganomics programme, the administration also cut back sharply on the regulation of everything from monopoly and oligopoly to pollution and product safety, important elements that likewise effect the aggregate supply curve.

Whether or not this supply side experiment did work is a question that is difficult to answer. The Reagan years witnessed significant declines in both inflation and interest rates, while the United States enjoyed a record-long peacetime expansion, and the economy roared back to full employment. Unfortunately, however, as the economy boomed, so too did America's budget deficit, and as the budget deficit soared America's trade deficit soared with it.

These so-called twin deficits deeply concerned Reagan's successor, George Bush, particularly after the budget deficit jumped to over $200 billion at the midpoint of his term in 1990. The economy began to slide into recession. To Keynesians, this onset of recession would have been a clear signal to engage in expansionary policy. However, in the Bush White House, Ronald Reagan's supply side advisers had been supplanted by a new breed of macroeconomic thinkers, the so called new classicals, who had abandoned the old theory of adaptive expectations in favour of a new behavioural model known as rational expectations.

6. The Warring Schools of Macroeconomics

6.1. New classical economics and rational versus adaptive expectations

The so-called new classical school is rooted in the classical economic tradition. It is important not just because of the strong influence it has had on recent macroeconomic theory, but also because new classical economists played a pivotol role in the 1992 defeat of George Bush by Bill Clinton. New classical economics is based on the controversial theory of rational expectations. This theory was developed by Nobel laureate Robert Lucas of the University of Chicago along with Thomas Sargent of Stanford and Robert Barrow of Harvard. It provides a sharp contrast to the notion of adaptive expectations on inflation and unemployment.

Adaptive expectations implies that people tend to assume that inflation will continue to be what it already is. For example, if inflation was 3% last year then adaptive expectations will lead you to predict that inflation will be 3% next year. In contrast, if people form their expectations rationally, they will take into account all available information including the future effects of activist fiscal and monetary policies. The idea behind rational expectations is that such activist policies might be able to fool people for a while. However, after a while people will learn from their experiences, and then you can't fool them at all. The central policy implication of this idea profound. Rational expectations render activist fiscal and monetary policies completely ineffective, so they should be abandoned.

Adaptive expectations
Suppose the federal reserve undertakes expansionary monetary policy to close a recessionary gap. Repeated experiences with such activist policy have taught people that increases in the money supply fuel inflation. To protect themselves in a world of rational expectations, businesses will immediately respond to the Fed's expansion by raising prices. Workers will demand higher wages and the attempted stimulus will be completely offset by the contractionary effects of inflation. Alternatively, suppose the government undertakes expansionary fiscal policy to stimulate the economy. People with rational expectations will increase their savings and reduce consumption and offset any expansionary effect because they know that a larger budget deficit means higher taxes later, so they prepare for this by saving more.

To illustrate the rational expectations dynamic, contrast the adjustment process of the economy with adaptive expectations versus rational expectations. The vertical line represents the long run aggregate supply curve at that natural rate of unemployment and the economy is in both the short and long run equilibrium at full employment output Y1 and price P1. This is where the short-run aggregate supply and aggregate demand curves cross at point A.

First assume adaptive expectations. The government undertakes expansionary policy to increase output above the full employment rate. This expansion shifts the aggregate demand curve out to AD1 and the economy temporarily reaches a new equilibrium output at point B. Here, output is Y2, at a new price level of P2. Once businesses and workers realise that inflation is higher, they add these inflationary expectations into their calculations of prices and wages. This shifts the aggregate supply curve inwards to AS2 and the economy falls back to point C. The end result is a short run spurt of growth above full employment output, followed by a return to the natural rate, albeit at a higher price level of P3.

Rational expectations
The new classical school asserts that rather than travel from point A to point B and back to point C, the economy will enjoy no short run growth spurt at point B. Instead, the economy will move instantaneously from point A to point C and the only result of the government's activist policy will be higher inflation. This is because people with rational expectations anticipate the future impacts of current government policy decisions and react immediately.

Now there are several things to say about rational expectations theory, from both and economic and political perspective. Economically, critics of rational expectation contend that most people are not as sophisticated in their economic thinking as the theory requires. Therefore, adjustments will not take place with anywhere near the speed they're supposed to. However, this criticism should not detract from the central point of rational expectations, namely that people's behaviour may partially, or perhaps, completely counteract goals of activist fiscal monetary policy.

Politically however, as George Bush painfully learned, relying on new classical economic thinking can be hazardous. Presidents Bush's new classical advisers flatly rejected any Keynesian quick fix to Bush's deepening recession. Instead, in their economic report to the President, they called for more stable and systematic policies based on long term goals, rather than a continued reliance on short sighted discretionary reactions. Bush took the new classical advice. The economy limped into the 1992 presidential election and like Richard Nixon in 1960, Bush lost to a Democrat promising to get the economy moving again.

What is perhaps most interesting about this transistion of power, is that Bill Clinton actually did very little to stimulate the economy. The mere fact that Clinton promised a more activist approach helped restore business and consumer confidence. At the same time, congressional passage of Clinton's deficit reduction legislation in 1993, sent Wall Street a clear signal that his administration was serious about budget balance. Together, these factors helped accelerate a recovery that had already begun by the end of Bush's term and set the stage for Clinton's remarkably easy reelection in 1996.

6.2. The Great Recession of 2007 and quantitative easing

The roaring 1990s would truly be a macroeconomist's dream. A technology boom would usher in the age of the internet and this digital revolution helped robustly push the aggregate supply curve out. This shift of the AS curve significantly increased potential output, while dropping the natural rate and actual rate of unemployment. In this Goldilocks economy, not too hot, not too cold, real GDP growth averaged close to 4% a year. A resultant surge in tax revenues and drop in welfare payments helped balance the US budget at the end of the Clinton Administration for the first time in decades.

Just two months after newly elected George W Bush took office, the March 2001 recession in the United States would start what would be more than a decade of slow growth and trouble for much of the world. In the five and half decades prior to 2001 the real GDP of the United States grew at a rate of roughly 3.5%. Over the next decade that growth would fall to around 1.5%. The rule of thumb is that one percentage point of GDP growth lost is equal to one million new jobs not created, so a difference of 3.5% growth versus 1.6% growth in the 2000s is about two GDP points a year or two million jobs lost per year. Over a decade, that is about 20 million jobs not created. That was about the same amount the US needed to bring its unemployment rate back down to its natural rate.

Wage growth would fall dramatically as well. In fact, average median household income, the best measure of income growth plunged to roughly zero during the 2000s, after growing close to 2% a year in the previous two decades. The worst part of the 2000s was the Great Recession of 2007. This was the steepest economic downturn since the Great Depression. It was an era characterised by massive bailouts, not just to private corporations like General Motors and AIG, but also public corporations like housing agencies, Fannie Mae and Freddie Mac. In the slow growth years following the Great Recession, the outgoing Bush Administration and the new Obama Administration would team up to execute the largest fiscal stimulus in world history.

At the same time, central bankers worldwide would print vast sums of money in their Keynesian struggle to restart their respective economies. The US Federal Reserve alone added trillions in liabilities to its balance sheet while printing money. Moreover, in an effort to stimulate the US economy in an era of nearly zero short-term interest rates, Fed Chairman Ben Bernanke would inaugurate a new Keynesian monetary policy tool known as quantitative easing or QE. QE involves the massive purchase of long-term government bonds by the Fed to drive up bond process and thereby drive down yields and interest rates.

The Fed's goal in lowering long-term interest rates was to stimulate both domestic investment and US exports. Domestic investment benefits from low, fixed long-term rates because most investment requires longer term financing. At the same time, lower long-term interest rates, and a flood of easy money, would help depress the value of the US dollar, giving US exports a boost. Despite all these Keynesian fiscal and monetary policy stimuli, unemployment in both the US and Europe would soar to double digits. The next question is why, just as in the 1970s, was Keynesian economics so inadequate at bringing about a full and robust global economic recovery?

6.3. How to forecast the business cycles and structural trade imbalances

Structural change
The relative failure of Keynesian's policies in the wake of the great recession to stimulate the US and global economies back to their full potential may be traced to the failure of macroeconomists in the White House and elsewhere to recognise the underlying structural nature of the slow growth problem. To understand the nature of this structural problem, it is useful to consider economic growth and the business cycle, and learn how it is measured, plotted, and forecasted. Real GDP rises and falls over time as the business cycle goes through expansionary peaks and recessionary troughs.

These short term oscillations occur around an upward sloping secular or long term growth trend line. During the slowdown of the 2000s, this secular long term growth trend line actually flattened for the US, Europe, and many other economies around the world. Indicating a structural shift to lower growth. To draw this business cycle, real GDP must be plotted over time. The basic approach most economic forecasters take is to look at the four major drivers of growth as illustrated in this Keynesian aggregate demand equation:

GDP = C + I + G + (X - M)

Leading economic indicators
These four drivers of GDP growth include consumption, investment, government spending, and net exports, where net exports represent the difference between the exports of a nation, and its imports. If imports exceed exports, a country is running a trade deficit. Forecasters use the so called leading economic indicators to predict movements in a business cycle. For example, to track consumption forecasters may watch consumer confidence closely. The idea is that a more confident consumer will spend more and therefore GDP growth will increase. Hence, consumer confidence is considered to be a leading economic indicator of future growth.

Similarily to track investment, a forecaster may watch a leading economic indicator, like the ISM Manufacturing Index. This is a broad and quite accurate measure of the health of the manufacturing sector, and a healthy ISM index with the value above 50 likely means an expanding economy. Forecasters pay very close attention to inflation indicators like consumer price index or CPI. If this index shows inflation rising, the Federal Reserve might raise the interest rates and thereby slow down GDP growth. Manufacturing businesses getting ready to up their production may benefit from this forecasting information.

The generic structural problem, faced by both the US and European economies, as well as other major economies like that of Japan and South Korea, as the world emerged from recession in the 2010s, is that if a country runs a trade deficit, this directly subtracts from its GDP growth. From that observation, is is possible to see the two main structure drags on growth for many developed nations like the US. The first has been the direct drag of the large trade deficits. The second has been the indirect drag of lower domestic investment growth as multi-national companies like Caterpillar and General Electric and General Motors have built more plants in other countries and fewer plants in the US. Most of the off-shoring of productions gone to China.

Not coincidentally, at the start of the America's new era of slow growth in 2001, China joined the World Trade Organisation or WTO, and was given full access to American markets. Contrary to the rules of the WTO, China began to immediately flood the US with cheap, often illegally subsidised exports, and over the next decade the US would see the loss of over 50,000 factories and more than 5,000,000 manufacturing jobs. During this time the economies of Europe, India, Brazil, among others, would likewise begin to have large growth-sapping trade deficits with China. This would reduce global growth below what it would otherwise have been. The result would be the structural emergence of a growth-sapping global trade imbalance.

There have been chronic annual trade deficits on the order of 200 to 300 billion dollar annually with the heavily exporting China. By the year 2012, these deficits would help to slow growth dramatically in both Europe and the US. China's two biggest customers would thereby be too weak to sustain China's export dependent growth. In a ripple effect, slow growth in China, in turn, would lead to slower growth in so called commodity countries like Australia, Brazil and Canada, whose economies depend heavily on the sale of natural resources like coal, iron ore and soybeans to China. Most broadly, these structural trade relationships would lead to a new type of butterfly effect the world had not yet seen.

Weak demand for Chinese exports from Europe and the US in turn leads to weak import demand from China for commodities and other natural resources. In this way, chronic trade imbalances between China and other countries around the world would, make it very difficult for a robust global economic recovery. This butterfly effect caused expansionary Keynesian fiscal and monetary stimulus in the US and Europe not to have the full effects anticipated. Indeed, this short-run Keynesian approach did nothing to address the underlying chronic long-term structural trade imbalances, acting as a drag on both the US and European economies, and by extension, much of the rest of the world.

6.4. What causes macroeconomic instability and is the economy self-correcting?

There are three important questions we have to ask to fully evaluate the warring schools of macroeconomics. Number one, what causes instability in the economy so that it deviates from its full employment output? Two, is the economy self correcting, and if so, what is the speed of the adjustment back to full employment output? And three, should the government adhere to a set of hard and fast rules, or rather use discretion in setting fiscal and monetary policy?

The first area of controversy is the question of what can drive an economy away from its full employment output? The main stream view is Keynesian based. It holds that instability in the economy arises from two sources. The first, most common problem is significant changes in investment spending, and to a lesser extent consumption spending, both of which change aggregate demand. The second more occasional problem is adverse supply side shocks which change aggregate supply. Now in contrast to the Keynesian view, the monetarists hold that it is inappropriate government policies that are the major cause of macroeconomic instability.

Modern monetarism is a classically based perspective. This is because, like classical economics, monetarism argues that the price and wage flexibility provided by competitive markets cause fluctuations in aggregate demand to alter product and resource prices, rather than output and employment. The problem, as monetarists see it, is that wages cannot adjust freely downward because of government policies, ranging from minimum wage and pro-union legislation, to guaranteeing prices for farm products, pro-business monopoly protections, and so on.

Even more importantly, the monetarists also blame the government's clumsy and often misguided attempts to achieve greater stability to activists monetary policies. This problem of a misguided government is rooted in the monetarists view of the economy through the lens of the equation of exchange and quantity theory of money. If the velocity of money V is stable, and real output Q is independent of the price level P, changes in the money supply M can only lead to changes in inflation. It is a matter of debate as to whether the velocity of money is stable. Keynesians take the view that velocity is actually unstable.

From the perspective of supply side economics, supply siders agree with the Keynesians that macroeconomic instability can result from supply side shocks. However, in this regard supply siders at least partly share the classical and monetarist view that it is often the government, not just droughts and oil price hikes, that is to blame for causing the shocks. Of particular concern to the supply siders are high tax rates and regulations that reduce supply incentives.

