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1.
Explain what the Industrial Revolution was and where it began.
2.
Explain the difference between property rights and contractual rights. Why do they matter to economic growth?
3.
Are there other ways in which we can measure productivity besides the amount produced per hour of work?
4.
Assume there are two countries: South Korea and the United States. South Korea grows at 4% and the United States grows at 1%. For the sake of simplicity, assume they both start from the same fictional income level, \$10,000. What will the incomes of the United States and South Korea be in 20 years? By how many multiples will each country’s income grow in 20 years?
5.
What do the growth accounting studies conclude are the determinants of growth? Which is more important, the determinants or how they are combined?
6.
What policies can the government of a free-market economy implement to stimulate economic growth?
7.
List the areas where government policy can help economic growth.
8.
Use an example to explain why, after periods of rapid growth, a low-income country that has not caught up to a high-income country may feel poor.
9.
Would the following events usually lead to capital deepening? Why or why not?
1. A weak economy in which businesses become reluctant to make long-term investments in physical capital.
2. A rise in international trade.
3. A trend in which many more adults participate in continuing education courses through their employers and at colleges and universities.
10.
What are the “advantages of backwardness” for economic growth?
11.
Would you expect capital deepening to result in diminished returns? Why or why not? Would you expect improvements in technology to result in diminished returns? Why or why not?
12.
Why does productivity growth in high-income economies not slow down as it runs into diminishing returns from additional investments in physical capital and human capital? Does this show one area where the theory of diminishing returns fails to apply? Why or why not?
7.09: Review Questions
13.
How did the Industrial Revolution increase the economic growth rate and income levels in the United States?
14.
How much should a nation be concerned if its rate of economic growth is just 2% slower than other nations?
15.
How is GDP per capita calculated differently from labor productivity?
16.
How do gains in labor productivity lead to gains in GDP per capita?
17.
What is an aggregate production function?
18.
What is capital deepening?
19.
What do economists mean when they refer to improvements in technology?
20.
For a high-income economy like the United States, what aggregate production function elements are most important in bringing about growth in GDP per capita? What about a middle-income country such as Brazil? A low-income country such as Niger?
21.
List some arguments for and against the likelihood of convergence.
7.10: Critical Thinking Questions
22.
Over the past 50 years, many countries have experienced an annual growth rate in real GDP per capita greater than that of the United States. Some examples are China, Japan, South Korea, and Taiwan. Does that mean the United States is regressing relative to other countries? Does that mean these countries will eventually overtake the United States in terms of the growth rate of real GDP per capita? Explain.
23.
Labor Productivity and Economic Growth outlined the logic of how increased productivity is associated with increased wages. Detail a situation where this is not the case and explain why it is not.
24.
Change in labor productivity is one of the most watched international statistics of growth. Visit the St. Louis Federal Reserve website and find the data section (http://research.stlouisfed.org). Find international comparisons of labor productivity, listed under the FRED Economic database (Growth Rate of Total Labor Productivity), and compare two countries in the recent past. State what you think the reasons for differences in labor productivity could be.
25.
Refer back to the Work It Out about Comparing the Economies of Two Countries and examine the data for the two countries you chose. How are they similar? How are they different?
26.
Education seems to be important for human capital deepening. As people become better educated and more knowledgeable, are there limits to how much additional benefit more education can provide? Why or why not?
27.
Describe some of the political and social tradeoffs that might occur when a less developed country adopts a strategy to promote labor force participation and economic growth via investment in girls’ education.
28.
Why is investing in girls’ education beneficial for growth?
29.
How is the concept of technology, as defined with the aggregate production function, different from our everyday use of the word?
30.
What sorts of policies can governments implement to encourage convergence?
31.
As technological change makes us more sedentary and food costs increase, obesity is likely. What factors do you think may limit obesity?
7.11: Problems
32.
An economy starts off with a GDP per capita of \$5,000. How large will the GDP per capita be if it grows at an annual rate of 2% for 20 years? 2% for 40 years? 4% for 40 years? 6% for 40 years?
33.
An economy starts off with a GDP per capita of 12,000 euros. How large will the GDP per capita be if it grows at an annual rate of 3% for 10 years? 3% for 30 years? 6% for 30 years?
34.
Say that the average worker in Canada has a productivity level of \$30 per hour while the average worker in the United Kingdom has a productivity level of \$25 per hour (both measured in U.S. dollars). Over the next five years, say that worker productivity in Canada grows at 1% per year while worker productivity in the UK grows 3% per year. After five years, who will have the higher productivity level, and by how much?
35.
Say that the average worker in the U.S. economy is eight times as productive as an average worker in Mexico. If the productivity of U.S. workers grows at 2% for 25 years and the productivity of Mexico’s workers grows at 6% for 25 years, which country will have higher worker productivity at that point? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/07%3A_Economic_Growth/7.08%3A_Self-Check_Questions.txt |
Figure 8.1 Out of Business Borders was one of the many companies unable to recover from the 2008-2009 economic recession. (Credit: modification of "Factory Automation Robotics Palettizing Bread" by KUKA Roboter GmbH/Wikimedia Commons, Public Domain)
Chapter Objectives
In this chapter, you will learn about:
• How Economists Define and Compute Unemployment Rate
• Patterns of Unemployment
• What Causes Changes in Unemployment over the Short Run
• What Causes Changes in Unemployment over the Long Run
Bring It Home
Unemployment and the COVID-19 Pandemic: A Complicated Story
It was the most abrupt economic change in the post-World War II era. Between March 2020 and April 2020, the U.S. unemployment rate increased from 4.4% to 14.8%. As a result of the COVID-19 pandemic, millions of people were left without work as businesses shut down and people stayed home and cut their spending, especially on restaurants, tourism, and travel. As confidence and spending were slowly restored, and as the situation with the virus steadily improved, unemployment began to tick down. By 2022, with the availability of vaccines and boosters and other improved health measures, things were better still, but the presence of dangerous variants prevented a full return to normal.
The COVID-19 pandemic had other effects on the labor market as well. Labor force participation—the rate at which people are employed or actively searching for work—declined and as of early-2022 remained lower than it was in 2019. Some were forced to stop working because of school and childcare closures. Others were concerned about how safe their workplaces would be in the middle of a global pandemic. And still others simply chose to retire early. Labor force participation remains a sore spot in the labor market's recovery.
These two statistics—unemployment and labor force participation—show how complicated the labor market can be. As the unemployment rate declined through 2021, the disappointing statistics on labor force participation show weak points. One day you may have read a headline about how easy it was to find a job, and the next day a headline would describe how difficult it was for employers to find workers. By the end of this chapter, you will be in a much better position to make sense of these events.
Unemployment can be a terrible and wrenching life experience—like a serious automobile accident or a messy divorce—whose consequences only someone who has gone through it can fully understand. For unemployed individuals and their families, there is the day-to-day financial stress of not knowing from where the next paycheck is coming. There are painful adjustments, like watching your savings account dwindle, selling a car and buying a cheaper one, or moving to a less expensive place to live. Even when the unemployed person finds a new job, it may pay less than the previous one. For many people, their job is an important part of their self worth. When unemployment separates people from the workforce, it can affect family relationships as well as mental and physical health.
The human costs of unemployment alone would justify making a low level of unemployment an important public policy priority. However, unemployment also includes economic costs to the broader society. When millions of unemployed but willing workers cannot find jobs, economic resource are unused. An economy with high unemployment is like a company operating with a functional but unused factory. The opportunity cost of unemployment is the output that the unemployed workers could have produced.
This chapter will discuss how economists define and compute the unemployment rate. It will examine the patterns of unemployment over time, for the U.S. economy as a whole, for different demographic groups in the U.S. economy, and for other countries. It will then consider an economic explanation for unemployment, and how it explains the patterns of unemployment and suggests public policies for reducing it. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/08%3A_Unemployment/8.01%3A_Introduction_to_Unemployment.txt |
Learning Objectives
By the end of this section, you will be able to:
• Calculate the labor force participation rate and the unemployment rate
• Explain hidden unemployment and what it means to be in or out of the labor force
• Evaluate the collection and interpretation of unemployment data
Newspaper or television reports typically describe unemployment as a percentage or a rate. A recent report might have said, for example, from September 2021 to October 2021, the U.S. unemployment rate declined from 4.8% to 4.6%. At a glance, the changes between the percentages may seem small. However, remember that the U.S. economy has about 162 million adults (as of the beginning of 2022) who either have jobs or are looking for them. A rise or fall of just 0.1% in the unemployment rate of 162 million potential workers translates into 160,000 people, which is roughly the total population of a city like Syracuse, New York, Brownsville, Texas, or Pasadena, California. Large rises in the unemployment rate mean large numbers of job losses. In April 2020, at the peak of the pandemic-induced recession, over 20 million people were out of work. Even with the unemployment rate at 4.2% in November 2021, about 7 million people who were looking for jobs were out of work.
Link It Up
The Bureau of Labor Statistics tracks and reports all data related to unemployment.
Who’s In or Out of the Labor Force?
Should we count everyone without a job as unemployed? Of course not. For example, we should not count children as unemployed. Surely, we should not count the retired as unemployed. Many full-time college students have only a part-time job, or no job at all, but it seems inappropriate to count them as suffering the pains of unemployment. Some people are not working because they are rearing children, ill, on vacation, or on parental leave.
The point is that we do not just divide the adult population into employed and unemployed. A third group exists: people who do not have a job, and for some reason—retirement, looking after children, taking a voluntary break before a new job—are not interested in having a job, either. It also includes those who do want a job but have quit looking, often due to discouragement due to their inability to find suitable employment. Economists refer to this third group of those who are not working and not looking for work as out of the labor force or not in the labor force.
The U.S. unemployment rate, which is based on a monthly survey carried out by the U.S. Bureau of the Census, asks a series of questions to divide the adult population into employed, unemployed, or not in the labor force. To be classified as unemployed, a person must be without a job, currently available to work, and actively looking for work in the previous four weeks. Thus, a person who does not have a job but who is not currently available to work or has not actively looked for work in the last four weeks is counted as out of the labor force.
Employed: currently working for pay
Unemployed: Out of work and actively looking for a job
Out of the labor force: Out of paid work and not actively looking for a job
Labor force: the number of employed plus the unemployed
Calculating the Unemployment Rate
Figure 8.2 shows the three-way division of the 16-and-over population. In January 2017, about 62.9% of the adult population was "in the labor force"; that is, people are either employed or without a job but looking for work. We can divide those in the labor force into the employed and the unemployed. Table 8.1 shows those values. The unemployment rate is not the percentage of the total adult population without jobs, but rather the percentage of adults who are in the labor force but who do not have jobs:
$Unemployment rate=Unemployed peopleTotal labor force × 100Unemployment rate=Unemployed peopleTotal labor force × 100$
Figure 8.2 Employed, Unemployed, and Out of the Labor Force Distribution of Adult Population (age 16 and older), January 2021 The total adult, working-age population in January 2021 was 262.029 million. Out of this total population, 155.175 million were classified as employed, and 6.877 million were classified as unemployed. The remaining 99.977 million were classified as out of the labor force. As you will learn, however, this seemingly simple chart does not tell the whole story. As you will learn, however, this seemingly simple chart does not tell the whole story.
Total adult population over the age of 16 262.029 million
In the labor force 162.052 million (59.2%)
Employed 155.175 million
Unemployed 6.877 million
Out of the labor force 99.977 million (38.2%)
Table 8.1 U.S. Employment and Unemployment, November 2021 (Source: data.bls.gov)
In this example, we can calculate the unemployment rate as 7.635 million unemployed people divided by 159.716 million people in the labor force, which works out to a 4.8% rate of unemployment. The following Work It Out feature will walk you through the steps of this calculation.
Work It Out
Calculating Labor Force Percentages
How do economists arrive at the percentages in and out of the labor force and the unemployment rate? We will use the values in Table 8.1 to illustrate the steps.
To determine the percentage in the labor force:
Step 1. Divide the number of people in the labor force (159.716 million) by the total adult (working-age) population (254.082 million).
Step 2. Multiply by 100 to obtain the percentage.
$Percentage out of the labor force=159.716254.082=0.6286=62.9%Percentage out of the labor force=159.716254.082=0.6286=62.9%$
To determine the percentage out of the labor force:
Step 1. Divide the number of people out the labor force (94.366 million) by the total adult (working-age) population (254.082 million).
Step 2. Multiply by 100 to obtain the percentage.
$Percentage in the labor force=94.366254.082=0.3714=37.1%Percentage in the labor force=94.366254.082=0.3714=37.1%$
To determine the unemployment rate:
Step 1. Divide the number of unemployed people (7.635 million) by the total labor force (157 million).
Step 2. Multiply by 100 to obtain the rate.
$Unemployment rate=7.635159.716=0.0478 =4.8%Unemployment rate=7.635159.716=0.0478 =4.8%$
Hidden Unemployment
Even with the “out of the labor force” category, there are still some people who are mislabeled in the categorization of employed, unemployed, or out of the labor force. There are some people who have only part time or temporary jobs, and they are looking for full time and permanent employment that are counted as employed, although they are not employed in the way they would like or need to be. Additionally, there are individuals who are underemployed. This includes those who are trained or skilled for one type or level of work but are working in a lower paying job or one that does not utilize their skills. For example, we would consider an individual with a college degree in finance who is working as a sales clerk underemployed. They are, however, also counted in the employed group. All of these individuals fall under the umbrella of the term “hidden unemployment.” Discouraged workers, those who have stopped looking for employment and, hence, are no longer counted in the unemployed also fall into this group
Labor Force Participation Rate
Another important statistic is the labor force participation rate. This is the percentage of adults in an economy who are either employed or who are unemployed and looking for a job. Using the data in Figure 8.2 and Table 8.1, those included in this calculation would be the 162.052 million individuals in the labor force. We calculate the rate by taking the number of people in the labor force, that is, the number employed and the number unemployed, divided by the total adult population and multiplying by 100 to get the percentage. For the data from November 2021, the labor force participation rate is 61.8%. Historically, the civilian labor force participation rate in the United States climbed beginning in the 1960s as women increasingly entered the workforce, and it peaked at just over 67% in late 1999 to early 2000. Since then, the labor force participation rate has steadily declined, slowly to about 66% in 2008, early in the Great Recession, and then more rapidly during and after that recession. The labor force then climbed slowly during the 2010s but declined again during the pandemic in March–April 2020 and remained lower than pre-pandemic levels as of early 2022.
The Establishment Payroll Survey
When the unemployment report comes out each month, the Bureau of Labor Statistics (BLS) also reports on the number of jobs created—which comes from the establishment payroll survey. The payroll survey is based on a survey of about 147,000 businesses and government agencies throughout the United States. It generates payroll employment estimates by the following criteria: all employees, average weekly hours worked, and average hourly, weekly, and overtime earnings. One of the criticisms of this survey is that it does not count the self-employed. It also does not make a distinction between new, minimum wage, part time or temporary jobs and full time jobs with “decent” pay.
How Does the U.S. Bureau of Labor Statistics Collect the U.S. Unemployment Data?
The unemployment rate announced by the U.S. Bureau of Labor Statistics on the first Friday of each month for the previous month is based on the Current Population Survey (CPS), which the Bureau has carried out every month since 1940. The Bureau takes great care to make this survey representative of the country as a whole. The country is first divided into 3,137 areas. The U.S. Bureau of the Census then selects 729 of these areas to survey. It divides the 729 areas into districts of about 300 households each, and divides each district into clusters of about four dwelling units. Every month, Census Bureau employees call about 15,000 of the four-household clusters, for a total of 60,000 households. Employees interview households for four consecutive months, then rotate them out of the survey for eight months, and then interview them again for the same four months the following year, before leaving the sample permanently.
Based on this survey, state, industry, urban and rural areas, gender, age, race or ethnicity, and level of education statistics comprise components that contribute to unemployment rates. A wide variety of other information is available, too. For example, how long have people been unemployed? Did they become unemployed because they quit, or were laid off, or their employer went out of business? Is the unemployed person the only wage earner in the family? The Current Population Survey is a treasure trove of information about employment and unemployment. If you are wondering what the difference is between the CPS and EPS, read the following Clear it Up feature.
Clear It Up
What is the difference between CPS and EPS?
The United States Census Bureau conducts the Current Population Survey (CPS), which measures the percentage of the labor force that is unemployed. The Bureau of Labor Statistics' establishment payroll survey (EPS) is a payroll survey that measures the net change in jobs created for the month.
Criticisms of Measuring Unemployment
There are always complications in measuring the number of unemployed. For example, what about people who do not have jobs and would be available to work, but are discouraged by the lack of available jobs in their area and stopped looking? Such people, and their families, may be suffering the pains of unemployment. However, the survey counts them as out of the labor force because they are not actively looking for work. Other people may tell the Census Bureau that they are ready to work and looking for a job but, truly, they are not that eager to work and are not looking very hard at all. They are counted as unemployed, although they might more accurately be classified as out of the labor force. Still other people may have a job, perhaps doing something like yard work, child care, or cleaning houses, but are not reporting the income earned to the tax authorities. They may report being unemployed, when they actually are working.
Although the unemployment rate gets most of the public and media attention, economic researchers at the Bureau of Labor Statistics publish a wide array of surveys and reports that try to measure these kinds of issues and to develop a more nuanced and complete view of the labor market. It is not exactly a hot news flash that economic statistics are imperfect. Even imperfect measures like the unemployment rate, however, can still be quite informative, when interpreted knowledgeably and sensibly.
Link It Up
Click here to learn more about the CPS and to read frequently asked questions about employment and labor. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/08%3A_Unemployment/8.02%3A_How_Economists_Define_and_Compute_Unemployment_Rate.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain historical patterns of unemployment in the U.S.
• Identify trends of unemployment based on demographics
• Evaluate global unemployment rates
Let’s look at how unemployment rates have changed over time and how various groups of people are affected by unemployment differently.
The Historical U.S. Unemployment Rate
Figure 8.3 shows the historical pattern of U.S. unemployment since 1955.
Figure 8.3 The U.S. Unemployment Rate, 1948–2020 The U.S. unemployment rate moves up and down as the economy moves in and out of recessions. However, over time, the unemployment rate seems to return to a range of 4% to 6%. There does not seem to be a long-term trend toward the rate moving generally higher or generally lower. (Source: Federal Reserve Economic Data (FRED) research.stlouisfed.org/fred...UN64TTUSA156S0)
As we look at this data, several patterns stand out:
1. Unemployment rates do fluctuate over time. During the deep recessions of the early 1980s, 2007–2009, and 2021, unemployment reached roughly 10%. For comparison, during the 1930s Great Depression, the unemployment rate reached almost 25% of the labor force.
2. Unemployment rates in the late 1990s and into the mid-2000s were rather low by historical standards. The unemployment rate was below 5% from 1997 to 2000, and near 5% during almost all of 2006–2007, and 5% or less from September 2015 through March 2020. The previous time unemployment had been less than 5% for three consecutive years was three decades earlier, from 1968 to 1970.
3. The unemployment rate never falls all the way to zero. It almost never seems to get below 3%—and it stays that low only for very short periods. (We discuss reasons why this is the case later in this chapter.)
4. The timing of rises and falls in unemployment matches fairly well with the timing of upswings and downswings in the overall economy, except that unemployment tends to lag changes in economic activity, and especially so during upswings of the economy following a recession. During periods of recession and depression, unemployment is high. During periods of economic growth, unemployment tends to be lower.
5. No significant upward or downward trend in unemployment rates is apparent. This point is especially worth noting because the U.S. population more than quadrupled from 76 million in 1900 to over 324 million by 2017. Moreover, a higher proportion of U.S. adults are now in the paid workforce, because women have entered the paid labor force in significant numbers in recent decades. Women comprised 18% of the paid workforce in 1900 and nearly half of the paid workforce in 2021. However, despite the increased number of workers, as well as other economic events like globalization and the continuous invention of new technologies, the economy has provided jobs without causing any long-term upward or downward trend in unemployment rates.
Unemployment Rate from 1948. Similar to the graph in the figure above, the rate moves up and down as the economy moves in and out of recessions.
Unemployment Rates by Group
Unemployment is not distributed evenly across the U.S. population. Figure 8.4 shows unemployment rates broken down in various ways: by gender, age, and race/ethnicity.
Figure 8.4 Unemployment Rate by Demographic Group (a) By gender, 1948–2020. Unemployment rates for men used to be lower than unemployment rates for women, but in recent decades, the two rates have been very close, often– and especially during and soon after the Great Recession – with the unemployment rate for men somewhat higher. (b) By age, 1948–2020. Unemployment rates are highest for the very young and become lower with age. (c) By race and ethnicity, 1974–2020. Although unemployment rates for all groups tend to rise and fall together, the unemployment rate for Black people is typically about twice as high as that for White people, while the unemployment rate for Hispanic people is in between. (Source: www.bls.gov)
The unemployment rate for women had historically tended to be higher than the unemployment rate for men, perhaps reflecting the historical pattern that women were seen as “secondary” earners. By about 1980, however, the unemployment rate for women was essentially the same as that for men, as Figure 8.4 (a) shows. During the pandemic-induced recession of 2020 and in the immediate aftermath, the unemployment rate for women exceeded the unemployment rate for men. Subsequently, however, the gap has narrowed.
Link It Up
Read this report for detailed information on the 2008–2009 recession. It also provides some very useful information on the statistics of unemployment.
Younger workers tend to have higher unemployment, while middle-aged workers tend to have lower unemployment, probably because the middle-aged workers feel the responsibility of needing to have a job more heavily. Younger workers move in and out of jobs more than middle-aged workers, as part of the process of matching of workers and jobs, and this contributes to their higher unemployment rates. In addition, middle-aged workers are more likely to feel the responsibility of needing to have a job more heavily. Elderly workers have extremely low rates of unemployment, because those who do not have jobs often exit the labor force by retiring, and thus are not counted in the unemployment statistics. Figure 8.4 (b) shows unemployment rates for women divided by age. The pattern for men is similar.
The unemployment rate for African-Americans is substantially higher than the rate for other racial or ethnic groups, a fact that surely reflects, to some extent, a pattern of discrimination that has constrained Black people’s labor market opportunities. However, the gaps between unemployment rates for White, Black, and Hispanic people have diminished in the 1990s, as Figure 8.4 (c) shows. In fact, unemployment rates for Black and Hispanic people were at the lowest levels for several decades in the mid-2000s before rising during the recent Great Recession.
Finally, those with less education typically suffer higher unemployment. In November 2021, for example, the unemployment rate for those with a college degree was 2.3%; for those with some college but not a four year degree, the unemployment rate was 3.7%; for high school graduates with no additional degree, the unemployment rate was 5.2%; and for those without a high school diploma, the unemployment rate was 5.7%. This pattern arises because additional education typically offers better connections to the labor market and higher demand. With less attractive labor market opportunities for low-skilled workers compared to the opportunities for the more highly-skilled, including lower pay, low-skilled workers may be less motivated to find jobs.
Breaking Down Unemployment in Other Ways
The Bureau of Labor Statistics also gives information about the reasons for unemployment, as well as the length of time individuals have been unemployed. Table 8.2, for example, shows the four reasons for unemployment and the percentages of the currently unemployed that fall into each category. Table 8.3 shows the length of unemployment. For both of these, the data is from November 2021.(bls.gov)
Reason Percentage
New Entrants 6.5%
Re-entrants 31.8%
Job Leavers 12.5%
Job Losers: Temporary 11.8%
Job Losers: Non Temporary 37.3%
Table 8.2 Reasons for Unemployment, November 2021
Length of Time Percentage
Under 5 weeks 22.3%
5 to 14 weeks 22.3%
15 to 26 weeks 17.6%
Over 27 weeks 37.7%
Table 8.3 Length of Unemployment, November 2021
Link It Up
Watch this speech on the impact of droids on the labor market.
International Unemployment Comparisons
From an international perspective, the U.S. unemployment rate typically has looked a little better than average. Table 8.4 compares unemployment rates for 1991, 1996, 2001, 2006 (just before the Great Recession), and 2019 (just before the pandemic-induced recession) from several other high-income countries.
Country 1991 1996 2001 2006 2019
United States 6.8% 5.4% 4.8% 4.4% 3.7%
Canada 9.8% 8.8% 6.4% 6.2% 5.7%
Japan 2.1% 3.4% 5.1% 4.5% 2.4%
France 9.5% 12.5% 8.7% 10.1% 8.5%
Germany 5.6% 9.0% 8.9% 9.8% 3.1%
Italy 6.9% 11.7% 9.6% 7.8% 10.0%
Sweden 3.1% 9.9% 5.0% 5.2% 7.0%
United Kingdom 8.8% 8.1% 5.1% 5.5% 3.9%
Table 8.4 International Comparisons of Unemployment Rates
However, we need to treat cross-country comparisons of unemployment rates with care, because each country has slightly different definitions of unemployment, survey tools for measuring unemployment, and also different labor markets. For example, Japan’s unemployment rates appear quite low, but Japan’s economy has been mired in slow growth and recession since the late 1980s, and Japan’s unemployment rate probably paints too rosy a picture of its labor market. In Japan, workers who lose their jobs are often quick to exit the labor force and not look for a new job, in which case they are not counted as unemployed. In addition, Japanese firms are often quite reluctant to fire workers, and so firms have substantial numbers of workers who are on reduced hours or officially employed, but doing very little. We can view this Japanese pattern as an unusual method for society to provide support for the unemployed, rather than a sign of a healthy economy.
Link It Up
We hear about the Chinese economy in the news all the time. The value of the Chinese yuan in comparison to the U.S. dollar is likely to be part of the nightly business report, so why is the Chinese economy not included in this discussion of international unemployment? The lack of reliable statistics is the reason. This article explains why.
Comparing unemployment rates in the United States and other high-income economies with unemployment rates in Latin America, Africa, Eastern Europe, and Asia is very difficult. One reason is that the statistical agencies in many poorer countries lack the resources and technical capabilities of the U.S. Bureau of the Census. However, a more difficult problem with international comparisons is that in many low-income countries, most workers are not involved in the labor market through an employer who pays them regularly. Instead, workers in these countries are engaged in short-term work, subsistence activities, and barter. Moreover, the effect of unemployment is very different in high-income and low-income countries. Unemployed workers in the developed economies have access to various government programs like unemployment insurance, welfare, and food stamps. Such programs may barely exist in poorer countries. Although unemployment is a serious problem in many low-income countries, it manifests itself in a different way than in high-income countries. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/08%3A_Unemployment/8.03%3A_Patterns_of_Unemployment.txt |
Learning Objectives
By the end of this section, you will be able to:
• Analyze cyclical unemployment
• Explain the relationship between sticky wages and employment using various economic arguments
• Apply supply and demand models to unemployment and wages
We have seen that unemployment varies across times and places. What causes changes in unemployment? There are different answers in the short run and in the long run. Let's look at the short run first.
Cyclical Unemployment
Let’s make the plausible assumption that in the short run, from a few months to a few years, the quantity of hours that the average person is willing to work for a given wage does not change much, so the labor supply curve does not shift much. In addition, make the standard ceteris paribus assumption that there is no substantial short-term change in the age structure of the labor force, institutions and laws affecting the labor market, or other possibly relevant factors.
One primary determinant of the demand for labor from firms is how they perceive the state of the macro economy. If firms believe that business is expanding, then at any given wage they will desire to hire a greater quantity of labor, and the labor demand curve shifts to the right. Conversely, if firms perceive that the economy is slowing down or entering a recession, then they will wish to hire a lower quantity of labor at any given wage, and the labor demand curve will shift to the left. Economists call the variation in unemployment that the economy causes moving from expansion to recession or from recession to expansion (i.e. the business cycle) cyclical unemployment.
From the standpoint of the supply-and-demand model of competitive and flexible labor markets, unemployment represents something of a puzzle. In a supply-and-demand model of a labor market, as Figure 8.5 illustrates, the labor market should move toward an equilibrium wage and quantity. At the equilibrium wage (We), the equilibrium quantity (Qe) of labor supplied by workers should be equal to the quantity of labor demanded by employers.
Figure 8.5 The Unemployment and Equilibrium in the Labor Market In a labor market with flexible wages, the equilibrium will occur at wage We and quantity Qe, where the number of people who want jobs (shown by S) equals the number of jobs available (shown by D).
One possibility for unemployment is that people who are unemployed are those who are not willing to work at the current equilibrium wage, say \$10 an hour, but would be willing to work at a higher wage, like \$20 per hour. The monthly Current Population Survey would count these people as unemployed, because they say they are ready and looking for work (at \$20 per hour). However, from an economist’s perspective, these people are choosing to be unemployed.
Probably a few people are unemployed because of unrealistic expectations about wages, but they do not represent the majority of the unemployed. Instead, unemployed people often have friends or acquaintances of similar skill levels who are employed, and the unemployed would be willing to work at the jobs and wages similar to what those people are receiving. However, the employers of their friends and acquaintances do not seem to be hiring. In other words, these people are involuntarily unemployed. What causes involuntary unemployment?
Why Wages Might Be Sticky Downward
If a labor market model with flexible wages does not describe unemployment very well—because it predicts that anyone willing to work at the going wage can always find a job—then it may prove useful to consider economic models in which wages are not flexible or adjust only very slowly. In particular, even though wage increases may occur with relative ease, wage decreases are few and far between.
One set of reasons why wages may be “sticky downward,” as economists put it, involves economic laws and institutions. For low-skilled workers receiving minimum wage, it is illegal to reduce their wages. For union workers operating under a multiyear contract with a company, wage cuts might violate the contract and create a labor dispute or a strike. However, minimum wages and union contracts are not a sufficient reason why wages would be sticky downward for the U.S. economy as a whole. After all, out of the 73.3 million or so employed workers in the U.S. economy who earn wages by the hour, only about 1.1 million—less than 2% of the total—do not receive compensation above the minimum wage. Similarly, labor unions represent only about 12% of American wage and salary workers. In other high-income countries, more workers may have their wages determined by unions or the minimum wage may be set at a level that applies to a larger share of workers. However, for the United States, these two factors combined affect only about 15% or less of the labor force.
Economists looking for reasons why wages might be sticky downwards have focused on factors that may characterize most labor relationships in the economy, not just a few. Many have proposed a number of different theories, but they share a common tone.
One argument is that even employees who are not union members often work under an implicit contract, which is that the employer will try to keep wages from falling when the economy is weak or the business is having trouble, and the employee will not expect huge salary increases when the economy or the business is strong. This wage-setting behavior acts like a form of insurance: the employee has some protection against wage declines in bad times, but pays for that protection with lower wages in good times. Clearly, this sort of implicit contract means that firms will be hesitant to cut wages, lest workers feel betrayed and work less hard or even leave the firm.
Efficiency wage theory argues that workers' productivity depends on their pay, and so employers will often find it worthwhile to pay their employees somewhat more than market conditions might dictate. One reason is that employees who receive better pay than others will be more productive because they recognize that if they were to lose their current jobs, they would suffer a decline in salary. As a result, they are motivated to work harder and to stay with the current employer. In addition, employers know that it is costly and time-consuming to hire and train new employees, so they would prefer to pay workers a little extra now rather than to lose them and have to hire and train new workers. Thus, by avoiding wage cuts, the employer minimizes costs of training and hiring new workers, and reaps the benefits of well-motivated employees.
The adverse selection of wage cuts argument points out that if an employer reacts to poor business conditions by reducing wages for all workers, then the best workers, those with the best employment alternatives at other firms, are the most likely to leave. The least attractive workers, with fewer employment alternatives, are more likely to stay. Consequently, firms are more likely to choose which workers should depart, through layoffs and firings, rather than trimming wages across the board. Sometimes companies that are experiencing difficult times can persuade workers to take a pay cut for the short term, and still retain most of the firm’s workers. However, it is far more typical for companies to lay off some workers, rather than to cut wages for everyone.
The insider-outsider model of the labor force, in simple terms, argues that those already working for firms are “insiders,” while new employees, at least for a time, are “outsiders.” A firm depends on its insiders to keep the organization running smoothly, to be familiar with routine procedures, and to train new employees. However, cutting wages will alienate the insiders and damage the firm’s productivity and prospects.
Finally, the relative wage coordination argument points out that even if most workers were hypothetically willing to see a decline in their own wages in bad economic times as long as everyone else also experiences such a decline, there is no obvious way for a decentralized economy to implement such a plan. Instead, workers confronted with the possibility of a wage cut will worry that other workers will not have such a wage cut, and so a wage cut means being worse off both in absolute terms and relative to others. As a result, workers fight hard against wage cuts.
These theories of why wages tend not to move downward differ in their logic and their implications, and figuring out the strengths and weaknesses of each theory is an ongoing subject of research and controversy among economists. All tend to imply that wages will decline only very slowly, if at all, even when the economy or a business is having tough times. When wages are inflexible and unlikely to fall, then either short-run or long-run unemployment can result. Figure 8.6 illustrates this.
Figure 8.6 Sticky Wages in the Labor Market Because the wage rate is stuck at W, above the equilibrium, the number of those who want jobs (Qs) is greater than the number of job openings (Qd). The result is unemployment, shown by the bracket in the figure.
Figure 8.7 shows the interaction between shifts in labor demand and wages that are sticky downward. Figure 8.7 (a) illustrates the situation in which the demand for labor shifts to the right from D0 to D1. In this case, the equilibrium wage rises from W0 to W1 and the equilibrium quantity of labor hired increases from Q0 to Q1. It does not hurt employee morale at all for wages to rise.
Figure 8.7 (b) shows the situation in which the demand for labor shifts to the left, from D0 to D1, as it would tend to do in a recession. Because wages are sticky downward, they do not adjust toward what would have been the new equilibrium wage (W1), at least not in the short run. Instead, after the shift in the labor demand curve, the same quantity of workers is willing to work at that wage as before; however, the quantity of workers demanded at that wage has declined from the original equilibrium (Q0) to Q2. The gap between the original equilibrium quantity (Q0) and the new quantity demanded of labor (Q2) represents workers who would be willing to work at the going wage but cannot find jobs. The gap represents the economic meaning of unemployment.
Figure 8.7 Rising Wage and Low Unemployment: Where Is the Unemployment in Supply and Demand? (a) In a labor market where wages are able to rise, an increase in the demand for labor from D0 to D1 leads to an increase in equilibrium quantity of labor hired from Q0 to Q1 and a rise in the equilibrium wage from W0 to W1. (b) In a labor market where wages do not decline, a fall in the demand for labor from D0 to D1 leads to a decline in the quantity of labor demanded at the original wage (W0) from Q0 to Q2. These workers will want to work at the prevailing wage (W0), but will not be able to find jobs.
This analysis helps to explain the connection that we noted earlier: that unemployment tends to rise in recessions and to decline during expansions. The overall state of the economy shifts the labor demand curve and, combined with wages that are sticky downwards, unemployment changes. The rise in unemployment that occurs because of a recession is cyclical unemployment.