New classical view
The second area of controversy is the question of whether the economy self corrects. In this debate, it not just a question of whether an economy corrects itself when instability does occur, economists also disagree as to the length of time it will take for any such self correction to happen. In this regard, both the monetarists and the new classical economists take the view that when the economy occasionally diverges from its full employment output, internal mechanisms within the economy automatically move it back to that output. This perspective is associated with the theories of adaptive and rational expectations.

In the new classical view of self correction, an unanticipated increase in aggregate demand from AD1 to AD2 moves the economy from point a to point b. This causes the price level to rise from P1 to P2, as real output increases from Q1 to Q2. In the long run, nominal wages will rise to restore the real wages that have been eroded by inflation. This causes per unit production cost to rise, and eventually the short run aggregate supply curve shifts leftward and inward, from AS1 to AS2. As the economy moves from point b to point c, the price level rises from P2 to P3, and the economy returns to the full employment level of Q1.

What about the speed of adjustment issue? There is much controversy on this issue, even within the various schools of macroeconomics. For example, classically orientated monetarists usually hold the adaptive expectations view that people form their expectations on present realities, and only gradually change their expectations as experience unfolds. This implies that the shifts in the short run aggregate supply curves may not occur for two or three years or even longer. On the other hand, the new classical economists accept the rational expectations assumption that workers anticipate some future outcomes before they even occur. This suggests that when price level changes are fully anticipated, the adjustments in our figures occur very quickly, indeed even instantaneously.

What do the Keynesians think about all this? Almost all economists today acknowledge that new classical economics has taught us some important lessons about the theory of aggregate supply. Nonetheless, most mainstream economists strongly disagree with new classical rational expectations theory on the question of downward price and wage flexibility. There appears to be ample evidence, contend mainstream economists, that many prices and wages are inflexible downward for long periods. As a result, it may take years for an economy to move from recession back to full employment output, unless it gets help from fiscal and monetary policy.

6.5. Rules versus discretion

A third major area of disagreement among the varying schools of macroeconomics is the use of policy rules or discretion. This discussion follows naturally from the debates over the causes of macroeconomic instability, whether such instability is self-correcting and how long it takes for the self-correction to take place. The monetarist and new classical perspective indicates that the government should adhere to policy rules that prohibit it from causing instability in an economy that would otherwise be stable. The Keynesian view indicates that the government should use discretionary fiscal and monetary policy when needed to stabilise a sometimes unstable economy. The supply side view indicates that the government should pursue discretionary policies to increase aggregate supply as a way of increasing output and reducing inflationary pressures.

Monetary rule
The monetarists and new classicals support of policy rules for the conduct of monetary policy and balancing the budget. The purpose of such rules is to prevent government from trying to manage aggregate demand. In this view, such management is misguided and thus likely to cause more instability than it cures. For the monetarist, the enactment of a monetary rule makes the most sense. This is because monetarists believe inappropriate monetary policy is the major source of macroeconomic instability.

Such a rule would direct the Federal Reserve to expand the money supply each year at the same annual rate as the typical growth of the economy's production capacity. The Feds sole monetary rule would then be to use tools, such as open market operations, changes in the reserve requirement, and discount rate changes to ensure that the nation's money supply grows steadily by say 3 to 5% a year. The father of monetarism, Milton Friedman, thought that such a rule would eliminate the major cause of instability in the economy, a capricious and unpredictable impact of counter cyclical monetary policy.

It is possible illustrate the rationale for a monetary rule. Assume that the economy is operating at a full employment real output of Q1. Also assume that the nation's long run aggregate supply curve shifts rightward each year, as from ASLR1 to ASLR2. This shift depicts the average annual potential increase in real output. Now the monetarist monetary rule would tie increases in the money supply to the typical rightward shift of long run aggregate supply. In view of the direct link between changes in the money supply and aggregate demand, this would ensure that the AD curve shifts rightward as from AD1 to AD2 each year. As a result, real GDP would rise from Q1 to Q2 and the price level would remain constant at P1. In this view, a monetary rule would promote steady growth of real output along with price stability.

Generally new classical rational expectations economists also support a monetary rule. They conclude that an easy or tight money policy will alter the rate of inflation but not real output. For example, suppose the Federal Reserve implements an easy money policy to reduce interest rates, expand investment spending and boost real GDP. On the basis of past experience and economic knowledge, the public will anticipate that this policy is inflationary and take self protective action. Workers will press for higher wages, firms will increase product prices, and lenders will raise their nominal interest rates. While these responses are designed to prevent inflation from having adverse effects on real income of workers, businesses, and lenders, the collective impact is to immediate raise wage and price levels. This offsets the increase in aggregate demand brought about by easy money so real output and employment do not expand, but wages and prices do.

6.6. A balanced budget rule, crowding out, and where the warring schools converge

A second rule that is often debated is that of a balanced budget rule. In this regard, monetarists and new classical economists question the effectiveness of fiscal policy. And at the extreme, a few of these economists favour a constitutional amendment to require the federal government to annually balance its budget. Still others simply suggest that the government be passive in its fiscal policy, meaning that it should not intentionally create budget deficits or surpluses. This is because in this view, deficits and surpluses caused by recession or inflationary expansion will eventually correct themselves as the economy self-corrects to its full-employment output.

So how do Keynesian based mainstream economists respond to the calls by monetarists and new classical economists for a monetary rule, and a balanced budget requirement? In supporting discretionary monetary policy, Keynesian based economists argue that the rationale for a monetary rule is flawed. While there is indeed a close relationship between the money supply and nominal GDP over long periods, in shorter periods this relationship breaks down. This argument goes back to the argument about the stability of the velocity of money alleged by the monetarists. Arguing that velocity is variable, both cyclically and over time, the Keynesian based economists contend that a constant annual rate of increase in the money supply need not eliminate fluctuations in aggregate demand.

In terms of the equation of exchange, a steady rise in M does not guarantee a steady expansion of aggregate demand because the velocity V can change. As for the use of discretionary fiscal policy, the major area of debate revolves around one of the most important concepts in macroeconomics, the so called crowding out of private sector investment by expansionary fiscal policy. Crowding out is the offsetting effect on private expenditures caused by the government sale of bonds to finance expansionary fiscal policy. It may happen in the following way. When the federal government borrows money to finance a budget deficit, the US treasury sells IOU's in the form of bonds or treasury bills directly to the private capital markets, and uses the proceeds of the sales to finance the deficit.

In this case, the Federal Reserve is out of the loop and the US Treasury is competing directly in the capital markets with private corporations that may also be seeking to sell bonds and stocks in order to raise capital to invest in new plant and equipment. In order to compete for these scarce investment dollars, the treasury typically must raise the interest rate it is offering in order to attract enough funds. This is because, in this case, running a deficit is largely a zero sum game. The money used to finance the deficit is money that would otherwise have been borrowed and spent by corporations and businesses on private investment. In this case, deficit spending by the government is said to crowd out private investment.

Crowding out
An increase in investment demand by the government shifts the investment demand curve from Id1 to Id2. This raises the interest rate and reduces private investment. If the economy starts at point a and moves to point b, crowding out will be equal to h1 minus h2. But if the economy starts at point c in a recession and moves to point b, crowding out need not occur. What is perhaps most interesting about the crowding out effect within the context of our warring schools of macroeconomics is this. Monetarists believe that substantial crowding out is associated with discretionary expansionary fiscal policy, and therefore conclude that it should not be used because it is ineffective.

On the other hand, while Keynesian based economists recognised the possibility of crowding out, they do not think it is a major problem when business borrowing is depressed, as is usually the case in a recession. Therefore, activist expansionary fiscal policy is appropriate. As for a balanced budget rule, Keynesian based mainstream economists are likewise opposed. They argue the tax revenues fall sharply during recessions, and rise briskly during periods of demand-pull inflation. Therefore, a law or constitutional amendment mandating an annually-balanced budget would require the government to increase tax rates and reduce government spending during recession, and reduce tax rates and increase government spending during economic booms. Clearly, the first set of actions would worsen recession, while the second set would fuel inflation.

Now let's turn to the supply side perspective, on the issue of rules versus discretion. Supply siders argue that marginal tax rates and government regulations must be reduced in order to get more output without added inflation. Thus, supply siders favour discretionary policy actions much like Keynesians do. However, very often, the focus of such actions is classically oriented, in that the actions advocated seek to reduce or undo the negative effects of earlier government regulations or tax policies.

There are fundamental areas of disagreement but there are also areas where thoughts have converged. For example, most Keynesian based economists now agree with the monetarists that money matters and that excessive growth of the money supply is the major cause of long-lasting rapid inflation. Keynesian based economists also agree with the rational expectations proponents that expectations are important. If the government can create expectations of price stability, full employment, and economic growth, households and firms will tend to act in ways to make that happen. Finally, Keynesians concur with the supply siders that governments need to focus on policies to increase economic growth. Thanks to ongoing challenges to the conventional wisdom, macroeconomics continues to be an evolving policy science.

7. Economic Growth and Productivity

7.1. Overview of the four wheels of growth

The daily business news is dominated by reports of stock price fluctuations, the monthly unemployment and inflation rates, trade statistics and speculation about whether the Federal Reserve will raise interest rates. But as important as these events are for job hunters or investors, they are only small ripples on the longer wave of economic growth. Year in and year out, advanced economies like the United States accumulate larger quantities of capital equipment, push out the frontiers of technological knowledge and become steadily more productive. Over the long run of decades and generations, living standards as measured by output per capita or consumption per household, are primarily determined by the level of productivity and growth of a country.

Examining the complicated process of economic growth will not only help to better understand the critical role that productivity plays in this process, but also to gain some valuable insights into both how and why government policies play a critical role in the growth process.

The four wheels of economic growth
Economic growth represents the expansion of a country's potential GDP or national output. A closely related concept is the growth rate of output per person. This determines the rate at which the country's standard of living is rising. So what is the recipe for such economic growth? To begin with, successful countries need not follow the same path. Britain, for example, became the world economic leader in the 1800s by pioneering the industrial revolution, inventing steam engines and railroads, and emphasising free trade. Japan by contrast came to the economic growth race later. It made its mark by first imitating foreign technologies and protecting domestic industries from imports, and then by developing tremendous expertise in manufacturing and electronics.

Even though their specific paths may differ, all rapidly growing countries share certain common traits. Economists who have studied growth have found that the engine of economic progress must ride on the same four supply side wheels, no matter how rich or poor the country. These four wheels, or supply factors of growth, are (1) human resources, including labour supply, education, discipline and motivation, (2) natural resources including land, minerals, fuels and environmental quality, (3) capital formation including machines, factories and roads, and (4) technology from science and engineering to management and entrepreneurship.

7.2. The four wheels of growth in detail

Labour inputs include the quantity of workers. However, many economists believe that the quality of labour inputs, the skills, knowledge, and discipline of the labour force, is the single most important element in economic growth. A country might buy the most modern telecommunications devices, computers, electricity generating equipment, and fighter aircraft. However, these capital goods can be effectively used and maintained only by skilled and trained workers. Improvements in literacy, health, and discipline, and most recently, the ability to use computers, add greatly to the productivity of labour.

The second supply factor or production is natural resources such as areable land, oil and gas, forests, water, and mineral resources. Some high income countries like Canada and Norway have grown primarily on the basis of their resource base, with large outputs in agriculture, fisheries, and forestry. Similarly, the United States is the world's largest producer and exporter of grains. But the possession of natural resources is hardly necessary for economic success in the modern world. New York City prospers primarily on its high density of service industries. While many countries that have virtually no natural resources, such as Japan, have thrived by concentrating on sectors that depend more on labour and capital than on indigenous resources.

The third supply factor of growth is capital formation. Tangible capital includes structures like roads, and power plants, and equipment, like trucks and computers. In this regard, some of the most dramatic stories in economic history often involve the rapid accumulation of capital. For example, in the 19th century, the transcontinental railroads of North America brought commerce to the American heartland, which had been living in isolation. While in the 20th century, successive waves of investment in automobiles, roads, and power plants, increase productivity, and provided the infrastructure which created entire new industries.

Accumulating capital requires a sacrifice of current consumption over many years. Countries that grow rapidly tend to invest heavily in new capital goods. In the most rapidly growing countries, 10 to 20% of output may go into capital formation. Many of those investments are undertaken only by governments and provide the necessary social overhead capital and infrastructure for businesses to prosper. Roads, irrigation and water projects, and public health measures are important. All these involve large investments that tend to be indivisible or lumpy and sometimes have increasing returns to scale. These projects generally involve external economies or spill-overs that private firms cannot capture.

In addition to the three supply factors discussed above, technological advance has been a vital fourth ingredient in the rapid growth of living standards. Historically, growth has definitely not been a process of simple replication, adding rows of steel mills, or power plants next to each other. Rather, a never-ending stream of inventions and technological advances led to a vast improvement in the production possibilites of Europe, North America, and Japan. Technological change denotes changes in production processes or the introduction of new products or services.

Production possibilities frontier analysis
Process inventions that have greatly increased productivity were the steam engine, the generation of electricity, the internal combustion engine, the wide bodied jet, the photocopier machine, and the fax machine. Fundamental product inventions include the telephone, the radio, the airplane, the phonograph, the television, and the VCR. Today the most dramatic technological developments are occurring in electronics and computers where tiny notebook computers can now outperform the fastest computers of the 1960s. Technological change is a continuous process of small and large improvements. The United States issues over 100,000 new patents annually and there are millions of small refinements that are part of the routine progress of an economy.

While the four supply factors of growth relate to the physical ability of the economy to expand, there are two other factors that are equally important. First, there is the demand factor. To realise its growing production potential, a nation must fully employ its expanding supply of resources. This requires a growing level of aggregate demand. Second, there is the efficiency factor. To reach its production potential, a nation must not only achieve full employment, but also two kinds of economic efficiency. Productive efficiency means that a country must use its existing and new resources in the least costly way to produce what it does. Allocative efficiency means that the mix of goods and services a country produces must maximise society's well-being.

Denisen research
It is possible to illustrate how the six factors of economic growth interact using the following production possibilities curve. For example, a country starts at point a. Then growth is made possible by the four supply factors which shift the production possibilities curve outward AB to CD. But economic growth is realised only when the demand and efficiency factors move the economy from point a to point b.

One of the most famous studies ever conducted in economics was done by Edward Denisen. He estimated what percentage of annual US growth between 1929 and 1982 was accounted for by each factor listed in the table. Here, we see quite clearly that productivity growth has been the most important force underlying the growth of US real output and income. He found that 1/3 of the increase in real output occurred because of increases in the quantity of labour and that the remaining 2/3 was due to increases in labour productivity.

The quantity of capital, more education and training, economies of scale and production, and improved resource allocation, have all been important. However, the most important factor, accounting for a full 28% of increased productivity, has been technological advance, just as the growth theory suggested. The eighth category is a negative number. It estimates the negative impact that legal and regulatory constraints have had on productivity and growth.

7.3. The growth models of Adam Smith and Thomas Malthus

Smith versus Malthus
There is much controversy surrounding the relative importance of the various factors that determine economic growth. While some economists and policy makers stress the need to increase capital investment, others advocate measures to stimulate research and development and technological change. A third group emphasises the role of a better educated work force. To better understand this controversy, it is useful to trace the history of growth theory. Early economists like Adam Smith and Thomas Malthus stressed the critical role of land in economic growth. The Wealth of Nations, published in 1776, Adam Smith provided a handbook of economic development.

He began with a hypothetical idyllic age, the original state of things, which precedes both the appropriation of land and the accumulation of capital stock. This was a time when land was freely available to all and before capital accumulation had begun to matter. What would be the dynamics of economic growth in such a golden age? Because land is freely available, people simply spread out onto more acres as the population increases, just as the settlers did in the American west. There was no capital so national output exactly doubled as population doubled. Wages earned the entire national income because there was no subtraction for land rent or interest on capital. Output expanded in step with population so the real wage per worker was constant over time.

This golden age could not continue forever. As population growth continued, all the land became occupied and a balanced growth of land, labour and output was no longer possible. New labourers began to crowd onto already worked soils. Land became scarce and rents rose to ration it among different uses. Population still grew and so did the national product. Output had to grow more slowly than population because of an immutable law known in economics as the law of diminishing returns. With new labourers added to a fixed supply of land, each worker had less land to work with. At some point, the extra or marginal product of each additional worker began to decrease and real wages declined because of this decline in productivity.

How bad could get things get? Thomas Malthus thought that population pressures would drive the economy to a point where workers were at a minimum level of subsistence. In particular, Malthus reasoned that whenever wages were above the subsistence level, population would expand, while below subsistence wages would lead to high mortality and population decline. Therefore, Malthus reasoned, only at the level of subsistence wages could there be a stable equilibrium of population. Malthus believed that the working classes would be destined to a life that, in the words of the philosopher Thomas Hobbes, would be nasty, brutish, and short. In fact it was this gloomy Malthusian picture that lead to the critical depiction of economics as the dismal science.

Fortunately, Malthus' dismal forecast was wide of the mark because Malthus did not recognise that technological innovation and capital investment could overcome the law of diminishing returns. As a result, land did not become the limiting factor in production. Instead the Industrial Revolution brought forth power driven machinery that increased production, factories that gathered teams of workers into giant firms, railroads and steamships that linked together the far points of the world, and iron and steel that made possible stronger machines and faster locomotives. Important new industries grew up around the telephone, the automobile, and electric power. Capital accumulation and new technologies became the dominant force effecting economic development.

7.4. Solow's neoclassical growth model

To understand how these twin forces of capital accumulation, and technological change can affect an economy, it is helpful to understand the so-called neoclassical model of economic growth. This approach was pioneered by Professor Robert Solow of MIT, who was awarded the 1987 Nobel Prize for this and other contributions to economic growth theory. The major new ingredients in Solow's neoclassical growth model are, capital and technological change. The approach of this growth model is to use a tool known as the aggregate production function (APF), which relates technology and inputs like capital and labour to total potential GDP.

It is very useful to first understand the underlying principle of the neoclassical growth model and then understand three of its major insights. The basic underlying principal of the neoclassical growth model is what economists call capital deepening. This is the process of increasing the amount of capital per worker. Examples of capital deepening include more farm machinery and irrigation systems in farming, more railroads and highways in transportation and, more computers and communication systems in banking. In each of these industries societies have invested heavily in capital goods. As a result, the output per worker has grown enormously in farming, transportation, and banking.

The first major insight of the model is that in the absence of technological change, capital deepening does not lead to a proportional increase in output because of the law of diminishing returns. The basic idea is that as more and more capital is added to a fixed supply of labour, eventually the marginal product of capital must fall as the law of diminishing returns kicks in.

The second major insight of the neoclassical growth model is that while capital deepening can dramatically increase the productive output of an economy, it will eventually lead to economic stagnation in the absence of technological change. The wage rate paid to workers will tend to rise as capital deepening takes place because each worker has more capital to work with and his or her marginal product therefore rises. As a result the competitive wage rate rises along with the marginal product of labour.

However, for the owners of capital, the news is less satisfying. As capital deepens, diminishing returns to capital set in, so the rate of return on capital and the real interest rate fall. What this means, is that in the long run, the economy will enter a so-called steady state in which capital deepening ceases as the capital labour ratio stops rising. This is because even as capital deepening is driving real wages up, the returns to capital are falling, so that at some point further investments in capital deepening become unprofitable. At this point, the economy enters a steady state in which, without technological change, both capital incomes and wages end up stagnating.

This is a far better outcome than the nasty and brutish world of subsistence wages predicted by Malthus. Nonetheless, the long run equilibrium of the neoclassical growth model makes it clear that if economic growth consists only of accumulating capital through replicating factories with existing methods of production, then people's standard of living will eventually stop rising. The importance of technological change in averting this fate must be recognised, as modern economies in this century have so obviously done.

Solow's increase in productivity
The third major insight of the neoclassical growth model is that it is ultimately only through technological change that the trap of economic stagnation can be avoided. Technological change represents both advances in production processes, and the introduction of new and improved goods and services. It also includes new managerial techniques, as well as new forms of business organisaton. For example, gas in diesel engines, conveyor belts, and assembly lines were significant developments of the more distant past. More recent developments are bigger, faster and more fuel efficient aircraft, integrated microcircuits, computers, xerography, containerised shipping, and the internet, not to mention biotechnology, lasers, and superconductivity.

This figure uses the concept of the aggregate production function that we have discussed earlier to illustrate the differing roles that capital deepening and technological change play in economic growth. On the horizontal axis, capital deepening is measured by capital for worker, while output per worker is represented on the vertical axis and represents the upward march of economic growth. The gray line represents the aggregate production function for the technology available in 1950. It traces the pace of economic growth, that would occur because of capital deepening, holding the technology constant. Similarly, the red line represents the aggregate production function for the technology available in 1995.

In this case, technological change is represented in the figure by an upward shift of the APF curve from the gray line to the red line that is, from APF1950 to APF1995. This upward shift shows the advances in productivity that are generated by the vast array of new processes and products, like electronics, computers, advances in metallurgy, improved service technologies, and so forth. As for how we measure the total effect of capital deepening, and technological change on growth. One way to do it is simply by using the arrow in the figure. It indicates the increase in output per worker from Q / L1950, to Q / L1995. The good news is that instead of settling into a steady state of economic stagnation, the economy enjoys rising output per worker, rising wages, and increasing living standards, even as the returns to capital rise as well.

7.5. The pros and cons of growth and how to stimulate growth

Is more growth always good? If so, what demand and supply side government policies might be used to improve productivity and growth? Increased economic growth increases our wages and our standard of living, but there are some major disadvantages of rapid growth that have been noted by many economists. Indeed critics of growth say it results in dirtier air, a dying ocean, global warming, ozone depletion and other environmental problems. Such critics also point out that while growth may permit us to make a better living it does not guarantee us the good life in this sense. Growth often means worker burnout and alienation, and accompanying health problems, not just for assembly line workers, but in the high stress managerial ranks as well.

The advantage of supply side options
These are all fair comments, but one important distinction to make in talking about the merits of growth is between economic growth and population growth. In this regard, congested neighborhoods, crowded cities, and gridlocked freeways are often the consequence of too many people, not too many goods and services. This observation points to the really essential measure of growth, GDP per capita, and the underlying question of whether there are really any serious grounds for desiring less GDP per person, and a reduced standard of living.

Another question is how the government can use public policy to stimulate growth? From the demand-side of the equation, low growth is often the consequence of inadequate aggregate demand and the result in recessionary gap. Both fiscal and monetary policies can be used to address this problem. For example, monetary policy, which provides low real interest rates, helps promote high levels of investment spending, while a fiscal policy that eliminates budget deficits can reinforce this easy money policy. Having said this, when economists think about ways to stimulate productivity and growth, they are more often thinking about the supply side of the equation. A major reason is that policies which can successfully shift the economy's supply curve out, do so with the twin advantages of both lower unemployment and lower inflation.

Growth theory and the various factors of growth offer some supply side policy options. First, productivity increases as the ratio of capital to labour increases. To boost the capital labour ratio, the rate of investment in new plant and equipment must accelerate. The current US tax code offers a variety of incentives to stimulate investment, including accelerated depreciation, tax credits for new investments, and lower business tax rates.

The second way to increase productivity is to improve the quality of human capital, which is the labour force and its managers. In this category, policy options range from tuition tax credits and expanded student loans to job retraining programmes and a focus on lifetime-learning.

A third way to increase productivity is to, accelerate the rate of technological change, because such change allows us to produce more goods and services from a given amount of resources. Here the policy options are very similar to those for increasing investment in new plant and equipment, namely tax incentives. In this regard, an increase in the rate of investment in new plant and equipment works hand in hand with increased R&D. Because it speeds the diffusion of new technology and accelerates the rate of productivity gains.

A fourth way to increase the rate of productivity growth is to raise the level of investment in public infrastructure. Just as new plant and equipment help workers produce more, so to does modern infrastructure help businesses produce more. This means that in the quest to balance its budget, the United States must be careful not to ignore appropriate investments in basic infrastructure. Bridges and airports to smart roads and the information superhighway. Indeed, as President Clinton once remarked during his administration, deficit reduction at expensive public investment has been and will continue to be self-defeating.

More broadly, many of the factors that determine productivity growth, will be enhanced by in increase in the domestic savings rate. This is because increased saving ultimately helps provide the funds necessary to invest in new plant and equipment, human capital, research and development, and public infrastructure. At present, the US has one of the lowest savings rates of any of the industrialised nations. And policy options to address this problem include such things as expanded tax preferences for individual retirement accounts and other pension funds.

8. Budget Deficits and the Public Debt

8.1. Budget deficits and the public debt defined

The purpose of this lesson is to examine the economic consequences of chronic budget deficits and the potential dangers of an upward spiraling government debt. Historically, classical economics have argued that such budget deficits are bad, and should be avoided, except in wartime. In contrast, Keynesians believe that, at least during recessions, budget deficits are a necessary byproduct of an expansionary fiscal policy. Nonetheless, both classical and Keynesian economists agree that chronic budget deficits, such as the nation has been experiencing, are undesirable. The important policy question is how big a danger are these chronic deficits and a collateral soaring national debt?

The dark side of using discretionary fiscal policy is the deficit and debt that can occur when the government uses the fiscal policy level to boost aggregate demand. Keynesian economics focuses on the use of fiscal policy to solve our macroeconomic problems. The policy guidelines are quite simple. Use fiscal stimulus, increased government spending or tax cuts, to fight recession and unemployment. Use fiscal restraint, reduced spending, or increased taxes, to fight inflation. One problem with this Keynesian strategy, however, is that it implies that federal expenditures and receipts will not always be equal.

When the government engages in fiscal stimulus, it typically is engaging in deficit spending, a situation in which the government borrows funds to pay for spending that exceeds tax revenues. The sise of the resulting budget deficit is captured in this formula:

budget deficit = government spending - tax revenues

A budget surplus occurs when all taxes and other revenues exceed government expenditures for the year. When revenues and expenditures are equal in the increasingly rare instance, the government has a balanced budget. When the government incurs a budget deficit, it must borrow from the public to pay its bills. In this case, it issues bonds, and the government debt, or the national or public debt, as it is also called, is simply the total dollar value of the bonds owned by the public. This debt is simply the accumulated budget deficits minus the accumulated surpluses:

public debt = accumulated budget deficits - accumulated surpluses

This debt is held, not only by banks, households, and businesses in the US but, also by foreign investors as well. Whatever the merits of Keynesian economics are, the practice of using discretionary fiscal policy has produced precious few budget surpluses since the 1930s. This has been especially true since the 1970s.

8.2. The Debt-to-GDP Ratio; Real versus nominal deficit; Structural versus cyclical deficit

In thinking about the size of our national debt, the first thing we want to do is to establish a benchmark of comparison. In this regard, economists like to compare the debt to the size of the nation's gross domestic product or GDP. The reason is simple. In the abstract, a five trillion dollar national debt is a very large number. However, such a debt would pose a far more crushing burden to a small nation such as Thailand than it does to the United States. Accordingly, comparing the debt to the GDP, gives a measure of a nation's ability to produce and therefore its ability to pay off its debt.

A second important way to think about the size of the national debt is to distinguish between the real and nominal budget deficits. This distinction is important because it makes it possible to measure how inflation in any given year reduces the effective burden of the debt. The real deficit in any given year is the actual or nominal deficit adjusted for inflation's effect on the debt. In particular the real deficit equals the nominal deficit minus the inflation rate time the total debt:

real deficit = nominal deficit - (inflation rate * total debt)

If the nominal deficit is $100 billion, inflation is 10%, and the total debt is $5 trillion, the real deficit is minus $400 billion. The inflation rate of 10% times the existing debt of $5 trillion is $500 billion. This must be substracted from the nominal deficit of $100 billion to get a real deficit of minus $400 billion. Even though there is a nominal deficit, inflation has eroded the actual burden of the total debt. This suggests that one way the government can lower the burden of the national debt is by increasing the inflation rate. This is a controversial strategy to reduce the debt. Such a strategy can only work if the inflation is unanticipated, otherwise bond holders will demand a higher interest rate to compensate for the anticipated inflation and thereby drive up the nominal deficit through higher interest payments.