Link It Up
The St. Louis Federal Reserve Bank is the best resource for macroeconomic time series data, known as the Federal Reserve Economic Data (FRED). FRED provides complete data sets on various measures of the unemployment rate as well as the monthly Bureau of Labor Statistics report on the results of the household and employment surveys. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/08%3A_Unemployment/8.04%3A_What_Causes_Changes_in_Unemployment_over_the_Short_Run.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain frictional and structural unemployment
• Assess relationships between the natural rate of employment and potential real GDP, productivity, and public policy
• Identify recent patterns in the natural rate of employment
• Propose ways to combat unemployment
Cyclical unemployment explains why unemployment rises during a recession and falls during an economic expansion, but what explains the remaining level of unemployment even in good economic times? Why is the unemployment rate never zero? Even when the U.S. economy is growing strongly, the unemployment rate only rarely dips as low as 4%. Moreover, the discussion earlier in this chapter pointed out that unemployment rates in many European countries like Italy, France, and Germany have often been remarkably high at various times in the last few decades. Why does some level of unemployment persist even when economies are growing strongly? Why are unemployment rates continually higher in certain economies, through good economic years and bad? Economists have a term to describe the remaining level of unemployment that occurs even when the economy is healthy: they call it the natural rate of unemployment.
The Long Run: The Natural Rate of Unemployment
The natural rate of unemployment is not “natural” in the sense that water freezes at 32 degrees Fahrenheit or boils at 212 degrees Fahrenheit. It is not a physical and unchanging law of nature. Instead, it is only the “natural” rate because it is the unemployment rate that would result from the combination of economic, social, and political factors that exist at a time—assuming the economy was neither booming nor in recession. These forces include the usual pattern of companies expanding and contracting their workforces in a dynamic economy, social and economic forces that affect the labor market, or public policies that affect either the eagerness of people to work or the willingness of businesses to hire. Let’s discuss these factors in more detail.
Frictional Unemployment
In a market economy, some companies are always going broke for a variety of reasons: old technology; poor management; good management that happened to make bad decisions; shifts in tastes of consumers so that less of the firm’s product is desired; a large customer who went broke; or tough domestic or foreign competitors. Conversely, other companies will be doing very well for just the opposite reasons and looking to hire more employees. In a perfect world, all of those who lost jobs would immediately find new ones. However, in the real world, even if the number of job seekers is equal to the number of job vacancies, it takes time to find out about new jobs, to interview and figure out if the new job is a good match, or perhaps to sell a house and buy another in proximity to a new job. Economists call the unemployment that occurs in the meantime, as workers move between jobs, frictional unemployment. Frictional unemployment is not inherently a bad thing. It takes time on part of both the employer and the individual to match those looking for employment with the correct job openings. For individuals and companies to be successful and productive, you want people to find the job for which they are best suited, not just the first job offered.
In the mid-2000s, before the 2008–2009 recession, it was true that about 7% of U.S. workers saw their jobs disappear in any three-month period. However, in periods of economic growth, these destroyed jobs are counterbalanced for the economy as a whole by a larger number of jobs created. In 2019, for example, there were typically about 6 million unemployed people at any given time in the U.S. economy. Even though about two-thirds of those unemployed people found a job in 14 weeks or fewer, the unemployment rate did not change much during the year, because those who found new jobs were largely offset by others who lost jobs.
Of course, it would be preferable if people who were losing jobs could immediately and easily move into newly created jobs, but in the real world, that is not possible. Someone who is laid off by a textile mill in South Carolina cannot turn around and immediately start working for a textile mill in California. Instead, the adjustment process happens in ripples. Some people find new jobs near their old ones, while others find that they must move to new locations. Some people can do a very similar job with a different company, while others must start new career paths. Some people may be near retirement and decide to look only for part-time work, while others want an employer that offers a long-term career path. The frictional unemployment that results from people moving between jobs in a dynamic economy may account for one to two percentage points of total unemployment.
The level of frictional unemployment will depend on how easy it is for workers to learn about alternative jobs, which may reflect the ease of communications about job prospects in the economy. The extent of frictional unemployment will also depend to some extent on how willing people are to move to new areas to find jobs—which in turn may depend on history and culture.
Frictional unemployment and the natural rate of unemployment also seem to depend on the age distribution of the population. Figure 8.4 (b) showed that unemployment rates are typically lower for people between 25–54 years of age or aged 55 and over than they are for those who are younger. “Prime-age workers,” as those in the 25–54 age bracket are sometimes called, are typically at a place in their lives when they want to have a job and income arriving at all times. In addition, older workers who lose jobs may prefer to opt for retirement. By contrast, it is likely that a relatively high proportion of those who are under 25 will be trying out jobs and life options, and this leads to greater job mobility and hence higher frictional unemployment. Thus, a society with a relatively high proportion of young workers, like the U.S. beginning in the mid-1960s when Baby Boomers began entering the labor market, will tend to have a higher unemployment rate than a society with a higher proportion of its workers in older ages.
Structural Unemployment
Another factor that influences the natural rate of unemployment is the amount of structural unemployment. The structurally unemployed are individuals who have no jobs because they lack skills valued by the labor market, either because demand has shifted away from the skills they do have, or because they never learned any skills. An example of the former would be the unemployment among aerospace engineers after the U.S. space program downsized in the 1970s. An example of the latter would be high school dropouts.
Some people worry that technology causes structural unemployment. In the past, new technologies have put lower skilled employees out of work, but at the same time they create demand for higher skilled workers to use the new technologies. Education seems to be the key in minimizing the amount of structural unemployment. Individuals who have degrees can be retrained if they become structurally unemployed. For people with no skills and little education, that option is more limited.
Natural Unemployment and Potential Real GDP
The natural unemployment rate is related to two other important concepts: full employment and potential real GDP. Economists consider the economy to be at full employment when the actual unemployment rate is equal to the natural unemployment rate. When the economy is at full employment, real GDP is equal to potential real GDP. By contrast, when the economy is below full employment, the unemployment rate is greater than the natural unemployment rate and real GDP is less than potential. Finally, when the economy is above full employment, then the unemployment rate is less than the natural unemployment rate and real GDP is greater than potential. Operating above potential is only possible for a short while, since it is analogous to all workers working overtime.
Productivity Shifts and the Natural Rate of Unemployment
Unexpected shifts in productivity can have a powerful effect on the natural rate of unemployment. Over time, workers' productivity determines the level of wages in an economy. After all, if a business paid workers more than could be justified by their productivity, the business will ultimately lose money and go bankrupt. Conversely, if a business tries to pay workers less than their productivity then, in a competitive labor market, other businesses will find it worthwhile to hire away those workers and pay them more.
However, adjustments of wages to productivity levels will not happen quickly or smoothly. Employers typically review wages only once or twice a year. In many modern jobs, it is difficult to measure productivity at the individual level. For example, how precisely would one measure the quantity produced by an accountant who is one of many people working in the tax department of a large corporation? Because productivity is difficult to observe, employers often determine wage increases based on recent experience with productivity. If productivity has been rising at, say, 2% per year, then wages rise at that level as well. However, when productivity changes unexpectedly, it can affect the natural rate of unemployment for a time.
The U.S. economy in the 1970s and 1990s provides two vivid examples of this process. In the 1970s, productivity growth slowed down unexpectedly (as we discussed in Economic Growth). For example, output per hour of U.S. workers in the business sector increased at an annual rate of 3.3% per year from 1960 to 1973, but only 0.8% from 1973 to 1982. Figure 8.8 (a) illustrates the situation where the demand for labor—that is, the quantity of labor that business is willing to hire at any given wage—has been shifting out a little each year because of rising productivity, from D0 to D1 to D2. As a result, equilibrium wages have been rising each year from W0 to W1 to W2. However, when productivity unexpectedly slows down, the pattern of wage increases does not adjust right away. Wages keep rising each year from W2 to W3 to W4, but the demand for labor is no longer shifting up. A gap opens where the quantity of labor supplied at wage level W4 is greater than the quantity demanded. The natural rate of unemployment rises. In the aftermath of this unexpectedly low productivity in the 1970s, the national unemployment rate did not fall below 7% from May, 1980 until 1986. Over time, the rise in wages will adjust to match the slower gains in productivity, and the unemployment rate will ease back down, but this process may take years.
Figure 8.8 Unexpected Productivity Changes and Unemployment (a) Productivity is rising, increasing the demand for labor. Employers and workers become used to the pattern of wage increases. Then productivity suddenly stops increasing. However, the expectations of employers and workers for wage increases do not shift immediately, so wages keep rising as before. However, the demand for labor has not increased, so at wage W4, unemployment exists where the quantity supplied of labor exceeds the quantity demanded. (b) The rate of productivity increase has been zero for a time, so employers and workers have come to accept the equilibrium wage level (W). Then productivity increases unexpectedly, shifting demand for labor from D0 to D1. At the wage (W), this means that the quantity demanded of labor exceeds the quantity supplied, and with job offers plentiful, the unemployment rate will be low.
The late 1990s provide an opposite example: instead of the surprise decline in productivity that occurred in the 1970s, productivity unexpectedly rose in the mid-1990s. The annual growth rate of real output per hour of labor increased from 1.7% from 1980–1995, to an annual rate of 2.6% from 1995–2001. Let’s simplify the situation a bit, so that the economic lesson of the story is easier to see graphically, and say that productivity had not been increasing at all in earlier years, so the intersection of the labor market was at point E in Figure 8.8 (b), where the demand curve for labor (D0) intersects the supply curve for labor. As a result, real wages were not increasing. Now, productivity jumps upward, which shifts the demand for labor out to the right, from D0 to D1. At least for a time, however, wages are still set according to the earlier expectations of no productivity growth, so wages do not rise. The result is that at the prevailing wage level (W), the quantity of labor demanded (Qd) will for a time exceed the quantity of labor supplied (Qs), and unemployment will be very low—actually below the natural level of unemployment for a time. This pattern of unexpectedly high productivity helps to explain why the unemployment rate stayed below 4.5%—quite a low level by historical standards—from 1998 until after the U.S. economy had entered a recession in 2001.
Levels of unemployment will tend to be somewhat higher on average when productivity is unexpectedly low, and conversely, will tend to be somewhat lower on average when productivity is unexpectedly high. However, over time, wages do eventually adjust to reflect productivity levels.
Public Policy and the Natural Rate of Unemployment
Public policy can also have a powerful effect on the natural rate of unemployment. On the supply side of the labor market, public policies to assist the unemployed can affect how eager people are to find work. For example, if a worker who loses a job is guaranteed a generous package of unemployment insurance, welfare benefits, food stamps, and government medical benefits, then the opportunity cost of unemployment is lower and that worker will be less eager to seek a new job.
What seems to matter most is not just the amount of these benefits, but how long they last. A society that provides generous help for the unemployed that cuts off after, say, six months, may provide less of an incentive for unemployment than a society that provides less generous help that lasts for several years. Conversely, government assistance for job search or retraining can in some cases encourage people back to work sooner. See the Clear it Up to learn how the U.S. handles unemployment insurance.
Clear It Up
How does U.S. unemployment insurance work?
Unemployment insurance is a joint federal–state program that the federal government enacted in 1935. While the federal government sets minimum standards for the program, state governments conduct most of the administration.
The funding for the program is a federal tax collected from employers. The federal government requires tax collection on the first \$7,000 in wages paid to each worker; however, states can choose to collect the tax on a higher amount if they wish, and 41 states have set a higher limit. States can choose the length of time that they pay benefits, although most states limit unemployment benefits to 26 weeks—with extensions possible in times of especially high unemployment. The states then use the fund to pay benefits to those who become unemployed. Average unemployment benefits are equal to about one-third of the wage that the person earned in their previous job, but the level of unemployment benefits varies considerably across states.
Bottom 10 States That Pay the Lowest Benefit per Week Top 10 States That Pay the Highest Benefit per Week
Michigan \$362 Washington \$929
North Carolina \$350 Massachusetts \$823
South Carolina \$326 Minnesota \$740
Missouri \$320 New Jersey \$713
Florida \$275 Connecticut \$649
Tennessee \$275 Oregon \$648
Alabama \$275 Hawaii \$648
Louisiana \$275 North Dakota \$618
Arizona \$240 Colorado \$618
Mississippi \$235 Rhode Island \$586
Table 8.5 Maximum Weekly Unemployment Benefits by State in 2021
One other interesting thing to note about the classifications of unemployment—an individual does not have to collect unemployment benefits to be classified as unemployed. While there are statistics kept and studied relating to how many people are collecting unemployment insurance, this is not the source of unemployment rate information.
Link It Up
View this article for an explanation of exactly who is eligible for unemployment benefits.
On the demand side of the labor market, government rules, social institutions, and the presence of unions can affect the willingness of firms to hire. For example, if a government makes it hard for businesses to start up or to expand, by wrapping new businesses in bureaucratic red tape, then businesses will become more discouraged about hiring. Government regulations can make it harder to start a business by requiring that a new business obtain many permits and pay many fees, or by restricting the types and quality of products that a company can sell. Other government regulations, like zoning laws, may limit where companies can conduct business, or whether businesses are allowed to be open during evenings or on Sunday.
Whatever defenses may be offered for such laws in terms of social value—like the value some Christians place on not working on Sunday, or Orthodox Jews or highly observant Muslims on Saturday—these kinds of restrictions impose a barrier between some willing workers and other willing employers, and thus contribute to a higher natural rate of unemployment. Similarly, if government makes it difficult to fire or lay off workers, businesses may react by trying not to hire more workers than strictly necessary—since laying these workers off would be costly and difficult. High minimum wages may discourage businesses from hiring low-skill workers. Government rules may encourage and support powerful unions, which can then push up wages for union workers, but at a cost of discouraging businesses from hiring those workers.
The Natural Rate of Unemployment in Recent Years
The underlying economic, social, and political factors that determine the natural rate of unemployment can change over time, which means that the natural rate of unemployment can change over time, too.
Estimates by economists of the natural rate of unemployment in the U.S. economy in the early 2000s run at about 4.5 to 5.5%. This is a lower estimate than earlier. We outline three of the common reasons that economists propose for this change below.
1. The internet has provided a remarkable new tool through which job seekers can find out about jobs at different companies and can make contact with relative ease. An internet search is far easier than trying to find a list of local employers and then hunting up phone numbers for all of their human resources departments, and requesting a list of jobs and application forms. Social networking sites such as LinkedIn have changed how people find work as well.
2. The growth of the temporary worker industry has probably helped to reduce the natural rate of unemployment. In the early 1980s, only about 0.5% of all workers held jobs through temp agencies. By the early 2000s, the figure had risen above 2%. Temp agencies can provide jobs for workers while they are looking for permanent work. They can also serve as a clearinghouse, helping workers find out about jobs with certain employers and getting a tryout with the employer. For many workers, a temp job is a stepping-stone to a permanent job that they might not have heard about or obtained any other way, so the growth of temp jobs will also tend to reduce frictional unemployment.
3. The aging of the “baby boom generation”—the especially large generation of Americans born between 1946 and 1964—meant that the proportion of young workers in the economy was relatively high in the 1970s, as the boomers entered the labor market, but is relatively low today. As we noted earlier, middle-aged and older workers are far more likely to experience low unemployment than younger workers, a factor that tends to reduce the natural rate of unemployment as the baby boomers age.
The combined result of these factors is that the natural rate of unemployment was on average lower in the 1990s and the early 2000s than in the 1980s. The 2008–2009 Great Recession pushed monthly unemployment rates up to 10% in late 2009. However, even at that time, the Congressional Budget Office was forecasting that by 2015, unemployment rates would fall back to about 5%. During the first two months of 2020, the unemployment rate held steady at 3.5%. As of the first quarter of 2022, the Congressional Budget Office estimates the natural rate to be 4.6%.
The Natural Rate of Unemployment in Europe
By the standards of other high-income economies, the natural rate of unemployment in the U.S. economy appears relatively low. Through good economic years and bad, many European economies have had unemployment rates hovering near 10%, or even higher, since the 1970s. European rates of unemployment have been higher not because recessions in Europe have been deeper, but rather because the conditions underlying supply and demand for labor have been different in Europe, in a way that has created a much higher natural rate of unemployment.
Many European countries have a combination of generous welfare and unemployment benefits, together with nests of rules that impose additional costs on businesses when they hire. In addition, many countries have laws that require firms to give workers months of notice before laying them off and to provide substantial severance or retraining packages after laying them off. The legally required notice before laying off a worker can be more than three months in Spain, Germany, Denmark, and Belgium, and the legally required severance package can be as high as a year’s salary or more in Austria, Spain, Portugal, Italy, and Greece. Such laws will surely discourage laying off or firing current workers. However, when companies know that it will be difficult to fire or lay off workers, they also become hesitant about hiring in the first place.
We can attribute the typically higher levels of unemployment in many European countries in recent years, which have prevailed even when economies are growing at a solid pace, to the fact that the sorts of laws and regulations that lead to a high natural rate of unemployment are much more prevalent in Europe than in the United States.
A Preview of Policies to Fight Unemployment
The Government Budgets and Fiscal Policy and Macroeconomic Policy Around the World chapters provide a detailed discussion of how to fight unemployment, when we can discuss these policies in the context of the full array of macroeconomic goals and frameworks for analysis. However, even at this preliminary stage, it is useful to preview the main issues concerning policies to fight unemployment.
The remedy for unemployment will depend on the diagnosis. Cyclical unemployment is a short-term problem, caused because the economy is in a recession. Thus, the preferred solution will be to avoid or minimize recessions. As Government Budgets and Fiscal Policy discusses, governments can enact this policy by stimulating the overall buying power in the economy, so that firms perceive that sales and profits are possible, which makes them eager to hire.
Dealing with the natural rate of unemployment is trickier. In a market-oriented economy, firms will hire and fire workers. Governments cannot control this. Furthermore, the evolving age structure of the economy's population, or unexpected shifts in productivity are beyond a government's control and, will affect the natural rate of unemployment for a time. However, as the example of high ongoing unemployment rates for many European countries illustrates, government policy clearly can affect the natural rate of unemployment that will persist even when GDP is growing.
When a government enacts policies that will affect workers or employers, it must examine how these policies will affect the information and incentives employees and employers have to find one another. For example, the government may have a role to play in helping some of the unemployed with job searches. Governments may need to rethink the design of their programs that offer assistance to unemployed workers and protections to employed workers so that they will not unduly discourage the supply of labor. Similarly, governments may need to reassess rules that make it difficult for businesses to begin or to expand so that they will not unduly discourage the demand for labor. The message is not that governments should repeal all laws affecting labor markets, but only that when they enact such laws, a society that cares about unemployment will need to consider the tradeoffs involved.
Bring It Home
Unemployment and the COVID-19 Pandemic
Almost two years after the pandemic began, the unemployment rate was on track to go below 4% again by early- to mid-2022. While this is great news for workers, we have also seen that the story of the labor market is more complicated than a single statistic might suggest. Millions remained out of the labor force due to the public health situation, and the percentage of workers unemployed for longer than 26 weeks was still high.
The shift to remote work helped the unemployment rate come down by providing greater flexibility for workers concerned with their health and safety. But it didn't help workers, especially women, who continued to be burdened with excessive care responsibilities at home. During 2020, the unemployment rate for women exceeded that of men by over a full percentage point. Additionally, virus variants in other countries threatened to disrupt progress made at home and abroad.
The pandemic has helped shed light on how we can use information from all areas of the labor market to evaluate the health of the economy. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/08%3A_Unemployment/8.05%3A_What_Causes_Changes_in_Unemployment_over_the_Long_Run.txt |
adverse selection of wage cuts argument
if employers reduce wages for all workers, the best will leave
cyclical unemployment
unemployment closely tied to the business cycle, like higher unemployment during a recession
discouraged workers
those who have stopped looking for employment due to the lack of suitable positions available
efficiency wage theory
the theory that the productivity of workers, either individually or as a group, will increase if the employer pays them more
frictional unemployment
unemployment that occurs as workers move between jobs
implicit contract
an unwritten agreement in the labor market that the employer will try to keep wages from falling when the economy is weak or the business is having trouble, and the employee will not expect huge salary increases when the economy or the business is strong
insider-outsider model
those already working for the firm are “insiders” who know the procedures; the other workers are “outsiders” who are recent or prospective hires
labor force participation rate
this is the percentage of adults in an economy who are either employed or who are unemployed and looking for a job
natural rate of unemployment
the unemployment rate that would exist in a growing and healthy economy from the combination of economic, social, and political factors that exist at a given time
out of the labor force
those who are not working and not looking for work—whether they want employment or not; also termed “not in the labor force”
relative wage coordination argument
across-the-board wage cuts are hard for an economy to implement, and workers fight against them
structural unemployment
unemployment that occurs because individuals lack skills valued by employers
underemployed
individuals who are employed in a job that is below their skills
unemployment rate
the percentage of adults who are in the labor force and thus seeking jobs, but who do not have jobs
8.07: Key Concepts and Summary
8.1 How Economists Define and Compute Unemployment Rate
Unemployment imposes high costs. Unemployed individuals experience loss of income and stress. An economy with high unemployment suffers an opportunity cost of unused resources. We can divide the adult population into those in the labor force and those out of the labor force. In turn, we divide those in the labor force into employed and unemployed. A person without a job must be willing and able to work and actively looking for work to be counted as unemployed; otherwise, a person without a job is counted as out of the labor force. Economists define the unemployment rate as the number of unemployed persons divided by the number of persons in the labor force (not the overall adult population). The Current Population Survey (CPS) conducted by the United States Census Bureau measures the percentage of the labor force that is unemployed. The establishment payroll survey by the Bureau of Labor Statistics measures the net change in jobs created for the month.
8.2 Patterns of Unemployment
The U.S. unemployment rate rises during periods of recession and depression, but falls back to the range of 4% to 6% when the economy is strong. The unemployment rate never falls to zero. Despite enormous growth in the size of the U.S. population and labor force in the twentieth century, along with other major trends like globalization and new technology, the unemployment rate shows no long-term rising trend.
Unemployment rates differ by group: higher for African-Americans and Hispanic people than for White people; higher for less educated than more educated; higher for the young than the middle-aged. Women’s unemployment rates used to be higher than men’s, but in recent years men’s and women’s unemployment rates have been very similar. In recent years, unemployment rates in the United States have compared favorably with unemployment rates in most other high-income economies.
8.3 What Causes Changes in Unemployment over the Short Run
Cyclical unemployment rises and falls with the business cycle. In a labor market with flexible wages, wages will adjust in such a market so that quantity demanded of labor always equals the quantity supplied of labor at the equilibrium wage. Economists have proposed many theories for why wages might not be flexible, but instead may adjust only in a “sticky” way, especially when it comes to downward adjustments: implicit contracts, efficiency wage theory, adverse selection of wage cuts, insider-outsider model, and relative wage coordination.
8.4 What Causes Changes in Unemployment over the Long Run
The natural rate of unemployment is the rate of unemployment that the economic, social, and political forces in the economy would cause even when the economy is not in a recession. These factors include the frictional unemployment that occurs when people either choose to change jobs or are put out of work for a time by the shifts of a dynamic and changing economy. They also include any laws concerning conditions of hiring and firing that have the undesired side effect of discouraging job formation. They also include structural unemployment, which occurs when demand shifts permanently away from a certain type of job skill. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/08%3A_Unemployment/8.06%3A_Key_Terms.txt |
1.
Suppose the adult population over the age of 16 is 237.8 million and the labor force is 153.9 million (of whom 139.1 million are employed). How many people are “not in the labor force?” What are the proportions of employed, unemployed and not in the labor force in the population? Hint: Proportions are percentages.
2.
Using the above data, what is the unemployment rate? These data are U.S. statistics from 2010. How does it compare to the February 2015 unemployment rate computed earlier?
3.
Over the long term, has the U.S. unemployment rate generally trended up, trended down, or remained at basically the same level?
4.
Whose unemployment rates are commonly higher in the U.S. economy:
1. White or non-White people?
2. The young or the middle-aged?
3. College graduates or high school graduates?
5.
Beginning in the 1970s and continuing for three decades, women entered the U.S. labor force in a big way. If we assume that wages are sticky in a downward direction, but that around 1970 the demand for labor equaled the supply of labor at the current wage rate, what do you imagine happened to the wage rate, employment, and unemployment as a result of increased labor force participation?
6.
Is the increase in labor force participation rates among women better thought of as causing an increase in cyclical unemployment or an increase in the natural rate of unemployment? Why?
7.
Many college students graduate from college before they have found a job. When graduates begin to look for a job, they are counted as what category of unemployed?
8.09: Review Questions
8.
What is the difference between being unemployed and being out of the labor force?
9.
How do you calculate the unemployment rate? How do you calculate the labor force participation rate?
10.
Are all adults who do not hold jobs counted as unemployed?
11.
If you are out of school but working part time, are you considered employed or unemployed in U.S. labor statistics? If you are a full time student and working 12 hours a week at the college cafeteria are you considered employed or not in the labor force? If you are a senior citizen who is collecting social security and a pension and working as a greeter at Wal-Mart are you considered employed or not in the labor force?
12.
What happens to the unemployment rate when unemployed workers are reclassified as discouraged workers?
13.
What happens to the labor force participation rate when employed individuals are reclassified as unemployed? What happens when they are reclassified as discouraged workers?
14.
What are some of the problems with using the unemployment rate as an accurate measure of overall joblessness?
15.
What criteria do the BLS use to count someone as employed? As unemployed?
16.
Assess whether the following would be counted as “unemployed” in the Current Employment Statistics survey.
1. A husband willingly stays home with children while his wife works.
2. A manufacturing worker whose factory just closed down.
3. A college student doing an unpaid summer internship.
4. A retiree.
5. Someone who has been out of work for two years but keeps looking for a job.
6. Someone who has been out of work for two months but isn’t looking for a job.
7. Someone who hates her present job and is actively looking for another one.
8. Someone who decides to take a part time job because she could not find a full time position.
17.
Are U.S. unemployment rates typically higher, lower, or about the same as unemployment rates in other high-income countries?
18.
Are U.S. unemployment rates distributed evenly across the population?
19.
When would you expect cyclical unemployment to be rising? Falling?
20.
Why is there unemployment in a labor market with flexible wages?
21.
Name and explain some of the reasons why wages are likely to be sticky, especially in downward adjustments.
22.
What term describes the remaining level of unemployment that occurs even when the economy is healthy?
23.
What forces create the natural rate of unemployment for an economy?
24.
Would you expect the natural rate of unemployment to be roughly the same in different countries?
25.
Would you expect the natural rate of unemployment to remain the same within one country over the long run of several decades?
26.
What is frictional unemployment? Give examples of frictional unemployment.
27.
What is structural unemployment? Give examples of structural unemployment.
28.
After several years of economic growth, would you expect the unemployment in an economy to be mainly cyclical or mainly due to the natural rate of unemployment? Why?
29.
What type of unemployment (cyclical, frictional, or structural) applies to each of the following:
1. landscapers laid off in response to a drop in new housing construction during a recession.
2. coal miners laid off due to EPA regulations that shut down coal fired power
3. a financial analyst who quits his/her job in Chicago and is pursing similar work in Arizona
4. printers laid off due to drop in demand for printed catalogues and flyers as firms go the internet to promote an advertise their products.
5. factory workers in the U.S. laid off as the plants shut down and move to Mexico and Ireland. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/08%3A_Unemployment/8.08%3A_Self-Check_Questions.txt |
30.
Using the definition of the unemployment rate, is an increase in the unemployment rate necessarily a bad thing for a nation?
31.
Is a decrease in the unemployment rate necessarily a good thing for a nation? Explain.
32.
If many workers become discouraged from looking for jobs, explain how the number of jobs could decline but the unemployment rate could fall at the same time.
33.
Would you expect hidden unemployment to be higher, lower, or about the same when the unemployment rate is high, say 10%, versus low, say 4%? Explain.
34.
Is the higher unemployment rates for minority workers necessarily an indication of discrimination? What could be some other reasons for the higher unemployment rate?
35.
While unemployment is highly negatively correlated with the level of economic activity, in the real world it responds with a lag. In other words, firms do not immediately lay off workers in response to a sales decline. They wait a while before responding. Similarly, firms do not immediately hire workers when sales pick up. What do you think accounts for the lag in response time?
36.
Why do you think that unemployment rates are lower for individuals with more education?
37.
Do you think it is rational for workers to prefer sticky wages to wage cuts, when the consequence of sticky wages is unemployment for some workers? Why or why not? How do the reasons for sticky wages explained in this section apply to your argument?
38.
Under what condition would a decrease in unemployment be bad for the economy?
39.
Under what condition would an increase in the unemployment rate be a positive sign?
40.
As the baby boom generation retires, the ratio of retirees to workers will increase noticeably. How will this affect the Social Security program? How will this affect the standard of living of the average American?
41.
Unemployment rates have been higher in many European countries in recent decades than in the United States. Is the main reason for this long-term difference in unemployment rates more likely to be cyclical unemployment or the natural rate of unemployment? Explain briefly.
42.
Is it desirable to pursue a goal of zero unemployment? Why or why not?
43.
Is it desirable to eliminate natural unemployment? Why or why not? Hint: Think about what our economy would look like today and what assumptions would have to be met to have a zero rate of natural unemployment.
44.
The U.S. unemployment rate increased from 4.6% in July 2001 to 5.9% by June 2002. Without studying the subject in any detail, would you expect that a change of this kind is more likely to be due to cyclical unemployment or a change in the natural rate of unemployment? Why?
8.11: Problems
45.
A country with a population of eight million adults has five million employed, 500,000 unemployed, and the rest of the adult population is out of the labor force. What’s the unemployment rate? What share of population is in the labor force? Sketch a pie chart that divides the adult population into these three groups.
46.
A government passes a family-friendly law that no companies can have evening, nighttime, or weekend hours, so that everyone can be home with their families during these times. Analyze the effect of this law using a demand and supply diagram for the labor market: first assuming that wages are flexible, and then assuming that wages are sticky downward.
47.
As the baby boomer generation retires, what should happen to wages and employment? Can you show this graphically? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/08%3A_Unemployment/8.10%3A_Critical_Thinking_Questions.txt |
Figure 9.1 Big Bucks in Zimbabwe This bill was worth 100 billion Zimbabwean dollars when issued in 2008. There were even bills issued with a face value of 100 trillion Zimbabwean dollars. The bills had \$100,000,000,000,000 written on them. Unfortunately, they were almost worthless. At one point, 621,984,228 Zimbabwean dollars were equal to one U.S. dollar. Eventually, the country abandoned its own currency and allowed people to use foreign currency for purchases. (Credit: modification of "100 Billion Dollars" by Peat Bakke/Flickr, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Tracking Inflation
• How to Measure Changes in the Cost of Living
• How the U.S. and Other Countries Experience Inflation
• The Confusion Over Inflation
• Indexing and Its Limitations
Bring It Home
A \$550 Million Loaf of Bread?
If you were born within the last three decades in the United States, Canada, or many other countries in the developed world, you probably have no real experience with a high rate of inflation. Inflation is when most prices in an entire economy are rising. However, there is an extreme form of inflation called hyperinflation. This occurred in Germany between 1921 and 1928, and more recently in Zimbabwe between 2008 and 2009. In November 2008, Zimbabwe had an inflation rate of 79.6 billion percent. In contrast, in 2014, the United States had an average annual rate of inflation of 1.6%.
Zimbabwe’s inflation rate was so high it is difficult to comprehend, so let’s put it into context. It is equivalent to price increases of 98% per day. This means that, from one day to the next, prices essentially double. What is life like in an economy afflicted with hyperinflation? Most of you reading this will have never experienced this phenomenon. The government adjusted prices for commodities in Zimbabwean dollars several times each day. There was no desire to hold on to currency since it lost value by the minute. The people there spent a great deal of time getting rid of any cash they acquired by purchasing whatever food or other commodities they could find. At one point, a loaf of bread cost 550 million Zimbabwean dollars. Teachers' salaries were in the trillions a month; however, this was equivalent to only one U.S. dollar a day. At its height, it took 621,984,228 Zimbabwean dollars to purchase one U.S. dollar.
Government agencies had no money to pay their workers so they started printing money to pay their bills rather than raising taxes. Rising prices caused the government to enact price controls on private businesses, which led to shortages and the emergence of black markets. In 2009, the country abandoned its currency and allowed people to use foreign currencies for purchases.
How does this happen? How can both government and the economy fail to function at the most basic level? Before we consider these extreme cases of hyperinflation, let’s first look at inflation itself.
Inflation is a general and ongoing rise in the level of prices in an entire economy. Inflation does not refer to a change in relative prices. A relative price change occurs when you see that the price of tuition has risen, but the price of laptops has fallen. Inflation, on the other hand, means that there is pressure for prices to rise in most markets in the economy. In addition, price increases in the supply-and-demand model were one-time events, representing a shift from a previous equilibrium to a new one. Inflation implies an ongoing rise in prices. If inflation happened for one year and then stopped, then it would not be inflation any more.
This chapter begins by showing how to combine prices of individual goods and services to create a measure of overall inflation. It discusses the historical and recent experience of inflation, both in the United States and in other countries around the world. Other chapters have sometimes included a note under an exhibit or a parenthetical reminder in the text saying that the numbers have been adjusted for inflation. In this chapter, it is time to show how to use inflation statistics to adjust other economic variables, so that you can tell how much of, for example, we can attribute the rise in GDP over different periods of time to an actual increase in the production of goods and services and how much we should attribute to the fact that prices for most items have risen.
Inflation has consequences for people and firms throughout the economy, in their roles as lenders and borrowers, wage-earners, taxpayers, and consumers. The chapter concludes with a discussion of some imperfections and biases in the inflation statistics, and a preview of policies for fighting inflation that we will discuss in other chapters. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/09%3A_Inflation/9.01%3A_Introduction_to_Inflation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Calculate the annual rate of inflation
• Explain and use index numbers and base years when simplifying the total quantity spent over a year for products
• Calculate inflation rates using index numbers
Dinner table conversations where you might have heard about inflation usually entail reminiscing about when “everything seemed to cost so much less. You used to be able to buy three gallons of gasoline for a dollar and then go see an afternoon movie for another dollar.” Table 9.1 compares some prices of common goods in 1970 and 2017. Of course, the average prices in this table may not reflect the prices where you live. The cost of living in New York City is much higher than in Houston, Texas, for example. In addition, certain products have evolved over recent decades. A new car in 2021, loaded with antipollution equipment, safety gear, computerized engine controls, and many other technological advances, is a more advanced machine (and more fuel efficient) than your typical 1970s car. However, put details like these to one side for the moment, and look at the overall pattern. The primary reason behind the price rises in Table 9.1—and all the price increases for the other products in the economy—is not specific to the market for housing or cars or gasoline or movie tickets. Instead, it is part of a general rise in the level of all prices. At the beginning of 2021, \$1 had about the same purchasing power in overall terms of goods and services as 15 cents did in 1972, because of the amount of inflation that has occurred over that time period.
Items 1970 2021
Pound of ground beef \$0.66 \$5.96
Pound of butter \$0.87 \$3.50
Movie ticket \$1.55 \$13.70
Sales price of new home (median) \$22,000 \$408,800
New car \$3,000 \$42,000
Gallon of gasoline \$0.36 \$3.32
Average hourly wage for a manufacturing worker \$3.23 \$30.11
Per capita GDP \$5,069 \$63,543
Table 9.1 Price Comparisons, 1970 and 2021 (Sources: See chapter References at end of book.)