A third crucial distinction to make in thinking about budget deficits is between the structural deficit and the cyclical or passive deficit. The structural deficit is that part of the actual budget deficit that would exist even if the economy were at full employment. It is due to the existing structure of tax and spending programmes. Accordingly, the structural part of the budget is thought of as active. It is determined by discretionary fiscal policies, such as those covering tax rates, public works projects, and education and defence spending.

In contrast, the cyclical or passive deficit is that part of the actual budget deficit attributable to a recessionary economy. It results, at least partly, from the government's automatic stabilisers. Those increased income transfers that kick in during a recession, on such things as unemployment compensation, food stamps, and other welfare benefits. However, the cyclical deficit results primarily from the shortfall of tax revenues that arises when the government's resources are underutilised, such as in the downward portion of the business cycle. Hence, it is called a cyclical deficit.

The nature of the cyclical deficit depends on automatic stabilisers and income transfers. Income transfers are payments to the individuals by the government for which no current goods or services are exchanged. They include payments for entitlement programmes like Social Security, welfare, and unemployment benefits. At least some of these income transfers, particularly, welfare and unemployment, are part of the government's automatic stabiliser system, where automatic stabilisers are defined as federal revenues or expenditures that automatically respond to changes in the GDP in a counter-cyclical way.

The table illustrates how income transfers can affect the economy. When the unemployment rate increases, the budget deficit increases. This is because even as government spending for items such as food stamps and unemployment benefits are rising. Government tax revenues are falling. In this case, government spending is acting counter-cyclically, helping to offset the recession. An increase in inflation can also widen the budget deficit. This is at least partly because some income transfer programmes like Social Security are indexed to inflation. Neither the president nor the congress has complete control over the federal deficit. That is one major reason why the distinction between the structural and cyclical deficits is so important.

8.3. Calculating the structural and cyclical parts of the budget deficit

It is possible to calculate the structural and cyclical parts of the budget deficit. Suppose the gross domestic product is $10 trillion, the budget deficit is $100 billion, and the unemployment rate is 7% or 1% above the assumed full employment rate. Suppose further that the marginal tax rate is 30%, meaning that for every additional dollar that the GDP grows, the government will collect 30 additional cents in taxes. To calculate which portion of the 100 billion dollar deficit is structural and which portion is cyclical, Okun's law can be used. Okun's Law states that a 1% fall in the unemployment rate will lead to a 2% increase in GDP.

If the unemployment rate falls by 1% from 7% to the full employment rate of 6%, by Okun's law, real GDP must increase by 2% times $10 trillion, or a total of $200 billion. The additional tax revenues the government would collect from this increase in GDP at the assumed marginal tax rate of 30% for the additional $200 billion of GDP income, would generate an additional $60 billion in tax revenues. In this case, the structural deficit is $40 billion because that is how much of the deficit that would remain at full employment. That means that the cyclical deficit must be $60 billion.

This distinction is important because it helps policymakers distinguish between long-term changes in the budget caused by discretionary policies versus short run changes caused by the business cycle. In doing so, this distinction helps provide policy guide to tackling the deficit problem. For example, since it is possible to grow out of a cyclical deficit by reaching full employment, expansionary fiscal or monetary policies may well be appropriate in a sluggish economy. In fact, such a Keynsian policy prescription, would've been quite inappropriate in 1958.

At that time, in the middle of a recession, the Eisenhower Administration was running a deficit of $10 billion, totally cyclical in nature. Vice President Richard Nixon was deeply concerned that a stagnating economy would make him vulnerable in the upcoming 1960 Presidential election. Accordingly, Nixon vigorously advocated an expansionary tax cut to stimulate the economy. However President Eisenhower wanted to balance the budget before he left office and rejected such a tax cut for fear it would balloon the deficit. Absent any stimulus the economy limped into the presidential election season.

John F Kennedy seized on the slogan: "Let's get the country moving again," and Kennedy squeaked by Nixon in one of the tightest presidential races in history. If Eisenhower had listened to Nixon and cut taxes, the result would not only have been strong economic growth, Eisenhower would have left office basking in the glow of a budget surplus of about $5 billion, more than enough to have paid for Nixon's tax cut. This is because the additional economic growth would have generated billions of dollars of additional tax revenues.

President Bill Clinton's campaign for reelection in 1996 offers a final example of why understanding the difference between the structural and cyclical deficits can be useful. In the 1996 campaign, Clinton proclaimed that policies such as his deficit reduction act of 1993, had been successful in reducing the budget deficit by more than half. However, Clinton's Republican critics argued that it was mainly the recovery from recession that was responsible for the improvement. Some of these critics even claimed that it was George Bush who deserved most of the credit since the economic recovery began well before Clinton ever took office.

Between 1992 and 1996, the federal deficit declined by $146 billion from $290 billion to $144 billion, more than a 50% reduction. How much of this deficit reduction was structural? According to the Congressional Budget Office (CBO), the structural deficit declined by $70 billion between 1992 and 1996 from $224 billion to $154 billion. This means that, of the $146 billion in deficit reduction, about half was due to Clinton Administration policies. The other half was due to improved economic conditions.

Calculation of the structural deficit, is clearly determined by what economists assume the full employment, natural rate of unemployment to be. In particular, the structural deficit will be lower if we assume the economy can sustain a 4% rate of unemployment without increasing inflation as opposed to a 6% rate. In fact, using Okun's Law, and again assuming a $10 trillion GDP, it is possible to calculate the difference in the assumed structural deficit for these two different unemployment rate scenarios to be $120 billion.

There is a fiscal policy problem here. Suppose that economists believe that the 4% unemployment rate is the correct assumption for full employment output and that the economy is currently at 6% with a budget deficit of $120 billion. Based on that 4% assumption, they must conclude that the budget deficit is purely cyclical in nature. A Keynesian would clearly argue for an expansionary fiscal policy, both to close a perceived recessionary gap and eliminate the perceived purely cyclical deficit. If however, it turns out that the natural rate of unemployment was actually 6%, the Keynesian expansion would not eliminate the cyclical deficit, which turned out to be purely structural. It would also result in an even bigger deficit and a bad case of demand-pull inflation.

8.4. Financing budget deficits and associated problems; The balanced budget multiplier

There are various economic problems created by chronic budget deficits and a growing government debt. The kind of problems the deficit and debt may cause is in large part determined by how the deficit is financed. There are three major ways the government can finance a deficit, which are raising taxes, borrowing money or printing money. Best way to draw this distinction is again by example. Suppose then that the budget is initially in balance and that the government undertakes an expansionary fiscal policy to close a recessionary gap. Suppose further that this expansionary policy involves a net increase of government expenditures of $25 billion.

How should these expenditures be financed? The raise taxes option is interesting because at first glance it seems unclear how the economy can expand if taxes and expenditures are going up by the same amount. The answer lies in the dynamics of the marginal propensity to consume. If the government raises taxes by $25 billion to cover the increase in government expenditures, and the marginal propensity to consume is 0.8, consumption will only fall by $20 billion, which is 0.8 times $25 billion. This means that even after the tax hike, the net increase in aggregate expenditures is still $5 billion. Given that the marginal propensity to consume is 0.8, the multiplier will be 5. This $5 billion increase in aggregate expenditures can be multiplied by the multiplier of five, in order to get a total economic expansion of $25 billion, which is exactly equal to the original outlay of government expenditures.

Macroeconomists refer to this phenomenon as the balanced budget multiplier. This multiplier has a value of one because, when there is a simultaneous increase government expenditures and increase in taxes by the same amount, there will be an economic expansion exactly equal to the increase in government expenditures. While the balance budget multiplier approach to financing a deficit may sound like a great way to conduct expansionary fiscal policy without increasing the budget deficit, this macroeconomic technique is rarely used. The reason is that raising taxes is politically unpopular. This means that the government has to resort to one of two other means to finance the deficit: borrowing money or printing money, both of which create their own problems.

Crowding out revisited
With the borrow money option, the US Treasury sells IOUs in the form of bonds or treasury bills directly to the private capital markets and uses the proceeds of the sales to finance the deficit. In this case the Federal Reserve is out of the loop. The US Treasury is competing directly in the capital markets with private corporations, which may also be seeking to sell bonds and stocks in order to raise capital to invest in new plant equipment. In order to compete for these scarce investment dollars, the Treasury typically must raise the interest rate it is offering in order to attract enough funds.

This is because in the borrow money option, running a deficit is largely a zero sum game. Money used to finance the deficit is money that would otherwise have been borrowed and spent by corporations and businesses on private investment. In this case, deficit spending by the government is said to crowd out private investment. Crowding out is the offsetting effect on private expenditures caused by the governments sale of bonds to finance expansionary fiscal policy. The increase in investment demand by the government shifts the demand curve from Id1 to Id2.

This raises the interest rate, and reduces private investment. If the economy starts at point A and moves to point B, crowding out will be equal to H1 minus H2. But if the economy starts at point C in a recession and moves to point B, crowding out need not occur. Crowding out applies only to structural deficits. If the cyclical deficit rises because of a recession, the logic of crowding out does not apply because a recession causes the decline in the demand for money and leads to lower interest rates. The Federal Reserve tends to loosen monetary policy in a recession. This point is important because it underscores the observation that there is no automatic link between deficits and investment.

Crowding out illustrated in Keynesian model
It is possible to use the Keynesian model to illustrate how the crowding out effect might reduce the actual effectiveness of fiscal policy. In the Keynesian model, the initial equilibrium is at Y, where the aggregate expenditure curve AE crosses the aggregate production curve AP. However, expansionary fiscal policy shifts the aggregated spenditure curve up to AE1. This leads to a new equalibrium of Y1. However, because the government has had to borrow money from the private capital markets to finance these expenditures, interest rates rise. This reduces investment and a resulting contractionary effect shifts the aggregate expenditure curve back down from AE1 to AE2.

The final equilibrium is at Y2. The net economic expansion equals Y2 - Y. The partial crowing out of private investment maybe measured by Y1 - Y2. On the basis of this kind of analysis critics of discretionary Keynesian fiscal policy have argued that it is a very weak policy tool. In fact, monetarists tend to take the view that crowding out is almost complete so that fiscal policy is completely ineffective. Keynesians, on the other hand, typically argue that crowding out is minimal.

At least in theory, it's possible to avoid crowding out all together with the print money option. With this option, the Federal Reserve is said to accommodate the Treasury's expansionary fiscal policy. In particular, the Fed buys the Treasury's securities itself rather than letting the securities be sold in the open capital markets. To pay for these deficit financing treasury securities, the Federal Reserve simply prints new money. Problem with this option is that the increase in the money supply can cause inflation, an undesirable result in itself. Moreover, if such inflation drives interest rates up and private investment down, as it likely do do, the end result of the print money option may be a crowding out effect as well.

8.5. Budget deficit pros and cons

Deficit consequences
Deficit hawks view deficits and a rising government debt as a serious threat and the deficit doves would take the position that such deficits and debt are relatively harmless. The deficit hawk argument is that chronic budget deficits have not only been responsible for crowding out private investment, but also for America's huge trade deficits over the last several decades. These problems are illustrated.

As government deficits drive interest rates up in boxes 1 and 2, we observe crowding out in box 3. However, the plot thickens when we get to box 4. Here higher US interest rates attract foreign investors. But, in order for these investors to invest, they must exchange their foreign currencies for dollars. This not only leads to an increase US external debt in box 5, it also drives up the value of the dollar in box 6. A stronger US dollar makes US exports less competitive and exports decrease in box 7 even as imports increase in box 8. The result is a larger trade deficit in box 9.

That is why the budget and trade deficits are often referred to as the twin deficits. Unfortunately a trade deficit means a nation is not exporting enough to pay for its imports. The difference can be paid for either by borrowing from abroad or by selling US assets. To finance its trade deficit, the United States sold off assets such as factories, shopping centers, hotels, golf courses, and farms to foreign investors. Over the longer run deficit hawks warn that this mortgaging of America will reduce both the rate of economic growth and the level of real income of Americans.

Government debt effects economic growth and living standards over the longer run. To address this issue, the distinction between the external and internal debt is important. Deficit doves argue that national debt is not really a serious matter because most of the debt is internal. Nonetheless, the deficit hawks counter that since 1960, the fraction of the total US debt held externally has more than quadrupled, and this large external debt now exposes America to significant economic and political dangers. On the economic front, paying interest on the external debt acts like a tax on US citizens by foreigners. This reduces domestic consumption, savings and investment and thereby reduces the economy's long and short term growth rates. On a political front, the holding of large amounts of America's debt by foreigners exposes American public policy to undue political pressures.

It is not just the external debt that deficit hawks object to, they even consider a large internal debt as unacceptable for four reasons. First, an internal debt requires payments of interest to bondholders. This in turn means higher taxes and as micro economics teaches us, such taxes inevitably distort allocation of national resources and lead to an efficiency loss. Second, paying interest on the internal debt unfairly redistributes income from the poor and middle class to the rich. This happens because government bondholders as a group tend to be wealthier than taxpayers as a group.

Third, paying interest on the debt uses hundreds of billions of dollars each year, and this money could otherwise be spent on providing taxpayers with more education, health care, and other government services. In this regard, the deficit hawks point out that the size of the interest payments to service the debt, relative to total tax revenues, has been steadily rising. Finally the deficit hawks argue that the accumulation of such a large debt places an unreasonable burden on future generations. Which must pay this debt off. The same time, the dove's point out any debt that occurred now as a result of public investment will provide benefits, not just a burden, to future generations. This argument leads to our next bone of contention between the deficit hawks and doves, the impact of the deficit on investment and productivity.