Moreover, the power of inflation does not affect just goods and services, but wages and income levels, too. The second-to-last row of Table 9.1 shows that the average hourly wage for a manufacturing worker increased nearly ten-fold from 1970 to 2021. The average worker in 2021 is better educated and more productive than the average worker in 1970—but not six times more productive. Per capita GDP increased substantially from 1970 to 2021, but is the average person in the U.S. economy really more than twelve times better off in just 51 years? Not likely.
A modern economy has millions of goods and services whose prices are continually quivering in the breezes of supply and demand. How can all of these shifts in price attribute to a single inflation rate? As with many problems in economic measurement, the conceptual answer is reasonably straightforward: Economists combine prices of a variety of goods and services into a single price level. The inflation rate is simply the percentage change in the price level. Applying the concept, however, involves some practical difficulties.
The Price of a Basket of Goods
To calculate the price level, economists begin with the concept of a basket of goods and services, consisting of the different items individuals, businesses, or organizations typically buy. The next step is to look at how the prices of those items change over time. In thinking about how to combine individual prices into an overall price level, many people find that their first impulse is to calculate the average of the prices. Such a calculation, however, could easily be misleading because some products matter more than others.
Changes in the prices of goods for which people spend a larger share of their incomes will matter more than changes in the prices of goods for which people spend a smaller share of their incomes. For example, an increase of 10% in the rental rate on housing matters more to most people than whether the price of carrots rises by 10%. To construct an overall measure of the price level, economists compute a weighted average of the prices of the items in the basket, where the weights are based on the actual quantities of goods and services people buy. The following Work It Out feature walks you through the steps of calculating the annual rate of inflation based on a few products.
Work It Out
Calculating an Annual Rate of Inflation
Consider the simple basket of goods with only three items, represented in Table 9.2. Say that in any given month, a college student spends money on 20 hamburgers, one bottle of aspirin, and five movies. The table provides prices for these items over four years through each time period (Pd). Prices of some goods in the basket may rise while others fall. In this example, the price of aspirin does not change over the four years, while movies increase in price and hamburgers bounce up and down. The table shows the cost of buying the given basket of goods at the prices prevailing at that time.
Items Hamburger Aspirin Movies Total Inflation Rate
Qty 20 1 bottle 5 - -
(Pd 1) Price \$3.00 \$10.00 \$6.00 - -
(Pd 1) Amount Spent \$60.00 \$10.00 \$30.00 \$100.00 -
(Pd 2) Price \$3.20 \$10.00 \$6.50 - -
(Pd 2) Amount Spent \$64.00 \$10.00 \$32.50 \$106.50 6.5%
(Pd 3) Price \$3.10 \$10.00 \$7.00 - -
(Pd 3) Amount Spent \$62.00 \$10.00 \$35.00 \$107.00 0.5%
(Pd 4) Price \$3.50 \$10.00 \$7.50 - -
(Pd 4) Amount Spent \$70.00 \$10.00 \$37.50 \$117.50 9.8%
Table 9.2 A College Student’s Basket of Goods
To calculate the annual rate of inflation in this example:
Step 1. Find the percentage change in the cost of purchasing the overall basket of goods between the time periods. The general equation for percentage changes between two years, whether in the context of inflation or in any other calculation, is:
$Level in new year – Level in previous yearLevel in previous year x 100 = Percentage changeLevel in new year – Level in previous yearLevel in previous year x 100 = Percentage change$
Step 2. From period 1 to period 2, the total cost of purchasing the basket of goods in Table 9.2 rises from \$100 to \$106.50. Therefore, the percentage change over this time—the inflation rate—is:
$106.50 – 100100.0 = 0.065 = 6.5%106.50 – 100100.0 = 0.065 = 6.5%$
Step 3. From period 2 to period 3, the overall change in the cost of purchasing the basket rises from \$106.50 to \$107. Thus, the inflation rate over this time, again calculated by the percentage change, is approximately:
$107 – 106.50106.50 = 0.0047 = 0.47%107 – 106.50106.50 = 0.0047 = 0.47%$
Step 4. From period 3 to period 4, the overall cost rises from \$107 to \$117.50. The inflation rate is thus:
$117.50 – 107107 = 0.098 = 9.8%117.50 – 107107 = 0.098 = 9.8%$
This calculation of the change in the total cost of purchasing a basket of goods accounts for how much a student spends on each good. Hamburgers are the lowest-priced good in this example, and aspirin is the highest-priced. If an individual buys a greater quantity of a low-price good, then it makes sense that changes in the price of that good should have a larger impact on the buying power of that person’s money. The larger impact of hamburgers shows up in the “amount spent” row, where, in all time periods, hamburgers are the largest item within the amount spent row.
Index Numbers
The numerical results of a calculation based on a basket of goods can get a little messy. The simplified example in Table 9.2 has only three goods and the prices are in even dollars, not numbers like 79 cents or \$124.99. If the list of products were much longer, and we used more realistic prices, the total quantity spent over a year might be some messy-looking number like \$17,147.51 or \$27,654.92.
To simplify the task of interpreting the price levels for more realistic and complex baskets of goods, economists typically report the price level in each period as an index number, rather than as the dollar amount for buying the basket of goods. Economists create price indices to calculate an overall average change in relative prices over time. To convert the money spent on the basket to an index number, economists arbitrarily choose one year to be the base year, or starting point from which we measure changes in prices. The base year, by definition, has an index number equal to 100. This sounds complicated, but it is really a simple math trick. In the example above, say that we choose time period 3 as the base year. Since the total amount of spending in that year is \$107, we divide that amount by itself (\$107) and multiply by 100. Again, this is because the index number in the base year always has to have a value of 100. Then, to figure out the values of the index number for the other years, we divide the dollar amounts for the other years by 1.07 as well. Note also that the dollar signs cancel out so that index numbers have no units.
Table 9.3 shows calculations for the other values of the index number, based on the example in Table 9.2. Because we calculate the index numbers so that they are in exactly the same proportion as the total dollar cost of purchasing the basket of goods, we can calculate the inflation rate based on the index numbers, using the percentage change formula. Thus, the inflation rate from period 1 to period 2 would be
$99.5 – 93.493.4 = 0.065 = 6.5%99.5 – 93.493.4 = 0.065 = 6.5%$
This is the same answer that we derived when measuring inflation based on the dollar cost of the basket of goods for the same time period.
Total Spending Index Number Inflation Rate Since Previous Period
Period 1 \$100 $1001.07 = 93.41001.07 = 93.4$
Period 2 \$106.50 $106.501.07 = 99.5106.501.07 = 99.5$ $99.5 – 93.493.4 = 0.065 = 6.5%99.5 – 93.493.4 = 0.065 = 6.5%$
Period 3 \$107 $1071.07 = 100.01071.07 = 100.0$ $100 – 99.599.5 = 0.005 = 0.5%100 – 99.599.5 = 0.005 = 0.5%$
Period 4 \$117.50 $117.501.07 = 109.8117.501.07 = 109.8$ $109.8 – 100100 = 0.098 = 9.8%109.8 – 100100 = 0.098 = 9.8%$
Table 9.3 Calculating Index Numbers When Period 3 is the Base Year
If the inflation rate is the same whether it is based on dollar values or index numbers, then why bother with the index numbers? The advantage is that indexing allows easier eyeballing of the inflation numbers. If you glance at two index numbers like 107 and 110, you know automatically that the rate of inflation between the two years is about, but not quite exactly equal to, 3%. By contrast, imagine that we express the price levels in absolute dollars of a large basket of goods, so that when you looked at the data, the numbers were \$19,493.62 and \$20,040.17. Most people find it difficult to eyeball those kinds of numbers and say that it is a change of about 3%. However, the two numbers expressed in absolute dollars are exactly in the same proportion of 107 to 110 as the previous example. If you’re wondering why simple subtraction of the index numbers wouldn’t work, read the following Clear It Up feature.
Clear It Up
Why do you not just subtract index numbers?
A word of warning: When a price index moves from, say, 107 to 110, the rate of inflation is not exactly 3%. Remember, the inflation rate is not derived by subtracting the index numbers, but rather through the percentage-change calculation. We calculate the precise inflation rate as the price index moves from 107 to 110 as 100 x (110 – 107) / 107 = 100 x 0.028 = 2.8%. When the base year is fairly close to 100, a quick subtraction is not a terrible shortcut to calculating the inflation rate—but when precision matters down to tenths of a percent, subtracting will not give the right answer.
Two final points about index numbers are worth remembering. First, index numbers have no dollar signs or other units attached to them. Although we can use index numbers to calculate a percentage inflation rate, the index numbers themselves do not have percentage signs. Index numbers just mirror the proportions that we find in other data. They transform the other data so that it is easier to work with the data.
Second, the choice of a base year for the index number—that is, the year that is automatically set equal to 100—is arbitrary. We choose it as a starting point from which we can track changes in prices. In the official inflation statistics, it is common to use one base year for a few years, and then to update it, so that the base year of 100 is relatively close to the present. However, any base year that we choose for the index numbers will result in exactly the same inflation rate. To see this in the previous example, imagine that period 1 is the base year when total spending was \$100, and we assign it an index number of 100. At a glance, you can see that the index numbers would now exactly match the dollar figures, and the inflation rate in the first period would be 6.5%.
Now that we see how indexes work to track inflation, the next module will show us how economists measure the cost of living.
Link It Up
Watch this video from the cartoon Duck Tales to view a mini-lesson on inflation. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/09%3A_Inflation/9.02%3A_Tracking_Inflation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Use the Consumer Price Index (CPI) to calculate U.S. inflation rates
• Identify several ways the Bureau of Labor Statistics avoids biases in the Consumer Price Index (CPI)
• Differentiate among the Consumer Price Index (CPI), the Producer Price Index (PPI), the International Price Index, the Employment Cost Index, and the GDP deflator.
The most commonly cited measure of inflation in the United States is the Consumer Price Index (CPI). Government statisticians at the U.S. Bureau of Labor Statistics calculate the CPI based on the prices in a fixed basket of goods and services that represents the purchases of the average family of four. In recent years, the statisticians have paid considerable attention to a subtle problem: that the change in the total cost of buying a fixed basket of goods and services over time is conceptually not quite the same as the change in the cost of living, because the cost of living represents how much it costs for a person to feel that their consumption provides an equal level of satisfaction or utility.
To understand the distinction, imagine that over the past 10 years, the cost of purchasing a fixed basket of goods increased by 25% and your salary also increased by 25%. Has your personal standard of living held constant? If you do not necessarily purchase an identical fixed basket of goods every year, then an inflation calculation based on the cost of a fixed basket of goods may be a misleading measure of how your cost of living has changed. Two problems arise here: substitution bias and quality/new goods bias.
When the price of a good rises, consumers tend to purchase less of it and to seek out substitutes instead. Conversely, as the price of a good falls, people will tend to purchase more of it. This pattern implies that goods with generally rising prices should tend over time to become less important in the overall basket of goods used to calculate inflation, while goods with falling prices should tend to become more important. Consider, as an example, a rise in the price of peaches by \$100 per pound. If consumers were utterly inflexible in their demand for peaches, this would lead to a big rise in the price of food for consumers. Alternatively, imagine that people are utterly indifferent to whether they have peaches or other types of fruit. Now, if peach prices rise, people completely switch to other fruit choices and the average price of food does not change at all. A fixed and unchanging basket of goods assumes that consumers are locked into buying exactly the same goods, regardless of price changes—not a very likely assumption. Thus, substitution bias—the rise in the price of a fixed basket of goods over time—tends to overstate the rise in a consumer’s true cost of living, because it does not take into account that the person can substitute away from goods whose relative prices have risen.
The other major problem in using a fixed basket of goods as the basis for calculating inflation is how to deal with the arrival of improved versions of older goods or altogether new goods. Consider the problem that arises if a cereal is improved by adding 12 essential vitamins and minerals—and also if a box of the cereal costs 5% more. It would clearly be misleading to count the entire resulting higher price as inflation, because the new price reflects a higher quality (or at least different) product. Ideally, one would like to know how much of the higher price is due to the quality change, and how much of it is just a higher price. The Bureau of Labor Statistics, which is responsible for computing the Consumer Price Index, must deal with these difficulties in adjusting for quality changes.
Link It Up
Visit this website to view a list of Ford car prices between 1909 and 1927. Consider how these prices compare to today’s models. Is the product today of a different quality?
We can think of a new product as an extreme improvement in quality—from something that did not exist to something that does. However, the basket of goods that was fixed in the past obviously does not include new goods created since then. The basket of goods and services in the Consumer Price Index (CPI) is revised and updated over time, and so new products are gradually included. However, the process takes some time. For example, room air conditioners were widely sold in the early 1950s, but were not introduced into the basket of goods behind the Consumer Price Index until 1964. The VCR and personal computer were available in the late 1970s and widely sold by the early 1980s, but did not enter the CPI basket of goods until 1987. By 1996, there were more than 40 million cellular phone subscribers in the United States—but cell phones were not yet part of the CPI basket of goods. The parade of inventions has continued, with the CPI inevitably lagging a few years behind.
The arrival of new goods creates problems with respect to the accuracy of measuring inflation. The reason people buy new goods, presumably, is that the new goods offer better value for money than existing goods. Thus, if the price index leaves out new goods, it overlooks one of the ways in which the cost of living is improving. In addition, the price of a new good is often higher when it is first introduced and then declines over time. If the new good is not included in the CPI for some years, until its price is already lower, the CPI may miss counting this price decline altogether. Taking these arguments together, the quality/new goods bias means that the rise in the price of a fixed basket of goods over time tends to overstate the rise in a consumer’s true cost of living, because it does not account for how improvements in the quality of existing goods or the invention of new goods improves the standard of living. The following Clear It Up feature is a must-read on how statisticians comprise and calculate the CPI.
Clear It Up
How do U.S. government statisticians measure the Consumer Price Index?
When the U.S. Bureau of Labor Statistics (BLS) calculates the Consumer Price Index, the first task is to decide on a basket of goods that is representative of the purchases of the average household. We do this by using the Consumer Expenditure Survey, a national survey of about 7,000 households, which provides detailed information on spending habits. Statisticians divide consumer expenditures into eight major groups (seen below), which in turn they divide into more than 200 individual item categories. The BLS currently uses 1982–1984 as the base period.
For each of the 200 individual expenditure items, the BLS chooses several hundred very specific examples of that item and looks at the prices of those examples. In figuring out the “breakfast cereal” item under the overall category of “foods and beverages,” the BLS picks several hundred examples of breakfast cereal. One example might be the price of a 24-oz. box of a particular brand of cereal sold at a particular store. The BLS statistically selects specific products and sizes and stores to reflect what people buy and where they shop. The basket of goods in the Consumer Price Index thus consists of about 80,000 products; that is, several hundred specific products in over 200 broad-item categories. Statisticians rotate about one-quarter of these 80,000 specific products of the sample each year, and replace them with a different set of products.
The next step is to collect data on prices. Data collectors visit or call about 23,000 stores in 87 urban areas all over the United States every month to collect prices on these 80,000 specific products. The BLS also conducts a survey of 50,000 landlords or tenants to collect information about rents.
Statisticians then calculate the Consumer Price Index by taking the 80,000 prices of individual products and combining them, using weights (see Figure 9.2) determined by the quantities of these products that people buy and allowing for factors like substitution between goods and quality improvements, into price indices for the 200 or so overall items. Then, the statisticians combine the price indices for the 200 items into an overall Consumer Price Index. According the Consumer Price Index website, there are eight categories that data collectors use:
The Eight Major Categories in the Consumer Price Index
1. Food and beverages (breakfast cereal, milk, coffee, chicken, wine, full-service meals, and snacks)
2. Housing (renter’s cost of housing, homeowner’s cost of housing, fuel oil, bedroom furniture)
3. Apparel (men’s shirts and sweaters, women’s dresses, jewelry)
4. Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance)
5. Medical care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
6. Recreation (televisions, cable television, pets and pet products, sports equipment, admissions)
7. Education and communication (college tuition, postage, telephone services, computer software and accessories)
8. Other goods and services (tobacco and smoking products, haircuts and other personal services, funeral expenses)
Figure 9.2 The Weighting of CPI Components Of the eight categories used to generate the Consumer Price Index, housing is the highest at 42.4%. The next highest category, food and beverage at 15.1%, is less than half the size of housing. Other goods and services, and apparel, are the lowest at 3.2% and 2.7%, respectively. (Source: www.bls.gov/cpi)
The CPI and Core Inflation Index
Imagine if you were driving a company truck across the country- you probably would care about things like the prices of available roadside food and motel rooms as well as the truck’s operating condition. However, the manager of the firm might have different priorities. He would care mostly about the truck’s on-time performance and much less so about the food you were eating and the places you were staying. In other words, the company manager would be paying attention to the firm's production, while ignoring transitory elements that impacted you, but did not affect the company’s bottom line.
In a sense, a similar situation occurs with regard to measures of inflation. As we’ve learned, CPI measures prices as they affect everyday household spending. Economists typically calculate a core inflation index by taking the CPI and excluding volatile economic variables. In this way, economists have a better sense of the underlying trends in prices that affect the cost of living.
Examples of excluded variables include energy and food prices, which can jump around from month to month because of the weather. According to an article by Kent Bernhard, during Hurricane Katrina in 2005, a key supply point for the nation’s gasoline was nearly knocked out. Gas prices quickly shot up across the nation, in some places by up to 40 cents a gallon in one day. This was not the cause of an economic policy but rather a short-lived event until the pumps were restored in the region. In this case, the CPI that month would register the change as a cost of living event to households, but the core inflation index would remain unchanged. As a result, the Federal Reserve’s decisions on interest rates would not be influenced. Similarly, droughts can cause world-wide spikes in food prices that, if temporary, do not affect the nation’s economic capability.
As former Chairman of the Federal Reserve Ben Bernanke noted in 1999 about the core inflation index, “It provide(s) a better guide to monetary policy than the other indices, since it measures the more persistent underlying inflation rather than transitory influences on the price level.” Bernanke also noted that it helps communicate that the Federal Reserve does not need to respond to every inflationary shock since some price changes are transitory and not part of a structural change in the economy.
In sum, both the CPI and the core inflation index are important, but serve different audiences. The CPI helps households understand their overall cost of living from month to month, while the core inflation index is a preferred gauge from which to make important government policy changes.
Practical Solutions for the Substitution and the Quality/New Goods Biases
By the early 2000s, the Bureau of Labor Statistics was using alternative mathematical methods for calculating the Consumer Price Index, more complicated than just adding up the cost of a fixed basket of goods, to allow for some substitution between goods. It was also updating the basket of goods behind the CPI more frequently, so that it could include new and improved goods more rapidly. For certain products, the BLS was carrying out studies to try to measure the quality improvement. For example, with computers, an economic study can try to adjust for changes in speed, memory, screen size, and other product characteristics, and then calculate the change in price after accounting for these product changes. However, these adjustments are inevitably imperfect, and exactly how to make these adjustments is often a source of controversy among professional economists.
By the early 2000s, the substitution bias and quality/new goods bias had been somewhat reduced, so that since then the rise in the CPI probably overstates the true rise in inflation by only about 0.5% per year. Over one or a few years, this is not much. Over a period of a decade or two, even half of a percent per year compounds to a more significant amount. In addition, the CPI tracks prices from physical locations, and not at online sites like Amazon, where prices can be lower.
When measuring inflation (and other economic statistics, too), a tradeoff arises between simplicity and interpretation. If we calculate the inflation rate with a basket of goods that is fixed and unchanging, then the calculation of an inflation rate is straightforward, but the problems of substitution bias and quality/new goods bias will arise. However, when the basket of goods is allowed to shift and evolve to reflect substitution toward lower relative prices, quality improvements, and new goods, the technical details of calculating the inflation rate grow more complex.
Additional Price Indices: PPI, GDP Deflator, and More
The basket of goods behind the Consumer Price Index represents an average hypothetical U.S. household's consumption, which is to say that it does not exactly capture anyone’s personal experience. When the task is to calculate an average level of inflation, this approach works fine. What if, however, you are concerned about inflation experienced by a certain group, like the elderly, or the poor, or single-parent families with children, or Hispanic-Americans? In specific situations, a price index based on the buying power of the average consumer may not feel quite right.
This problem has a straightforward solution. If the Consumer Price Index does not serve the desired purpose, then invent another index, based on a basket of goods appropriate for the group of interest. The Bureau of Labor Statistics publishes a number of experimental price indices: some for particular groups like the elderly or the poor, some for different geographic areas, and some for certain broad categories of goods like food or housing.
The BLS also calculates several price indices that are not based on baskets of consumer goods. For example, the Producer Price Index (PPI) is based on prices paid for supplies and inputs by producers of goods and services. We can break it down into price indices for different industries, commodities, and stages of processing (like finished goods, intermediate goods, or crude materials for further processing). There is an International Price Index based on the prices of merchandise that is exported or imported. An Employment Cost Index measures wage inflation in the labor market. The GDP deflator, which the Bureau of Economic Analysis measures, is a price index that includes all the GDP components (that is, consumption plus investment plus government plus exports minus imports). Unlike the CPI, its baskets are not fixed but re-calculate what that year’s GDP would have been worth using the base-year’s prices. MIT's Billion Prices Project is a more recent alternative attempt to measure prices: economists collect data online from retailers and then put them into an index that they compare to the CPI (Source: http://bpp.mit.edu/usa/).
What’s the best measure of inflation? If one is concerned with the most accurate measure of inflation, one should use the GDP deflator as it picks up the prices of goods and services produced. However, it is not a good measure of the cost of living as it includes prices of many products not purchased by households (for example, aircraft, fire engines, factory buildings, office complexes, and bulldozers). If one wants the most accurate measure of inflation as it impacts households, one should use the CPI, as it only picks up prices of products purchased by households. That is why economists sometimes refer to the CPI as the cost-of-living index. As the Bureau of Labor Statistics states on its website: “The ‘best’ measure of inflation for a given application depends on the intended use of the data.” | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/09%3A_Inflation/9.03%3A_How_to_Measure_Changes_in_the_Cost_of_Living.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify patterns of inflation for the United States using data from the Consumer Price Index
• Identify patterns of inflation on an international level
In the last three decades, inflation has been relatively low in the U.S. economy, with the Consumer Price Index typically rising 2% to 4% per year. Looking back over the twentieth century, there have been several periods where inflation caused the price level to rise at double-digit rates, but nothing has come close to hyperinflation.
Historical Inflation in the U.S. Economy
Figure 9.3 (a) shows the level of prices in the Consumer Price Index stretching back to 1913. In this case, the base years (when the CPI is defined as 100) are set for the average level of prices that existed from 1982 to 1984. Figure 9.3 (b) shows the annual percentage changes in the CPI over time, which is the inflation rate.
Figure 9.3 U.S. Price Level and Inflation Rates since 1947 Graph a shows the trends in the U.S. price level from the year 1947 to 2020. In 1947, the graph starts out close to 22. It gradually increases until about 1973, then increases more rapidly through the remainder of the 1970s and beyond, with periodic dips, until 2020, when it reached around 260. Graph b shows the trends in U.S. inflation rates from the year 1948 to 2020. In 1948, the graph starts out with inflation at almost 7%, goes up and down periodically, with peaks in the 1940s and the 1970s, until settling to around 1.2% in 2020.
Inflation as measured by the consumer price index reflects the annual percentage change in the cost to the average consumer of acquiring a basket of goods and services that may be fixed or changed at specified intervals, such as yearly.
The first two waves of inflation are easy to characterize in historical terms: they are right after World War I and World War II. However, there are also two periods of severe negative inflation—called deflation—in the early decades of the twentieth century: one following the deep 1920-21 recession and the other during the Great Depression of the 1930s. (Since inflation is a time when the buying power of money in terms of goods and services is reduced, deflation will be a time when the buying power of money in terms of goods and services increases.) For the period from 1900 to about 1960, the major inflations and deflations nearly balanced each other out, so the average annual rate of inflation over these years was only about 1% per year. A third wave of more severe inflation arrived in the 1970s and departed in the early 1980s.
Link It Up
Visit this website to use an inflation calculator and discover how prices have changed in the last 100 years.
Times of recession or depression often seem to be times when the inflation rate is lower, as in the recession of 1920–1921, the Great Depression, the recession of 1980–1982, and the Great Recession in 2008–2009. There were a few months in 2009 that were deflationary, but not at an annual rate. High levels of unemployment typically accompany recessions, and the total demand for goods falls, pulling the price level down. Conversely, the rate of inflation often, but not always, seems to start moving up when the economy is growing very strongly, like right after wartime or during the 1960s. The frameworks for macroeconomic analysis, that we developed in other chapters, will explain why recession often accompanies higher unemployment and lower inflation, while rapid economic growth often brings lower unemployment but higher inflation.
Inflation around the World
Around the rest of the world, the pattern of inflation has been very mixed; Figure 9.4 shows inflation rates over the last several decades. Many industrialized countries, not just the United States, had relatively high inflation rates in the 1970s. For example, in 1975, Japan’s inflation rate was over 8% and the inflation rate for the United Kingdom was almost 25%. In the 1980s, inflation rates came down in the United States and in Europe and have largely stayed down.
Figure 9.4 Countries with Relatively Low Inflation Rates, 1961–2020 This chart shows the annual percentage change in consumer prices compared with the previous year’s consumer prices in the United States, the United Kingdom, Japan, and Germany.
Countries with controlled economies in the 1970s, like the Soviet Union and China, historically had very low rates of measured inflation—because prices were forbidden to rise by law, except for the cases where the government deemed a price increase to be due to quality improvements. However, these countries also had perpetual shortages of goods, since forbidding prices to rise acts like a price ceiling and creates a situation where quantity demanded often exceeds quantity supplied. As Russia and China made a transition toward more market-oriented economies, they also experienced outbursts of inflation, although we should regard the statistics for these economies as somewhat shakier. Inflation in China averaged about 10% per year for much of the 1980s and early 1990s, although it has dropped off since then. Russia experienced hyperinflation—an outburst of high inflation—of 2,500% per year in the early 1990s, although by 2006 Russia’s consumer price inflation had dipped below 10% per year, as Figure 9.5 shows. The closest the United States has ever reached hyperinflation was during the 1860–1865 Civil War, in the Confederate states.
Figure 9.5 Countries with Relatively High Inflation Rates, 1981–2020 These charts show the percentage change in consumer prices compared with the previous year’s consumer prices in Brazil, China, and Russia. (a) Of these, Brazil and Russia experienced very high inflation at some point between the late-1980s and late-1990s. (b) Though not as high, China also had high inflation rates in the mid-1990s. Even though their inflation rates have come down over the last two decades, several of these countries continue to see significant inflation rates. (Sources: www.inflation.eu/inflation-rates; http://research.stlouisfed.org/fred2...FPCPITOTLZGBRA; http://research.stlouisfed.org/fred2...HNCPIALLMINMEI; http://research.stlouisfed.org/fred2...FPCPITOTLZGRUS)
Many countries in Latin America experienced raging inflation during the 1980s and early 1990s, with inflation rates often well above 100% per year. In 1990, for example, both Brazil and Argentina saw inflation climb above 2000%. Certain countries in Africa experienced extremely high rates of inflation, sometimes bordering on hyperinflation, in the 1990s. Nigeria, the most populous country in Africa, had an inflation rate of 75% in 1995.
In the early 2000s, the problem of inflation appears to have diminished for most countries, at least in comparison to the worst times of recent decades. As we noted in this earlier Bring it Home feature, in recent years, the world’s worst example of hyperinflation was in Zimbabwe, where at one point the government was issuing bills with a face value of \$100 trillion (in Zimbabwean dollars)—that is, the bills had \$100,000,000,000,000 written on the front, but were almost worthless. In many countries, the memory of double-digit, triple-digit, and even quadruple-digit inflation is not very far in the past. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/09%3A_Inflation/9.04%3A_How_the_U.S._and_Other_Countries_Experience_Inflation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how inflation can cause redistributions of purchasing power
• Identify ways inflation can blur the perception of supply and demand
• Explain the economic benefits and challenges of inflation
Economists usually oppose high inflation, but they oppose it in a milder way than many non-economists. Robert Shiller, one of 2013’s Nobel Prize winners in economics, carried out several surveys during the 1990s about attitudes toward inflation. One of his questions asked, “Do you agree that preventing high inflation is an important national priority, as important as preventing drug use or preventing deterioration in the quality of our schools?” Answers were on a scale of 1–5, where 1 meant “Fully agree” and 5 meant “Completely disagree.” For the U.S. population as a whole, 52% answered “Fully agree” that preventing high inflation was a highly important national priority and just 4% said “Completely disagree.” However, among professional economists, only 18% answered “Fully agree,” while the same percentage of 18% answered “Completely disagree.”
The Land of Funny Money
What are the economic problems caused by inflation, and why do economists often regard them with less concern than the general public? Consider a very short story: “The Land of Funny Money.”
One morning, everyone in the Land of Funny Money awakened to find that everything denominated in money had increased by 20%. The change was completely unexpected. Every price in every store was 20% higher. Paychecks were 20% higher. Interest rates were 20 % higher. The amount of money, everywhere from wallets to savings accounts, was 20% larger. This overnight inflation of prices made newspaper headlines everywhere in the Land of Funny Money. However, the headlines quickly disappeared, as people realized that in terms of what they could actually buy with their incomes, this inflation had no economic impact. Everyone’s pay could still buy exactly the same set of goods as it did before. Everyone’s savings were still sufficient to buy exactly the same car, vacation, or retirement that they could have bought before. Equal levels of inflation in all wages and prices ended up not mattering much at all.
When the people in Robert Shiller’s surveys explained their concern about inflation, one typical reason was that they feared that as prices rose, they would not be able to afford to buy as much. In other words, people were worried because they did not live in a place like the Land of Funny Money, where all prices and wages rose simultaneously. Instead, people live here on Planet Earth, where prices might rise while wages do not rise at all, or where wages rise more slowly than prices.
Economists note that over most periods, the inflation level in prices is roughly similar to the inflation level in wages, and so they reason that, on average, over time, people’s economic status is not greatly changed by inflation. If all prices, wages, and interest rates adjusted automatically and immediately with inflation, as in the Land of Funny Money, then no one’s purchasing power, profits, or real loan payments would change. However, if other economic variables do not move exactly in sync with inflation, or if they adjust for inflation only after a time lag, then inflation can cause three types of problems: unintended redistributions of purchasing power, blurred price signals, and difficulties in long-term planning.
Unintended Redistributions of Purchasing Power
Inflation can cause redistributions of purchasing power that hurt some and help others. People who are hurt by inflation include those who are holding considerable cash, whether it is in a safe deposit box or in a cardboard box under the bed. When inflation happens, the buying power of cash diminishes. However, cash is only an example of a more general problem: anyone who has financial assets invested in a way that the nominal return does not keep up with inflation will tend to be affected by inflation. For example, if a person has money in a bank account that pays 4% interest, but inflation rises to 5%, then the real rate of return for the money invested in that bank account is negative 1%.
The problem of a good-looking nominal interest rate transforming into an ugly-looking real interest rate can be worsened by taxes. The U.S. income tax is charged on the nominal interest received in dollar terms, without an adjustment for inflation. Thus, the government taxes a person who invests \$10,000 and receives a 5% nominal rate of interest on the \$500 received—no matter whether the inflation rate is 0%, 5%, or 10%. If inflation is 0%, then the real interest rate is 5% and all \$500 is a gain in buying power. However, if inflation is 5%, then the real interest rate is zero and the person had no real gain—but owes income tax on the nominal gain anyway. If inflation is 10%, then the real interest rate is negative 5% and the person is actually falling behind in buying power, but would still owe taxes on the \$500 in nominal gains.
Inflation can cause unintended redistributions for wage earners, too. Wages do typically creep up with inflation over time, eventually. The last row of Table 9.1 at the start of this chapter showed that the average hourly wage in manufacturing in the U.S. economy increased from \$3.23 in 1970 to \$30.11 in 2021, which is an increase by a factor of close to ten. Over that time period, the Consumer Price Index increased by about a factor of eight. However, increases in wages may lag behind inflation for a year or two, since wage adjustments are often somewhat sticky and occur only once or twice a year. Moreover, the extent to which wages keep up with inflation creates insecurity for workers and may involve painful, prolonged conflicts between employers and employees. If the government adjusts minimum wage for inflation only infrequently, minimum wage workers are losing purchasing power from their nominal wages, as Figure 9.6 shows.
Figure 9.6 U.S. Minimum Wage and Inflation After adjusting for inflation, the federal minimum wage dropped about 30 percent from 1965–2020, even though the nominal figure climbed from \$1.40 to \$7.25 per hour. Increases in the minimum wage in between 2008 and 2010 kept the decline from being worse—as it would have been if the wage had remained the same as it did from 1997 through 2007. Since 2010, the real minimum wage has continued to decline. (Sources: http://www.dol.gov/whd/minwage/chart.htm and http://data.bls.gov/cgi-bin/surveymost?cu)
One sizable group of people has often received a large share of their income in a form that does not increase over time: retirees who receive a private company pension. Most pensions have traditionally been set as a fixed nominal dollar amount per year at retirement. For this reason, economists call pensions “defined benefits” plans. Even if inflation is low, the combination of inflation and a fixed income can create a substantial problem over time. A person who retires on a fixed income at age 65 will find that losing just 1% to 2% of buying power per year to inflation compounds to a considerable loss of buying power after a decade or two.
Fortunately, pensions and other defined benefits retirement plans are increasingly rare, replaced instead by “defined contribution” plans, such as 401(k)s and 403(b)s. In these plans, the employer contributes a fixed amount to the worker’s retirement account on a regular basis (usually every pay check). The employee often contributes as well. The worker invests these funds in a wide range of investment vehicles. These plans are tax deferred, and they are portable so that if the individual takes a job with a different employer, their 401(k) comes with them. To the extent that the investments made generate real rates of return, retirees are not burdened by the inflation costs of traditional pensioners.
However, ordinary people can sometimes benefit from the unintended redistributions of inflation. Consider someone who borrows \$10,000 to buy a car at a fixed interest rate of 9%. If inflation is 3% at the time the loan is made, then the borrower must repay the loan at a real interest rate of 6%. However, if inflation rises to 9%, then the real interest rate on the loan is zero. In this case, the borrower’s benefit from inflation is the lender’s loss. A borrower paying a fixed interest rate, who benefits from inflation, is just the flip side of an investor receiving a fixed interest rate, who suffers from inflation. The lesson is that when interest rates are fixed, rises in the rate of inflation tend to penalize suppliers of financial capital, who receive repayment in dollars that are worth less because of inflation, while demanders of financial capital end up better off, because they can repay their loans in dollars that are worth less than originally expected.
The unintended redistributions of buying power that inflation causes may have a broader effect on society. America’s widespread acceptance of market forces rests on a perception that people’s actions have a reasonable connection to market outcomes. When inflation causes a retiree who built up a pension or invested at a fixed interest rate to suffer, however, while someone who borrowed at a fixed interest rate benefits from inflation, it is hard to believe that this outcome was deserved in any way. Similarly, when homeowners benefit from inflation because the price of their homes rises, while renters suffer because they are paying higher rent, it is hard to see any useful incentive effects. One of the reasons that the general public dislikes inflation is a sense that it makes economic rewards and penalties more arbitrary—and therefore likely to be perceived as unfair – even dangerous, as the next Clear It Up feature shows.
Clear It Up
Is there a connection between German hyperinflation and Hitler’s rise to power?
Germany suffered an intense hyperinflation of its currency, the Mark, in the years after World War I, when the Weimar Republic in Germany resorted to printing money to pay its bills and the onset of the Great Depression created the social turmoil that Adolf Hitler was able to take advantage of in his rise to power. Shiller described the connection this way in a National Bureau of Economic Research 1996 Working Paper:
A fact that is probably little known to young people today, even in Germany, is that the final collapse of the Mark in 1923, the time when the Mark’s inflation reached astronomical levels (inflation of 35,974.9% in November 1923 alone, for an annual rate that month of 4.69 × 1028%), came in the same month as did Hitler’s Beer Hall Putsch, his Nazi Party’s armed attempt to overthrow the German government. This failed putsch resulted in Hitler’s imprisonment, at which time he wrote his book Mein Kampf, setting forth an inspirational plan for Germany’s future, suggesting plans for world domination. . .
. . . Most people in Germany today probably do not clearly remember these events; this lack of attention to it may be because its memory is blurred by the more dramatic events that succeeded it (the Nazi seizure of power and World War II). However, to someone living through these historical events in sequence . . . [the putsch] may have been remembered as vivid evidence of the potential effects of inflation.
Blurred Price Signals
Prices are the messengers in a market economy, conveying information about conditions of demand and supply. Inflation blurs those price messages. Inflation means that we perceive price signals more vaguely, like a radio program received with considerable static. If the static becomes severe, it is hard to tell what is happening.
In Israel, when inflation accelerated to an annual rate of 500% in 1985, some stores stopped posting prices directly on items, since they would have had to put new labels on the items or shelves every few days to reflect inflation. Instead, a shopper just took items from a shelf and went up to the checkout register to find out the price for that day. Obviously, this situation makes comparing prices and shopping for the best deal rather difficult. When the levels and changes of prices become uncertain, businesses and individuals find it harder to react to economic signals. In a world where inflation is at a high rate, but bouncing up and down to some extent, does a higher price of a good mean that inflation has risen, or that supply of that good has decreased, or that demand for that good has increased? Should a buyer of the good take the higher prices as an economic hint to start substituting other products—or have the prices of the substitutes risen by an equal amount? Should a seller of the good take a higher price as a reason to increase production—or is the higher price only a sign of a general inflation in which the prices of all inputs to production are rising as well? The true story will presumably become clear over time, but at a given moment, who can say?
High and variable inflation means that the incentives in the economy to adjust in response to changes in prices are weaker. Markets will adjust toward their equilibrium prices and quantities more erratically and slowly, and many individual markets will experience a greater chance of surpluses and shortages.
Problems of Long-Term Planning
Inflation can make long-term planning difficult. In discussing unintended redistributions, we considered the case of someone trying to plan for retirement with a pension that is fixed in nominal terms and a high rate of inflation. Similar problems arise for all people trying to save for retirement, because they must consider what their money will really buy several decades in the future when we cannot know the rate of future inflation.
Inflation, especially at moderate or high levels, will pose substantial planning problems for businesses, too. A firm can make money from inflation—for example, by paying bills and wages as late as possible so that it can pay in inflated dollars, while collecting revenues as soon as possible. A firm can also suffer losses from inflation, as in the case of a retail business that gets stuck holding too much cash, only to see inflation eroding the value of that cash. However, when a business spends its time focusing on how to profit by inflation, or at least how to avoid suffering from it, an inevitable tradeoff strikes: less time is spent on improving products and services or on figuring out how to make existing products and services more cheaply. An economy with high inflation rewards businesses that have found clever ways of profiting from inflation, which are not necessarily the businesses that excel at productivity, innovation, or quality of service.
In the short term, low or moderate levels of inflation may not pose an overwhelming difficulty for business planning, because costs of doing business and sales revenues may rise at similar rates. If, however, inflation varies substantially over the short or medium term, then it may make sense for businesses to stick to shorter-term strategies. The evidence as to whether relatively low rates of inflation reduce productivity is controversial among economists. There is some evidence that if inflation can be held to moderate levels of less than 3% per year, it need not prevent a nation’s real economy from growing at a healthy pace. For some countries that have experienced hyperinflation of several thousand percent per year, an annual inflation rate of 20–30% may feel basically the same as zero. However, several economists have pointed to the suggestive fact that when U.S. inflation heated up in the early 1970s—to 10%—U.S. growth in productivity slowed down, and when inflation slowed down in the 1980s, productivity edged up again not long thereafter, as Figure 9.7 shows.
Figure 9.7 U.S. Inflation Rate and U.S. Labor Productivity, 1961–2020 Over the last several decades in the United States, there have been times when rising inflation rates have been closely followed by lower productivity rates and lower inflation rates have corresponded to increasing productivity rates. As the graph shows, however, this correlation does not always exist.
Any Benefits of Inflation?
Although the economic effects of inflation are primarily negative, two countervailing points are worth noting. First, the impact of inflation will differ considerably according to whether it is creeping up slowly at 0% to 2% per year, galloping along at 10% to 20% per year, or racing to the point of hyperinflation at, say, 40% per month. Hyperinflation can rip an economy and a society apart. An annual inflation rate of 2%, 3%, or 4%, however, is a long way from a national crisis. Low inflation is also better than deflation which occurs with severe recessions.
Second, economists sometimes argue that moderate inflation may help the economy by making wages in labor markets more flexible. The discussion in Unemployment pointed out that wages tend to be sticky in their downward movements and that unemployment can result. A little inflation could nibble away at real wages, and thus help real wages to decline if necessary. In this way, even if a moderate or high rate of inflation may act as sand in the gears of the economy, perhaps a low rate of inflation serves as oil for the gears of the labor market. This argument is controversial. A full analysis would have to account for all the effects of inflation. It does, however, offer another reason to believe that, all things considered, very low rates of inflation may not be especially harmful. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/09%3A_Inflation/9.05%3A_The_Confusion_Over_Inflation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the relationship between indexing and inflation
• Identify three ways the government can control inflation through macroeconomic policy
When a price, wage, or interest rate is adjusted automatically with inflation, economists use the term indexed. An indexed payment increases according to the index number that measures inflation. Those in private markets and government programs observe a wide range of indexing arrangements. Since the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not another—say, increasing the prices that people pay but not the wages that workers receive—indexing will take some of the sting out of inflation.
Indexing in Private Markets
In the 1970s and 1980s, labor unions commonly negotiated wage contracts that had cost-of-living adjustments (COLAs) which guaranteed that their wages would keep up with inflation. These contracts were sometimes written as, for example, COLA plus 3%. Thus, if inflation was 5%, the wage increase would automatically be 8%, but if inflation rose to 9%, the wage increase would automatically be 12%. COLAs are a form of indexing applied to wages.
Loans often have built-in inflation adjustments, too, so that if the inflation rate rises by two percentage points, then the interest rate that a financial institution charges on the loan rises by two percentage points as well. An adjustable-rate mortgage (ARM) is a type of loan that one can use to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able to receive a lower interest rate if borrowing with an ARM, compared to a fixed-rate loan. The reason is that with an ARM, the lender is protected against the risk that higher inflation will reduce the real loan payments, and so the risk premium part of the interest rate can be correspondingly lower.
A number of ongoing or long-term business contracts also have provisions that prices will adjust automatically according to inflation. Sellers like such contracts because they are not locked into a low nominal selling price if inflation turns out higher than expected. Buyers like such contracts because they are not locked into a high buying price if inflation turns out to be lower than expected. A contract with automatic adjustments for inflation in effect agrees on a real price for the borrower to pay, rather than a nominal price.
Indexing in Government Programs
Many government programs are indexed to inflation. The U.S. income tax code is designed so that as a person’s income rises above certain levels, the tax rate on the marginal income earned rises as well. That is what the expression “move into a higher tax bracket” means. For example, according to the basic tax tables from the Internal Revenue Service, in 2020, a married person filing jointly owed 10% of all taxable income from \$0 to \$19,750; 12% of all income from \$19,751 to \$80,250; 22% of all taxable income from \$80,251 to \$171,050; 24% of all taxable income from \$171,051 to \$326,600; 32% of all taxable income from \$326,601 to \$414,700; 35% of all taxable income from \$414,701 to \$622,050; and 37% of all income from \$622,051 and above.
Because of the many complex provisions in the rest of the tax code, it is difficult to determine exactly the taxes an individual owes the government based on these numbers, but the numbers illustrate the basic theme that tax rates rise as the marginal dollar of income rises. Until the late 1970s, if nominal wages increased along with inflation, people were moved into higher tax brackets and owed a higher proportion of their income in taxes, even though their real income had not risen. In 1981, the government eliminated this “bracket creep”. Now, the income levels where higher tax rates kick in are indexed to rise automatically with inflation.
The Social Security program offers two examples of indexing. Since the passage of the Social Security Indexing Act of 1972, the level of Social Security benefits increases each year along with the Consumer Price Index. Also, Social Security is funded by payroll taxes, which the government imposes on the income earned up to a certain amount—\$137,700 in 2020. The government adjusts this level of income upward each year according to the rate of inflation, so that an indexed increase in the Social Security tax base accompanies the indexed rise in the benefit level.
As yet another example of a government program affected by indexing, in 1996 the U.S., government began offering indexed bonds. Bonds are means by which the U.S. government (and many private-sector companies as well) borrows money; that is, investors buy the bonds, and then the government repays the money with interest. Traditionally, government bonds have paid a fixed rate of interest. This policy gave a government that had borrowed an incentive to encourage inflation, because it could then repay its past borrowing in inflated dollars at a lower real interest rate. However, indexed bonds promise to pay a certain real rate of interest above whatever inflation rate occurs. In the case of a retiree trying to plan for the long term and worried about the risk of inflation, for example, indexed bonds that guarantee a rate of return higher than inflation—no matter the level of inflation—can be a very comforting investment.
Might Indexing Reduce Concern over Inflation?
Indexing may seem like an obviously useful step. After all, when individuals, firms, and government programs are indexed against inflation, then people can worry less about arbitrary redistributions and other effects of inflation.
However, some of the fiercest opponents of inflation express grave concern about indexing. They point out that indexing is always partial. Not every employer will provide COLAs for workers. Not all companies can assume that costs and revenues will rise in lockstep with the general rates of inflation. Not all interest rates for borrowers and savers will change to match inflation exactly. However, as partial inflation indexing spreads, the political opposition to inflation may diminish. After all, older people whose Social Security benefits are protected against inflation, or banks that have loaned their money with adjustable-rate loans, no longer have as much reason to care whether inflation heats up. In a world where some people are indexed against inflation and some are not, financially savvy businesses and investors may seek out ways to be protected against inflation, while the financially unsophisticated and small businesses may feel it the most.
A Preview of Policy Discussions of Inflation
This chapter has focused on how economists measure inflation, historical experience with inflation, how to adjust nominal variables into real ones, how inflation affects the economy, and how indexing works. We have barely hinted at the causes of inflation, and we have not addressed government policies to deal with inflation. We will examine these issues in depth in other chapters. However, it is useful to offer a preview here.
We can sum up the cause of inflation in one phrase: Too many dollars chasing too few goods. The great surges of inflation early in the twentieth century came after wars, which are a time when government spending is very high, but consumers have little to buy, because production is going to the war effort. Governments also commonly impose price controls during wartime. After the war, the price controls end and pent-up buying power surges forth, driving up inflation. Otherwise, if too few dollars are chasing too many goods, then inflation will decline or even turn into deflation. Therefore, we typically associate slowdowns in economic activity, as in major recessions and the Great Depression, with a reduction in inflation or even outright deflation.
The policy implications are clear. If we are to avoid inflation, the amount of purchasing power in the economy must grow at roughly the same rate as the production of goods. Macroeconomic policies that the government can use to affect the amount of purchasing power—through taxes, spending, and regulation of interest rates and credit—can thus cause inflation to rise or reduce inflation to lower levels.
Bring It Home
Inflation in a Pandemic—A Return to the 1970s, or a Temporary Adjustment?
The pandemic-induced recession caused all sorts of disruptions to our economy, including inflation. During the pandemic, the prices for goods like gas and cars fell as people shifted to remote work and canceled travel plans. But as the economy started to recover from the pandemic in early 2021, we started to see large increases in these prices. Higher prices were also fueled by the injections of cash into the economy through stimulus checks and unemployment benefits. The pandemic also caused shortages throughout the global supply chain, further pushing prices up (you'll learn more about this idea in a few chapters when we talk about aggregate supply and demand).
With headline annualized inflation rates in 2021 exceeding 6%, the question in the next few years is whether we'll see permanently high inflation rates of 9%, 10%, or more, like we did in the 1970s and early-1980s. Some economists believe the pandemic-induced inflation is just a transitory adjustment—indeed, used car and gasoline prices rose dramatically in 2010 and 2011 as well, as we were recovering from the Great Recession. Others are more concerned that the inflation is permanent. Shortages continue to exist throughout the economy as of early 2022, and if consumers expect higher inflation, it can be a self-fulfilling prophecy, as they start buying things now in order to avoid future bouts of inflation.
As you learned about earlier, inflation is a major concern of consumers, if less of an issue among economists. But inflation should be matched by increases in living standards, otherwise there could be major implications for the economy. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/09%3A_Inflation/9.06%3A_Indexing_and_Its_Limitations.txt |
adjustable-rate mortgage (ARM)
a loan a borrower uses to purchase a home in which the interest rate varies with market interest rates
base year
arbitrary year whose value as an index number economists define as 100; inflation from the base year to other years can easily be seen by comparing the index number in the other year to the index number in the base year—for example, 100; so, if the index number for a year is 105, then there has been exactly 5% inflation between that year and the base year
basket of goods and services
a hypothetical group of different items, with specified quantities of each one meant to represent a “typical” set of consumer purchases, used as a basis for calculating how the price level changes over time
Consumer Price Index (CPI)
a measure of inflation that U.S. government statisticians calculate based on the price level from a fixed basket of goods and services that represents the average consumer's purchases
core inflation index
a measure of inflation typically calculated by taking the CPI and excluding volatile economic variables such as food and energy prices to better measure the underlying and persistent trend in long-term prices
cost-of-living adjustments (COLAs)
a contractual provision that wage increases will keep up with inflation
deflation
negative inflation; most prices in the economy are falling
Employment Cost Index
a measure of inflation based on wages paid in the labor market
GDP deflator
a measure of inflation based on the prices of all the GDP components
hyperinflation
an outburst of high inflation that often occurs (although not exclusively) when economies shift from a controlled economy to a market-oriented economy
index number
a unit-free number derived from the price level over a number of years, which makes computing inflation rates easier, since the index number has values around 100
indexed
a price, wage, or interest rate is adjusted automatically for inflation
inflation
a general and ongoing rise in price levels in an economy
International Price Index
a measure of inflation based on the prices of merchandise that is exported or imported
Producer Price Index (PPI)
a measure of inflation based on prices paid for supplies and inputs by producers of goods and services
quality/new goods bias
inflation calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living, because it does not account for improvements in the quality of existing goods or the invention of new goods
substitution bias
an inflation rate calculated using a fixed basket of goods over time tends to overstate the true rise in the cost of living, because it does not take into account that the person can substitute away from goods whose prices rise considerably
9.08: Key Concepts and Summary
9.1 Tracking Inflation
Economists measure the price level by using a basket of goods and services and calculating how the total cost of buying that basket of goods will increase over time. Economists often express the price level in terms of index numbers, which transform the cost of buying the basket of goods and services into a series of numbers in the same proportion to each other, but with an arbitrary base year of 100. We measure the inflation rate as the percentage change between price levels or index numbers over time.
9.2 How to Measure Changes in the Cost of Living
Measuring price levels with a fixed basket of goods will always have two problems: the substitution bias, by which a fixed basket of goods does not allow for buying more of what becomes relatively less expensive and less of what becomes relatively more expensive; and the quality/new goods bias, by which a fixed basket cannot account for improvements in quality and the advent of new goods. These problems can be reduced in degree—for example, by allowing the basket of goods to evolve over time—but we cannot totally eliminate them. The most commonly cited measure of inflation is the Consumer Price Index (CPI), which is based on a basket of goods representing what the typical consumer buys. The Core Inflation Index further breaks down the CPI by excluding volatile economic commodities. Several price indices are not based on baskets of consumer goods. The GDP deflator is based on all GDP components. The Producer Price Index is based on prices of supplies and inputs bought by producers of goods and services. An Employment Cost Index measures wage inflation in the labor market. An International Price Index is based on the prices of merchandise that is exported or imported.
9.3 How the U.S. and Other Countries Experience Inflation
In the U.S. economy, the annual inflation rate in the last two decades has typically been around 2% to 4%. The periods of highest inflation in the United States in the twentieth century occurred during the years after World Wars I and II, and in the 1970s. The period of lowest inflation—actually, with deflation—was the 1930s Great Depression.
9.4 The Confusion Over Inflation
Unexpected inflation will tend to hurt those whose money received, in terms of wages and interest payments, does not rise with inflation. In contrast, inflation can help those who owe money that they can pay in less valuable, inflated dollars. Low rates of inflation have relatively little economic impact over the short term. Over the medium and the long term, even low rates of inflation can complicate future planning. High rates of inflation can muddle price signals in the short term and prevent market forces from operating efficiently, and can vastly complicate long-term savings and investment decisions.
9.5 Indexing and Its Limitations
A payment is indexed if it is automatically adjusted for inflation. Examples of indexing in the private sector include wage contracts with cost-of-living adjustments (COLAs) and loan agreements like adjustable-rate mortgages (ARMs). Examples of indexing in the public sector include tax brackets and Social Security payments. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/09%3A_Inflation/9.07%3A_Key_Terms.txt |
1.
Table 9.4 shows the fruit prices that the typical college student purchased from 2001 to 2004. What is the amount spent each year on the “basket” of fruit with the quantities shown in column 2?
Items Qty (2001) Price (2001) Amount Spent (2002) Price (2002) Amount Spent (2003) Price (2003) Amount Spent (2004) Price (2004) Amount Spent
Apples 10 \$0.50 \$0.75 \$0.85 \$0.88
Bananas 12 \$0.20 \$0.25 \$0.25 \$0.29
Grapes 2 \$0.65 \$0.70 \$0.90 \$0.95
Raspberries 1 \$2.00 \$1.90 \$2.05 \$2.13 \$2.13
Total
Table 9.4
2.
Construct the price index for a “fruit basket” in each year using 2003 as the base year.
3.
Compute the inflation rate for fruit prices from 2001 to 2004.
4.
Edna is living in a retirement home where most of her needs are taken care of, but she has some discretionary spending. Based on the basket of goods in Table 9.5, by what percentage does Edna’s cost of living increase between time 1 and time 2?
Items Quantity (Time 1) Price (Time 2) Price
Gifts for grandchildren 12 \$50 \$60
Pizza delivery 24 \$15 \$16
Blouses 6 \$60 \$50
Vacation trips 2 \$400 \$420
Table 9.5
5.
How to Measure Changes in the Cost of Living introduced a number of different price indices. Which price index would be best to use to adjust your paycheck for inflation?
6.
The Consumer Price Index is subject to the substitution bias and the quality/new goods bias. Are the Producer Price Index and the GDP Deflator also subject to these biases? Why or why not?
7.
Go to this website for the Purchasing Power Calculator at MeasuringWorth.com. How much money would it take today to purchase what one dollar would have bought in the year of your birth?
8.
If inflation rises unexpectedly by 5%, would a state government that had recently borrowed money to pay for a new highway benefit or lose?
9.
How should an increase in inflation affect the interest rate on an adjustable-rate mortgage?
10.
A fixed-rate mortgage has the same interest rate over the life of the loan, whether the mortgage is for 15 or 30 years. By contrast, an adjustable-rate mortgage changes with market interest rates over the life of the mortgage. If inflation falls unexpectedly by 3%, what would likely happen to a homeowner with an adjustable-rate mortgage?
9.10: Review Questions
11.
How do economists use a basket of goods and services to measure the price level?
12.
Why do economists use index numbers to measure the price level rather than dollar value of goods?
13.
What is the difference between the price level and the rate of inflation?
14.
Why does “substitution bias” arise if we calculate the inflation rate based on a fixed basket of goods?
15.
Why does the “quality/new goods bias” arise if we calculate the inflation rate based on a fixed basket of goods?
16.
What has been a typical range of inflation in the U.S. economy in the last decade or so?
17.
Over the last century, during what periods was the U.S. inflation rate highest and lowest?
18.
What is deflation?
19.
Identify several parties likely to be helped and hurt by inflation.
20.
What is indexing?
21.
Name several forms of indexing in the private and public sector.
9.11: Critical Thinking Questions
22.
Inflation rates, like most statistics, are imperfect measures. Can you identify some ways that the inflation rate for fruit does not perfectly capture the rising price of fruit?
23.
Given the federal budget deficit in recent years, some economists have argued that by adjusting Social Security payments for inflation using the CPI, Social Security is overpaying recipients. What is their argument, and do you agree or disagree with it?
24.
Why is the GDP deflator not an accurate measure of inflation as it impacts a household?
25.
Imagine that the government statisticians who calculate the inflation rate have been updating the basic basket of goods once every 10 years, but now they decide to update it every five years. How will this change affect the amount of substitution bias and quality/new goods bias?
26.
Describe a situation, either a government policy situation, an economic problem, or a private sector situation, where using the CPI to convert from nominal to real would be more appropriate than using the GDP deflator.
27.
Describe a situation, either a government policy situation, an economic problem, or a private sector situation, where using the GDP deflator to convert from nominal to real would be more appropriate than using the CPI.
28.
Why do you think the U.S. experience with inflation over the last 50 years has been so much milder than in many other countries?
29.
If, over time, wages and salaries on average rise at least as fast as inflation, why do people worry about how inflation affects incomes?
30.
Who in an economy is the big winner from inflation?
31.
If a government gains from unexpected inflation when it borrows, why would it choose to offer indexed bonds?
32.
Do you think perfect indexing is possible? Why or why not?
9.12: Problems
33.
The index number representing the price level changes from 110 to 115 in one year, and then from 115 to 120 the next year. Since the index number increases by five each year, is five the inflation rate each year? Is the inflation rate the same each year? Explain your answer.
34.
The total price of purchasing a basket of goods in the United Kingdom over four years is: year 1=£940, year 2=£970, year 3=£1000, and year 4=£1070. Calculate two price indices, one using year 1 as the base year (set equal to 100) and the other using year 4 as the base year (set equal to 100). Then, calculate the inflation rate based on the first price index. If you had used the other price index, would you get a different inflation rate? If you are unsure, do the calculation and find out.
35.
Within 1 or 2 percentage points, what has the U.S. inflation rate been during the last 20 years? Draw a graph to show the data.
36.
If inflation rises unexpectedly by 5%, indicate for each of the following whether the economic actor is helped, hurt, or unaffected:
1. A union member with a COLA wage contract
2. Someone with a large stash of cash in a safe deposit box
3. A bank lending money at a fixed rate of interest
4. A person who is not due to receive a pay raise for another 11 months
37.
Rosalie the Retiree knows that when she retires in 16 years, her company will give her a one-time payment of \$20,000. However, if the inflation rate is 6% per year, how much buying power will that \$20,000 have when measured in today’s dollars? Hint: Start by calculating the rise in the price level over the 16 years. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/09%3A_Inflation/9.09%3A_Self-Check_Questions.txt |
Figure 10.1 A World of Money We are all part of the global financial system, which includes many different currencies. (Credit: modification of "Money from around the world" by Images Money/Flickr, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Measuring Trade Balances
• Trade Balances in Historical and International Context
• Trade Balances and Flows of Financial Capital
• The National Saving and Investment Identity
• The Pros and Cons of Trade Deficits and Surpluses
• The Difference between Level of Trade and the Trade Balance
Bring It Home
More than Meets the Eye in the Congo
How much do you interact with the global financial system? Do you think not much? Think again. Suppose you take out a student loan, or you deposit money into your bank account. You just affected domestic savings and borrowing. Now say you are at the mall and buy two T-shirts “made in China,” and later contribute to a charity that helps refugees. What is the impact? You affected how much money flows into and out of the United States. If you open an IRA savings account and put money in an international mutual fund, you are involved in the flow of money overseas. While your involvement may not seem as influential as that of someone like the president, who can increase or decrease foreign aid and, thereby, have a huge impact on money flows in and out of the country, you do interact with the global financial system on a daily basis.
The balance of payments—a term you will meet soon—seems like a huge topic, but once you learn the specific components of trade and money, it all makes sense. Along the way, you may have to give up some common misunderstandings about trade and answer some questions: If a country is running a trade deficit, is that bad? Is a trade surplus good? For example, look at the Democratic Republic of the Congo (often referred to as “Congo”), a large country in Central Africa. In 2013, it ran a trade surplus of \$1 billion, so it must be doing well, right? In contrast, the trade deficit in the United States was \$508 billion in 2013. Do these figures suggest that the United States economy is performing worse than the Congolese economy? Not necessarily. The U.S. trade deficit tends to worsen as the economy strengthens. In contrast, high poverty rates in the Congo persist, and these rates are not going down even with the positive trade balance. Clearly, it is more complicated than simply asserting that running a trade deficit is bad for the economy. You will learn more about these issues and others in this chapter.
The balance of trade (or trade balance) is any gap between a nation’s dollar value of its exports, or what its producers sell abroad, and a nation’s dollar value of imports, or the foreign-made products and services that households and businesses purchase. Recall from The Macroeconomic Perspective that if exports exceed imports, the economy has a trade surplus. If imports exceed exports, the economy has a trade deficit. If exports and imports are equal, then trade is balanced, but what happens when trade is out of balance and large trade surpluses or deficits exist?
Germany, for example, has had substantial trade surpluses in recent decades, in which exports have greatly exceeded imports. According to the World Bank, in 2020, Germany ran a trade surplus of \$242 billion. In contrast, the U.S. economy in recent decades has experienced large trade deficits, in which imports have considerably exceeded exports. In 2020, for example, U.S. imports exceeded exports by \$651 billion.
A series of financial crises triggered by unbalanced trade can lead economies into deep recessions. These crises begin with large trade deficits. At some point, foreign investors become pessimistic about the economy and move their money to other countries. The economy then drops into deep recession, with real GDP often falling up to 10% or more in a single year. This happened to Mexico in 1995 when their GDP fell 8.1%. A number of countries in East Asia—Thailand, South Korea, Malaysia, and Indonesia—succumbed to the same economic illness in 1997–1998 (called the Asian Financial Crisis). In the late 1990s and into the early 2000s, Russia and Argentina had the identical experience. What are the connections between imbalances of trade in goods and services and the flows of international financial capital that set off these economic avalanches?
We will start by examining the balance of trade in more detail, by looking at some patterns of trade balances in the United States and around the world. Then we will examine the intimate connection between international flows of goods and services and international flows of financial capital, which to economists are really just two sides of the same coin. People often assume that trade surpluses like those in Germany must be a positive sign for an economy, while trade deficits like those in the United States must be harmful. As it turns out, both trade surpluses and deficits can be either good or bad. We will see why in this chapter. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/10%3A_The_International_Trade_and_Capital_Flows/10.01%3A_Introduction_to_the_International_Trade_and_Capital_Flows.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain merchandise trade balance, current account balance, and unilateral transfers
• Identify components of the U.S. current account balance
• Calculate the merchandise trade balance and current account balance using import and export data for a country
A few decades ago, it was common to track the solid or physical items that planes, trains, and trucks transported between countries as a way of measuring the balance of trade. Economists call this measurement the merchandise trade balance. In most high-income economies, including the United States, goods comprise less than half of a country’s total production, while services comprise more than half. The last two decades have seen a surge in international trade in services, powered by technological advances in telecommunications and computers that have made it possible to export or import customer services, finance, law, advertising, management consulting, software, construction engineering, and product design. Most global trade still takes the form of goods rather than services, and the government announces and the media prominently report the merchandise trade balance. Old habits are hard to break. Economists, however, typically rely on broader measures such as the balance of trade or the current account balance which includes other international flows of income and foreign aid.
Components of the U.S. Current Account Balance
Table 10.1 breaks down the four main components of the U.S. current account balance for the last quarter of 2015 (seasonally adjusted). The first line shows the merchandise trade balance; that is, exports and imports of goods. Because imports exceed exports, the trade balance in the final column is negative, showing a merchandise trade deficit. We can explain how the government collects this trade information in the following Clear It Up feature.
Value of Exports (money flowing into the United States) Value of Imports (money flowing out of the United States) Balance
Goods \$1,428.8 \$2,350.8 –\$922.0
Services \$705.6 \$460.3 \$245.3
Income receipts and payments \$957.9 \$769.4 \$188.5
Unilateral transfers \$166.3 \$294.2 –\$127.9
Current account balance \$3,258.6 \$3,874.7 –\$616.1
Table 10.1 Components of the U.S. Current Account Balance for 2020 (in billions of dollars). Source: https://apps.bea.gov/itable/index.cfm, ITA Table 1.1.
Clear It Up
How does the U.S. government collect trade statistics?
Do not confuse the balance of trade (which tracks imports and exports), with the current account balance, which includes not just exports and imports, but also income from investment and transfers.
The Bureau of Economic Analysis (BEA) within the U.S. Department of Commerce compiles statistics on the balance of trade using a variety of different sources. Merchandise importers and exporters must file monthly documents with the Census Bureau, which provides the basic data for tracking trade. To measure international trade in services—which can happen over a telephone line or computer network without shipping any physical goods—the BEA carries out a set of surveys. Another set of BEA surveys tracks investment flows, and there are even specific surveys to collect travel information from U.S. residents visiting Canada and Mexico. For measuring unilateral transfers, the BEA has access to official U.S. government spending on aid, and then also carries out a survey of charitable organizations that make foreign donations.
The BEA then cross-checks this information on international flows of goods and capital against other available data. For example, the Census Bureau also collects data from the shipping industry, which it can use to check the data on trade in goods. All companies involved in international flows of capital—including banks and companies making financial investments like stocks—must file reports, which the U.S. Department of the Treasury ultimately checks. The BEA also can cross check information on foreign trade by looking at data collected by other countries on their foreign trade with the United States, and also at the data collected by various international organizations. Take these data sources, stir carefully, and you have the U.S. balance of trade statistics. Much of the statistics that we cite in this chapter come from these sources.
The second row of Table 10.1 provides data on trade in services. Here, the U.S. economy is running a surplus. Although the level of trade in services is still relatively small compared to trade in goods, the importance of services has expanded substantially over the last few decades. For example, U.S. exports of services were equal to about one-half of U.S. exports of goods in 2020, compared to one-fifth in 1980.
The third component of the current account balance, labeled “income payments,” refers to money that U.S. financial investors received on their foreign investments (money flowing into the United States) and payments to foreign investors who had invested their funds here (money flowing out of the United States). The reason for including this money on foreign investment in the overall measure of trade, along with goods and services, is that, from an economic perspective, income is just as much an economic transaction as car, wheat, or oil shipments: it is just trade that is happening in the financial capital market.
The final category of the current account balance is unilateral transfers, which are payments that government, private charities, or individuals make in which they send money abroad without receiving any direct good or service. Economic or military assistance from the U.S. government to other countries fits into this category, as does spending abroad by charities to address poverty or social inequalities. When an individual in the United States sends money overseas, as is the case with some immigrants, it is also counted in this category. The current account balance treats these unilateral payments like imports, because they also involve a stream of payments leaving the country. For the U.S. economy, unilateral transfers are almost always negative. This pattern, however, does not always hold. In 1991, for example, when the United States led an international coalition against Saddam Hussein’s Iraq in the Gulf War, many other nations agreed that they would make payments to the United States to offset the U.S. war expenses. These payments were large enough that, in 1991, the overall U.S. balance on unilateral transfers was a positive \$10 billion.
The following Work It Out feature steps you through the process of using the values for goods, services, and income payments to calculate the merchandise balance and the current account balance.
Work It Out
Calculating the Merchandise Balance and the Current Account Balance
Exports (in \$ billions) Imports (in \$ billions) Balance
Goods
Services
Income payments
Unilateral transfers
Current account balance
Table 10.2 Calculating Merchandise Balance and Current Account Balance
Use the information given below to fill in Table 10.2, and then calculate:
• The merchandise balance
• The current account balance
Known information:
• Unilateral transfers: \$130
• Exports in goods: \$1,046
• Exports in services: \$509
• Imports in goods: \$1,562
• Imports in services: \$371
• Income received by U.S. investors on foreign stocks and bonds: \$561
• Income received by foreign investors on U.S. assets: \$472
Step 1. Focus on goods and services first. Enter the dollar amount of exports of both goods and services under the Export column.
Step 2. Enter imports of goods and services under the Import column.
Step 3. Under the Export column and in the row for Income payments, enter the financial flows of money coming back to the United States. U.S. investors are earning this income from abroad.
Step 4. Under the Import column and in the row for Income payments, enter the financial flows of money going out of the United States to foreign investors. Foreign investors are earning this money on U.S. assets, like stocks.
Step 5. Unilateral transfers are money flowing out of the United States in the form of, for example, military aid, foreign aid, and global charities. Because the money leaves the country, enter it under Imports and in the final column as well, as a negative.
Step 6. Calculate the trade balance by subtracting imports from exports in both goods and services. Enter this in the final Balance column. This can be positive or negative.
Step 7. Subtract the income payments flowing out of the country (under Imports) from the money coming back to the United States (under Exports) and enter this amount under the Balance column.
Step 8. Enter unilateral transfers as a negative amount under the Balance column.
Step 9. The merchandise trade balance is the difference between exports of goods and imports of goods—the first number under Balance.
Step 10. Now sum up your columns for Exports, Imports, and Balance. The final balance number is the current account balance.
The merchandise balance of trade is the difference between exports and imports. In this case, it is equal to \$1,046 – \$1,562, a trade deficit of –\$516 billion. The current account balance is –\$419 billion. See the completed Table 10.3.
Value of Exports (money flowing into the United States) Value of Imports (money flowing out of the United States) Balance
Goods \$1,046 \$1,562 –\$516
Services \$509 \$371 \$138
Income receipts and payments \$561 \$472 \$89
Unilateral transfers \$0 \$130 –\$130
Current account balance \$2,116 \$2,535 –\$419
Table 10.3 Completed Merchandise Balance and Current Account Balance | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/10%3A_The_International_Trade_and_Capital_Flows/10.02%3A_Measuring_Trade_Balances.txt |
Learning Objectives
By the end of this section, you will be able to:
• Analyze graphs of the current account balance and the merchandise trade balance
• Identify patterns in U.S. trade surpluses and deficits
• Compare the U.S. trade surpluses and deficits to other countries' trade surpluses and deficits
We present the history of the U.S. current account balance in recent decades in several different ways. Figure 10.2 (a) shows the current account balance and the merchandise trade balance—the latter of which is simply the balance on goods exported versus imported—in dollar terms. Figure 10.2 (b) shows the current account balance and merchandise account balance yet again, this time as a share of the GDP for that year. By dividing the trade deficit in each year by GDP in that year, Figure 10.2 (b) factors out both inflation and growth in the real economy.