8.6. Impacts of budget deficits and debt on investment and productivity

Deficit doves like professor Robert Eisner argue that the productivity of the private sector depends critically on public investment in a wide variety of public goods and services from education, training and basic research. The public infrastructure such as roads, bridges and even the information super highway. Therefore, in some cases running deficits can actually increase the productivity of the private sector and thereby boost both economic growth and real national income. Instead the deficit hawks think that far too many government expenditures are made on what the late senator William Proxmeyer once called wasting assets rather than productive capital.

For the deficit hawks, roads and bridges, and more education may well increase productivity and stimulate economic growth. However, wasting assets such as fighter planes, tanks and inefficient social welfare programmes simply do not. At the same time, these deficit hawks point out there is a wealth of empirical evidence suggesting that public sector investment is less productive than private sector investment. Thus when deficit spending crowds out private sector investment, it reduces the rate of long term economic growth because it substitutes less productive government expenditures for more productive private investment.

A line of argument against chronic budget deficits is that a large and growing public debt makes it politically difficult to use the necessary discretionary fiscal policies during a recession. For example in 1991 and 1992, the Federal Reserve substantially reduced interest rates to stimulate the sluggish economy. However, this expansionary monetary policy was slow to expand output and reduce unemployment. At that time, had the public debt not been at historic highs, it would have been much more politically feasible to engage in expansionary fiscal policy as well, by reducing taxes or increasing spending. But, the growing debt problem rules out this stimulus on political grounds.

On the one hand, the deficit hawks warn that chronic budget deficits increase the trade deficit, crowd out private investment and reduce economic growth. These hawks likewise warn that the growing national debt is unfairly burdening future generations and exposing America to dangerous political pressures form foreign governments. Moreover, servicing the interest payments on this debt redistributes income from the poor and middle-class to the rich.

In contrast, the deficit doves see the deficit primarily as a stimulus to economic growth and reject both the crowding out and trade deficit arguments. They see the national debt as productive investment in public goods and infrastructure. They view the debt as manageable relative to the size of our economy and they believe that since we owe it largely to ourselves, it's not a problem. Accordingly, the deficit doves advocate a more cautious approach to deficit reduction.

Perhaps the most widely debated policy response has been a balanced budget amendment. Such a constitutional amendment would compel Congress to annually balance its budget. A balanced budget amendment would make it almost impossible to use discretionary fiscal policy and that's why most economists oppose the idea. The biggest problem is that such an amendment would force the government to balance the budget during a recession by either increasing taxes or cutting spending. From a Keynesian perspective it is possible to see that the likely result would be to plunge the economy deeper into recession.

9. International Trade and Protectionism

9.1. Absolute versus comparative advantage

This lecture is about the economic principles governing international trade. The questions in this regard are why do nations trade and how do nations decide what to import and export. In answering these questions, the concepts of absolute advantage and comparative advantage are needed.

The idea of absolute advantage as a basis for trade was set forth by Adam Smith. A country that can produce a good at a lower cost than another country is said to have an absolute advantage in the production of that good. For example, Saudi Arabia has millions of barrels of cheaply accessible oil but growing food in its desert climate and sandy soil is very expensive.

In contrast the United States can grow food cheaply in its tempered climate and fertile soil but American oil isn't as cheap to extract as Saudi crude. Because it can produce a certain amount of oil with fewer resources. Saudi Arabia has an absolute advantage over the United States in producing oil. Just as the United States has an absolute advantage over Saudi Arabia in producing food. And the theory of absolute advantage would predict. In this case, quite correctly. That America should sell food to Saudi Arabia and buy oil from it.

At first glance, the principle of absolute advantage appears to make sense. Nonetheless it has a significant implication in one that is badly flawed. For example, if there are two countries, Germany and Algeria, producing two goods, food and autos, with the same amount of resources. The Germans are able to produce both food and autos with fewer resources than Algeria.

In this case, the theory of absolute advantage would predict that Germany has nothing to gain from trading with Algeria. This is where a more subtle understanding of trade patterns enters the picture, which is embodied in the theory of comparative advantage. The theory of comparative advantage was first set forth in 1817 by the same English economist David Ricardo.

The historical context for the development of Ricardo's theory of comparative advantage is interesting in and of itself. At the time, Europe was considering protecting its markets from American imports through the use of tariffs or quotas. Europe's concern was that America with its abundant land and inexpensive labour would have an absolute advantage in producing many goods and might therefore not import anything from Europe, but merely export its cheaper goods, thereby destroying jobs in Europe.

Riccardo addressed these concerns by articulating the principle of comparative advantage. It holds that each country will benefit if it specialises in the production and export of those goods that it can produce at relatively low cost. Conversely, each country will benefit if it imports those goods that it produces at relatively high costs. And it is this simple principle that provides the unshakable basis for international trade.

9.2. The nuts and bolts of comparative advantage and the gains from trade

Cost of food and clothing Europe versus America
To demonstrate the theory of Comparative Advantage, let's go back in our time machine to Ricardo's day and imagine a debate between Ricardo and another economist in front of a group of European trade ministers trying to decide whether to impose protective tariffs on America. The othe economists is John Strawman and he is a strong supporter of the theory of absolute advantage.

Strawman has just presented this table in support of his recommendation for a heavy tariff against American imports. This table illustrates how much labour is necessary to produce food and clothing in America verses Europe. Which country has the absolute advantage in food? And which has the absolute advantage in clothing? Clearly, America has the absolute advantage in the production of both food and clothing.

In America, it takes one hour of labour to produce one unit of food, while a unit of clothing requires two hours of labour. In contrast, in Europe, the cost of one unit of food is three hours of labour, while one unit of clothing costs four hours of labour. But looking at this table, the skeptical David Ricardo asked John Strawman the same question I'll now ask you. Which country has the comparative advantage in food versus clothing? From the table, you can see that America has the comparative advantage in food while Europe has the comparative advantage in clothing. This is because clothing is relatively more expensive in America, while food is relatively more expensive in Europe.

PPF of food and clothing Europe versus America
In America, a unit of food costs one half that of a unit of clothing. However, in Europe a unit of food costs 3/4ths that of a unit of clothing. If the Europeans could trade some of their clothing for some of America's food, both countries would be better off. John's Strawman does not yet understand this, so David Ricardo has to use a simple production possibilities frontier analysis to demonstrate it. Ricardo assumes that both America and Europe have 600 hours of labour available. Further he assumes that costs are constant so that he can draw the production possibilities curve as straight lines. Finally, he assumes that transportation costs are zero.

PPF of food and clothing Europe with trade
America can produce 300 units of clothing or 600 units of food or some combination thereof. In contrast, Europe can produce 150 units of clothing or 200 units of food. So one conclusion that can be drawn is that if Europe does cut off trade with America, the best it can do is to consume no more than 150 units of clothing or 200 units of food or some combination thereof.

At this point in the demonstration, Ricardo turned to John Strawman and said, "Suppose I sent you to American with 150 units of clothing. How many units of food could you trade that for?" Te answer to Ricardo's question is that, because clothing costs twice as much as food, in terms of labour requirements, John Strawman might be able to trade Europe's clothing for as much as 300 units of food. This is 100 units more than Europe could have produced with its own labour resources alone. The grey area in the figure represents the possible gains from trade that Europe would forego with protectionism instead of specialising in clothing production and trading with America for its food.

PPF of food and clothing America with trade
Now, Ricardo asked John Strawman to look at the trade issue from America's perspective. Specifically, he asked whether America might be better off trading with Europe, even though it can produce both food and clothing more efficiently than Europe. He framed the question this way. Suppose the American president sent a trade representative to Europe with 100 units of food and instructions to trade for as much clothing as possible. Would America be pleased with the result in deal? Because the cost of producing four units of clothing in Europe is three units of food, an American trader could come to Europe and exchange 100 units of food for as much as 75 units of clothing, and America is clearly better off from this trade.

This is because, in the absence of trade, the 100 units of labour that went into producing the food in America could alternatively have only produced 50 units of clothing in America. In this example, America's net gain from trade is 25 units of clothing. The grey area in the figure represents the gains from trade that America might achieve from specialising in food production and trading with Europe for its clothing. This is despite having an absolute advantage in food production. The theory of comparative advantage is one of the deepest truths in all of economics. Nations that disregard the lessons of comparative advantage will pay a heavy price in terms of their living standards and economic growth.

9.3. Tariffs, quotas, trade barriers, protectionism, and the deadweight loss

World food market
To better understand the politics of protectionism, let us return in the time machine to another meeting between David Ricardo and the European trade ministers. It is now two years after these trade ministers voiced their support for free trade. Since that time, there has been a flood of American food imports into Europe. While the European clothing industry has grown dramatically, and is experiencing record profits because of heavy exports to America, thousands of European farmers have been put out of work.

Domestic industry gains
This unemployment has provoked political unrest. Newspapers from farm districts around Europe have fanned the flames of discontent. They have written scathing editorials calling for voters to throw out the political rascals and replace them with leaders who will protect the European economy by supporting strict quotas on American food imports.

This is an age-old problem faced by political leaders who support free trade. Even though free trade can provide benefits to all countries and create thousands of jobs in export industries, it can just as easily destroy jobs domestically in import-competing industries. Given the enormous political pressures that can build for protectionism, it is useful to analyze the two most common ways of restricting trade, tariffs and quotas.

It is important to understand why, from a political perspective, quotas are often preferred to tariffs. Assume that in the domestic market for food in Europe equilibrium occurs at point A at a price of $8 and quantity of 200 units. Now, suppose that food is available in an unlimited amount from the rest of the world at a price of $4 per unit. The world supply curve is represented by the red horizontal line at $4.

Consumer losses
With free trade, in the absence of any transport costs, the food price in Europe must be equal to the world price of $4. At this price, domestic European production is measured by the line segment BC and will be 100 units, considerably less than before free trade. American imports are measured by the line segment CD and are equal to 200 units. Revenues from the sale of these imports are equal to the shaded area CDEF.

Foreign industry losses
Suppose that the farmers and their lobbyists are able to successfully lobby the European trade ministers who impose a tariff of $2 per unit of imports. Domestic producers win because their production not only rises by fifty units, but their profits rise by the shaded area BCHG. Equally clearly European food consumers loose, not only because the price of food rises from $4 to $6, but also because they consume fifty less units of food.

In fact, the total loss to consumers is measured by the area BDIG. The other big loser is the American food industry, which now exports one hundred fewer units and looses revenues equal to the shaded areas CJLE and KDMF. The other big winner is none other than the European governments that imposed the tariff. They collect tariff revenues equal to the area HIJK.
Government gains

From a political perspective, what is perhaps most interesting is that a relatively small number of people in one domestic industry, farming, has gained a considerable profit at the expense of a much larger, but politically less powerful group, namely food consumers.

This protectionist tariff has also considerably harmed food producers in America. This group is unlikely to remain silent on the tariff question. In fact, one likely result is that pressure will build politically in America to retaliate against European food tariffs with protectionist tariffs of its own, for example on European clothing imports.

Foreign industry gains
There may however be a way for Europe to avert this trade war. Replacing the European tariff on food with an equivalent quota might be a viable political solution. Aquota is an explicit quantity limit on imports. An equivalent quota in this case would be a 100 unit limit on American food since that is the level of imports after the $2 per unit tariff. One of the big losers from the tariff would become a big winner with a quota.

Under a tariff, the shaded area HIKJ goes to the European governments in the form of tariff revenues. However, under a quota foreign exporters, in this case American food producers, will be able to capture these revenues. In many cases, these additional revenues will largely offset their losses from selling fewer exports. The result in America will be far less political pressure from food producers for retaliatory tariffs.

Deadweight loss
The efficiency or deadweight loss associated with the imposition of a tariff or quota can also be shown in a figure. In fact, the loss is the same regardless of whether a tariff or quota is used. The shaded area CHJ represents the loss in producer surplus, in this case too many European resources are being diverted into the inefficient production of food at the expense of production in other sectors. At the same time the shaded area KID represents the loss in consumer surplus, the loss in consumer satisfaction from consuming fewer units of food. Together the two triangles measure the deadweight loss.

9.4. The pros and cons of protectionism

There are a few legitimate as well as illegitimate arguments for protectionism and trade barriers. First there is the national defence or military self sufficiency argument. This is not an economic argument but rather a political and strategic one. In particular, protective tariffs are needed to preserve or strengthen industries, such as steel or motor vehicles, producing goods and materials essential for defence or war. Unfortunately, there is no objective criterion for weighing the worth of an increase in national security, relative to a decrease in economic efficiency. Accompanying the re-allocation of resources towards strategic industries.

A second argument for protectionism is to save jobs. This is an argument that often becomes politically fashionable, when a country enters a recession. It is also an argument that is often made in the context of discussions of cheap foreign labour. As the argument goes, more highly paid workers such as in the United States, must be protected from countries like Mexico and China which pay workers a few dollars a day.

Closely related to the jobs argument is the dumping argument. Dumping occurs when foreign producers sell their exports at a price less than the cost of production. One possible reason for doing this is to drive competitors out of a market, seize that market, and then use the new found monopoly power to later raise prices. In such a case, the long term economic profits resulting from this dumping strategy may more than offset the earlier losses which accompanied the dumping. Because dumping is a legitimate concern, it is prohibited under American trade law. Where dumping occurs and is shown to injure American firms, the federal government can impose tariffs called anti-dumping duties on the specific goods.

The fact that one country may use protectionism or dumping to create jobs at the expense of its neighbors raises a fourth argument for protectionism, namely to retaliate against another nation that engages in such protectionist measures. Unfortunately, it is through such retaliatory measures that trade wars are born. A graphic case in point is the Smoot Hawley tariff act of 1930, approved by the American Congress. It imposed some of the highest tariffs ever enacted in the United States. While it was designed to protect American jobs during the onset of a severe recession, it backfired miserably. As one nation after another retaliated with its own restrictions, the resultant trade war helped push the entire global economy into the Great Depression.