Figure 10.2 Current Account Balance and Merchandise Trade Balance, 1960–2020 (a) The current account balance and the merchandise trade balance in billions of dollars from 1960 to 2020. The merchandise trade balance is the trade balance on goods only. If the lines are above zero dollars, the United States was running a positive trade balance and current account balance. If the lines fall below zero dollars, the United States is running a trade deficit and a deficit in its current account balance. (b) This shows the same items—trade balance and current account balance—in relationship to the size of the U.S. economy, or GDP, from 1960 to 2020.
By either measure, the U.S. balance of trade pattern is clear. From the 1960s into the 1970s, the U.S. economy had mostly small trade surpluses—that is, the graphs in Figure 10.2 show positive numbers. However, starting in the 1980s, the trade deficit increased rapidly, and after a tiny surplus in 1991, the current account trade deficit became even larger in the late 1990s and into the mid-2000s. However, the trade deficit declined in 2009 after the recession had taken hold, then rebounded partially in 2010 and remained stable up through 2019, before falling again in 2020.
Current Account Balance in Billions of Dollars.
Table 10.4 shows the U.S. trade picture in 2013 compared with some other economies from around the world. While the U.S. economy has consistently run trade deficits in recent years, Japan and many European nations, among them France and Germany, have consistently run trade surpluses. Some of the other countries listed include Brazil, the largest economy in Latin America; Nigeria, along with South Africa competing to be the largest economy in Africa; and China, India, and Korea. The first column offers one measure of an economy's globalization: exports of goods and services as a percentage of GDP. The second column shows the trade balance. Usually, most countries have trade surpluses or deficits that are less than 5% of GDP. As you can see, the U.S. current account balance is –2.6% of GDP, while Germany's is 8.4% of GDP.
Exports of Goods and Services Current Account Balance
United States 10.2% –2.9%
Japan 15.5% 3.2%
Germany 43.4% 7.0%
United Kingdom 27.9% –2.6%
Canada 29.0% –1.8%
Sweden 44.6% 5.7%
Korea 36.4% 4.6%
Mexico 40.2% 2.4%
Brazil 16.9% –1.8%
China 18.5% 1.9%
India 18.7% 1.2%
Nigeria 8.8% –3.9%
World - 0.0%
Table 10.4 Level and Balance of Trade (Balance of Payments basis) in 2020 (figures as a percentage of GDP, Source: http://data.worldbank.org/indicator/BN.CAB.XOKA.GD.ZS) | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/10%3A_The_International_Trade_and_Capital_Flows/10.03%3A_Trade_Balances_in_Historical_and_International_Context.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the connection between trade balances and financial capital flows
• Calculate comparative advantage
• Explain balanced trade in terms of investment and capital flows
As economists see it, trade surpluses can be either good or bad, depending on circumstances, and trade deficits can be good or bad, too. The challenge is to understand how the international flows of goods and services are connected with international flows of financial capital. In this module we will illustrate the intimate connection between trade balances and flows of financial capital in two ways: a parable of trade between Robinson Crusoe and Friday, and a circular flow diagram representing flows of trade and payments.
A Two-Person Economy: Robinson Crusoe and Friday
To understand how economists view trade deficits and surpluses, consider a parable based on the story of Robinson Crusoe. Crusoe, as you may remember from the classic novel by Daniel Defoe first published in 1719, was shipwrecked on a desert island. After living alone for some time, he is joined by a second person, whom he names Friday. Think about the balance of trade in a two-person economy like that of Robinson and Friday.
Robinson and Friday trade goods and services. Perhaps Robinson catches fish and trades them to Friday for coconuts, or Friday weaves a hat out of tree fronds and trades it to Robinson for help in carrying water. For a period of time, each individual trade is self-contained and complete. Because each trade is voluntary, both Robinson and Friday must feel that they are receiving fair value for what they are giving. As a result, each person’s exports are always equal to his imports, and trade is always in balance between the two. Neither person experiences either a trade deficit or a trade surplus.
However, one day Robinson approaches Friday with a proposition. Robinson wants to dig ditches for an irrigation system for his garden, but he knows that if he starts this project, he will not have much time left to fish and gather coconuts to feed himself each day. He proposes that Friday supply him with a certain number of fish and coconuts for several months, and then after that time, he promises to repay Friday out of the extra produce that he will be able to grow in his irrigated garden. If Friday accepts this offer, then a trade imbalance comes into being. For several months, Friday will have a trade surplus: that is, he is exporting to Robinson more than he is importing. More precisely, he is giving Robinson fish and coconuts, and at least for the moment, he is receiving nothing in return. Conversely, Robinson will have a trade deficit, because he is importing more from Friday than he is exporting.
This parable raises several useful issues in thinking about what a trade deficit and a trade surplus really mean in economic terms. The first issue that this story of Robinson and Friday raises is this: Is it better to have a trade surplus or a trade deficit? The answer, as in any voluntary market interaction, is that if both parties agree to the transaction, then they may both be better off. Over time, if Robinson’s irrigated garden is a success, it is certainly possible that both Robinson and Friday can benefit from this agreement.
The parable raises a second issue: What can go wrong? Robinson’s proposal to Friday introduces an element of uncertainty. Friday is, in effect, making a loan of fish and coconuts to Robinson, and Friday’s happiness with this arrangement will depend on whether Robinson repays that loan as planned, in full and on time. Perhaps Robinson spends several months loafing and never builds the irrigation system, or perhaps Robinson has been too optimistic about how much he will be able to grow with the new irrigation system, which turns out not to be very productive. Perhaps, after building the irrigation system, Robinson decides that he does not want to repay Friday as much as he previously agreed. Any of these developments will prompt a new round of negotiations between Friday and Robinson. Why the repayment failed is likely to shape Friday’s attitude toward these renegotiations. If Robinson worked very hard and the irrigation system just did not increase production as intended, Friday may have some sympathy. If Robinson loafed or if he just refuses to pay, Friday may become irritated.
A third issue that the parable raises is that an intimate relationship exists between a trade deficit and international borrowing, and between a trade surplus and international lending. The size of Friday’s trade surplus is exactly how much he is lending to Robinson. The size of Robinson’s trade deficit is exactly how much he is borrowing from Friday. To economists, a trade surplus literally means the same thing as an outflow of financial capital, and a trade deficit literally means the same thing as an inflow of financial capital. This last insight is worth exploring in greater detail, which we will do in the following section.
The story of Robinson and Friday also provides a good opportunity to consider the law of comparative advantage, which you learn more about in the International Trade chapter. The following Work It Out feature steps you through calculating comparative advantage for the wheat and cloth traded between the United States and Great Britain in the 1800s.
Work It Out
Calculating Comparative Advantage
In the 1800s, the United States and Britain traded wheat and cloth. Table 10.5 shows the varying hours of labor per unit of output.
Wheat (in bushels) Cloth (in yards) Relative labor cost of wheat (Pw/Pc) Relative labor cost of cloth (Pc/Pw)
United States 8 9 8/9 9/8
Britain 4 3 4/3 3/4
Table 10.5
Step 1. Observe from Table 10.5 that, in the United States, it takes eight hours to supply a bushel of wheat and nine hours to supply a yard of cloth. In contrast, it takes four hours to supply a bushel of wheat and three hours to supply a yard of cloth in Britain.
Step 2. Recognize the difference between absolute advantage and comparative advantage. Britain has an absolute advantage (lowest cost) in each good, since it takes a lower amount of labor to make each good in Britain. Britain also has a comparative advantage in the production of cloth (lower opportunity cost in cloth (3/4 versus 9/8)). The United States has a comparative advantage in wheat production (lower opportunity cost of 8/9 versus 4/3).
Step 3. Determine the relative price of one good in terms of the other good. The price of wheat, in this example, is the amount of cloth you have to give up. To find this price, convert the hours per unit of wheat and cloth into units per hour. To do so, observe that in the United States it takes eight hours to make a bushel of wheat, so workers can process 1/8 of a bushel of wheat in an hour. It takes nine hours to make a yard of cloth in the United States, so workers can produce 1/9 of a yard of cloth in an hour. If you divide the amount of cloth (1/9 of a yard) by the amount of wheat you give up (1/8 of a bushel) in an hour, you find the price (8/9) of one good (wheat) in terms of the other (cloth).
The Balance of Trade as the Balance of Payments
The connection between trade balances and international flows of financial capital is so close that economists sometimes describe the balance of trade as the balance of payments. Each category of the current account balance involves a corresponding flow of payments between a given country and the rest of the world economy.
Figure 10.3 shows the flow of goods and services and payments between one country—the United States in this example—and the rest of the world. The top line shows U.S. exports of goods and services, while the second line shows financial payments from purchasers in other countries back to the U.S. economy. The third line then shows U.S. imports of goods, services, and investment, and the fourth line shows payments from the home economy to the rest of the world. Flow of goods and services (lines one and three) show up in the current account, while we find flow of funds (lines two and four) in the financial account.
The bottom four lines in Figure 10.3 show the flows of investment income. In the first of the bottom lines, we see investments made abroad with funds flowing from the home country to the rest of the world. Investment income stemming from an investment abroad then runs in the other direction from the rest of the world to the home country. Similarly, we see on the bottom third line, an investment from the rest of the world into the home country and investment income (bottom fourth line) flowing from the home country to the rest of the world. We find the investment income (bottom lines two and four) in the current account, while investment to the rest of the world or into the home country (lines one and three) is in the financial account. This figure does not show unilateral transfers, the fourth item in the current account.
Figure 10.3 Flow of Investment Goods and Capital Each element of the current account balance involves a flow of financial payments between countries. The top line shows exports of goods and services leaving the home country; the second line shows the money that the home country receives for those exports. The third line shows imports that the home country receives; the fourth line shows the payments that the home country sent abroad in exchange for these imports.
A current account deficit means that, the country is a net borrower from abroad. Conversely, a positive current account balance means a country is a net lender to the rest of the world. Just like the parable of Robinson and Friday, the lesson is that a trade surplus means an overall outflow of financial investment capital, as domestic investors put their funds abroad, while a deficit in the current account balance is exactly equal to the overall or net inflow of foreign investment capital from abroad.
It is important to recognize that an inflow and outflow of foreign capital does not necessarily refer to a debt that governments owe to other governments, although government debt may be part of the picture. Instead, these international flows of financial capital refer to all of the ways in which private investors in one country may invest in another country—by buying real estate, companies, and financial investments like stocks and bonds. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/10%3A_The_International_Trade_and_Capital_Flows/10.04%3A_Trade_Balances_and_Flows_of_Financial_Capital.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the determinants of trade and current account balance
• Identify and calculate supply and demand for financial capital
• Explain how a nation's own level of domestic saving and investment determines a nation's balance of trade
• Predict the rising and falling of trade deficits based on a nation's saving and investment identity
The close connection between trade balances and international flows of savings and investments leads to a macroeconomic analysis. This approach views trade balances—and their associated flows of financial capital—in the context of the overall levels of savings and financial investment in the economy.
Understanding the Determinants of the Trade and Current Account Balance
The national saving and investment identity provides a useful way to understand the determinants of the trade and current account balance. In a nation’s financial capital market, the quantity of financial capital supplied at any given time must equal the quantity of financial capital demanded for purposes of making investments. What is on the supply and demand sides of financial capital? See the following Clear It Up feature for the answer to this question.
Clear It Up
What comprises the supply and demand of financial capital?
A country’s national savings is the total of its domestic savings by household and companies (private savings) as well as the government (public savings). If a country is running a trade deficit, it means money from abroad is entering the country and the government considers it part of the supply of financial capital.
The demand for financial capital (money) represents groups that are borrowing the money. Businesses need to borrow to finance their investments in factories, materials, and personnel. When the federal government runs a budget deficit, it is also borrowing money from investors by selling Treasury bonds. Therefore, both business investment and the federal government can demand (or borrow) the supply of savings.
There are two main sources for the supply of financial capital in the U.S. economy: saving by individuals and firms, called S, and the inflow of financial capital from foreign investors, which is equal to the trade deficit (M – X), or imports minus exports. There are also two main sources of demand for financial capital in the U.S. economy: private sector investment, I, and government borrowing, where the government needs to borrow when government spending, G, is higher than the taxes collected, T. We can express this national savings and investment identity in algebraic terms:
$Supply of financial capital = Demand for financial capitalS + (M – X) = I + (G – T)Supply of financial capital = Demand for financial capitalS + (M – X) = I + (G – T)$
Again, in this equation, S is private savings, T is taxes, G is government spending, M is imports, X is exports, and I is investment. This relationship is true as a matter of definition because, for the macro economy, the quantity supplied of financial capital must be equal to the quantity demanded.
However, certain components of the national savings and investment identity can switch between the supply side and the demand side. Some countries, like the United States in most years since the 1970s, have budget deficits, which mean the government is spending more than it collects in taxes, and so the government needs to borrow funds. In this case, the government term would be G – T > 0, showing that spending is larger than taxes, and the government would be a demander of financial capital on the left-hand side of the equation (that is, a borrower), not a supplier of financial capital on the right-hand side. However, if the government runs a budget surplus so that the taxes exceed spending, as the U.S. government did from 1998 to 2001, then the government in that year was contributing to the supply of financial capital (T – G > 0), and would appear on the left (saving) side of the national savings and investment identity.
Similarly, if a national economy runs a trade surplus, the trade sector will involve an outflow of financial capital to other countries. A trade surplus means that the domestic financial capital is in surplus within a country and can be invested in other countries.
The fundamental notion that total quantity of financial capital demanded equals total quantity of financial capital supplied must always remain true. Domestic savings will always appear as part of the supply of financial capital and domestic investment will always appear as part of the demand for financial capital. However, the government and trade balance elements of the equation can move back and forth as either suppliers or demanders of financial capital, depending on whether government budgets and the trade balance are in surplus or deficit.
Domestic Saving and Investment Determine the Trade Balance
One insight from the national saving and investment identity is that a nation's own levels of domestic saving and investment determine a nation’s balance of trade. To understand this point, rearrange the identity to put the balance of trade all by itself on one side of the equation. Consider first the situation with a trade deficit, and then the situation with a trade surplus.
In the case of a trade deficit, the national saving and investment identity can be rewritten as:
$Trade deficit = Domestic investment – Private domestic saving – Government (or public) savings(M – X) = I – S – (T – G)Trade deficit = Domestic investment – Private domestic saving – Government (or public) savings(M – X) = I – S – (T – G)$
In this case, domestic investment is higher than domestic saving, including both private and government saving. The only way that domestic investment can exceed domestic saving is if capital is flowing into a country from abroad. After all, that extra financial capital for investment has to come from someplace.
Now consider a trade surplus from the standpoint of the national saving and investment identity:
$Trade surplus = Private domestic saving + Public saving – Domestic investment(X – M) = S + (T – G) – ITrade surplus = Private domestic saving + Public saving – Domestic investment(X – M) = S + (T – G) – I$
In this case, domestic savings (both private and public) is higher than domestic investment. That extra financial capital will be invested abroad.
This connection of domestic saving and investment to the trade balance explains why economists view the balance of trade as a fundamentally macroeconomic phenomenon. As the national saving and investment identity shows, the performance of certain sectors of an economy, like cars or steel, do not determine the trade balance. Further, whether the nation’s trade laws and regulations encourage free trade or protectionism also does not determine the trade balance (see Globalization and Protectionism).
Exploring Trade Balances One Factor at a Time
The national saving and investment identity also provides a framework for thinking about what will cause trade deficits to rise or fall. Begin with the version of the identity that has domestic savings and investment on the left and the trade deficit on the right:
$Domestic investment – Private domestic savings – Public domestic savings = Trade deficitI – S – (T – G) = (M – X)Domestic investment – Private domestic savings – Public domestic savings = Trade deficitI – S – (T – G) = (M – X)$
Now, consider the factors on the left-hand side of the equation one at a time, while holding the other factors constant.
As a first example, assume that the level of domestic investment in a country rises, while the level of private and public saving remains unchanged. Table 10.6 shows the result in the first row under the equation. Since the equality of the national savings and investment identity must continue to hold—it is, after all, an identity that must be true by definition—the rise in domestic investment will mean a higher trade deficit. This situation occurred in the U.S. economy in the late 1990s. Because of the surge of new information and communications technologies that became available, business investment increased substantially. A fall in private saving during this time and a rise in government saving more or less offset each other. As a result, the financial capital to fund that business investment came from abroad, which is one reason for the very high U.S. trade deficits of the late 1990s and early 2000s.
Domestic Investment Private Domestic Savings Public Domestic Savings = Trade Deficit
I S (T – G) = (M – X)
Up No change No change Then M – X must rise
No change Up No change Then M – X must fall
No change No change Down Then M – X must rise
Table 10.6 Causes of a Changing Trade Balance
As a second scenario, assume that the level of domestic savings rises, while the level of domestic investment and public savings remain unchanged. In this case, the trade deficit would decline. As domestic savings rises, there would be less need for foreign financial capital to meet investment needs. For this reason, a policy proposal often made for reducing the U.S. trade deficit is to increase private saving—although exactly how to increase the overall rate of saving has proven controversial.
As a third scenario, imagine that the government budget deficit increased dramatically, while domestic investment and private savings remained unchanged. This scenario occurred in the U.S. economy in the mid-1980s. The federal budget deficit increased from \$79 billion in 1981 to \$221 billion in 1986—an increase in the demand for financial capital of \$142 billion. The current account balance collapsed from a surplus of \$5 billion in 1981 to a deficit of \$147 billion in 1986—an increase in the supply of financial capital from abroad of \$152 billion. The connection at that time is clear: a sharp increase in government borrowing increased the U.S. economy’s demand for financial capital, and foreign investors through the trade deficit primarily supplied that increase. The following Work It Out feature walks you through a scenario in which private domestic savings has to rise by a certain amount to reduce a trade deficit.
Work It Out
Solving Problems with the Saving and Investment Identity
Use the saving and investment identity to answer the following question: Country A has a trade deficit of \$200 billion, private domestic savings of \$500 billion, a government deficit of \$200 billion, and private domestic investment of \$500 billion. To reduce the \$200 billion trade deficit by \$100 billion, by how much does private domestic savings have to increase?
Step 1. Write out the savings investment formula solving for the trade deficit or surplus on the left:
$(X – M) = S + (T – G) – I(X – M) = S + (T – G) – I$
Step 2. In the formula, put the amount for the trade deficit in as a negative number (X – M). The left side of your formula is now:
$–200 = S + (T – G) – I–200 = S + (T – G) – I$
Step 3. Enter the private domestic savings (S) of \$500 in the formula:
$–200 = 500 + (T – G) – I –200 = 500 + (T – G) – I$
Step 4. Enter the private domestic investment (I) of \$500 into the formula:
$–200 = 500 + (T – G) – 500 –200 = 500 + (T – G) – 500$
Step 5. The government budget surplus or balance is represented by (T – G). Enter a budget deficit amount for (T – G) of –200:
$–200 = 500 + (–200) – 500 –200 = 500 + (–200) – 500$
Step 6. Your formula now is:
$(X – M) = S + (T – G) – I–200 = 500 + (–200) – 500(X – M) = S + (T – G) – I–200 = 500 + (–200) – 500$
The question is: To reduce your trade deficit (X – M) of –200 to –100 (in billions of dollars), by how much will savings have to rise?
$(X – M) = S + (T – G) – I–100 = S + (–200) – 500600 = S(X – M) = S + (T – G) – I–100 = S + (–200) – 500600 = S$
Step 7. Summarize the answer: Private domestic savings needs to rise by \$100 billion, to a total of \$600 billion, for the two sides of the equation to remain equal (–100 = –100).
Short-Term Movements in the Business Cycle and the Trade Balance
In the short run, whether an economy is in a recession or on the upswing can affect trade imbalances. A recession tends to make a trade deficit smaller, or a trade surplus larger, while a period of strong economic growth tends to make a trade deficit larger, or a trade surplus smaller. These are not hard-and-fast rules, however.
As an example, note in Figure 10.2 that the U.S. trade deficit declined by almost half from 2006 to 2009. One primary reason for this change is that during the recession, as the U.S. economy slowed down, it purchased fewer of all goods, including fewer imports from abroad. However, buying power abroad fell less, and so U.S. exports did not fall by as much. On the other hand, during the 2020 pandemic-induced recession, the trade deficit expanded (current account balance plummeted) as the U.S. economy became more reliant on other countries for goods and services.
Conversely, in the mid-2000s, when the U.S. trade deficit became very large, a contributing short-term reason is that the U.S. economy was growing. As a result, there was considerable aggressive buying in the U.S. economy, including the buying of imports. Thus, a trade deficit (or a much lower trade surplus) often accompanies a rapidly growing domestic economy, while a trade surplus (or a much lower trade deficit) accompanies a slowing or recessionary domestic economy.
Regardless of whether the trade deficit falls or rises during expansions or downturns, when the trade deficit rises, it necessarily means a greater net inflow of foreign financial capital. The national saving and investment identity teaches that the rest of the economy can absorb this inflow of foreign financial capital in several different ways. For example, reduced private savings could offset the additional inflow of financial capital from abroad, leaving domestic investment and public saving unchanged. Alternatively, the inflow of foreign financial capital could result in higher domestic investment, leaving private and public saving unchanged. Yet another possibility is that greater government borrowing could absorb the inflow of foreign financial capital, leaving domestic saving and investment unchanged. The national saving and investment identity does not specify which of these scenarios, alone or in combination, will occur—only that one of them must occur. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/10%3A_The_International_Trade_and_Capital_Flows/10.05%3A_The_National_Saving_and_Investment_Identity.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify three ways in which borrowing money or running a trade deficit can result in a healthy economy
• Identify three ways in which borrowing money or running a trade deficit can result in a weaker economy
Because flows of trade always involve flows of financial payments, flows of international trade are actually the same as flows of international financial capital. The question of whether trade deficits or surpluses are good or bad for an economy is, in economic terms, exactly the same question as whether it is a good idea for an economy to rely on net inflows of financial capital from abroad or to make net investments of financial capital abroad. Conventional wisdom often holds that borrowing money is foolhardy, and that a prudent country, like a prudent person, should always rely on its own resources. While it is certainly possible to borrow too much—as anyone with an overloaded credit card can testify—borrowing at certain times can also make sound economic sense. For both individuals and countries, there is no economic merit in a policy of abstaining from participation in financial capital markets.
It makes economic sense to borrow when you are buying something with a long-run payoff; that is, when you are making an investment. For this reason, it can make economic sense to borrow for a college education, because the education will typically allow you to earn higher wages, and so to repay the loan and still come out ahead. It can also make sense for a business to borrow in order to purchase a machine that will last 10 years, as long as the machine will increase output and profits by more than enough to repay the loan. Similarly, it can make economic sense for a national economy to borrow from abroad, as long as it wisely invests the money in ways that will tend to raise the nation’s economic growth over time. Then, it will be possible for the national economy to repay the borrowed money over time and still end up better off than before.
One vivid example of a country that borrowed heavily from abroad, invested wisely, and did perfectly well is the United States during the nineteenth century. The United States ran a trade deficit in 40 of the 45 years from 1831 to 1875, which meant that it was importing capital from abroad over that time. However, that financial capital was mostly invested in projects like railroads that brought a substantial economic payoff. (See the following Clear It Up feature for more on this.)
A more recent example along these lines is the experience of South Korea, which had trade deficits during much of the 1970s—and so was an importer of capital over that time. However, South Korea also had high rates of investment in physical plant and equipment, and its economy grew rapidly. From the mid-1980s into the mid-1990s, South Korea often had trade surpluses—that is, it was repaying its past borrowing by sending capital abroad.
In contrast, some countries have run large trade deficits, borrowed heavily in global capital markets, and ended up in all kinds of trouble. Two specific sorts of trouble are worth examining. First, a borrower nation can find itself in a bind if it does not invest the incoming funds from abroad in a way that leads to increased productivity. Several of Latin America's large economies, including Mexico and Brazil, ran large trade deficits and borrowed heavily from abroad in the 1970s, but the inflow of financial capital did not boost productivity sufficiently, which meant that these countries faced enormous troubles repaying the money borrowed when economic conditions shifted during the 1980s. Similarly, it appears that a number of African nations that borrowed foreign funds in the 1970s and 1980s did not invest in productive economic assets. As a result, several of those countries later faced large interest payments, with no economic growth to show for the borrowed funds.
Clear It Up
Are trade deficits always harmful?
For most years of the nineteenth century, U.S. imports exceeded exports and the U.S. economy had a trade deficit. Yet the string of trade deficits did not hold back the economy at all. Instead, the trade deficits contributed to the strong economic growth that gave the U.S. economy the highest per capita GDP in the world by around 1900.
The U.S. trade deficits meant that the U.S. economy was receiving a net inflow of foreign capital from abroad. Much of that foreign capital flowed into two areas of investment—railroads and public infrastructure like roads, water systems, and schools—which were important to helping the U.S. economy grow.
We should not overstate the effect of foreign investment capital on U.S. economic growth. In most years the foreign financial capital represented no more than 6–10% of the funds that the government used for overall physical investment in the economy. Nonetheless, the trade deficit and the accompanying investment funds from abroad were clearly a help, not a hindrance, to the U.S. economy in the nineteenth century.
A second “trouble” is: What happens if the foreign money flows in, and then suddenly flows out again? We raised this scenario at the start of the chapter. In the mid-1990s, a number of countries in East Asia—Thailand, Indonesia, Malaysia, and South Korea—ran large trade deficits and imported capital from abroad. However, in 1997 and 1998 many foreign investors became concerned about the health of these economies, and quickly pulled their money out of stock and bond markets, real estate, and banks. The extremely rapid departure of that foreign capital staggered the banking systems and economies of these countries, plunging them into deep recession. We investigate and discuss the links between international capital flows, banks, and recession in The Impacts of Government Borrowing.
While a trade deficit is not always harmful, there is no guarantee that running a trade surplus will bring robust economic health. For example, Germany and Japan ran substantial trade surpluses for most of the last three decades. Regardless of their persistent trade surpluses, both countries have experienced occasional recessions and neither country has had especially robust annual growth in recent years. Read more about Japan’s trade surplus in the next Clear It Up feature.
Link It Up
Watch this video on whether or not trade deficit is good for the economy.
The sheer size and persistence of the U.S. trade deficits and inflows of foreign capital since the 1980s are a legitimate cause for concern. The huge U.S. economy will not be destabilized by an outflow of international capital as easily as, say, the comparatively tiny economies of Thailand and Indonesia were in 1997–1998. Even an economy that is not knocked down, however, can still be shaken. American policymakers should certainly be paying attention to those cases where a pattern of extensive and sustained current account deficits and foreign borrowing has gone badly—if only as a cautionary tale.
Clear It Up
Are trade surpluses always beneficial? Considering Japan since the 1990s.
Perhaps no economy around the world is better known for its trade surpluses than Japan. Since 1990, the size of these surpluses has often been near \$100 billion per year. When Japan’s economy was growing vigorously in the 1960s and 1970s, many, especially non-economists, described its large trade surpluses either a cause or a result of its robust economic health. However, from a standpoint of economic growth, Japan’s economy has been teetering in and out of recession since 1990, with real GDP growth averaging only about 1% per year, and an unemployment rate that has been creeping higher. Clearly, a whopping trade surplus is no guarantee of economic good health.
Instead, Japan’s trade surplus reflects that Japan has a very high rate of domestic savings, more than the Japanese economy can invest domestically, and so it invests the extra funds abroad. In Japan’s slow economy, consumption of imports is relatively low, and the growth of consumption is relatively slow. Thus, Japan’s exports continually exceed its imports, leaving the trade surplus continually high. Recently, Japan’s trade surpluses began to deteriorate. In 2013, Japan ran a trade deficit due to the high cost of imported oil. By 2015, Japan again had a surplus and continues to run one today. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/10%3A_The_International_Trade_and_Capital_Flows/10.06%3A_The_Pros_and_Cons_of_Trade_Deficits_and_Surpluses.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify three factors that influence a country's level of trade
• Differentiate between balance of trade and level of trade
A nation’s level of trade may at first sound like much the same issue as the balance of trade, but these two are actually quite separate. It is perfectly possible for a country to have a very high level of trade—measured by its exports of goods and services as a share of its GDP—while it also has a near-balance between exports and imports. A high level of trade indicates that the nation exports a good portion of its production. It is also possible for a country’s trade to be a relatively low share of GDP, relative to global averages, but for the imbalance between its exports and its imports to be quite large. We emphasized this general theme earlier in Measuring Trade Balances, which offered some illustrative figures on trade levels and balances.
A country’s level of trade tells how much of its production it exports. We measure this by the percent of exports out of GDP. It indicates the degree of an economy's globalization. Some countries, such as Germany, have a high level of trade—they export almost 50% of their total production. The balance of trade tells us if the country is running a trade surplus or trade deficit. A country can have a low level of trade but a high trade deficit. (For example, the United States only exports around 10% of its GDP, but it has a trade deficit of over \$600 billion.)
Three factors strongly influence a nation’s level of trade: the size of its economy, its geographic location, and its history of trade. Large economies like the United States can do much of their trading internally, while small economies like Sweden have less ability to provide what they want internally and tend to have higher ratios of exports and imports to GDP. Nations that are neighbors tend to trade more, since costs of transportation and communication are lower. Moreover, some nations have long and established patterns of international trade, while others do not.
Consequently, a relatively small economy like Sweden, with many nearby trading partners across Europe and a long history of foreign trade, has a high level of trade. Brazil and India, which are fairly large economies that have often sought to inhibit trade in recent decades, have lower levels of trade; whereas, the United States and Japan are extremely large economies that have comparatively few nearby trading partners. Both countries actually have quite low levels of trade by world standards. The ratio of exports to GDP in either the United States or in Japan is about half of the world average.
The balance of trade is a separate issue from the level of trade. The United States has a low level of trade, but had enormous trade deficits for most years from the mid-1980s into the 2000s. Japan has a low level of trade by world standards, but has typically shown large trade surpluses in recent decades. Nations like Germany and the United Kingdom have medium to high levels of trade by world standards, but Germany had a moderate trade surplus in 2020, while the United Kingdom had a moderate trade deficit. Their trade picture was roughly in balance in the late 1990s. Sweden had a high level of trade and a moderate trade surplus in 2020, while Canada had a high level of trade and a moderate trade deficit that same year.
In short, it is quite possible for nations with a relatively low level of trade, expressed as a percentage of GDP, to have relatively large trade deficits. It is also quite possible for nations with a near balance between exports and imports to worry about the consequences of high levels of trade for the economy. It is not inconsistent to believe that a high level of trade is potentially beneficial to an economy, because of the way it allows nations to play to their comparative advantages, and to also be concerned about any macroeconomic instability caused by a long-term pattern of large trade deficits. The following Clear It Up feature discusses how this sort of dynamic played out in Colonial India.
Clear It Up
Are trade surpluses always beneficial? Considering Colonial India.
India was formally under British rule from 1858 to 1947. During that time, India consistently had trade surpluses with Great Britain. Anyone who believes that trade surpluses are a sign of economic strength and dominance while trade deficits are a sign of economic weakness must find this pattern odd, since it would mean that colonial India was successfully dominating and exploiting Great Britain for almost a century—which was not true.
Instead, India’s trade surpluses with Great Britain meant that each year there was an overall flow of financial capital from India to Great Britain. In India, many heavily criticized this financial capital flow as the “drain,” and they viewed eliminating the financial capital drain as one of the many reasons why India would benefit from achieving independence.
Final Thoughts about Trade Balances
Trade deficits can be a good or a bad sign for an economy, and trade surpluses can be a good or a bad sign. Even a trade balance of zero—which just means that a nation is neither a net borrower nor lender in the international economy—can be either a good or bad sign. The fundamental economic question is not whether a nation’s economy is borrowing or lending at all, but whether the particular borrowing or lending in the particular economic conditions of that country makes sense.
It is interesting to reflect on how public attitudes toward trade deficits and surpluses might change if we could somehow change the labels that people and the news media affix to them. If we called a trade deficit “attracting foreign financial capital”—which accurately describes what a trade deficit means—then trade deficits might look more attractive. Conversely, if we called a trade surplus “shipping financial capital abroad”—which accurately captures what a trade surplus does—then trade surpluses might look less attractive. Either way, the key to understanding trade balances is to understand the relationships between flows of trade and flows of international payments, and what these relationships imply about the causes, benefits, and risks of different kinds of trade balances. The first step along this journey of understanding is to move beyond knee-jerk reactions to terms like “trade surplus,” “trade balance,” and “trade deficit.”
Bring It Home
More than Meets the Eye in the Congo
Now that you see the big picture, you undoubtedly realize that all of the economic choices you make, such as depositing savings or investing in an international mutual fund, do influence the flow of goods and services as well as the flows of money around the world.
You now know that a trade surplus does not necessarily tell us whether an economy is performing well or not. The Democratic Republic of the Congo ran a trade surplus in 2013, as we learned in the beginning of the chapter. Yet its current account balance was –\$2.8 billion. However, the return of political stability and the rebuilding in the aftermath of the civil war there has meant a flow of investment and financial capital into the country. In this case, a negative current account balance means the country is being rebuilt—and that is a good thing. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/10%3A_The_International_Trade_and_Capital_Flows/10.07%3A_The_Difference_between_Level_of_Trade_and_the_Trade_Balance.txt |
balance of trade (trade balance)
the gap, if any, between a nation’s exports and imports
current account balance
a broad measure of the balance of trade that includes trade in goods and services, as well as international flows of income and foreign aid
exports of goods and services as a percentage of GDP
the dollar value of exports divided by the dollar value of a country’s GDP
financial capital
the international flows of money that facilitates trade and investment
merchandise trade balance
the balance of trade looking only at goods
national savings and investment identity
the total of private savings and public savings (a government budget surplus)
unilateral transfers
“one-way payments” that governments, private entities, or individuals make that they sent abroad with nothing received in return
10.09: Key Concepts and Summary
10.1 Measuring Trade Balances
The trade balance measures the gap between a country’s exports and its imports. In most high-income economies, goods comprise less than half of a country’s total production, while services comprise more than half. The last two decades have seen a surge in international trade in services; however, most global trade still takes the form of goods rather than services. The current account balance includes the trade in goods, services, and money flowing into and out of a country from investments and unilateral transfers.
10.2 Trade Balances in Historical and International Context
The United States developed large trade surpluses in the early 1980s, swung back to a tiny trade surplus in 1991, and then had even larger trade deficits in the late 1990s and early 2000s. As we will see below, a trade deficit necessarily means a net inflow of financial capital from abroad, while a trade surplus necessarily means a net outflow of financial capital from an economy to other countries.
10.3 Trade Balances and Flows of Financial Capital
International flows of goods and services are closely connected to the international flows of financial capital. A current account deficit means that, after taking all the flows of payments from goods, services, and income together, the country is a net borrower from the rest of the world. A current account surplus is the opposite and means the country is a net lender to the rest of the world.
10.4 The National Saving and Investment Identity
The national saving and investment identity is based on the relationship that the total quantity of financial capital supplied from all sources must equal the total quantity of financial capital demanded from all sources. If S is private saving, T is taxes, G is government spending, M is imports, X is exports, and I is investment, then for an economy with a current account deficit and a budget deficit:
$Supply of financial capital = Demand for financial capitalS + (M – X)=I + (G – T) Supply of financial capital = Demand for financial capitalS + (M – X)=I + (G – T)$
A recession tends to increase the trade balance (meaning a higher trade surplus or lower trade deficit), while economic boom will tend to decrease the trade balance (meaning a lower trade surplus or a larger trade deficit).
10.5 The Pros and Cons of Trade Deficits and Surpluses
Trade surpluses are no guarantee of economic health, and trade deficits are no guarantee of economic weakness. Either trade deficits or trade surpluses can work out well or poorly, depending on whether a government wisely invests the corresponding flows of financial capital.
10.6 The Difference between Level of Trade and the Trade Balance
There is a difference between the level of a country’s trade and the balance of trade. The government measures its level of trade by the percentage of exports out of GDP, or the size of the economy. Small economies that have nearby trading partners and a history of international trade will tend to have higher levels of trade. Larger economies with few nearby trading partners and a limited history of international trade will tend to have lower levels of trade. The level of trade is different from the trade balance. The level of trade depends on a country’s history of trade, its geography, and the size of its economy. A country’s balance of trade is the dollar difference between its exports and imports.
Trade deficits and trade surpluses are not necessarily good or bad—it depends on the circumstances. Even if a country is borrowing, if it invests that money in productivity-boosting investments it can lead to an improvement in long-term economic growth. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/10%3A_The_International_Trade_and_Capital_Flows/10.08%3A_Key_Terms.txt |
1.
If foreign investors buy more U.S. stocks and bonds, how would that show up in the current account balance?
2.
If the trade deficit of the United States increases, how is the current account balance affected?
3.
State whether each of the following events involves a financial flow to the Mexican economy or a financial flow out of the Mexican economy:
1. Mexico imports services from Japan
2. Mexico exports goods to Canada
3. U.S. investors receive a return from past financial investments in Mexico
4.
In what way does comparing a country’s exports to GDP reflect its degree of globalization?
5.
At one point Canada’s GDP was \$1,800 billion and its exports were \$542 billion. What was Canada’s export ratio at this time?
6.
The GDP for the United States is \$18,036 billion and its current account balance is –\$484 billion. What percent of GDP is the current account balance?
7.
Why does the trade balance and the current account balance track so closely together over time?
8.
State whether each of the following events involves a financial flow to the U.S. economy or away from the U.S. economy:
1. Export sales to Germany
2. Returns paid on past U.S. financial investments in Brazil
3. Foreign aid from the U.S. government to Egypt
4. Imported oil from the Russian Federation
5. Japanese investors buying U.S. real estate
9.
How does the bottom portion of Figure 10.3, showing the international flow of investments and capital, differ from the upper portion?
10.
Explain the relationship between a current account deficit or surplus and the flow of funds.
11.
Using the national savings and investment identity, explain how each of the following changes (ceteris paribus) will increase or decrease the trade balance:
1. A lower domestic savings rate
2. The government changes from running a budget surplus to running a budget deficit
3. The rate of domestic investment surges
12.
If a country is running a government budget surplus, why is (T – G) on the left side of the saving-investment identity?
13.
What determines the size of a country’s trade deficit?
14.
If domestic investment increases, and there is no change in the amount of private and public saving, what must happen to the size of the trade deficit?
15.
Why does a recession cause a trade deficit to increase?
16.
Both the United States and global economies are booming. Will U.S. imports and/or exports increase?
17.
For each of the following, indicate which type of government spending would justify a budget deficit and which would not.
1. Increased federal spending on Medicare
2. Increased spending on education
3. Increased spending on the space program
4. Increased spending on airports and air traffic control
18.
How did large trade deficits hurt the East Asian countries in the mid 1980s? (Recall that trade deficits are equivalent to inflows of financial capital from abroad.)
19.
Describe a scenario in which a trade surplus benefits an economy and one in which a trade surplus is occurring in an economy that performs poorly. What key factor or factors are making the difference in the outcome that results from a trade surplus?
20.
The United States exports 14% of GDP while Germany exports about 50% of its GDP. Explain what that means.
21.
Explain briefly whether each of the following would be more likely to lead to a higher level of trade for an economy, or a greater imbalance of trade for an economy.
1. Living in an especially large country
2. Having a domestic investment rate much higher than the domestic savings rate
3. Having many other large economies geographically nearby
4. Having an especially large budget deficit
5. Having countries with a tradition of strong protectionist legislation shutting out imports | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/10%3A_The_International_Trade_and_Capital_Flows/10.10%3A_Self-Check_Questions.txt |
22.
If imports exceed exports, is it a trade deficit or a trade surplus? What about if exports exceed imports?
23.
What is included in the current account balance?
24.
In recent decades, has the U.S. trade balance usually been in deficit, surplus, or balanced?
25.
Does a trade surplus mean an overall inflow of financial capital to an economy, or an overall outflow of financial capital? What about a trade deficit?
26.
What are the two main sides of the national savings and investment identity?
27.
What are the main components of the national savings and investment identity?
28.
When is a trade deficit likely to work out well for an economy? When is it likely to work out poorly?
29.
Does a trade surplus help to guarantee strong economic growth?
30.
What three factors will determine whether a nation has a higher or lower share of trade relative to its GDP?
31.
What is the difference between trade deficits and balance of trade?
10.12: Critical Thinking Questions
32.
Occasionally, a government official will argue that a country should strive for both a trade surplus and a healthy inflow of capital from abroad. Explain why such a statement is economically impossible.
33.
A government official announces a new policy. The country wishes to eliminate its trade deficit, but will strongly encourage financial investment from foreign firms. Explain why such a statement is contradictory.
34.
If a country is a big exporter, is it more exposed to global financial crises?
35.
If countries reduced trade barriers, would the international flows of money increase?
36.
Is it better for your country to be an international lender or borrower?
37.
Many think that the size of a trade deficit is due to a lack of competitiveness of domestic sectors, such as autos. Explain why this is not true.
38.
If you observed a country with a rapidly growing trade surplus over a period of a year or so, would you be more likely to believe that the country's economy was in a period of recession or of rapid growth? Explain.
39.
Occasionally, a government official will argue that a country should strive for both a trade surplus and a healthy inflow of capital from abroad. Is this possible?
40.
What is more important, a country’s current account balance or GDP growth? Why?
41.
Will nations that are more involved in foreign trade tend to have higher trade imbalances, lower trade imbalances, or is the pattern unpredictable?
42.
Some economists warn that the persistent trade deficits and a negative current account balance that the United States has run will be a problem in the long run. Do you agree or not? Explain your answer.
10.13: Problems
43.
In 2001, the United Kingdom's economy exported goods worth £192 billion and services worth another £77 billion. It imported goods worth £225 billion and services worth £66 billion. Receipts of income from abroad were £140 billion while income payments going abroad were £131 billion. Government transfers from the United Kingdom to the rest of the world were £23 billion, while various U.K government agencies received payments of £16 billion from the rest of the world.
1. Calculate the U.K. merchandise trade deficit for 2001.
2. Calculate the current account balance for 2001.
3. Explain how you decided whether payments on foreign investment and government transfers counted on the positive or the negative side of the current account balance for the United Kingdom in 2001.
44.
Imagine that the U.S. economy finds itself in the following situation: a government budget deficit of \$100 billion, total domestic savings of \$1,500 billion, and total domestic physical capital investment of \$1,600 billion. According to the national saving and investment identity, what will be the current account balance? What will be the current account balance if investment rises by \$50 billion, while the budget deficit and national savings remain the same?
45.
Table 10.7 provides some hypothetical data on macroeconomic accounts for three countries represented by A, B, and C and measured in billions of currency units. In Table 10.7, private household saving is SH, tax revenue is T, government spending is G, and investment spending is I.
A B C
SH 700 500 600
T 00 500 500
G 600 350 650
I 800 400 450
Table 10.7 Macroeconomic Accounts
1. Calculate the trade balance and the net inflow of foreign saving for each country.
2. State whether each one has a trade surplus or deficit (or balanced trade).
3. State whether each is a net lender or borrower internationally and explain.
46.
Imagine that the economy of Germany finds itself in the following situation: the government budget has a surplus of 1% of Germany’s GDP; private savings is 20% of GDP; and physical investment is 18% of GDP.
1. Based on the national saving and investment identity, what is the current account balance?
2. If the government budget surplus falls to zero, how will this affect the current account balance? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/10%3A_The_International_Trade_and_Capital_Flows/10.11%3A_Review_Questions.txt |
Figure 11.1 New Home Construction At the peak of the housing bubble, many people across the country were able to secure the loans necessary to build new houses. (Credit: modification of "our house! Again!" by Tim Pierce/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Macroeconomic Perspectives on Demand and Supply
• Building a Model of Aggregate Supply and Aggregate Demand
• Shifts in Aggregate Supply
• Shifts in Aggregate Demand
• How the AS–AD Model Incorporates Growth, Unemployment, and Inflation
• Keynes’ Law and Say’s Law in the AS–AD Model
Bring It Home
From Housing Bubble to Housing Bust
The United States experienced rising home ownership rates for most of the last two decades. Between 1990 and 2006, the U.S. housing market grew. Homeownership rates grew from 64% to a high of over 69% between 2004 and 2005. For many people, this was a period in which they could either buy first homes or buy a larger and more expensive home. During this time mortgage values tripled. Housing became more accessible to Americans and was considered to be a safe financial investment. Figure 11.2 shows how new single family home sales peaked in 2005 at 1,279,000 units.
Figure 11.2 New Single Family Houses Sold From the early 1990s up through 2005, the number of new single family houses sold rose steadily. In 2006, the number dropped dramatically and this dramatic decline continued through 2011. Beginning in 2012, the number of new houses sold began to climb back up. (Source: U.S. Census Bureau)
The housing bubble began to show signs of bursting in 2005, as delinquency and late payments began to grow and an oversupply of new homes on the market became apparent. Dropping home values contributed to a decrease in the overall wealth of the household sector and caused homeowners to pull back on spending. Several mortgage lenders were forced to file for bankruptcy because homeowners were not making their payments, and by 2008 the problem had spread throughout the financial markets. Lenders clamped down on credit and the housing bubble burst. Financial markets were now in crisis and unable or unwilling to even extend credit to credit-worthy customers.
The housing bubble and the crisis in the financial markets were major contributors to the Great Recession that led to unemployment rates over 10% and falling GDP. While the United States is still recovering from the impact of the Great Recession, it has made substantial progress in restoring financial market stability through implementing aggressive fiscal and monetary policy.
The economic history of the United States is cyclical in nature with recessions and expansions. Some of these fluctuations are severe, such as the economic downturn that occurred during the Great Depression in the 1930s which lasted several years. Why does the economy grow at different rates in different years? What are the causes of the cyclical behavior of the economy? This chapter will introduce an important model, the aggregate demand–aggregate supply model, to begin our understanding of why economies expand and contract over time.
New One-Family Houses Sold in the United States.
A key part of macroeconomics is the use of models to analyze macro issues and problems. How is the rate of economic growth connected to changes in the unemployment rate? Is there a reason why unemployment and inflation seem to move in opposite directions: lower unemployment and higher inflation from 1997 to 2000, higher unemployment and lower inflation in the early 2000s, lower unemployment and higher inflation in the mid-2000s, and then higher unemployment and lower inflation in 2009? Why did the current account deficit rise so high, but then decline in 2009?
To analyze questions like these, we must move beyond discussing macroeconomic issues one at a time, and begin building economic models that will capture the relationships and interconnections between them. The next three chapters take up this task. This chapter introduces the macroeconomic model of aggregate supply and aggregate demand, how the two interact to reach a macroeconomic equilibrium, and how shifts in aggregate demand or aggregate supply will affect that equilibrium. This chapter also relates the model of aggregate supply and aggregate demand to the three goals of economic policy (growth, unemployment, and inflation), and provides a framework for thinking about many of the connections and tradeoffs between these goals. The chapter on The Keynesian Perspective focuses on the macroeconomy in the short run, where aggregate demand plays a crucial role. The chapter on The Neoclassical Perspective explores the macroeconomy in the long run, where aggregate supply plays a crucial role. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/11%3A_The_Aggregate_Demand_Aggregate_Supply_Model/11.01%3A_Introduction_to_the_Aggregate_Demand_Aggregate_Supply_Model.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain Say’s Law and understand why it primarily applies in the long run
• Explain Keynes’ Law and understand why it primarily applies in the short run
Macroeconomists over the last two centuries have often divided into two groups: those who argue that supply is the most important determinant of the size of the macroeconomy while demand just tags along, and those who argue that demand is the most important factor in the size of the macroeconomy while supply just tags along.
Say’s Law and the Macroeconomics of Supply
Those economists who emphasize the role of supply in the macroeconomy often refer to the work of a famous early nineteenth century French economist named Jean-Baptiste Say (1767–1832). Say’s law is: “Supply creates its own demand.” As a matter of historical accuracy, it seems clear that Say never actually wrote down this law and that it oversimplifies his beliefs, but the law lives on as useful shorthand for summarizing a point of view.
The intuition behind Say’s law is that each time a good or service is produced and sold, it generates income that is earned for someone: a worker, a manager, an owner, or those who are workers, managers, and owners at firms that supply inputs along the chain of production. We alluded to this earlier in our discussion of the National Income approach to measuring GDP. The forces of supply and demand in individual markets will cause prices to rise and fall. The bottom line remains, however, that every sale represents income to someone, and so, Say’s law argues, a given value of supply must create an equivalent value of demand somewhere else in the economy. Because Jean-Baptiste Say, Adam Smith, and other economists writing around the turn of the nineteenth century who discussed this view were known as “classical” economists, modern economists who generally subscribe to the Say’s law view on the importance of supply for determining the size of the macroeconomy are called neoclassical economists.
If supply always creates exactly enough demand at the macroeconomic level, then (as Say himself recognized) it is hard to understand why periods of recession and high unemployment should ever occur. To be sure, even if total supply always creates an equal amount of total demand, the economy could still experience a situation of some firms earning profits while other firms suffer losses. Nevertheless, a recession is not a situation where all business failures are exactly counterbalanced by an offsetting number of successes. A recession is a situation in which the economy as a whole is shrinking in size, business failures outnumber the remaining success stories, and many firms end up suffering losses and laying off workers.
Say’s law that supply creates its own demand does seem a good approximation for the long run. Over periods of some years or decades, as the productive power of an economy to supply goods and services increases, total demand in the economy grows at roughly the same pace. However, over shorter time horizons of a few months or even years, recessions or even depressions occur in which firms, as a group, seem to face a lack of demand for their products.
Keynes’ Law and the Macroeconomics of Demand
The alternative to Say’s law, with its emphasis on supply, is Keynes’ law: “Demand creates its own supply.” As a matter of historical accuracy, just as Jean-Baptiste Say never wrote down anything as simpleminded as Say’s law, John Maynard Keynes never wrote down Keynes’ law, but the law is a useful simplification that conveys a certain point of view.
When Keynes wrote his influential work The General Theory of Employment, Interest, and Money during the 1930s Great Depression, he pointed out that during the Depression, the economy's capacity to supply goods and services had not changed much. U.S. unemployment rates soared higher than 20% from 1933 to 1935, but the number of possible workers had not increased or decreased much. Factories closed, but machinery and equipment had not disappeared. Technologies that had been invented in the 1920s were not un-invented and forgotten in the 1930s. Thus, Keynes argued that the Great Depression—and many ordinary recessions as well—were not caused by a drop in the ability of the economy to supply goods as measured by labor, physical capital, or technology. He argued the economy often produced less than its full potential, not because it was technically impossible to produce more with the existing workers and machines, but because a lack of demand in the economy as a whole led to inadequate incentives for firms to produce. In such cases, he argued, the level of GDP in the economy was not primarily determined by the potential of what the economy could supply, but rather by the amount of total demand.
Keynes’ law seems to apply fairly well in the short run of a few months to a few years, when many firms experience either a drop in demand for their output during a recession or so much demand that they have trouble producing enough during an economic boom. However, demand cannot tell the whole macroeconomic story, either. After all, if demand was all that mattered at the macroeconomic level, then the government could make the economy as large as it wanted just by pumping up total demand through a large increase in the government spending component or by legislating large tax cuts to push up the consumption component. Economies do, however, face genuine limits to how much they can produce, limits determined by the quantity of labor, physical capital, technology, and the institutional and market structures that bring these factors of production together. These constraints on what an economy can supply at the macroeconomic level do not disappear just because of an increase in demand.
Combining Supply and Demand in Macroeconomics
Two insights emerge from this overview of Say’s law with its emphasis on macroeconomic supply and Keynes’ law with its emphasis on macroeconomic demand. The first conclusion, which is not exactly a hot news flash, is that an economic approach focused only on the supply side or only on the demand side can be only a partial success. We need to take into account both supply and demand. The second conclusion is that since Keynes’ law applies more accurately in the short run and Say’s law applies more accurately in the long run, the tradeoffs and connections between the three goals of macroeconomics may be different in the short run and the long run. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/11%3A_The_Aggregate_Demand_Aggregate_Supply_Model/11.02%3A_Macroeconomic_Perspectives_on_Demand_and_Supply.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the aggregate supply curve and how it relates to real GDP and potential GDP
• Explain the aggregate demand curve and how it is influenced by price levels
• Interpret the aggregate demand/aggregate supply model
• Identify the point of equilibrium in the aggregate demand/aggregate supply model
• Define short run aggregate supply and long run aggregate supply
To build a useful macroeconomic model, we need a model that shows what determines total supply or total demand for the economy, and how total demand and total supply interact at the macroeconomic level. We call this the aggregate demand/aggregate supply model. This module will explain aggregate supply, aggregate demand, and the equilibrium between them. The following modules will discuss the causes of shifts in aggregate supply and aggregate demand.
The Aggregate Supply Curve and Potential GDP
Firms make decisions about what quantity to supply based on the profits they expect to earn. They determine profits, in turn, by the price of the outputs they sell and by the prices of the inputs, like labor or raw materials, that they need to buy. Aggregate supply (AS) refers to the total quantity of output (i.e. real GDP) firms will produce and sell. The aggregate supply (AS) curve shows the total quantity of output (i.e. real GDP) that firms will produce and sell at each price level.
Figure 11.3 shows an aggregate supply curve. In the following paragraphs, we will walk through the elements of the diagram one at a time: the horizontal and vertical axes, the aggregate supply curve itself, and the meaning of the potential GDP vertical line.
Figure 11.3 The Aggregate Supply Curve Aggregate supply (AS) slopes up, because as the price level for outputs rises, with the price of inputs remaining fixed, firms have an incentive to produce more to earn higher profits. The potential GDP line shows the maximum that the economy can produce with full employment of workers and physical capital.
The diagram's horizontal axis shows real GDP—that is, the level of GDP adjusted for inflation. The vertical axis shows the price level, which measures the average price of all goods and services produced in the economy. In other words, the price level in the AD-AS model is what we called the GDP Deflator in The Macroeconomic Perspective. Remember that the price level is different from the inflation rate. Visualize the price level as an index number, like the Consumer Price Index, while the inflation rate is the percentage change in the price level over time.
As the price level rises, real GDP rises as well. Why? The price level on the vertical axis represents prices for final goods or outputs bought in the economy—i.e. the GDP deflator—not the price level for intermediate goods and services that are inputs to production. Thus, the AS curve describes how suppliers will react to a higher price level for final outputs of goods and services, while holding the prices of inputs like labor and energy constant. If firms across the economy face a situation where the price level of what they produce and sell is rising, but their costs of production are not rising, then the lure of higher profits will induce them to expand production. In other words, an aggregate supply curve shows how producers as a group will respond to an increase in aggregate demand.
An AS curve's slope changes from nearly flat at its far left to nearly vertical at its far right. At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP, which we define as the amount of real GDP an economy can produce by fully employing its existing levels of labor, physical capital, and technology, in the context of its existing market and legal institutions. At these relatively low levels of output, levels of unemployment are high, and many factories are running only part-time, or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that businesses sell—while assuming no rise in input prices—can encourage a considerable surge in the quantity of aggregate supply because so many workers and factories are ready to swing into production.
As the GDP increases, however, some firms and industries will start running into limits: perhaps nearly all of the expert workers in a certain industry will have jobs or factories in certain geographic areas or industries will be running at full speed. In the AS curve's intermediate area, a higher price level for outputs continues to encourage a greater quantity of output—but as the increasingly steep upward slope of the aggregate supply curve shows, the increase in real GDP in response to a given rise in the price level will not be as large. (Read the following Clear It Up feature to learn why the AS curve crosses potential GDP.)
Clear It Up
Why does AS cross potential GDP?
Economists typically draw the aggregate supply curve to cross the potential GDP line. This shape may seem puzzling: How can an economy produce at an output level which is higher than its “potential” or “full employment” GDP? The economic intuition here is that if prices for outputs were high enough, producers would make fanatical efforts to produce: all workers would be on double-overtime, all machines would run 24 hours a day, seven days a week. Such hyper-intense production would go beyond using potential labor and physical capital resources fully, to using them in a way that is not sustainable in the long term. Thus, it is possible for production to sprint above potential GDP, but only in the short run.
At the far right, the aggregate supply curve becomes nearly vertical. At this quantity, higher prices for outputs cannot encourage additional output, because even if firms want to expand output, the inputs of labor and machinery in the economy are fully employed. In this example, the vertical line in the exhibit shows that potential GDP occurs at a total output of 9,500. When an economy is operating at its potential GDP, machines and factories are running at capacity, and the unemployment rate is relatively low—at the natural rate of unemployment. For this reason, potential GDP is sometimes also called full-employment GDP.
The Aggregate Demand Curve
Aggregate demand (AD) refers to the amount of total spending on domestic goods and services in an economy. (Strictly speaking, AD is what economists call total planned expenditure. We will further explain this distinction in the appendix The Expenditure-Output Model . For now, just think of aggregate demand as total spending.) It includes all four components of demand: consumption, investment, government spending, and net exports (exports minus imports). This demand is determined by a number of factors, but one of them is the price level—recall though, that the price level is an index number such as the GDP deflator that measures the average price of the things we buy. The aggregate demand (AD) curve shows the total spending on domestic goods and services at each price level.
Figure 11.4 presents an aggregate demand (AD) curve. Just like the aggregate supply curve, the horizontal axis shows real GDP and the vertical axis shows the price level. The AD curve slopes down, which means that increases in the price level of outputs lead to a lower quantity of total spending. The reasons behind this shape are related to how changes in the price level affect the different components of aggregate demand. The following components comprise aggregate demand: consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M): C + I + G + X – M.
Figure 11.4 The Aggregate Demand Curve Aggregate demand (AD) slopes down, showing that, as the price level rises, the amount of total spending on domestic goods and services declines.
The wealth effect holds that as the price level increases, the buying power of savings that people have stored up in bank accounts and other assets will diminish, eaten away to some extent by inflation. Because a rise in the price level reduces people’s wealth, consumption spending will fall as the price level rises.
The interest rate effect is that as prices for outputs rise, the same purchases will take more money or credit to accomplish. This additional demand for money and credit will push interest rates higher. In turn, higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and cars—thus reducing consumption and investment spending.
The foreign price effect points out that if prices rise in the United States while remaining fixed in other countries, then goods in the United States will be relatively more expensive compared to goods in the rest of the world. U.S. exports will be relatively more expensive, and the quantity of exports sold will fall. U.S. imports from abroad will be relatively cheaper, so the quantity of imports will rise. Thus, a higher domestic price level, relative to price levels in other countries, will reduce net export expenditures.
Among economists all three of these effects are controversial, in part because they do not seem to be very large. For this reason, the aggregate demand curve in Figure 11.4 slopes downward fairly steeply. The steep slope indicates that a higher price level for final outputs reduces aggregate demand for all three of these reasons, but that the change in the quantity of aggregate demand as a result of changes in price level is not very large.
Read the following Work It Out feature to learn how to interpret the AD/AS model. In this example, aggregate supply, aggregate demand, and the price level are given for the imaginary country of Xurbia.
Work It Out
Interpreting the AD/AS Model
Table 11.1 shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia. What information does Table 11.1 tell you about the state of the Xurbia’s economy? Where is the equilibrium price level and output level (this is the SR macroequilibrium)? Is Xurbia risking inflationary pressures or facing high unemployment? How can you tell?
Price Level Aggregate Demand Aggregate Supply
110 \$700 \$600
120 \$690 \$640
130 \$680 \$680
140 \$670 \$720
150 \$660 \$740
160 \$650 \$760
170 \$640 \$770
Table 11.1 Price Level: Aggregate Demand/Aggregate Supply
To begin to use the AD/AS model, it is important to plot the AS and AD curves from the data provided. What is the equilibrium?
Step 1. Draw your x- and y-axis. Label the x-axis Real GDP and the y-axis Price Level.
Step 2. Plot AD on your graph.
Step 3. Plot AS on your graph.
Step 4. Look at Figure 11.5 which provides a visual to aid in your analysis.
Figure 11.5 The AD/AS Curves AD and AS curves created from the data in Table 11.1.
Step 5. Determine where AD and AS intersect. This is the equilibrium with price level at 130 and real GDP at \$680.
Step 6. Look at the graph to determine where equilibrium is located. We can see that this equilibrium is fairly far from where the AS curve becomes near-vertical (or at least quite steep) which seems to start at about \$750 of real output. This implies that the economy is not close to potential GDP. Thus, unemployment will be high. In the relatively flat part of the AS curve, where the equilibrium occurs, changes in the price level will not be a major concern, since such changes are likely to be small.
Step 7. Determine what the steep portion of the AS curve indicates. Where the AS curve is steep, the economy is at or close to potential GDP.
Step 8. Draw conclusions from the given information:
• If equilibrium occurs in the flat range of AS, then economy is not close to potential GDP and will be experiencing unemployment, but stable price level.
• If equilibrium occurs in the steep range of AS, then the economy is close or at potential GDP and will be experiencing rising price levels or inflationary pressures, but will have a low unemployment rate.
Equilibrium in the Aggregate Demand/Aggregate Supply Model
The intersection of the aggregate supply and aggregate demand curves shows the equilibrium level of real GDP and the equilibrium price level in the economy. At a relatively low price level for output, firms have little incentive to produce, although consumers would be willing to purchase a large quantity of output. As the price level rises, aggregate supply rises and aggregate demand falls until the equilibrium point is reached.
Figure 11.6 combines the AS curve from Figure 11.3 and the AD curve from Figure 11.4 and places them both on a single diagram. In this example, the equilibrium point occurs at point E, at a price level of 90 and an output level of 8,800.
Figure 11.6 Aggregate Supply and Aggregate Demand The equilibrium, where aggregate supply (AS) equals aggregate demand (AD), occurs at a price level of 90 and an output level of 8,800.
Confusion sometimes arises between the aggregate supply and aggregate demand model and the microeconomic analysis of demand and supply in particular markets for goods, services, labor, and capital. Read the following Clear It Up feature to gain an understanding of whether AS and AD are macro or micro.
Clear It Up
Are AS and AD macro or micro?
These aggregate supply and demand models and the microeconomic analysis of demand and supply in particular markets for goods, services, labor, and capital have a superficial resemblance, but they also have many underlying differences.
For example, the vertical and horizontal axes have distinctly different meanings in macroeconomic and microeconomic diagrams. The vertical axis of a microeconomic demand and supply diagram expresses a price (or wage or rate of return) for an individual good or service. This price is implicitly relative: it is intended to be compared with the prices of other products (for example, the price of pizza relative to the price of fried chicken). In contrast, the vertical axis of an aggregate supply and aggregate demand diagram expresses the level of a price index like the Consumer Price Index or the GDP deflator—combining a wide array of prices from across the economy. The price level is absolute: it is not intended to be compared to any other prices since it is essentially the average price of all products in an economy. The horizontal axis of a microeconomic supply and demand curve measures the quantity of a particular good or service. In contrast, the horizontal axis of the aggregate demand and aggregate supply diagram measures GDP, which is the sum of all the final goods and services produced in the economy, not the quantity in a specific market.
In addition, the economic reasons for the shapes of the curves in the macroeconomic model are different from the reasons behind the shapes of the curves in microeconomic models. Demand curves for individual goods or services slope down primarily because of the existence of substitute goods, not the wealth effects, interest rate, and foreign price effects associated with aggregate demand curves. The slopes of individual supply and demand curves can have a variety of different slopes, depending on the extent to which quantity demanded and quantity supplied react to price in that specific market, but the slopes of the AS and AD curves are much the same in every diagram (although as we shall see in later chapters, short-run and long-run perspectives will emphasize different parts of the AS curve).
In short, just because the AD/AS diagram has two lines that cross, do not assume that it is the same as every other diagram where two lines cross. The intuitions and meanings of the macro and micro diagrams are only distant cousins from different branches of the economics family tree.
Defining SRAS and LRAS
In the Clear It Up feature titled “Why does AS cross potential GDP?” we differentiated between short run changes in aggregate supply which the AS curve shows and long run changes in aggregate supply which the vertical line at potential GDP defines. In the short run, if demand is too low (or too high), it is possible for producers to supply less GDP (or more GDP) than potential. In the long run, however, producers are limited to producing at potential GDP. For this reason, we may also refer to what we have been calling the AS curve as the short run aggregate supply (SRAS) curve. We may also refer to the vertical line at potential GDP as the long run aggregate supply (LRAS) curve. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/11%3A_The_Aggregate_Demand_Aggregate_Supply_Model/11.03%3A_Building_a_Model_of_Aggregate_Demand_and_Aggregate_Supply.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how productivity growth changes the aggregate supply curve
• Explain how changes in input prices change the aggregate supply curve
The original equilibrium in the AD/AS diagram will shift to a new equilibrium if the AS or AD curve shifts. When the aggregate supply curve shifts to the right, then at every price level, producers supply a greater quantity of real GDP. When the AS curve shifts to the left, then at every price level, producers supply a lower quantity of real GDP. This module discusses two of the most important factors that can lead to shifts in the AS curve: productivity growth and changes in input prices.
How Productivity Growth Shifts the AS Curve
In the long run, the most important factor shifting the AS curve is productivity growth. Productivity means how much output can be produced with a given quantity of labor. One measure of this is output per worker or GDP per capita. Over time, productivity grows so that the same quantity of labor can produce more output. Historically, the real growth in GDP per capita in an advanced economy like the United States has averaged about 2% to 3% per year, but productivity growth has been faster during certain extended periods like the 1960s and the late 1990s through the early 2000s, or slower during periods like the 1970s. A higher level of productivity shifts the AS curve to the right, because with improved productivity, firms can produce a greater quantity of output at every price level. Figure 11.7 (a) shows an outward shift in productivity over two time periods. The AS curve shifts out from SRAS0 to SRAS1 to SRAS2, and the equilibrium shifts from E0 to E1 to E2. Note that with increased productivity, workers can produce more GDP. Thus, full employment corresponds to a higher level of potential GDP, which we show as a rightward shift in LRAS from LRAS0 to LRAS1 to LRAS2.
Figure 11.7 Shifts in Aggregate Supply (a) The rise in productivity causes the SRAS curve to shift to the right. The original equilibrium E0 is at the intersection of AD and SRAS0. When SRAS shifts right, then the new equilibrium E1 is at the intersection of AD and SRAS1, and then yet another equilibrium, E2, is at the intersection of AD and SRAS2. Shifts in SRAS to the right, lead to a greater level of output and to downward pressure on the price level. (b) A higher price for inputs means that at any given price level for outputs, a lower real GDP will be produced so aggregate supply will shift to the left from SRAS0 to SRAS1. The new equilibrium, E1, has a reduced quantity of output and a higher price level than the original equilibrium (E0).
A shift in the SRAS curve to the right will result in a greater real GDP and downward pressure on the price level, if aggregate demand remains unchanged. However, if this shift in SRAS results from gains in productivity growth, which we typically measure in terms of a few percentage points per year, the effect will be relatively small over a few months or even a couple of years. Recall how in Choice in a World of Scarcity, we said that a nation's production possibilities frontier is fixed in the short run, but shifts out in the long run? This is the same phenomenon using a different model.
How Changes in Input Prices Shift the AS Curve
Higher prices for inputs that are widely used across the entire economy can have a macroeconomic impact on aggregate supply. Examples of such widely used inputs include labor and energy products. Increases in the price of such inputs will cause the SRAS curve to shift to the left, which means that at each given price level for outputs, a higher price for inputs will discourage production because it will reduce the possibilities for earning profits. Figure 11.7 (b) shows the aggregate supply curve shifting to the left, from SRAS0 to SRAS1, causing the equilibrium to move from E0 to E1. The movement from the original equilibrium of E0 to the new equilibrium of E1 will bring a nasty set of effects: reduced GDP or recession, higher unemployment because the economy is now further away from potential GDP, and an inflationary higher price level as well. For example, the U.S. economy experienced recessions in 1974–1975, 1980–1982, 1990–91, 2001, and 2007–2009 that were each preceded or accompanied by a rise in the key input of oil prices. In the 1970s, this pattern of a shift to the left in SRAS leading to a stagnant economy with high unemployment and inflation was nicknamed stagflation.
Conversely, a decline in the price of a key input like oil will shift the SRAS curve to the right, providing an incentive for more to be produced at every given price level for outputs. From 1985 to 1986, for example, the average price of crude oil fell by almost half, from \$24 a barrel to \$12 a barrel. Similarly, from 1997 to 1998, the price of a barrel of crude oil dropped from \$17 per barrel to \$11 per barrel. In both cases, the plummeting oil price led to a situation like that which we presented earlier in Figure 11.7 (a), where the outward shift of SRAS to the right allowed the economy to expand, unemployment to fall, and inflation to decline.
Along with energy prices, two other key inputs that may shift the SRAS curve are the cost of labor, or wages, and the cost of imported goods that we use as inputs for other products. In these cases as well, the lesson is that lower prices for inputs cause SRAS to shift to the right, while higher prices cause it to shift back to the left. Note that, unlike changes in productivity, changes in input prices do not generally cause LRAS to shift, only SRAS.
Other Supply Shocks
The aggregate supply curve can also shift due to shocks to input goods or labor. For example, an unexpected early freeze could destroy a large number of agricultural crops, a shock that would shift the AS curve to the left since there would be fewer agricultural products available at any given price.
Similarly, shocks to the labor market can affect aggregate supply. An extreme example might be an overseas war that required a large number of workers to cease their ordinary production in order to go fight for their country. In this case, SRAS and LRAS would both shift to the left because there would be fewer workers available to produce goods at any given price.