Finally, a favourite argument in support of protectionism in developing countries is the so-called infant industry argument. The idea here is that temporarily shielding young domestic firms from the severe competition of more mature and more efficient foreign firms will give infant industries a chance to develop and become efficient producers. This argument must be weighed cautiously. Historical studies have turned up some genuine cases of protected infant industries that grew up to stand on their own feet. Studies of successful newly industrialised countries such as Singapore and South Korea show that they have often protected their manufacturing industries from imports during the early stages of industrialisation.

But the history of tariffs reveals even more contrary cases like steel, sugar and textiles, in which perpetually protected infants have not shed their diapers after low these many years. Many nations also use so-called nontariff barriers or NTBs. NTBs, which include quotas, also consist of formal restrictions or regulations that make it difficult for countries to sell their goods in foreign markets. For example, a country such as Japan might restrict the import of all vegetables grown where certain pesticides are used, knowing full well that all other countries use these pesticides. The effect of such a regulation would be to halt the import of vegetables.

9.5. The limitations of Ricardian free trade in the real world and the case of China

In reality there can be severe real world limitations of the simplified Ricardian free trade model. The essence of that model is that if two countries engage in unrestricted trade, free of tariffs, quotas and other market restrictions. If these counties abide by the principles of comparative advantage, both countries are likely to experience gains from trade. In other words, free trade in this simplified Ricardian world is a win-win for both countries.

In the real world however, free trade between two countries is much like a marriage. If one partner cheats on the other, the relationship simply will not serve both partners' interests. If one country cheats by using unfair trade practices like illegal subsidies to promote its exports, or employs tariffs or non-tariff barriers to protect its own markets, free trade becomes much more of a zero sum game in which jobs and growth shift to the cheater at the expense of the country being cheated upon.

In the early part of the 21st century, we witnessed just such a problem between China and much of the rest of the world. When China joined the World Trade Organisation in 2001, and gained access to new markets around the world. It promised to abide by the rules of free and fair trade. However, over the next decade and beyond, China would systematically engage in unfair trade practices ranging from currency manipulation and the use of illegal export subsidies, to the theft of intellectual property, and the requirement of forced technology transfer for foreign corporations entering the Chinese market.

All of these violations, of both the spirit and letter of the world's free trade laws, would lead to a major structural shift in manufacturing to China at the expense of growth and jobs, in many other countries and regions, including both the United States and Europe as well as Australia, Canada, Mexico, and much of both Latin America and Africa. This was certainly not how David Ricardo envisioned free trade.

10. Exchange Rates, The Balance of Payments, and Trade Deficits

10.1. Are trade deficits a problem?

Mirror, mirror on the wall, who's the biggest debtor nation of them all? The surprising answer is not Brazil, Mexico or some other developing country, rather it is the richest nation in the world, the United States of America. In this regard the US has come full circle. For when America was in its infancy it was likewise a debtor nation. From the beginning of the revolutionary way until well after the Civil War, America borrowed heavily from the nations of Europe to build its capital stock and infrastructure. It wasn't until the US helped Europe fight two world wars that the debtor shoe was put on the other foot. During those years the US greatly expanded its exports to Europe and after each war it lent large sums of money to the combatants for post-war relief. In the course of doing so the US became the world's largest creditor nation.

Beginning in the early 1980's, America began running huge trade deficits. Over the years these trade deficits have led to an accumulated net foreign debt in the trillions and trillions of dollars. To many observers America's chronic trade deficits are every bit as dangerous as its chronic budget deficits. These trade deficit hawks warn that America is being forced to sell off its land and its factories and its future to finance these deficits. Others however see the trade deficits simply as an opportunity to buy inexpensive foreign goods and enjoy a higher standard of living than Americans could otherwise achieve. These trade deficit doves argue that if foreign countries are foolish enough to sell us cheap goods, we should be wise enough to buy and enjoy them and not try to erect protectionist trade barriers.

10.2. Some balance of payments accounting

US balance of payments
At the basis of the study of international trade is balance of payments accounting. There is a distinction between the so called current account and the capital account and there is a critical relationship between the two. This relationship is summarised in the so called Trade Identity Equation. It says that if a country runs a trade deficit in its current account, it must balance that deficit with inflows into its capital account.

The current account consists of three major items: the merchandise trade balance, fees for services and net investment income. The merchandise trade balance is by far the biggest item. It reflects trade in commodities such as food and fuels, and manufactured goods. The US shows accounting debits or imports of $803 billion, and credits or exports of $612 billion. After subtracting one from the other, there remains a net merchandise trade deficit of minus $191 billion. When you read in the newspaper that the US is running a trade deficit, it is this merchandise trade balance to which journalists often are referring.

This is only part of the total picture. The second item in the current account is fees for services. Such services include shipping, financial services and foreign travel. While this fees category is much smaller than the merchandise trade balance. It has been growing in recent years, as the US has shifted from a manufacturing economy to a more service-oriented economy. This growth has helped offset at least some of the large merchandise trade deficits, as is evident from the table. In particular, the service fees received by the US are $237 billion and fees paid out are $157 billion, yielding a net surplus of $80 billion. This in turn yields a net balance for goods and services of negative $111 billion.

Still a third item in the current account is investment income. The table shows a credit of $206 billion. This represents the amount of income earned by Americans holding foreign assets. While the debit of $203 billion represents the amount of income earned by foreigners holding US assets. Historically, this category is on a small surplus for the US. However, as foreigners have continued to accumulate more and more US assets, this category is starting to run in the red, further exacerbating the trade deficit. Finally the fourth item in the current account is unilateral transfers, which represent payments not in return for goods and services. The sum of these four items makes up the balance on the current account that shows a deficit of a $148 billion.

As indicated above by the basic trade identity, this deficit must be offset by a net surplus in the capital account. One part of the capital account shows official-reserve changes. When all countries have purely market-determined exchange rates, the category equals zero. However, when countries intervene in foreign exchange markets, they attempt to affect the exchange rate by buying and selling foreign currencies. This shows up in the balance of payments as changes in official reserves. This is a small category of only $7 billion. Of far greater consequence are the capital outflows and inflows, which track the purchases of both real assets like hotels and factories and financial assets such as stocks and bonds.

For example, foreign purchases of US assets represent capital inflows, and might include the purchase of government bonds by a German pension fund, the buying of American stock by a Dutch mutual fund, or the acquisition of a factory in Pennsylvania by Japanese investors. In this case this produces a credit of 517 billion. Similarly, when US investors purchase assets abroad like hotel chains or foreign stocks, this results in capital outflows and a debit, in this case $376 billion. Summing US and foreign purchases of assets, produces a balance of $141 billion. After adding official reserves to this sum, there is a plus $148 billion, just enough to offset the current account deficit, and to make the sum of the current capital accounts equal to zero, just as our basic trade identity equation requires.

10.3. Exchange rates defined and why they move

Exchange rate example
An exchange rate may be defined as the rate at which one nation's currency can be traded for another nation's currency. The first thing to understand about exchange rates is that they are quoted in pairs, with one country's currency exchanging for another country's at a particular rate. Exchange rates are determined by the forces of supply and demand in the global marketplace. For example, there is a market for Dollars versus Pounds. The equilibrium exchange rate will occur at the intersection of the demand for Pounds D1 and the supply of pounds S1. The equilibrium exchange rate is 1 British pound for $2.

The second thing to understand about exchange rates, is that they can rise and fall over time. If a country's currency gains in value relative to another, it is said to appreciate. In contrast, if a country's currency loses value relative to another, it is said to depreciate. Suppose the US dollar exchanges today for 1.2 Euros but by next year exchanges for 1.5 euros, $1 can by more euros so it has risen in value and therefore appreciated. In contrast, if the exchange rate falls to one euro for $1, the dollar can buy fewer euros, and therefore has depreciated.

Exchange rate example
There are five main reasons why exchange rates change over time, gaining or losing value. These include, differing rates of GDP growth between countries, differing rates of inflation, a change in real relative interest rates, a change in taste and simple speculation. The first reason why exchange rates may move is a change in the relative GDP growth of two nations. Faster GDP growth in one country relative to another country will typically lead to faster income growth in that nation. This faster income growth in turn means that consumers will increase their purchases of imports.

Assume that a recession hits the United States. In a recession, US income will fall relative to British income. As a result the US will buy fewer British imports and therefore need fewer British pounds to do so. This will decrease the demand for pounds and shift the demand curve inward. The result? The dollar appreciates relative to the British pound.

Differing rates of inflation also affect exchange rates. Suppose that the rate of inflation in Canada is higher than in Europe. In this case, the Canadian dollar will depreciate relative to the euro because exchange rates in the currency markets must reflect real inflation adjusted price differences in the goods markets.

Another way of looking at this important inflation factor driving exchange rates is the following. Suppose inflation raises the actual or nominal price of, say, an auto made in Canada relative to the nominal price of an identical auto made in Europe. In this case, there must be a corresponding adjustment in the exchange rate so that the real, inflation adjusted prices of the two autos stays the same. Economists refer to this key concept as The Law of One Price. Differing rates of inflation played a key role in the downfall of the so called gold standard, which was a key linchpin of the international monetary system for over 60 years.

Exchange rate example
A third reason why exchange rates move has to do with changes in relative interest rates across countries. Suppose that the US Federal Reserve raises interest rates while the Bank of England takes no such action. In this case US interest rates have risen relative to those in England. In this case, British investors will respond to a rise in American interest rates by shifting more of their investment funds from Britain to America.

For example, they may wish to buy US government bonds at the higher interest rates. But, in order to do this, they must first sell some of their domestic investments and then exchange pounds for dollars in global currency markets. This figure illustrates the adjustment process, as British investors trade their pounds for dollars in global currency markets. This increase in the supply of pounds leads to a rightward shift of the supply curve. This in turn causes the dollar to appreciate.

Still a fourth reason for exchange rate movements is a change in tastes. For example, suppose that Japanese autos decline in popularity in the United States, perhaps because of some increased concerns over safety. What do you think will happen to the value of the Japanese yen? Clearly, the Japanese yen will depreciate relative to the U.S. dollar, as U.S. consumers reduce their purchases of Japanese autos and therefore, their demand for yen.

The fifth, and final, reason for exchange rate movements has to do with currency speculation. For example, suppose currency traders believe that the Brazilian Central Bank is going to raise interest rates to fight inflation. Will currency traders be more likely to buy or sell Brazil's currency, the rial, before the Central Bank makes it's forecast and move. As we've learned, should Brazil's central bank raise interest rates, this rise in relative interest rates will likely attract more foreign investment into Brazil. This, in turn, should boost the demand for the Brazilian real. Therefore, a currency speculator is likely to buy the Brazilian real before the move, betting the real will appreciate.

10.4. Floating versus fixed exchange rates, the gold standard, and Hume's gold specie flow adjustment mechanism

In the examples we have used thus far, the value of the various currencies that we discussed were allowed to freely move in response to market conditions. This type of monetary system is called a floating exchange rate system. However, not all countries of the world allow their currencies to float. Instead, some use what is called a fixed exchange rate system. In a fixed exchange rate system, a country will peg the value of its currency tightly to the value of another. Most often, the US dollar, or a basket of currencies. The country will then make the necessary adjustments to maintain the value of that pay. To better understand these two starkly different systems, floating versus fixed exchange rates, let's take a trip through time.

Between 1867 and 1933, except for the period around World War I Most of the nations in the world were on the gold standard. Under this fixed exchange rate system, the currency issued by each country had to either be gold or redeemable in gold. And once a country agreed to be on the gold standard, its currency was convertible into a fixed amount of gold. With these fixed exchange rates, if the nation ran a trade deficit, it would be required to use its gold reserves to buy currency to prevent the value of the currency from falling. In contrast, if a nation ran a trade surplus, it would accumulate gold.

Gold specie flow mechanism
The gold standard was so popular because of the gold specie flow mechanism. This monetary adjustment mechanism was first described by Scottish philosopher and economist, David Hume in 1752. Suppose that both Britain and the US start with an equal amount of gold reserves and begin trade. The US initially runs a trade deficit, so that it has to ship some of its gold to Britain. If the US continues to run such a deficit it will eventually run out of gold. However, before that can happen, Humes adjustment mechanism takes hold. First, the U.S. money supply is reduced by its loss of gold. Second, the U.S. price level falls. At the same time, the British money supply increases and British prices rise.

This all happens because by the quantity theory of money. If the velocity of money V and real output Q stay the same, this reduction in money M must reduce the price level P. As a result of these changes in relative prices in the U.S. and Britain, four things happen. First, America decreases its imports of British and other foreign goods, which had become relatively expensive. Second, America's exports increase because America's domestically produced goods have become relatively inexpensive on world markets. Third British consumers import more of America's now more relatively inexpensive goods. And fourth British exports decline because British exports have become more expensive. In this way a balance of payments equilibrium is restored by the gold specie flow mechanism.

It is a matter of some debate whether Hume's Mechanism actually works. But what is true, is that the gold standard worked reasonably well at stabilising the currency markets right up until World War I. With the advent of the war, many nations had to temporarily abandon the gold standard to finance their war efforts. This led to inflation and to differing rates of inflation to differing countries.

Differing rates of inflation distort the relative value of currencies. Thus, when peace returned and nations return to the gold standard, the old exchange rates no longer reflected the true value of the different currencies. For example, the French Franc was significantly undervalued. As a result, upon its return to the gold standard, the French economy enjoyed an export led boom and France began to accumulate large surpluses of foreign currencies.

In contrast, Britain had sustained lower inflation rates than many of its trading partners so its currency was overvalued. As a result, Britain found it difficult to sell its exports and found itself overwhelmed by cheap imports. By 1930, Britain was so drained of its gold reserves that it had to abandon the gold standard. At that point the U.S. dollar came under a similar attack. France in particular began to unload large amounts of its surplus dollars for US gold. While the Hoover administration first stemmed this gold flow by raising domestic interest rates, this act of contractionary monetary policy also helped push the US further ended the Great Depression. Eventually in 1933, President Roosevelt followed the British in abandoning the gold standard.

With the collapse of the gold standard in the 1930s, countries desperate to create jobs in a depressionary global economy, engaged in so-called competitive devaluations. In particular, they began to devalue their currencies in order to boost exports and reduce imports. However, these competitive devaluations acted in a fact like a beggar thy neighbor trade policy. Jobs created in one country lead to job losses in other countries. These economic pressures in turn contributed to growing political pressures It eventually led to World War II. It was the harsh lessons of the 1930s that brought the Allied powers to Bretton Woods, New Hampshire in 1944, as representatives from 44 countries met for 22 days to design a new international monetary system.

10.5. The dollar standard and its collapse

The new system featured a modified fixed exchange rate system called, a partially fixed or adjustable peg system. This system replaced the gold standard with a US dollar standard. The US dollar was designated as the world's key currency. Most international trade and finance was to be transacted in dollars, and fixed exchange rate parities for all currencies were set in both gold and dollar terms. For example, the parity of the British pound was set at 12.5 per ounce of gold. Given that the gold price of the dollar was $35 per ounce, this implied an official exchange rate between the dollar and the pound of $35 divided by 12.5, equals $2.80 per one pound.

While the Bretton Woods agreement remained wedded to the concept of fixed exchange rates, there was one very important difference. Bretton Woods also provided for a cooperative mechanism in which the exchange rates were only partially fixed. These new partially fixed rates could be periodically adjusted to reflect changes in currency values in a process know as adjusting the peg. The idea of this new partially fixed or adjustable peg exchange rate system was to provide both the stability of the gold standard's fixed rates with the adaptability of flexible exchange rates. Through this adaptability, relative price changes across nations could be addressed through periodic and cooperative adjustments in exchange rates rather than through the painful deflations and recessions that have plagued the gold standard.

For the first decade of its existence, the Bretton Woods system was a great success. Under the Marshall Plan created in 1947, the US lent large sums of dollars to Europe for its rebuilding. These dollars flowed right back into the US for the purchase of machinery, equipment, and consumer goods. However, by the mid 1950s, the European economies had become increasingly self-sufficient. As US exports to Europe slowed, America's strong economy continued to attract foreign imports. At the same time US deficits were further fueled by an overvalued currency, budget deficits to finance the Vietnam war and growing oversea investments by American firms. By the 1960s, with the US trade deficits mounting a huge surplus of dollars began to pile up in foreign banks.

As speculative concerns increased that the US would devalue the dollar, many foreign governments began to redeem their surplus dollars for US gold. As US gold reserves fell dramatically, the US government tried unsuccessfully to pressure these foreign governments into retaining their surplus dollars, a surplus that had grown from virtually nothing in 1945 to $50 billion by the early 1970s. Finally, in August 1971, a reluctant Nixon Administration abandoned the dollar standard and Bretton Woods. No longer would dollars be redeemable for gold at $35 an ounce, and in the wake of that abandonment the dollar's value fell precipitously.

10.6. Today's hybrid exchange rate system, currency blocs, and fixed pegs

Unlike the earlier uniform systems of first the gold standard and then Bretton Woods', today's exchange rate system fits into no tidy mold. Without anyone having planned it, the world has moved to a hybrid system known as the managed float. It has the following major features. First, a few countries like the United States have a primarily flexible or floating exchange rate. In this approach, markets determine the currency's value and there is very little intervention. Second, other major countries, such as Canada, Japan, and more recently, Britain, have managed but flexible exchange rates. Under this system, a country will buy or sell its currency to reduce the day-to-day volatility of currency fluctuations. A country may also engage in systematic intervention to move its currency toward what it believes to be a more appropriate level.

Third, many countries, particularly small ones, peg their currencies to a major currency or to a basket of currencies. Sometimes the peg is allowed to glide smoothly upward or downward in a system known as a gliding or crawling peg. Some countries join together in a currency bloc in order to stabilise exchange rates amongst themselves. These countries then allow their single currency to float flexibly relative to those of the rest of the world. The most important of these blocks is the European Union, which in 1999 moved to a single currency, the Euro.

Finally, almost all countries tend to intervene either when markets become disorderly or when exchange rates seem far out of line with the existing price levels and trade flows. Government exchange rate intervention occurs when the government buys or sells its own or foreign currencies to affect excahgen rates. For example, the Japanese government on a given day might buy $1 billion worth of Japanese yen with US dollars. This would cause a rise in value or an appreciation of the yen. In general, a government intervenes when it believes its foreign exchange rate is out of line with its currency's fundamental value.

An excellent historical example of such intervention on a broad scale is offered by the actions of the so-called Group of Seven Nations. In 1987, this group, the US, Germany, Japan, Britain, France, Italy, and Canada. Agree to stabilise the value of the dollar relative to the other countries currencies. The problem was that during the previous two years, the dollar had declined rapidly because of large US trade deficits, and the G-7 nations other than the US were worried that any further weakening of the dollar Would stifle their exports and more broadly, disrupt economic growth. So these nations agreed to purchase large amounts of dollars to boost the dollar's value.

10.7. How chronic trade deficits can persist, the multiplier link and global coordination of fiscal and monetary policies

Our next question is this. How does the United States maintain a chronic trade deficit even though it operates under a largely flexible exchange rate system? Under such a system, shouldn't there be a natural adjustment of the US balance of payments due to the forces of supply and demand? After all, US trade deficits should lead to a surplus of dollars and foreign exchange markets and thereby drive down the dollar's value. This, in turn, should lower the price of the country's exports, increase the price of its imports, and restore balance to US trade flows. But such an adjustment process has not worked particularly well in curbing the chronic trade deficits of the United States. The question is why, and the answer lies in first understanding the nature of the US trade deficit.

There are several reasons for persistent US trade deficits. The first, of course, is the large chronic budget deficits that began in the 1980s. As we have discussed, the need for the government to finance these budget deficits drove up interest rates, strengthened the dollar, made exports more expensive and imports cheaper, and sent the trade deficit spiraling upward. That's not all. A declining savings rate in the U.S. has also been a major contributing factor to the trade deficit problem in this sense. As the US savings rate has fallen Investment rate has remained fairly stable, or even increased. This is impossible because foreign investment has filled the savings investment gap. One result is that US have been able to save less while consuming more. And at least part of that increase consumption has been on imported goods. In this sense, the US capital surplus may not only result from the trade deficit, but also help cause it.

The chain of causality
These two major causes of the U.S trade deficit are each driven, in some degree, by U.S domestic fiscal and monetary policies. Because this is so, it is important to understand how the conduct of domestic fiscal and monetary policies in a global economy can affect not only the domestic countries trade balance, but also significantly affect the rates of growth and unemployment in the domestic country's trading partners. Any imbalances in either capital or trade flows in one country, will affect all trading partners. This means, for example, that the US trade deficits and capital surpluses are not just domestic headaches. They are global problems as well. Perhaps the best way to understand this important point, is to illustrate the mechanisms through which domestic fiscal and monetary policies affect the global economy.

Fiscal policy is discussed first. Suppose that America's GDP falls. This might happen as a result of contractionary fiscal policy to slow inflation or it may simply be that demand in the private sector is weak. Regardless of the reason, the result is the same, and it is illustrated in the chain of causality. A lower income in America YA leads to lower imports from Europe ImA. The flip side of this coin, of course, is that as European exports ExE to the US falls, so too does European income YE. In other words, America's domestic fiscal policy can not only lead to a contraction in the American economy, it can also function as a contractionary fiscal policy for Europe, as well. In some textbooks, this chain of causality is referred to as the multiplier link.

Monetary policy effects
From this multiplier link, you can perhaps see why it has grown increasingly important for countries to coordinate their fiscal policies. For example, suppose that America wants to reduce its trade deficit with Japan, based on our discussions thus far. One way to do this, might be for the U.S. to adopt a more contractionary fiscal policy. However, such a policy might not be politically acceptable on the home front if the U.S. economy is in recession.

Alternatively, the U.S. might encourage Japan to adopt a more expansionary fiscal policy as a way of stimulating Japanese demand for U.S. imports. And strengthening the yen, relative to the dollar. In fact, this is precisely the kind of request that an American president might make to the Japanese prime minister at a bi-lateral trade summit. Such a coordinated macro-economic approach can work, only if each country benefits. For example, if Japan is in a recession with low inflation, it may well agree to the fiscal expansion. However, if Japan is at or near full employment, it may simply refuse any fiscal stimulus for fear of igniting inflation.

Domestic monetary policy in the United States can have an impact on the global economy. For example, when America raises its interest rates through contractionary monetary policy, this can be felt in Europe. As America's interest rate rA rises, investors sell European financial assets and buy American financial assets. This leads to an appreciation of the dollar eS and a depreciation of the European currencies. This in turn increases Europe's net exports ExE, and thereby raises European output and income.

The impact of a cut in the money supply
There is an important offsetting effect. Particularly, higher interest rates in America tend to raise European interest rates rE. These higher rates tend to depress domestic investment in Europe IE, and thereby lower Europe's output YE and employment. In its attempt to fight domestic inflation, the Federal Reserve of the United States has increased the chance that Europe will experience a recession. In some textbooks, this chain of events is referred to as the monetary link.

Unlike with fiscal policy in the multiplier link, the overall impact of monetary policy and the monetary link on domestic GDP is ambiguous and will depend on the particular situation. In a closed economy, a cut in the money supply reduces consumption and investment and helps relieve inflation pressures. However, if the money supply reduction increases domestic interest rates, this may trigger additional capital inflows and these increased capital inflows may frustrate monetary policy by increasing the money supply and holding down interest rates. These lower rates in turn may increase aggregate demand.

The increased capital inflows may also tend to increase the value of the US dollar and widen the trade deficit. The bottom line here is that the net impact of the contractionary monetary policy on domestic GDP is theoretically ambiguous, and will depend on the individual case. However, what should be unambiguous from this example, is the critical importance of globally coordinating not just fiscal policy but monetary policy as well. A more real world example should strongly reinforce this point at the same time that it highlights the difficulties of achieving such coordination.

10.8. The European Monetary System, Germany as a case study, and the benefits of policy coordination

In the late 1970's, in the aftermath of the demise of Bretton Woods and the dollar standard, the nations of Europe established a fixed exchange rate system, pegged to the German mark. These nations did so in the hopes of avoiding a repeat of the competitive devaluations and economic disruptions that had plagued Europe in the 1930's after the collapse of the gold standard. In fact this European Monetary System worked reasonably well for over a decade. However, in 1990, the reunification of Germany resulted in large budget deficits as West Germany subsidised East German industry. To cope the result in inflationary pressures, the Bundesbank, the German equivalent of the Federal Reserve, significantly raised interest rates.

This German monetary policy was clearly uncoordinated with that of its neighbors. It was being used for domestic macroeconomic management without regard to its impact on Germany's trading partners. The results, however, were severe. Faced with rising German interest rates, other European countries within the European monetary system, had to raise their interest rates to prevent their currencies from depreciating against the German mark, and moving outside the prescribed range of parities. These interest rate increases, along with a worldwide recession, pushed Euroupe outside of Germany into an ever-deepening recession.

Eventually, the European monetary system was brought down by speculators who believed that the beleaguered countries would not continue to tolerate unrealistic exchange rates and high interest rates. One by one, currencies came under attack, the Finish mark, the Swedish crown, the Italian lira, the British pound, Spanish pesetas and the system collapsed. The macroeconomic lesson of this crisis, is that a country cannot simultaneously have fixed exchange rates, open capital markets, and an independent monetary policy. In the wake of this crisis, the major European countries resolved this dilemma by moving to a common currency the euro. This is a step that strongly reinforces the importance of coordinating global macro-policies.

Income possibilities
It is possible to illustrate the potential benefits of global coordination with the income possibility curve. Assume that both Europe and America find themselves stuck at point U, with high unemployment and low incomes, and that the problem is due to high interest rates, stubborn government deficits, and strong protectionist lobbies for domestic industries. America considers taking a non-cooperative policy, perhaps by introducing trade barriers and raising interest rates to keep inflation down. This moves America to its non-cooperative optimum at point NA.

Europe likewise considers the same kind of non-cooperative policy, restricting trade, depreciating its currency, or increasing purchases from within its borders, moving to its non-cooperative point at NE. Pursuing these non-cooperative policies along the red colored NA-NE line, nations would not only beggar their neighbors, but beggar themselves as well. The alternative would be to find a cooperative approach that had positive rather than negative spill overs. This might involve lowering trade barriers, having a joint policy in monetary expansion, and tightening fiscal policies to increase savings and investment. If successfully designed and implemented, such a policy might move both America and Europe out to point C on the income possibility curve.

11. The Economics of Developing Countries

11.1. The four elements of development

While much of the focus of our macroeconomics studies has been on the major industrialised nations of the world, we are going to turn our attention now to the developing countries of Africa, Asia, and Latin America. Home to about three fourth of the world population. Begin, let's explain what we mean by a developing country. Some textbooks prefer the term less developed country, or LDC while others simply say developing country or DVC. Regardless, the most important characteristic of developing countries, is that the people have low per capita incomes. In addition, people in developing countries usually have poor health and a short life expectancy, suffer from malnutrition, and have low levels of literacy.

To put a human face on this, put yourself now in the shoes of a typical 25 year-old in a low income country such as Mali, India or Bangladesh. Your annual income barely averages $500. Your life expectancy is 4/5th that of the average person in an advanced country. Already, two of your brothers and sisters have died before reaching adulthood. You can barely read and you work very long hours in the fields without the benefit of machinery, and with but 1 60th of the horsepower of a prosperous North American worker. At night you sleep on a mat in a one-room room house, along with your parents and grand parents and five children. Your house has no electricity, indoor toilet or fresh water supply.

Population growth
You have little household furniture, perhaps a table and a radio. Your only mode of transportation is an old pair of boots while despite much sickness in your village, qualified doctors are far away tending to the needs of wealthier families. You and your fellow citizens in the 40 poorest countries, constitute 55% of the world's population, but must divide among each other only 4% of world income. You're often hungry and the food you eat is mainly roughage or rice, you have little or no hope of ever seeing your life improve. This is a grim life indeed.