Another example in this vein is a pandemic, like the COVID-19 pandemic. A pandemic causes many workers to become sick, temporarily reducing the supply of workers by a large amount. Further, workers might be cautious to go back to work in a pandemic because of health or safety concerns. While the shock to labor supply might not be permanent, it can cause a reduction in the supply of many goods and services, reflected in a leftward shift in the short-run aggregate supply curve. At various points during the COVID-19-induced pandemic, computer chips for automobiles, meat, and other consumer services were in short supply because of worker shortages around the world. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/11%3A_The_Aggregate_Demand_Aggregate_Supply_Model/11.04%3A_Shifts_in_Aggregate_Supply.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how imports influence aggregate demand
• Identify ways in which business confidence and consumer confidence can affect aggregate demand
• Explain how government policy can change aggregate demand
• Evaluate why economists disagree on the topic of tax cuts
As we mentioned previously, the components of aggregate demand are consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M). (Read the following Clear It Up feature for explanation of why imports are subtracted from exports and what this means for aggregate demand.) A shift of the AD curve to the right means that at least one of these components increased so that a greater amount of total spending would occur at every price level. A shift of the AD curve to the left means that at least one of these components decreased so that a lesser amount of total spending would occur at every price level. The Keynesian Perspective will discuss the components of aggregate demand and the factors that affect them. Here, the discussion will sketch two broad categories that could cause AD curves to shift: changes in consumer or firm behavior and changes in government tax or spending policy.
Clear It Up
Do imports diminish aggregate demand?
We have seen that the formula for aggregate demand is AD = C + I + G + X - M, where M is the total value of imported goods. Why is there a minus sign in front of imports? Does this mean that more imports will result in a lower level of aggregate demand? The short answer is yes, because aggregate demand is defined as total demand for domestically produced goods and services.
When an American buys a foreign product, for example, it gets counted along with all the other consumption. Thus, the income generated does not go to American producers, but rather to producers in another country. It would be wrong to count this as part of domestic demand. Therefore, imports added in consumption are subtracted back out in the M term of the equation.
Because of the way in which we write the demand equation, it is easy to make the mistake of thinking that imports are bad for the economy. Just keep in mind that every negative number in the M term has a corresponding positive number in the C or I or G term, and they always cancel out.
How Changes by Consumers and Firms Can Affect AD
When consumers feel more confident about the future of the economy, they tend to consume more. If business confidence is high, then firms tend to spend more on investment, believing that the future payoff from that investment will be substantial. Conversely, if consumer or business confidence drops, then consumption and investment spending decline.
The University of Michigan publishes a survey of consumer confidence and constructs an index of consumer confidence each month. The survey results are then reported at http://www.sca.isr.umich.edu, which break down the change in consumer confidence among different income levels. According to that index, consumer confidence averaged around 90 prior to the Great Recession, and then it fell to below 60 in late 2008, which was the lowest it had been since 1980. During the 2010s, confidence has climbed from a 2011 low of 55.8 back to a level in the upper 90s, before falling to the lower 70s in 2020 due to the COIVD-19 pandemic, which economists consider close to a healthy state.
The Organization for Economic Development and Cooperation (OECD) publishes one measure of business confidence: the "business tendency surveys". The OECD collects business opinion survey data for 21 countries on future selling prices and employment, among other business climate elements. After sharply declining during the Great Recession, the measure has risen above zero again and is back to long-term averages (the indicator dips below zero when business outlook is weaker than usual). Of course, either of these survey measures is not very precise. They can however, suggest when confidence is rising or falling, as well as when it is relatively high or low compared to the past.
Because economists associate a rise in confidence with higher consumption and investment demand, it will lead to an outward shift in the AD curve, and a move of the equilibrium, from E0 to E1, to a higher quantity of output and a higher price level, as Figure 11.8 (a) shows.
Consumer and business confidence often reflect macroeconomic realities; for example, confidence is usually high when the economy is growing briskly and low during a recession. However, economic confidence can sometimes rise or fall for reasons that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure. U.S. presidents, for example, must be careful in their public pronouncements about the economy. If they offer economic pessimism, they risk provoking a decline in confidence that reduces consumption and investment and shifts AD to the left, and in a self-fulfilling prophecy, contributes to causing the recession that the president warned against in the first place. Figure 11.8 (b) shows a shift of AD to the left, and the corresponding movement of the equilibrium, from E0 to E1, to a lower quantity of output and a lower price level.
Link It Up
Visit this website for data on consumer confidence.
Link It Up
Visit this website for data on business confidence.
Figure 11.8 Shifts in Aggregate Demand (a) An increase in consumer confidence or business confidence can shift AD to the right, from AD0 to AD1. When AD shifts to the right, the new equilibrium (E1) will have a higher quantity of output and also a higher price level compared with the original equilibrium (E0). In this example, the new equilibrium (E1) is also closer to potential GDP. An increase in government spending or a cut in taxes that leads to a rise in consumer spending can also shift AD to the right. (b) A decrease in consumer confidence or business confidence can shift AD to the left, from AD0 to AD1. When AD shifts to the left, the new equilibrium (E1) will have a lower quantity of output and also a lower price level compared with the original equilibrium (E0). In this example, the new equilibrium (E1) is also farther below potential GDP. A decrease in government spending or higher taxes that leads to a fall in consumer spending can also shift AD to the left.
How Government Macroeconomic Policy Choices Can Shift AD
Government spending is one component of AD. Thus, higher government spending will cause AD to shift to the right, as in Figure 11.8 (a), while lower government spending will cause AD to shift to the left, as in Figure 11.8 (b). For example, in the United States, government spending declined by 3.2% of GDP during the 1990s, from 21% of GDP in 1991, and to 17.8% of GDP in 1998. However, from 2005 to 2009, the peak of the Great Recession, government spending increased from 19% of GDP to 21.4% of GDP. If changes of a few percentage points of GDP seem small to you, remember that since GDP was about \$14.4 trillion in 2009, a seemingly small change of 2% of GDP is equal to close to \$300 billion. Since 2009, government expenditures have gone back down to around 17–18% of GDP, although in 2020 they rose to 18.5%.
Tax policy can affect consumption and investment spending, too. Tax cuts for individuals will tend to increase consumption demand, while tax increases will tend to diminish it. Tax policy can also pump up investment demand by offering lower tax rates for corporations or tax reductions that benefit specific kinds of investment. Shifting C or I will shift the AD curve as a whole.
During a recession, when unemployment is high and many businesses are suffering low profits or even losses, the U.S. Congress often passes tax cuts. During the 2001 recession, for example, the U.S. Congress enacted a tax cut into law. At such times, the political rhetoric often focuses on how people experiencing hard times need relief from taxes. The aggregate supply and aggregate demand framework, however, offers a complementary rationale, as Figure 11.9 illustrates. The original equilibrium during a recession is at point E0, relatively far from the full employment level of output. The tax cut, by increasing consumption, shifts the AD curve to the right. At the new equilibrium (E1), real GDP rises and unemployment falls and, because in this diagram the economy has not yet reached its potential or full employment level of GDP, any rise in the price level remains muted. Read the following Clear It Up feature to consider the question of whether economists favor tax cuts or oppose them.
Figure 11.9 Recession and Full Employment in the AD/AS Model Whether the economy is in a recession is illustrated in the AD/AS model by how close the equilibrium is to the potential GDP line as indicated by the vertical LRAS line. In this example, the level of output Y0 at the equilibrium E0 is relatively far from the potential GDP line, so it can represent an economy in recession, well below the full employment level of GDP. In contrast, the level of output Y1 at the equilibrium E1 is relatively close to potential GDP, and so it would represent an economy with a lower unemployment rate.
Clear It Up
Do economists favor tax cuts or oppose them?
One of the most fundamental divisions in American politics over the last few decades has been between those who believe that the government should cut taxes substantially and those who disagree. Ronald Reagan rode into the presidency in 1980 partly because of his promise, soon carried out, to enact a substantial tax cut. George Bush lost his bid for reelection against Bill Clinton in 1992 partly because he had broken his 1988 promise: “Read my lips! No new taxes!” In the 2000 presidential election, both George W. Bush and Al Gore advocated substantial tax cuts and Bush succeeded in pushing a tax cut package through Congress early in 2001. More recently in 2017 and 2018, Donald Trump initiated a new round of tax cuts throughout the economy, and President Biden promised his own set of tax cuts in his 2021 spending bills.
What side do economists take? Do they support broad tax cuts or oppose them? The answer, unsatisfying to zealots on both sides, is that it depends. One issue is whether equally large government spending cuts accompany the tax cuts. Economists differ, as does any broad cross-section of the public, on how large government spending should be and what programs the government might cut back. A second issue, more relevant to the discussion in this chapter, concerns how close the economy is to the full employment output level. In a recession, when the AD and AS curves intersect far below the full employment level, tax cuts can make sense as a way of shifting AD to the right. However, when the economy is already performing extremely well, tax cuts may shift AD so far to the right as to generate inflationary pressures, with little gain to GDP.
With the AD/AS framework in mind, many economists might readily believe that the 1981 Reagan tax cuts, which took effect just after two serious recessions, were beneficial economic policy. Similarly, Congress enacted the 2001 Bush tax cuts and the 2009 Obama tax cuts during recessions. However, some of the same economists who favor tax cuts during recession would be much more dubious about identical tax cuts at a time the economy is performing well and cyclical unemployment is low.
Government spending and tax rate changes can be useful tools to affect aggregate demand. We will discuss these in greater detail in the Government Budgets and Fiscal Policy chapter and The Impacts of Government Borrowing. Other policy tools can shift the aggregate demand curve as well. For example, as we will discuss in the Monetary Policy and Bank Regulation chapter, the Federal Reserve can affect interest rates and credit availability. Higher interest rates tend to discourage borrowing and thus reduce both household spending on big-ticket items like houses and cars and investment spending by business. Conversely, lower interest rates will stimulate consumption and investment demand. Interest rates can also affect exchange rates, which in turn will have effects on the export and import components of aggregate demand.
Clarifying the details of these alternative policies and how they affect the components of aggregate demand can wait for The Keynesian Perspective chapter. Here, the key lesson is that a shift of the aggregate demand curve to the right leads to a greater real GDP and to upward pressure on the price level. Conversely, a shift of aggregate demand to the left leads to a lower real GDP and a lower price level. Whether these changes in output and price level are relatively large or relatively small, and how the change in equilibrium relates to potential GDP, depends on whether the shift in the AD curve is happening in the AS curve's relatively flat or relatively steep portion. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/11%3A_The_Aggregate_Demand_Aggregate_Supply_Model/11.05%3A_Shifts_in_Aggregate_Demand.txt |
Learning Objectives
By the end of this section, you will be able to:
• Use the aggregate demand/aggregate supply model to show periods of economic growth and recession
• Explain how unemployment and inflation impact the aggregate demand/aggregate supply model
• Evaluate the importance of the aggregate demand/aggregate supply model
The AD/AS model can convey a number of interlocking relationships between the three macroeconomic goals of growth, unemployment, and low inflation. Moreover, the AD/AS framework is flexible enough to accommodate both the Keynes’ law approach that focuses on aggregate demand and the short run, while also including the Say’s law approach that focuses on aggregate supply and the long run. These advantages are considerable. Every model is a simplified version of the deeper reality and, in the context of the AD/AS model, the three macroeconomic goals arise in ways that are sometimes indirect or incomplete. In this module, we consider how the AD/AS model illustrates the three macroeconomic goals of economic growth, low unemployment, and low inflation.
Growth and Recession in the AD/AS Diagram
In the AD/AS diagram, long-run economic growth due to productivity increases over time will be represented by a gradual shift to the right of aggregate supply. The vertical line representing potential GDP (or the “full employment level of GDP”) will gradually shift to the right over time as well. Earlier Figure 11.7 (a) showed a pattern of economic growth over three years, with the AS curve shifting slightly out to the right each year. However, the factors that determine the speed of this long-term economic growth rate—like investment in physical and human capital, technology, and whether an economy can take advantage of catch-up growth—do not appear directly in the AD/AS diagram.
In the short run, GDP falls and rises in every economy, as the economy dips into recession or expands out of recession. The AD/AS diagram illustrates recessions when the equilibrium level of real GDP is substantially below potential GDP, as we see at the equilibrium point E0 in Figure 11.9. From another standpoint, in years of resurgent economic growth the equilibrium will typically be close to potential GDP, as equilibrium point E1 in that earlier figure shows.
Unemployment in the AD/AS Diagram
We described two types of unemployment in the Unemployment chapter. Short run variations in unemployment (cyclical unemployment) are caused by the business cycle as the economy expands and contracts. Over the long run, in the United States, the unemployment rate typically hovers around 5% (give or take one percentage point or so), when the economy is healthy. In many of the national economies across Europe, the unemployment rate in recent decades has only dropped to about 10% or a bit lower, even in good economic years. We call this baseline level of unemployment that occurs year-in and year-out the natural rate of unemployment and we determine it by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market. Potential GDP can imply different unemployment rates in different economies, depending on the natural rate of unemployment for that economy.
The AD/AS diagram shows cyclical unemployment by how close the economy is to the potential or full GDP employment level. Returning to Figure 11.9, relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP, as in the equilibrium point E1. Conversely, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point E0. Although we do not show the factors that determine the natural rate of unemployment separately in the AD/AS model, they are implicitly part of what determines potential GDP or full employment GDP in a given economy.
Inflationary Pressures in the AD/AS Diagram
Inflation fluctuates in the short run. Higher inflation rates have typically occurred either during or just after economic booms: for example, the biggest spurts of inflation in the U.S. economy during the twentieth century followed the wartime booms of World War I and World War II. Conversely, rates of inflation generally decline during recessions. As an extreme example, inflation actually became negative—a situation called “deflation”—during the Great Depression. Even during the relatively short 1991-1992 recession, the inflation rate declined from 5.4% in 1990 to 3.0% in 1992. During the relatively short 2001 recession, the rate of inflation declined from 3.4% in 2000 to 1.6% in 2002. During the deep recession of 2007–2009, the inflation rate declined from 3.8% in 2008 to –0.4% in 2009. Some countries have experienced bouts of high inflation that lasted for years. In the U.S. economy since the mid–1980s, inflation does not seem to have had any long-term trend to be substantially higher. Instead, it has stayed in the 1–5% range annually.
The AD/AS framework implies two ways that inflationary pressures may arise. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the AS curve's steep portion. In Figure 11.10 (a), there is a shift of aggregate demand to the right. The new equilibrium E1 is clearly at a higher price level than the original equilibrium E0. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods, because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.
Figure 11.10 Sources of Inflationary Pressure in the AD/AS Model (a) A shift in aggregate demand, from AD0 to AD1, when it happens in the area of the SRAS curve that is near potential GDP, will lead to a higher price level and to pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1) than the original equilibrium. (b) A shift in aggregate supply, from SRAS0 to SRAS1, will lead to a lower real GDP and to pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1), while the original equilibrium (E0) is at the lower price level (P0).
An alternative source of inflationary pressures can occur due to a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor—and causes the aggregate supply curve to shift back to the left. In Figure 11.10 (b), the SRAS curve's shift to the left also increases the price level from P0 at the original equilibrium (E0) to a higher price level of P1 at the new equilibrium (E1). In effect, the rise in input prices ends up, after the final output is produced and sold, passing along in the form of a higher price level for outputs.
The AD/AS diagram shows only a one-time shift in the price level. It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years. There are two explanations for why inflation may persist over time. One way that continual inflationary price increases can occur is if the government continually attempts to stimulate aggregate demand in a way that keeps pushing the AD curve when it is already in the SRAS curve's steep portion. A second possibility is that, if inflation has been occurring for several years, people might begin to expect a certain level of inflation. If they do, then these expectations will cause prices, wages and interest rates to increase annually by the amount of the inflation expected. These two reasons are interrelated, because if a government fosters a macroeconomic environment with inflationary pressures, then people will grow to expect inflation. However, the AD/AS diagram does not show these patterns of ongoing or expected inflation in a direct way.
Importance of the Aggregate Demand/Aggregate Supply Model
Macroeconomics takes an overall view of the economy, which means that it needs to juggle many different concepts. For example, start with the three macroeconomic goals of growth, low inflation, and low unemployment. Aggregate demand has four elements: consumption, investment, government spending, and exports less imports. Aggregate supply reveals how businesses throughout the economy will react to a higher price level for outputs. Finally, a wide array of economic events and policy decisions can affect aggregate demand and aggregate supply, including government tax and spending decisions; consumer and business confidence; changes in prices of key inputs like oil; and technology that brings higher levels of productivity.
The aggregate demand/aggregate supply model is one of the fundamental diagrams in this course (like the budget constraint diagram that we introduced in the Choice in a World of Scarcity chapter and the supply and demand diagram in the Demand and Supply chapter) because it provides an overall framework for bringing these factors together in one diagram. Some version of the AD/AS model will appear in every chapter in the rest of this book. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/11%3A_The_Aggregate_Demand_Aggregate_Supply_Model/11.06%3A_How_the_AD_AS_Model_Incorporates_Growth_Unemployment_and_Inflation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify the neoclassical zone, the intermediate zone, and the Keynesian zone in the aggregate demand/aggregate supply model
• Use an aggregate demand/aggregate supply model as a diagnostic test to understand the current state of the economy
We can use the AD/AS model to illustrate both Say’s law that supply creates its own demand and Keynes’ law that demand creates its own supply. Consider the SRAS curve's three zones which Figure 11.11 identifies: the Keynesian zone, the neoclassical zone, and the intermediate zone.
Figure 11.11 Keynes, Neoclassical, and Intermediate Zones in the Aggregate Supply Curve Near the equilibrium Ek, in the Keynesian zone at the far left of the SRAS curve, small shifts in AD, either to the right or the left, will affect the output level Yk, but will not much affect the price level. In the Keynesian zone, AD largely determines the quantity of output. Near the equilibrium En, in the neoclassical zone at the SRAS curve's far right, small shifts in AD, either to the right or the left, will have relatively little effect on the output level Yn, but instead will have a greater effect on the price level. In the neoclassical zone, the near-vertical SRAS curve close to the level of potential GDP largely determines the quantity of output. In the intermediate zone around equilibrium Ei, movement in AD to the right will increase both the output level and the price level, while a movement in AD to the left would decrease both the output level and the price level.
Focus first on the Keynesian zone, that portion of the SRAS curve on the far left which is relatively flat. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like Ek, then certain statements about the economic situation will follow. In the Keynesian zone, the equilibrium level of real GDP is far below potential GDP, the economy is in recession, and cyclical unemployment is high. If aggregate demand shifted to the right or left in the Keynesian zone, it will determine the resulting level of output (and thus unemployment). However, inflationary price pressure is not much of a worry in the Keynesian zone, since the price level does not vary much in this zone.
Now, focus your attention on the neoclassical zone of the SRAS curve, which is the near-vertical portion on the right-hand side. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like En where output is at or near potential GDP, then the size of potential GDP pretty much determines the level of output in the economy. Since the equilibrium is near potential GDP, cyclical unemployment is low in this economy, although structural unemployment may remain an issue. In the neoclassical zone, shifts of aggregate demand to the right or the left have little effect on the level of output or employment. The only way to increase the size of the real GDP in the neoclassical zone is for AS to shift to the right. However, shifts in AD in the neoclassical zone will create pressures to change the price level.
Finally, consider the SRAS curve's intermediate zone in Figure 11.11. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like Ei, then we might expect unemployment and inflation to move in opposing directions. For instance, a shift of AD to the right will move output closer to potential GDP and thus reduce unemployment, but will also lead to a higher price level and upward pressure on inflation. Conversely, a shift of AD to the left will move output further from potential GDP and raise unemployment, but will also lead to a lower price level and downward pressure on inflation.
This approach of dividing the SRAS curve into different zones works as a diagnostic test that we can apply to an economy, like a doctor checking a patient for symptoms. First, figure out in what zone the economy is. This will clarify the economic issues, tradeoffs, and policy choices. Some economists believe that the economy is strongly predisposed to be in one zone or another. Thus, hard-line Keynesian economists believe that the economies are in the Keynesian zone most of the time, and so they view the neoclassical zone as a theoretical abstraction. Conversely, hard-line neoclassical economists argue that economies are in the neoclassical zone most of the time and that the Keynesian zone is a distraction. The Keynesian Perspective and The Neoclassical Perspective should help to clarify the underpinnings and consequences of these contrasting views of the macroeconomy.
Bring It Home
The Pandemic-Induced Recession: Supply or Demand?
We mentioned earlier that a pandemic could cause a shock in the short- or long-run aggregate supply curve by temporarily reducing labor supply and slowing or stopping production of goods and services. Pandemics can also affect aggregate demand. When people are hesitant to spend or travel, or if they are not allowed to spend or travel because of social restrictions, this will affect spending in the economy. Consumers spend less at restaurants, hotels, and travel, among other areas, while firms stop investing because of the lack of demand and an uncertain future. Both actions lead to a leftward shift in the aggregate demand curve.
While there is some debate over whether the pandemic-induced recession that the U.S. economy experienced in 2020 was primarily a supply- or demand-driven one, most likely, it is a combination of both. In March and April 2020, workers left the labor market en masse, and later in the year, they were hesitant to return due to health and safety concerns. Many people were also forced to cancel travel plans or voluntarily did so out of concern for their safety, further reducing aggregate demand. These changes caused deep cuts in the global economy that continued to be felt two years after the initial pandemic-induced shocks.
11.08: Key Terms
aggregate demand (AD)
the amount of total spending on domestic goods and services in an economy
aggregate demand (AD) curve
the total spending on domestic goods and services at each price level
aggregate demand/aggregate supply model
a model that shows what determines total supply or total demand for the economy, and how total demand and total supply interact at the macroeconomic level
aggregate supply (AS)
the total quantity of output (i.e. real GDP) firms will produce and sell
aggregate supply (AS) curve
the total quantity of output (i.e. real GDP) that firms will produce and sell at each price level
full-employment GDP
another name for potential GDP, when the economy is producing at its potential and unemployment is at the natural rate of unemployment
intermediate zone
portion of the SRAS curve where GDP is below potential but not so far below as in the Keynesian zone; the SRAS curve is upward-sloping, but not vertical in the intermediate zone
Keynes’ law
“demand creates its own supply”
Keynesian zone
portion of the SRAS curve where GDP is far below potential and the SRAS curve is flat
long run aggregate supply (LRAS) curve
vertical line at potential GDP showing no relationship between the price level for output and real GDP in the long run
neoclassical economists
economists who generally emphasize the importance of aggregate supply in determining the size of the macroeconomy over the long run
neoclassical zone
portion of the SRAS curve where GDP is at or near potential output where the SRAS curve is steep
potential GDP
the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions
Say’s law
“supply creates its own demand”
short run aggregate supply (SRAS) curve
positive short run relationship between the price level for output and real GDP, holding the prices of inputs fixed
stagflation
an economy experiences stagnant growth and high inflation at the same time | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/11%3A_The_Aggregate_Demand_Aggregate_Supply_Model/11.07%3A_Keynes_Law_and_Says_Law_in_the_AD_AS_Model.txt |
11.1 Macroeconomic Perspectives on Demand and Supply
Neoclassical economists emphasize Say’s law, which holds that supply creates its own demand. Keynesian economists emphasize Keynes’ law, which holds that demand creates its own supply. Many mainstream economists take a Keynesian perspective, emphasizing the importance of aggregate demand, for the short run, and a neoclassical perspective, emphasizing the importance of aggregate supply, for the long run.
11.2 Building a Model of Aggregate Demand and Aggregate Supply
The upward-sloping short run aggregate supply (SRAS) curve shows the positive relationship between the price level and the level of real GDP in the short run. Aggregate supply slopes up because when the price level for outputs increases, while the price level of inputs remains fixed, the opportunity for additional profits encourages more production. The aggregate supply curve is near-horizontal on the left and near-vertical on the right. In the long run, we show the aggregate supply by a vertical line at the level of potential output, which is the maximum level of output the economy can produce with its existing levels of workers, physical capital, technology, and economic institutions.
The downward-sloping aggregate demand (AD) curve shows the relationship between the price level for outputs and the quantity of total spending in the economy. It slopes down because of: (a) the wealth effect, which means that a higher price level leads to lower real wealth, which reduces the level of consumption; (b) the interest rate effect, which holds that a higher price level will mean a greater demand for money, which will tend to drive up interest rates and reduce investment spending; and (c) the foreign price effect, which holds that a rise in the price level will make domestic goods relatively more expensive, discouraging exports and encouraging imports.
11.3 Shifts in Aggregate Supply
The aggregate demand/aggregate supply (AD/AS) diagram shows how AD and AS interact. The intersection of the AD and AS curves shows the equilibrium output and price level in the economy. Movements of either AS or AD will result in a different equilibrium output and price level. The aggregate supply curve will shift out to the right as productivity increases. It will shift back to the left as the price of key inputs rises, and will shift out to the right if the price of key inputs falls. If the AS curve shifts back to the left, the combination of lower output, higher unemployment, and higher inflation, called stagflation, occurs. If AS shifts out to the right, a combination of lower inflation, higher output, and lower unemployment is possible.
11.4 Shifts in Aggregate Demand
The AD curve will shift out as the components of aggregate demand—C, I, G, and X–M—rise. It will shift back to the left as these components fall. These factors can change because of different personal choices, like those resulting from consumer or business confidence, or from policy choices like changes in government spending and taxes. If the AD curve shifts to the right, then the equilibrium quantity of output and the price level will rise. If the AD curve shifts to the left, then the equilibrium quantity of output and the price level will fall. Whether equilibrium output changes relatively more than the price level or whether the price level changes relatively more than output is determined by where the AD curve intersects with the AS curve.
The AD/AS diagram superficially resembles the microeconomic supply and demand diagram on the surface, but in reality, what is on the horizontal and vertical axes and the underlying economic reasons for the shapes of the curves are very different. We can illustrate long-term economic growth in the AD/AS framework by a gradual shift of the aggregate supply curve to the right. We illustrate a recession when the intersection of AD and AS is substantially below potential GDP, while we illustrate an expanding economy when the intersection of AS and AD is near potential GDP.
11.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP. Cyclical unemployment is small in the AD/AS framework when the equilibrium is near potential GDP. The natural rate of unemployment, as determined by the labor market institutions of the economy, is built into what economists mean by potential GDP, but does not otherwise appear in an AD/AS diagram. The AD/AS framework shows pressures for inflation to rise or fall when the movement from one equilibrium to another causes the price level to rise or to fall. The balance of trade does not appear directly in the AD/AS diagram, but it appears indirectly in several ways. Increases in exports or declines in imports can cause shifts in AD. Changes in the price of key imported inputs to production, like oil, can cause shifts in AS. The AD/AS model is the key model we use in this book to understand macroeconomic issues.
11.6 Keynes’ Law and Say’s Law in the AD/AS Model
We can divide the SRAS curve into three zones. Keynes’ law says demand creates its own supply, so that changes in aggregate demand cause changes in real GDP and employment. We can show Keynes’ law on the horizontal Keynesian zone of the aggregate supply curve. The Keynesian zone occurs at the left of the SRAS curve where it is fairly flat, so movements in AD will affect output, but have little effect on the price level. Say’s law says supply creates its own demand. Changes in aggregate demand have no effect on real GDP and employment, only on the price level. We can show Say’s law on the vertical neoclassical zone of the aggregate supply curve. The neoclassical zone occurs at the right of the SRAS curve where it is fairly vertical, and so movements in AD will affect the price level, but have little impact on output. The intermediate zone in the middle of the SRAS curve is upward-sloping, so a rise in AD will cause higher output and price level, while a fall in AD will lead to a lower output and price level. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/11%3A_The_Aggregate_Demand_Aggregate_Supply_Model/11.09%3A_Key_Concepts_and_Summary.txt |
1.
Describe the mechanism by which supply creates its own demand.
2.
Describe the mechanism by which demand creates its own supply.
3.
The short run aggregate supply curve was constructed assuming that as the price of outputs increases, the price of inputs stays the same. How would an increase in the prices of important inputs, like energy, affect aggregate supply?
4.
In the AD/AS model, what prevents the economy from achieving equilibrium at potential output?
5.
Suppose the U.S. Congress passes significant immigration reform that makes it more difficult for foreigners to come to the United States to work. Use the AD/AS model to explain how this would affect the equilibrium level of GDP and the price level.
6.
Suppose concerns about the size of the federal budget deficit lead the U.S. Congress to cut all funding for research and development for ten years. Assuming this has an impact on technology growth, what does the AD/AS model predict would be the likely effect on equilibrium GDP and the price level?
7.
How would a dramatic increase in the value of the stock market shift the AD curve? What effect would the shift have on the equilibrium level of GDP and the price level?
8.
Suppose Mexico, one of our largest trading partners and purchaser of a large quantity of our exports, goes into a recession. Use the AD/AS model to determine the likely impact on our equilibrium GDP and price level.
9.
A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this?
10.
Many financial analysts and economists eagerly await the press releases for the reports on the home price index and consumer confidence index. What would be the effects of a negative report on both of these? What about a positive report?
11.
What impact would a decrease in the size of the labor force have on GDP and the price level according to the AD/AS model?
12.
Suppose, after five years of sluggish growth, the European Union's economy picks up speed. What would be the likely impact on the U.S. trade balance, GDP, and employment?
13.
Suppose the Federal Reserve begins to increase the supply of money at an increasing rate. What impact would that have on GDP, unemployment, and inflation?
14.
If the economy is operating in the neoclassical zone of the SRAS curve and aggregate demand falls, what is likely to happen to real GDP?
15.
If the economy is operating in the Keynesian zone of the SRAS curve and aggregate demand falls, what is likely to happen to real GDP?
11.11: Review Questions
16.
What is Say’s law?
17.
What is Keynes’ law?
18.
Do neoclassical economists believe in Keynes’ law or Say’s law?
19.
Does Say’s law apply more accurately in the long run or the short run? What about Keynes’ law?
20.
What is on the horizontal axis of the AD/AS diagram? What is on the vertical axis?
21.
What is the economic reason why the SRAS curve slopes up?
22.
What are the components of the aggregate demand (AD) curve?
23.
What are the economic reasons why the AD curve slopes down?
24.
Briefly explain the reason for the near-horizontal shape of the SRAS curve on its far left.
25.
Briefly explain the reason for the near-vertical shape of the SRAS curve on its far right.
26.
What is potential GDP?
27.
Name some factors that could cause the SRAS curve to shift, and say whether they would shift SRAS to the right or to the left.
28.
Will the shift of SRAS to the right tend to make the equilibrium quantity and price level higher or lower? What about a shift of SRAS to the left?
29.
What is stagflation?
30.
Name some factors that could cause AD to shift, and say whether they would shift AD to the right or to the left.
31.
Would a shift of AD to the right tend to make the equilibrium quantity and price level higher or lower? What about a shift of AD to the left?
32.
How is long-term growth illustrated in an AD/AS model?
33.
How is recession illustrated in an AD/AS model?
34.
How is cyclical unemployment illustrated in an AD/AS model?
35.
How is the natural rate of unemployment illustrated in an AD/AS model?
36.
How is pressure for inflationary price increases shown in an AD/AS model?
37.
What are some of the ways in which exports and imports can affect the AD/AS model?
38.
What is the Keynesian zone of the SRAS curve? How much is the price level likely to change in the Keynesian zone?
39.
What is the neoclassical zone of the SRAS curve? How much is the output level likely to change in the neoclassical zone?
40.
What is the intermediate zone of the SRAS curve? Will a rise in output be accompanied by a rise or a fall in the price level in this zone? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/11%3A_The_Aggregate_Demand_Aggregate_Supply_Model/11.10%3A_Self-Check_Questions.txt |
41.
Why would an economist choose either the neoclassical perspective or the Keynesian perspective, but not both?
42.
On a microeconomic demand curve, a decrease in price causes an increase in quantity demanded because the product in question is now relatively less expensive than substitute products. Explain why aggregate demand does not increase for the same reason in response to a decrease in the aggregate price level. In other words, what causes total spending to increase if it is not because goods are now cheaper?
43.
Economists expect that as the labor market continues to tighten going into the latter part of 2015 that workers should begin to expect wage increases in 2015 and 2016. Assuming this occurs and it was the only development in the labor market that year, how would this affect the AS curve? What if it was also accompanied by an increase in worker productivity?
44.
If new government regulations require firms to use a cleaner technology that is also less efficient than what they previously used, what would the effect be on output, the price level, and employment using the AD/AS diagram?
45.
During spring 2016 the Midwestern United States, which has a large agricultural base, experiences above-average rainfall. Using the AD/AS diagram, what is the effect on output, the price level, and employment?
46.
Hydraulic fracturing (fracking) has the potential to significantly increase the amount of natural gas produced in the United States. If a large percentage of factories and utility companies use natural gas, what will happen to output, the price level, and employment as fracking becomes more widely used?
47.
Some politicians have suggested tying the minimum wage to the consumer price index (CPI). Using the AD/AS diagram, what effects would this policy most likely have on output, the price level, and employment?
48.
If households decide to save a larger portion of their income, what effect would this have on the output, employment, and price level in the short run? What about the long run?
49.
If firms become more optimistic about the future of the economy and, at the same time, innovation in 3-D printing makes most workers more productive, what is the combined effect on output, employment, and the price-level?
50.
If Congress cuts taxes at the same time that businesses become more pessimistic about the economy, what is the combined effect on output, the price level, and employment using the AD/AS diagram?
51.
Suppose the level of structural unemployment increases. How would you illustrate the increase in structural unemployment in the AD/AS model? Hint: How does structural unemployment affect potential GDP?
52.
If foreign wealth-holders decide that the United States is the safest place to invest their savings, what would the effect be on the economy here? Show graphically using the AD/AS model.
53.
The AD/AS model is static. It shows a snapshot of the economy at a given point in time. Both economic growth and inflation are dynamic phenomena. Suppose economic growth is 3% per year and aggregate demand is growing at the same rate. What does the AD/AS model say the inflation rate should be?
54.
Explain why the short-run aggregate supply curve might be fairly flat in the Keynesian zone of the SRAS curve. How might we tell if we are in the Keynesian zone of the AS?
55.
Explain why the short-run aggregate supply curve might be vertical in the neoclassical zone of the SRAS curve. How might we tell if we are in the neoclassical zone of the AS?
56.
Why might it be important for policymakers to know which in zone of the SRAS curve the economy is?
57.
In your view, is the economy currently operating in the Keynesian, intermediate or neoclassical portion of the economy’s aggregate supply curve?
58.
Are Say’s law and Keynes’ law necessarily mutually exclusive?
11.13: Problems
59.
Review the problem in the Work It Out titled "Interpreting the AD/AS Model." Like the information provided in that feature, Table 11.2 shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia.
Price Level AD AS
110 700 600
120 690 640
130 680 680
140 670 720
150 660 740
160 650 760
170 640 770
Table 11.2 Price Level: AD/AS
1. Plot the AD/AS diagram from the data. Identify the equilibrium.
2. Imagine that, as a result of a government tax cut, aggregate demand becomes higher by 50 at every price level. Identify the new equilibrium.
3. How will the new equilibrium alter output? How will it alter the price level? What do you think will happen to employment?
60.