Now let's take a more systematic look at this problem. Let's start with this table, which shows the stark disparity in wealth among the nations of the world. Here, we see that the richest 20% of the world's population captures almost 83% of its income, while the poorest 20% earns less than 2%. To understand why some countries reach their potential while others fail, we need to look more systematically now at the process of economic development. Recall in our lesson on economic growth, we learned that productivity in growth in the modernised industrialised economies depend on four major supply side factors. Human resources, natural resources, capital formation and technology. Let's see now how each of these factors operates in developing countries.

Let's start with human resources, and here we have two dimensions. The quantity of labour, and it's quality. On the quantity issue because of rapid population growth, many poor countries are forever running hard just to stay in place. The problem is that even as a poor nation's GDP rises, so too does its population, so that many developing countries are never able to escape the Malthusian trap of high birth rates and stagnant incomes. This table and chart help put this population problem in its appropriate global perspective. The table on the left shows how birth rates in developing countries like Pakistan, Venezuela, and Kenya are more than twice that of the United States. Now take a look at the right hand figure. How much is the world population is expected to grow over the next century? And, in which category of countries will the bulk of this growth occur. You can see that world population is expected to double over the next century. More importantly, as the brown and pink portions of the figure indicate, most of this increase is expected to come in the low and middle income countries of the world. However, with such high birth rates, it will be extremely hard for poor countries to throw off their chains of poverty.

So what strategies might be adopted to address overpopulation? One such strategy is to try and directly control that growth, even when such actions run against prevailing religious norms. For example some Catholic countries in Latin America have introduced educational campaigns, and subsidised birth control despite church doctrine. In Asia, China has been particularly forceful in curbing population growth by putting tight quotas on the number of births, and imposing economic penalties, and mandatory sterilisation. On those who violate their baby quota. Note however, that some experts hold a view contrary to the traditional one that population growth can only be controlled directly. This demographic transition view holds that, rising income first must be achieved before slower population growth can be achieved. It is an interesting argument that based in large part on micro economic reasoning.

The idea is that there are both marginal costs and marginal benefits associated with having another child. In the developing countries, the marginal benefits are relatively large, because the extra child becomes an extra worker to support the family and a safety net for parents in their senior years. However, in the wealthier, industrialised nations, the marginal cost of children is much greater than in the developing countries, because of the high costs of things like health care, day care and education. The same time, in the industrialised nations, there is a government safety net for senior citizens, in the form of retirement and healthcare programmes, so children as retirement insurance are less necessary. Thus, in this demographic transition view, as a country industrialises, people will choose to have fewer children. Indeed in countries like Mexico, South Korea and Taiwan, we have seen birth rates drop sharply as their incomes rose and their populations receive more education.

11.2. Human resources, natural resources, and land ownership patterns

Turning now to human resource quality, the crucial role of skilled labour has been shown again and again when sophisticated mining, defence, or manufacturing machinery has fallen into disrepair and disuse because the labour force of developing countries did not have the necessary skills for operation and maitenance. Accordingly, development programmes to improve education, reduce illiteracy, and train workers, as well as to improve public safety and health, can make a developing country's population much more productive. This is because workers can learn to use capital more effectively, adopt new technologies, lose fewer days to sickness or injury, and better learn from their mistakes. In this regard, for advanced learning in science, engineering, medicine, and management, countries can benefit by sending their best minds abroad to bring back the newest advances. But, there is a big warning sign that must be posted here. Countries must be aware of the brain drain, in which the most able people get drawn off to high-wage countries.

Let's turn now to the second factor in economic growth, natural resources. Perhaps the most valuable natural resource of developing countries is arable land. Much of the labour force in developing countries is employed in farming. Hence, the productive use of land, with appropriate conservation, fertilisers, and tillage, will go far in increasing a poor nation's output. However, some poor countries of Africa and Asia have meager endowments of natural resources. And such land and minerals as they do possess must be divided among dense populations. Economists suspect that natural wealth from oil or minerals is not an unalloyed blessing. Some countries like the United States, Canada and Norway have used their natural wealth to form the solid base of industrial expansion. In other countries the wealth has been like loot subject to plunder and rent seeking by corrupt leaders and military cliques. Countries like Nigeria and Zaire, which are fabulously wealthy in terms of mineral resources fail to convert their underground assets into productive human or tangible capital because of venal rulers who drained that wealth into their own bank accounts and conspicuous consumption. The same time, land ownership patterns are key to providing farmers with strong incentives to invest in capital and technologies that will increase their land's yield. When farmers own theitr own land, they have better incentives to make improvements, such as irrigation systems, and undertake appropriate conservation practices. However, in developing countries, a small handful of the wealthy own a large percentage of the land. This kind of land ownership patterns not only discourages production. It has also led to violent socialist revolutions and civil strife in more than one developing country.

11.3. The importance of capital formation and technological change

Regarding the third factor in growth, capital formation, a modern economy requires a vast array of capital goods. However, the only way countries can rapidly deepen their capital stock is by abstaining from current consumption. And that's the catch for many developing countries that are poor to begin with. Because reducing current consumption to provide for future consumption often seems impossible. Nonetheless, the role of capital formation in economic growth cannot be understated. Consider that the leaders in the growth race invest at least 20% of output in capital formation. By contrast, the poorest agrarian countries are often able to save and invest only 5% of their national income. Moreover, much of the low level of savings goes to provide the growing population with housing and simple tools. Little is left over for development. The result is too little investment in the productive capital so indispensable for rapid economic progress.

Turning to the fourth supply factor of economic growth, technological change, developing countries have one potential advantage here, they can benefit by relying on the technological progress of more advanced nations. In this regard, poor countries do not need to find modern Newtons to discover the law of gravity. They can read about it in any physics book. Nor do they have to repeat the slow, meandering inventions of the Industrial Revolution. They can buy tractors, computers and power looms. Undreamed of by the great merchants of the past. Japan and the United States, clearly illustrate this pattern in their historical developments. Japan joined the industrial race late, and only at the end of the 19th century did it send students abroad to study Western technology. Same time, the Japanese government has taken an active role in stimulating the pace of development and in building infrastructure such as railroads and utilities.

The case of the United States likewise provides a hopeful example to the rest of the world. The key inventions involved in the automobile originated almost exclusively abroad. Nevertheless, Ford and General Motors applied foreign inventions and rapidly became the world leaders in the automotive industry. From the histories of Japan and the United States, it might appear that adaptation of foreign technology is an easy recipe for development. You might say, just go abroad, copy more efficient methods, put them into effect at home, and sit back and wait for the extra output to roll in. Last, technological change is not that simple. You can send a textbook on chemical engineering to Bangladesh or Somalia. Without adequate human resources, skilled scientists, engineers and entrepreneurs, these countries can't even begin to think about building a working petrochemical plant.

11.4. Why some countries prosper, the cycle of poverty, and nine policies to promote growth

The cycle of poverty
Having discussed the four major elements of growth and development, lets now come to better understand why some developing countries like Chili, Costa Rica and the Philippines enjoy relative prosperity. While others like Chad, Senegal and Gabon stagnate. Basic problem is the vicious circle of poverty that some countries fall prey to, as illustrated in this figure. The center of this circle is rapid population growth. This leads to low per capital income that leads to both a low level of savings and a low level of aggregate demand. This in turn leads to low levels of investment in both physical and human capital. The result is low productivity and low per capital income and the circle continues.

Other elements of poverty are likewise reinforcing because poverty is accompanied by low levels of education, literacy and skill. These in turn prevent the adoption of new and improved technologies. Over coming the barriers of poverty often requires a concerted effort on many fronts. And some development economist recommend a big push forward to break the vicious circle. If a country is fortunate, simultaneous steps to invest more improve health and education, develop skills and curb population growth. Can break the vicious cycle of poverty. And stimulate a virtuous circle of rapid economic development.

But, which countries will be the fortunate ones and why? Economists, historians and social scientists have long been fascinated by these questions. And the obvious differences in the pace of economic growth among nations. Some early theories stressed a hospitable climate noting that all advanced countries lie in the earth's temperate zone. Others have pointed to custom, culture or religion as a key factor. Max Weber, for example, emphasised the Protestant ethic as a driving force behind capitalism. More recently, Mancur Olson has argued that nations begin to decline when their decision structure becomes brittle and interest groups or oligarchies prevent social and economic change.

No doubt, each of these theories has some validity for a particular time and place but they do not hold up as universal explanations of economic development. Faber's theory leaves unexplained why the cradle of civilisation appeared in the near East and Greece while the later dominant Europeans lived in caves, worshiped trolls and wore bear skins. Where do we find the Protestant ethic in bustling Hong Kong? How can we explain that a country like Japan with a rigid social structure and powerful lobbies has become one of the world's most productive economies? The failure of these early theories to fully explain economic development has spawned more modern views.

Here is just a sampling of the debate over what the best strategy is for a country to break out of the vicious cycle of poverty and begin to mobilise the factors of economic development. Let's begin with the issue of relying upon an industrial or agricultural economy. One of the most important choices the leaders of a developing country can make is whether to pursue a strategy of rapid industrialisation to achieve growth as opposed to simply expanding and improving their agricultural base. In the past, such a choice was typically resolved in favour of industrialisation as developing countries sought to mimic the successes of the industrialised nations.

Today however, the lesson of decades of attempt to accelerate industrialisation at the expense of agriculture has led many analysts to rethink the role of farming. Here's the problem. Industrialisation is captial intensive. It attracts workers into crowded cities and it often produces high levels of unemployment. On the other hand, raising productivity on farms typically requires far less capital while providing productive employment for surplus labour. Indeed, if Bangladesh could increase the productivity of its farming by just 20%. That advance would do more to release resources for the production of comforts. Then we're trying to construct a domestic steel industry to displace imports.

The second major issue in development strategy is whether a country is better off relying upon a state-run versus market-oriented economy. The important elements of a market oriented policy include, an outward orientation and trade policy. Low tariffs and few quantitative trade restrictions, the promotion of small business and the fostering of competition. Moreover, markets work best in a stable macroeconomic environment. One, in which taxes are predictable and inflation is low. However, the problem here is that the cultures of many developing countries are hostile to the operation of markets. Often competition among firms or profit seeking behaviour is contrary to traditional practices, religious beliefs or vested interest. Yet decades of experience suggest that extensive reliance on markets provides the most effective way of managing economy and promotoing rapid economic growth.

Open versus closed economies
Still a third issue, development strategy has to do with the openness of an economy to international trade. For example, should a developing country pursue a strategy of import substitution by replacing most imports with domestic production? Or should a country pursue a strategy of openness or outward orientation? That is, should it strives to pay for its imports by improving efficiency and competitiveness, developing foreign markets and keeping trade barriers low? Historically policies of import substitution were often popular in Latin America until the 1980s. And indeed the policy most frequently used toward this end was to build high tariff walls around manufacturing industries, so that local firms could produce and sell goods that would otherwise be imported.

In contrast, in age show countries like Taiwan, South Korea and Singapore have preferred an openness strategy. Such a policy keeps trade barriers as low as practical by relying primarily on tariffs rather than quotas and other non-tariff barriers. It minimises the interference with capital flow and allows supply and demand to operate in financial markets. It avoids a state monopoly on exports and imports. It keeps government regulation to bare necessities for an orderly market economy. Above all, it relies primarily on a private market system of profits and losses to guide production, rather than depending on public ownership and control or the commands of a government planning system.

Now, what is perhaps most interesting here is that just a generation ago, Taiwan, South Korea and Singapore all had per capital incomes one-quarter to one-third of those in the wealthiest Latin American countries. Yet, by saving large fractions of their national incomes and channeling these to high-return export industries, these countries overtook every Latin American country by the late 1980s. Secret to success was not a doctrinaire laissez-faire policy but the government in fact engaged in selective planning and intervention. Rather, the openness and outward orientation allowed the countries to reap economies of scale and the benefits of international specialisation. And thus to increase employment, use domestic resources effectively, enjoy rapid productivity growth and provide enormous gains in living standards.

Policies for economic growth
This figure drives home the point that open economies generally do better than closed ones. You can see in the left-hand figure that closed economies, like Angola, Mozambique and Ghana grow slowly while in the right-hand figure, countries like Thailand, Malaysia and Indonesia have done much better.

So what's the bottom line for successful strategies of economic development. Decades of experience in dozens of countries have lead many development economists to this of nine suggstions to enhance economic growth. These range from, establishing the rule of law, opening economies to international trade. And controlling population growth to establishing independent central banks to avoid hyper inflation, establishing realistic exchange rate policies to prevent major currency shocks, and privatising state industries to improve efficiency and promote entrepreneurship.

At the same time it is clear that the industrialised nations of the world can play a very constructive role in helping the developing countries grow. One way is to provide more foreign capital, both public and private. And to better target such aid to the poorest developing countries. In this regard, the United States and many other industrialised nations already assist the developing countries with substantial foreign aid in the form of both loans and grants.

A second way for the industrialised nations to spur economic development in the developing countries would be to further reduce their own trade barriers. This would allow developing countries to expand their national incomes through increased trade. But such a step can be politically controversial because it raises the specter of industrialised workers having to compete against people willing to work for a dollar or less a day. Still a third way the industrialised nations can help is to provide debt relief. The problem here is that the current debt load of many developing countries is so large that monies which would otherwise go to investment in the countries has to be used for servicing these debts.

The fourth way the industrialised nations might help is by addressing an issue we raised earlier. The so called brain drain. The problem here is that many of the best and brightest workers int he developing countries come to the industrialised nations temporarily to get and education but wind up staying permanently to work. Rather than returning to help build the economies of their homelands. This brain drain contributes to the deterioration in the overall skill level and productivity of labour forces often least able to suffer such losses. A final way to help developing countries grow is to discourage arms sales to them. While such sales create jobs and profits in the industrialised nations, they also divert precious public expenditures from infrastructure and education.


1. Macroeconomics, 6th edition, David C.Colander, McGraw-Hill, 2006