The imaginary country of Harris Island has the aggregate supply and aggregate demand curves as Table 11.3 shows.
Price Level AD AS
100 700 200
120 600 325
140 500 500
160 400 570
180 300 620
Table 11.3 Price Level: AD/AS
1. Plot the AD/AS diagram. Identify the equilibrium.
2. Would you expect unemployment in this economy to be relatively high or low?
3. Would you expect concern about inflation in this economy to be relatively high or low?
4. Imagine that consumers begin to lose confidence about the state of the economy, and so AD becomes lower by 275 at every price level. Identify the new aggregate equilibrium.
5. How will the shift in AD affect the original output, price level, and employment?
61.
Table 11.4 describes Santher's economy.
Price Level AD AS
50 1,000 250
60 950 580
70 900 750
80 850 850
90 800 900
Table 11.4 Price Level: AD/AS
1. Plot the AD/AS curves and identify the equilibrium.
2. Would you expect unemployment in this economy to be relatively high or low?
3. Would you expect prices to be a relatively large or small concern for this economy?
4. Imagine that input prices fall and so AS shifts to the right by 150 units. Identify the new equilibrium.
5. How will the shift in AS affect the original output, price level, and employment? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/11%3A_The_Aggregate_Demand_Aggregate_Supply_Model/11.12%3A_Critical_Thinking_Questions.txt |
Figure 12.1 Signs of a Recession Home foreclosures were just one of the many signs and symptoms of the recent Great Recession. During that time, many businesses closed and many people lost their jobs. (Credit: modification of "Foreclosure" by Taber Andrew Bain/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Aggregate Demand in Keynesian Analysis
• The Building Blocks of Keynesian Analysis
• The Phillips Curve
• The Keynesian Perspective on Market Forces
Bring It Home
The Great Recession
The 2008–2009 Great Recession hit the U.S. economy hard. According to the Bureau of Labor Statistics (BLS), the number of unemployed Americans rose from 6.8 million in May 2007 to 15.4 million in October 2009. During that time, the U.S. Census Bureau estimated that approximately 170,000 small businesses closed. Mass layoffs peaked in February 2009 when employers gave 326,392 workers notice. U.S. productivity and output fell as well. Job losses, declining home values, declining incomes, and uncertainty about the future caused consumption expenditures to decrease. According to the BLS, household spending dropped by 7.8%.
Home foreclosures and the meltdown in U.S. financial markets called for immediate action by Congress, the President, and the Federal Reserve Bank. For example, the government implemented programs such as the American Restoration and Recovery Act to help millions of people by providing tax credits for homebuyers, paying “cash for clunkers,” and extending unemployment benefits. From cutting back on spending, filing for unemployment, and losing homes, millions of people were affected by the recession. While the United States is now on the path to recovery, people will feel the impact for many years to come.
What caused this recession and what prevented the economy from spiraling further into another depression? Policymakers looked to the lessons learned from the 1930s Great Depression and to John Maynard Keynes' models to analyze the causes and find solutions to the country’s economic woes. The Keynesian perspective is the subject of this chapter.
We have learned that the level of economic activity, for example output, employment, and spending, tends to grow over time. In The Keynesian Perspective we learned the reasons for this trend. The Macroeconomic Perspective pointed out that the economy tends to cycle around the long-run trend. In other words, the economy does not always grow at its average growth rate. Sometimes economic activity grows at the trend rate, sometimes it grows more than the trend, sometimes it grows less than the trend, and sometimes it actually declines. You can see this cyclical behavior in Figure 12.2.
Figure 12.2 U.S. Real Domestic Product, Percent Changes 1930–2020 The chart tracks the percent change in Real GDP since 1930. The magnitude of both recessions and peaks was quite large between 1930 and 1945. (Source: Bureau of Economic Analysis, “National Economic Accounts,” https://apps.bea.gov/itable/index.cfm)
This empirical reality raises two important questions: How can we explain the cycles, and to what extent can we moderate them? This chapter (on the Keynesian perspective) and The Neoclassical Perspective explore those questions from two different points of view, building on what we learned in The Aggregate Demand/Aggregate Supply Model.
Percent Change of U.S. Real Gross Domestic Product. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/12%3A_The_Keynesian_Perspective/12.01%3A_Introduction_to_the_Keynesian_Perspective.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain real GDP, recessionary gaps, and inflationary gaps
• Recognize the Keynesian AD/AS model
• Identify the determining factors of both consumption expenditure and investment expenditure
• Analyze the factors that determine government spending and net exports
The Keynesian perspective focuses on aggregate demand. The idea is simple: firms produce output only if they expect it to sell. Thus, while the availability of the factors of production determines a nation’s potential GDP, the amount of goods and services that actually sell, known as real GDP, depends on how much demand exists across the economy. Figure 12.3 illustrates this point.
Figure 12.3 The Keynesian AD/AS Model The Keynesian View of the AD/AS Model uses an SRAS curve, which is horizontal at levels of output below potential and vertical at potential output. Thus, when beginning from potential output, any decrease in AD affects only output, but not prices. Any increase in AD affects only prices, not output.
Keynes argued that, for reasons we explain shortly, aggregate demand is not stable—that it can change unexpectedly. Suppose the economy starts where AD intersects SRAS at P0 and Yp. Because Yp is potential output, the economy is at full employment. Because AD is volatile, it can easily fall. Thus, even if we start at Yp, if AD falls, then we find ourselves in what Keynes termed a recessionary gap. The economy is in equilibrium but with less than full employment, as Y1 in Figure 12.3 shows. Keynes believed that the economy would tend to stay in a recessionary gap, with its attendant unemployment, for a significant period of time.
In the same way (although we do not show it in the figure), if AD increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output. Consequently, the economy experiences inflation. The key policy implication for either situation is that government needs to step in and close the gap, increasing spending during recessions and decreasing spending during booms to return aggregate demand to match potential output.
Recall from The Aggregate Supply-Aggregate Demand Model that aggregate demand is total spending, economy-wide, on domestic goods and services. (Aggregate demand (AD) is actually what economists call total planned expenditure. Read the appendix on The Expenditure-Output Model for more on this.) You may also remember that aggregate demand is the sum of four components: consumption expenditure, investment expenditure, government spending, and spending on net exports (exports minus imports). In the following sections, we will examine each component through the Keynesian perspective.
What Determines Consumption Expenditure?
Consumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services. Durable goods are items that last and provide value over time, such as automobiles. Nondurable goods are things like groceries—once you consume them, they are gone. Recall from The Macroeconomic Perspective that services are intangible things consumers buy, like healthcare or entertainment.
Keynes identified three factors that affect consumption:
• Disposable income: For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay, also known as disposable income, which is income after taxes.
• Expected future income: Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend and increase overall aggregate demand. News of recession and troubles in the economy will make them pull back on consumption.
• Wealth or credit: When households experience a rise in wealth, they may be willing to consume a higher share of their income and to save less. When the U.S. stock market rose dramatically in the late 1990s, for example, U.S. savings rates declined, probably in part because people felt that their wealth had increased and there was less need to save. How do people spend beyond their income, when they perceive their wealth increasing? The answer is borrowing. On the other side, when the U.S. stock market declined about 40% from March 2008 to March 2009, people felt far greater uncertainty about their economic future, so savings rates increased while consumption declined.
Finally, Keynes noted that a variety of other factors combine to determine how much people save and spend. If household preferences about saving shift in a way that encourages consumption rather than saving, then AD will shift out to the right.
Link It Up
Visit this website for more information about how the recession affected various groups of people.
What Determines Investment Expenditure?
We call spending on new capital goods investment expenditure. Investment falls into four categories: producer’s durable equipment and software, nonresidential structures (such as factories, offices, and retail locations), changes in inventories, and residential structures (such as single-family homes, townhouses, and apartment buildings). Businesses conduct the first three types of investment, while households conduct the last.
Keynes’s treatment of investment focuses on the key role of expectations about the future in influencing business decisions. When a business decides to make an investment in physical assets, like plants or equipment, or in intangible assets, like skills or a research and development project, that firm considers both the expected investment benefits (future profit expectations) and the investment costs (interest rates).
• Expectations of future profits: The clearest driver of investment benefits is expectations for future profits. When we expect an economy to grow, businesses perceive a growing market for their products. Their higher degree of business confidence will encourage new investment. For example, in the second half of the 1990s, U.S. investment levels surged from 18% of GDP in 1994 to 21% in 2000. However, when a recession started in 2001, U.S. investment levels quickly sank back to 18% of GDP by 2002.
• Interest rates also play a significant role in determining how much investment a firm will make. Just as individuals need to borrow money to purchase homes, so businesses need financing when they purchase big ticket items. The cost of investment thus includes the interest rate. Even if the firm has the funds, the interest rate measures the opportunity cost of purchasing business capital. Lower interest rates stimulate investment spending and higher interest rates reduce it.
Many factors can affect the expected profitability on investment. For example, if the energy prices decline, then investments that use energy as an input will yield higher profits. If government offers special incentives for investment (for example, through the tax code), then investment will look more attractive; conversely, if government removes special investment incentives from the tax code, or increases other business taxes, then investment will look less attractive. As Keynes noted, business investment is the most variable of all the components of aggregate demand.
What Determines Government Spending?
The third component of aggregate demand is federal, state, and local government spending. Although we usually view the United States as a market economy, government still plays a significant role in the economy. As we discuss in Environmental Protection and Negative Externalities and Positive Externalities and Public Goods, government provides important public services such as national defense, transportation infrastructure, and education.
Keynes recognized that the government budget offered a powerful tool for influencing aggregate demand. Not only could more government spending stimulate AD (or less government spending reduce it), but lowering or raising tax rates could influence consumption and investment spending. Keynes concluded that during extreme times like deep recessions, only the government had the power and resources to move aggregate demand. For example, during the 2020 pandemic-induced recession, the federal government gave money to state and local governments and to households to support the economy when many firms and governments needed to shut down or suffered a large decline in revenue and needed to lay off workers.
What Determines Net Exports?
Recall that exports are domestically produced products that sell abroad while imports are foreign produced products that consumers purchase domestically. Since we define aggregate demand as spending on domestic goods and services, export expenditures add to AD, while import expenditures subtract from AD.
Two sets of factors can cause shifts in export and import demand: changes in relative growth rates between countries and changes in relative prices between countries. What is happening in the countries' economies that would be purchasing those exports heavily affects the level of demand for a nation's exports. For example, if major importers of American-made products like Canada, Japan, and Germany have recessions, exports of U.S. products to those countries are likely to decline. Conversely, the amount of income in the domestic economy directly affects the quantity of a nation's imports: more income will bring a higher level of imports.
Relative prices of goods in domestic and international markets can also affect exports and imports. If U.S. goods are relatively cheaper compared with goods made in other places, perhaps because a group of U.S. producers has mastered certain productivity breakthroughs, then U.S. exports are likely to rise. If U.S. goods become relatively more expensive, perhaps because a change in the exchange rate between the U.S. dollar and other currencies has pushed up the price of inputs to production in the United States, then exports from U.S. producers are likely to decline.
Table 12.1 summarizes the reasons we have explained for changes in aggregate demand.
Reasons for a Decrease in Aggregate Demand Reasons for an Increase in Aggregate Demand
Consumption
• Rise in taxes
• Fall in income
• Rise in interest rates
• Desire to save more
• Decrease in wealth
• Fall in future expected income
Consumption
• Decrease in taxes
• Increase in income
• Fall in interest rates
• Desire to save less
• Rise in wealth
• Rise in future expected income
Investment
• Fall in expected rate of return
• Rise in interest rates
• Drop in business confidence
Investment
• Rise in expected rate of return
• Drop in interest rates
• Rise in business confidence
Government
• Reduction in government spending
• Increase in taxes
Government
• Increase in government spending
• Decrease in taxes
Net Exports
• Decrease in foreign demand
• Relative price increase of U.S. goods
Net Exports
• Increase in foreign demand
• Relative price drop of U.S. goods
Table 12.1 Determinants of Aggregate Demand | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/12%3A_The_Keynesian_Perspective/12.02%3A_Aggregate_Demand_in_Keynesian_Analysis.txt |
Learning Objectives
By the end of this section, you will be able to:
• Evaluate the Keynesian view of recessions through an understanding of sticky wages and prices and the importance of aggregate demand
• Explain the coordination argument, menu costs, and macroeconomic externality
• Analyze the impact of the expenditure multiplier
Now that we have a clear understanding of what constitutes aggregate demand, we return to the Keynesian argument using the model of aggregate demand/aggregate supply (AD/AS). (For a similar treatment using Keynes’ income-expenditure model, see the appendix on The Expenditure-Output Model.)
Keynesian economics focuses on explaining why recessions and depressions occur and offering a policy prescription for minimizing their effects. The Keynesian view of recession is based on two key building blocks. First, aggregate demand is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment. Second, the macroeconomy may adjust only slowly to shifts in aggregate demand because of sticky wages and prices, which are wages and prices that do not respond to decreases or increases in demand. We will consider these two claims in turn, and then see how they are represented in the AD/AS model.
The first building block of the Keynesian diagnosis is that recessions occur when the level of demand for goods and services is less than what is produced when labor is fully employed. In other words, the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of GDP consistent with full employment. Suppose the stock market crashes, as in 1929, or suppose the housing market collapses, as in 2008. In either case, household wealth will decline, and consumption expenditure will follow. Suppose businesses see that consumer spending is falling or face restrictions from a pandemic that curtail their operations. That will reduce expectations of the profitability of investment, so businesses will decrease investment expenditure.
This seemed to be the case during the Great Depression, since the physical capacity of the economy to supply goods did not alter much. No flood or earthquake or other natural disaster ruined factories in 1929 or 1930. No outbreak of disease decimated the ranks of workers. No key input price, like the price of oil, soared on world markets. The U.S. economy in 1933 had just about the same factories, workers, and state of technology as it had had four years earlier in 1929—and yet the economy had shrunk dramatically. This also seems to be what happened in 2008.
As Keynes recognized, the events of the Depression contradicted Say’s law that “supply creates its own demand.” Although production capacity existed, the markets were not able to sell their products. As a result, real GDP was less than potential GDP.
Link It Up
Visit this website for raw data used to calculate GDP.
Wage and Price Stickiness
Keynes also pointed out that although AD fluctuated, prices and wages did not immediately respond as economists often expected. Instead, prices and wages are “sticky,” making it difficult to restore the economy to full employment and potential GDP. Keynes emphasized one particular reason why wages were sticky: the coordination argument. This argument points out that, even if most people would be willing—at least hypothetically—to see a decline in their own wages in bad economic times as long as everyone else also experienced such a decline, a market-oriented economy has no obvious way to implement a plan of coordinated wage reductions. Unemployment proposed a number of reasons why wages might be sticky downward, most of which center on the argument that businesses avoid wage cuts because they may in one way or another depress morale and hurt the productivity of the existing workers.
Some modern economists have argued in a Keynesian spirit that, along with wages, other prices may be sticky, too. Many firms do not change their prices every day or even every month. When a firm considers changing prices, it must consider two sets of costs. First, changing prices uses company resources: managers must analyze the competition and market demand and decide the new prices, they must update sales materials, change billing records, and redo product and price labels. Second, frequent price changes may leave customers confused or angry—especially if they discover that a product now costs more than they expected. These costs of changing prices are called menu costs—like the costs of printing a new set of menus with different prices in a restaurant. Prices do respond to forces of supply and demand, but from a macroeconomic perspective, the process of changing all prices throughout the economy takes time.
To understand the effect of sticky wages and prices in the economy, consider Figure 12.4 (a) illustrating the overall labor market, while Figure 12.4 (b) illustrates a market for a specific good or service. The original equilibrium (E0) in each market occurs at the intersection of the demand curve (D0) and supply curve (S0). When aggregate demand declines, the demand for labor shifts to the left (to D1) in Figure 12.4 (a) and the demand for goods shifts to the left (to D1) in Figure 12.4 (b). However, because of sticky wages and prices, the wage remains at its original level (W0) for a period of time and the price remains at its original level (P0).
As a result, a situation of excess supply—where the quantity supplied exceeds the quantity demanded at the existing wage or price—exists in markets for both labor and goods, and Q1 is less than Q0 in both Figure 12.4 (a) and Figure 12.4 (b). When many labor markets and many goods markets all across the economy find themselves in this position, the economy is in a recession; that is, firms cannot sell what they wish to produce at the existing market price and do not wish to hire all who are willing to work at the existing market wage. The Clear It Up feature discusses this problem in more detail.
Figure 12.4 Sticky Prices and Falling Demand in the Labor and Goods Market In both (a) and (b), demand shifts left from D0 to D1. However, the wage in (a) and the price in (b) do not immediately decline. In (a), the quantity demanded of labor at the original wage (W0) is Q0, but with the new demand curve for labor (D1), it will be Q1. Similarly, in (b), the quantity demanded of goods at the original price (P0) is Q0, but at the new demand curve (D1) it will be Q1. An excess supply of labor will exist, which we call unemployment. An excess supply of goods will also exist, where the quantity demanded is substantially less than the quantity supplied. Thus, sticky wages and sticky prices, combined with a drop in demand, bring about unemployment and recession.
Clear It Up
Why Was the Pace of Wage Adjustments Slow?
The recovery after the Great Recession in the United States was slow. In fact, many low-wage workers at McDonalds, Dominos, and Walmart threatened to strike for higher wages. Their plight was part of a larger trend in job growth and pay in the post–recession recovery.
Figure 12.5 Jobs Lost/Gained in the Recession/Recovery Data in the aftermath of the Great Recession suggests that jobs lost were in mid-wage occupations, while jobs gained were in low-wage occupations.
The National Employment Law Project compiled data from the Bureau of Labor Statistics and found that, during the Great Recession, 60% of job losses were in medium-wage occupations. Most of them were replaced during the recovery period with lower-wage jobs in the service, retail, and food industries. Figure 12.5 illustrates this data.
Wages in the service, retail, and food industries are at or near minimum wage and tend to be both downwardly and upwardly “sticky.” Wages are downwardly sticky due to minimum wage laws. They may be upwardly sticky if insufficient competition in low-skilled labor markets enables employers to avoid raising wages that would reduce their profits. At the same time, however, the Consumer Price Index increased 11% between 2007 and 2012, pushing real wages down.
The Two Keynesian Assumptions in the AD/AS Model
Figure 12.6 is the AD/AS diagram which illustrates these two Keynesian assumptions—the importance of aggregate demand in causing recession and the stickiness of wages and prices. Note that because of the stickiness of wages and prices, the aggregate supply curve is flatter than either supply curve (labor or specific good). In fact, if wages and prices were so sticky that they did not fall at all, the aggregate supply curve would be completely flat below potential GDP, as Figure 12.6 shows. This outcome is an important example of a macroeconomic externality, where what happens at the macro level is different from and inferior to what happens at the micro level. For example, a firm should respond to a decrease in demand for its product by cutting its price to increase sales. However, if all firms experience a decrease in demand for their products, sticky prices in the aggregate prevent aggregate demand from rebounding (which we would show as a movement along the AD curve in response to a lower price level).
The original equilibrium of this economy occurs where the aggregate demand function (AD0) intersects with AS. Since this intersection occurs at potential GDP (Yp), the economy is operating at full employment. When aggregate demand shifts to the left, all the adjustment occurs through decreased real GDP. There is no decrease in the price level. Since the equilibrium occurs at Y1, the economy experiences substantial unemployment.
Figure 12.6 A Keynesian Perspective of Recession This figure illustrates the two key assumptions behind Keynesian economics. A recession begins when aggregate demand declines from AD0 to AD1. The recession persists because of the assumption of fixed wages and prices, which makes the SRAS flat below potential GDP. If that were not the case, the price level would fall also, raising GDP and limiting the recession. Instead the intersection E1 occurs in the flat portion of the SRAS curve where GDP is less than potential.
The Expenditure Multiplier
A key concept in Keynesian economics is the expenditure multiplier. The expenditure multiplier is the idea that not only does spending affect the equilibrium level of GDP, but that spending is powerful. More precisely, it means that a change in spending causes a more than proportionate change in GDP.
$ΔY ΔSpending >1 ΔY ΔSpending >1$
The reason for the expenditure multiplier is that one person’s spending becomes another person’s income, which leads to additional spending and additional income so that the cumulative impact on GDP is larger than the initial increase in spending. The appendix on The Expenditure-Output Model provides the details of the multiplier process, but the concept is important enough for us to summarize here. While the multiplier is important for understanding the effectiveness of fiscal policy, it occurs whenever any autonomous increase in spending occurs. Additionally, the multiplier operates in a negative as well as a positive direction. Thus, when investment spending collapsed during the Great Depression, it caused a much larger decrease in real GDP. The size of the multiplier is critical and was a key element in discussions of the effectiveness of the Obama administration’s fiscal stimulus package, officially titled the American Recovery and Reinvestment Act of 2009. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/12%3A_The_Keynesian_Perspective/12.03%3A_The_Building_Blocks_of_Keynesian_Analysis.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the Phillips curve, noting its impact on the theories of Keynesian economics
• Graph a Phillips curve
• Identify factors that cause the instability of the Phillips curve
• Analyze the Keynesian policy for reducing unemployment and inflation
The simplified AD/AS model that we have used so far is fully consistent with Keynes’s original model. More recent research, though, has indicated that in the real world, an aggregate supply curve is more curved than the right angle that we used in this chapter. Rather, the real-world AS curve is very flat at levels of output far below potential (“the Keynesian zone”), very steep at levels of output above potential (“the neoclassical zone”) and curved in between (“the intermediate zone”). Figure 12.7 illustrates this. The typical aggregate supply curve leads to the concept of the Phillips curve.
Figure 12.7 Keynes, Neoclassical, and Intermediate Zones in the Aggregate Supply Curve Near the equilibrium Ek, in the Keynesian zone at the SRAS curve's far left, small shifts in AD, either to the right or the left, will affect the output level Yk, but will not much affect the price level. In the Keynesian zone, AD largely determines the quantity of output. Near the equilibrium En, in the neoclassical zone, at the SRAS curve's far right, small shifts in AD, either to the right or the left, will have relatively little effect on the output level Yn, but instead will have a greater effect on the price level. In the neoclassical zone, the near-vertical SRAS curve close to the level of potential GDP (as represented by the LRAS line) largely determines the quantity of output. In the intermediate zone around equilibrium Ei, movement in AD to the right will increase both the output level and the price level, while a movement in AD to the left would decrease both the output level and the price level.
The Discovery of the Phillips Curve
In the 1950s, A.W. Phillips, an economist at the London School of Economics, was studying the Keynesian analytical framework. The Keynesian theory implied that during a recession inflationary pressures are low, but when the level of output is at or even pushing beyond potential GDP, the economy is at greater risk for inflation. Phillips analyzed 60 years of British data and did find that tradeoff between unemployment and inflation, which became known as the Phillips curve. Figure 12.8 shows a theoretical Phillips curve, and the following Work It Out feature shows how the pattern appears for the United States.
Figure 12.8 A Keynesian Phillips Curve Tradeoff between Unemployment and Inflation A Phillips curve illustrates a tradeoff between the unemployment rate and the inflation rate. If one is higher, the other must be lower. For example, point A illustrates a 5% inflation rate and a 4% unemployment. If the government attempts to reduce inflation to 2%, then it will experience a rise in unemployment to 7%, as point B shows.
Work It Out
The Phillips Curve for the United States
Step 1. Go to this website to see the 2005 Economic Report of the President.
Step 2. Scroll down and locate Table B-63 in the Appendices. This table is titled “Changes in special consumer price indexes, 1960–2004.”
Step 3. Download the table in Excel by selecting the XLS option and then selecting the location in which to save the file.
Step 4. Open the downloaded Excel file.
Step 5. View the third column (labeled “Year to year”). This is the inflation rate, measured by the percentage change in the Consumer Price Index.
Step 6. Return to the website and scroll to locate the Appendix Table B-42 “Civilian unemployment rate, 1959–2004.
Step 7. Download the table in Excel.
Step 8. Open the downloaded Excel file and view the second column. This is the overall unemployment rate.
Step 9. Using the data available from these two tables, plot the Phillips curve for 1960–69, with unemployment rate on the x-axis and the inflation rate on the y-axis. Your graph should look like Figure 12.9.
Figure 12.9 The Phillips Curve from 1960–1969 This chart shows the negative relationship between unemployment and inflation.
Step 10. Plot the Phillips curve for 1960–1979. What does the graph look like? Do you still see the tradeoff between inflation and unemployment? Your graph should look like Figure 12.10.
Figure 12.10 U.S. Phillips Curve, 1960–1979 The tradeoff between unemployment and inflation appeared to break down during the 1970s as the Phillips Curve shifted out to the right.
Over this longer period of time, the Phillips curve appears to have shifted out. There is no tradeoff any more.
The Instability of the Phillips Curve
During the 1960s, economists viewed the Phillips curve as a policy menu. A nation could choose low inflation and high unemployment, or high inflation and low unemployment, or anywhere in between. Economies could use fiscal and monetary policy to move up or down the Phillips curve as desired. Then a curious thing happened. When policymakers tried to exploit the tradeoff between inflation and unemployment, the result was an increase in both inflation and unemployment. What had happened? The Phillips curve shifted.
The U.S. economy experienced this pattern in the deep recession from 1973 to 1975, and again in back-to-back recessions from 1980 to 1982. Many nations around the world saw similar increases in unemployment and inflation. This pattern became known as stagflation. (Recall from The Aggregate Demand/Aggregate Supply Model that stagflation is an unhealthy combination of high unemployment and high inflation.) Perhaps most important, stagflation was a phenomenon that traditional Keynesian economics could not explain.
Economists have concluded that two factors cause the Phillips curve to shift. The first is supply shocks, like the mid-1970s oil crisis, which first brought stagflation into our vocabulary. The second is changes in people’s expectations about inflation. In other words, there may be a tradeoff between inflation and unemployment when people expect no inflation, but when they realize inflation is occurring, the tradeoff disappears. Both factors (supply shocks and changes in inflationary expectations) cause the aggregate supply curve, and thus the Phillips curve, to shift.
In short, we should interpret a downward-sloping Phillips curve as valid for short-run periods of several years, but over longer periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher (as in the 1970s and early 1980s) or both lower (as in the early 1990s or first decade of the 2000s).
Keynesian Policy for Fighting Unemployment and Inflation
Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. For example, if aggregate demand was originally at ADr in Figure 12.11, so that the economy was in recession, the appropriate policy would be for government to shift aggregate demand to the right from ADr to ADf, where the economy would be at potential GDP and full employment.
Keynes noted that while it would be nice if the government could spend additional money on housing, roads, and other amenities, he also argued that if the government could not agree on how to spend money in practical ways, then it could spend in impractical ways. For example, Keynes suggested building monuments, like a modern equivalent of the Egyptian pyramids. He proposed that the government could bury money underground, and let mining companies start digging up the money again. These suggestions were slightly tongue-in-cheek, but their purpose was to emphasize that a Great Depression is no time to quibble over the specifics of government spending programs and tax cuts when the goal should be to pump up aggregate demand by enough to lift the economy to potential GDP.
Figure 12.11 Fighting Recession and Inflation with Keynesian Policy If an economy is in recession, with an equilibrium at Er, then the Keynesian response would be to enact a policy to shift aggregate demand to the right from ADr toward ADf. If an economy is experiencing inflationary pressures with an equilibrium at Ei, then the Keynesian response would be to enact a policy response to shift aggregate demand to the left, from ADi toward ADf.
The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment. If aggregate demand was originally at ADi in Figure 12.11, so that the economy was experiencing inflationary rises in the price level, the appropriate policy would be for government to shift aggregate demand to the left, from ADi toward ADf, which reduces the pressure for a higher price level while the economy remains at full employment.
In the Keynesian economic model, too little aggregate demand brings unemployment and too much brings inflation. Thus, you can think of Keynesian economics as pursuing a “Goldilocks” level of aggregate demand: not too much, not too little, but looking for what is just right. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/12%3A_The_Keynesian_Perspective/12.04%3A_The_Phillips_Curve.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the Keynesian perspective on market forces
• Analyze the role of government policy in economic management
Ever since the birth of Keynesian economics in the 1930s, controversy has simmered over the extent to which government should play an active role in managing the economy. In the aftermath of the human devastation and misery of the Great Depression, many people—including many economists—became more aware of vulnerabilities within the market-oriented economic system. Some supporters of Keynesian economics advocated a high degree of government planning in all parts of the economy.
However, Keynes himself was careful to separate the issue of aggregate demand from the issue of how well individual markets worked. He argued that individual markets for goods and services were appropriate and useful, but that sometimes that level of aggregate demand was just too low. When 10 million people are willing and able to work, but one million of them are unemployed, he argued, individual markets may be doing a perfectly good job of allocating the efforts of the nine million workers—the problem is that insufficient aggregate demand exists to support jobs for all 10 million. Thus, he believed that, while government should ensure that overall level of aggregate demand is sufficient for an economy to reach full employment, this task did not imply that the government should attempt to set prices and wages throughout the economy, nor to take over and manage large corporations or entire industries directly.
Even if one accepts the Keynesian economic theory, a number of practical questions remain. In the real world, can government economists identify potential GDP accurately? Is a desired increase in aggregate demand better accomplished by a tax cut or by an increase in government spending? Given the inevitable delays and uncertainties as governments enact policies into law, is it reasonable to expect that the government can implement Keynesian economics? Can fixing a recession really be just as simple as pumping up aggregate demand? Government Budgets and Fiscal Policy will probe these issues. The Keynesian approach, with its focus on aggregate demand and sticky prices, has proved useful in understanding how the economy fluctuates in the short run and why recessions and cyclical unemployment occur. In The Neoclassical Perspective, we will consider some of the shortcomings of the Keynesian approach and why it is not especially well-suited for long-run macroeconomic analysis.
Bring It Home
The Pandemic-Induced Recession and the Keynesian Perspective
The pandemic-induced recession of 2020 was unique. Unlike the Great Recession of 2007–2009 discussed in most of this chapter, it was not started by the burst of a housing bubble. It was started by a virus that caused sickness and death for millions of people worldwide and required substantial social policy in order to control its spread.
In some ways, the latest recession was influenced by fluctuations in aggregate demand. At its depth in April 2020, over 20 million people were unemployed, causing a massive decline in consumption and aggregate demand. As businesses were forced to shutter or move their operations online, many were pessimistic or uncertain about the future state of the economy, causing investment to decline. The federal government attempted to correct this aggregate demand shock through small business loans, direct aid to state and local governments, expanded unemployment insurance, and stimulus checks. As a result of all these measures, the economy was able to bounce back somewhat over the remainder of 2020. However, even at the start of 2022, millions of people remained out of work as new variants threatened to upend the economy once again.
The Keynesian perspective would have economic policy continue to focus on aggregate and restoring confidence in the economy. President Biden’s proposals largely reflect these goals, but with millions of workers still out of the labor market and a virus that is still not contained, it remains to be seen whether those policy prescriptions will be enough “medicine” to bring the economy back to normalcy. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/12%3A_The_Keynesian_Perspective/12.05%3A_The_Keynesian_Perspective_on_Market_Forces.txt |
contractionary fiscal policy
tax increases or cuts in government spending designed to decrease aggregate demand and reduce inflationary pressures
coordination argument
downward wage and price flexibility requires perfect information about the level of lower compensation acceptable to other laborers and market participants
disposable income
income after taxes
expansionary fiscal policy
tax cuts or increases in government spending designed to stimulate aggregate demand and move the economy out of recession
expenditure multiplier
Keynesian concept that asserts that a change in autonomous spending causes a more than proportionate change in real GDP
inflationary gap
equilibrium at a level of output above potential GDP
macroeconomic externality
occurs when what happens at the macro level is different from and inferior to what happens at the micro level; an example would be where upward sloping supply curves for firms become a flat aggregate supply curve, illustrating that the price level cannot fall to stimulate aggregate demand
menu costs
costs firms face in changing prices
Phillips curve
the tradeoff between unemployment and inflation
real GDP
the amount of goods and services actually sold in a nation
recessionary gap
equilibrium at a level of output below potential GDP
sticky wages and prices
a situation where wages and prices do not fall in response to a decrease in demand, or do not rise in response to an increase in demand
12.07: Key Concepts and Summary
12.1 Aggregate Demand in Keynesian Analysis
Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports. Consumption will change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels. Investment will change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment will also change when interest rates rise or fall. Political considerations determine government spending and taxes. Exports and imports change according to relative growth rates and prices between two economies.
12.2 The Building Blocks of Keynesian Analysis
Keynesian economics is based on two main ideas: (1) aggregate demand is more likely than aggregate supply to be the primary cause of a short-run economic event like a recession; (2) wages and prices can be sticky, and so, in an economic downturn, unemployment can result. The latter is an example of a macroeconomic externality. While surpluses cause prices to fall at the micro level, they do not necessarily at the macro level. Instead the adjustment to a decrease in demand occurs only through decreased quantities. One reason why prices may be sticky is menu costs, the costs of changing prices. These include internal costs a business faces in changing prices in terms of labeling, recordkeeping, and accounting, and also the costs of communicating the price change to (possibly unhappy) customers. Keynesians also believe in the existence of the expenditure multiplier—the notion that a change in autonomous expenditure causes a more than proportionate change in GDP.
12.3 The Phillips Curve
A Phillips curve shows the tradeoff between unemployment and inflation in an economy. From a Keynesian viewpoint, the Phillips curve should slope down so that higher unemployment means lower inflation, and vice versa. However, a downward-sloping Phillips curve is a short-term relationship that may shift after a few years.
Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left.
12.4 The Keynesian Perspective on Market Forces
The Keynesian prescription for stabilizing the economy implies government intervention at the macroeconomic level—increasing aggregate demand when private demand falls and decreasing aggregate demand when private demand rises. This does not imply that the government should be passing laws or regulations that set prices and quantities in microeconomic markets. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/12%3A_The_Keynesian_Perspective/12.06%3A_Key_Terms.txt |
1.
In the Keynesian framework, which of the following events might cause a recession? Which might cause inflation? Sketch AD/AS diagrams to illustrate your answers.
1. A large increase in the price of the homes people own.
2. Rapid growth in the economy of a major trading partner.
3. The development of a major new technology offers profitable opportunities for business.
4. The interest rate rises.
5. The good imported from a major trading partner become much less expensive.
2.
In a Keynesian framework, using an AD/AS diagram, which of the following government policy choices offer a possible solution to recession? Which offer a possible solution to inflation?
1. A tax increase on consumer income.
2. A surge in military spending.
3. A reduction in taxes for businesses that increase investment.
4. A major increase in what the U.S. government spends on healthcare.
3.
Use the AD/AS model to explain how an inflationary gap occurs, beginning from the initial equilibrium in Figure 12.6.
4.
Suppose the U.S. Congress cuts federal government spending in order to balance the Federal budget. Use the AD/AS model to analyze the likely impact on output and employment. Hint: revisit Figure 12.6.
5.
How would a decrease in energy prices affect the Phillips curve?
6.
Does Keynesian economics require government to set controls on prices, wages, or interest rates?
7.
List three practical problems with the Keynesian perspective.
12.09: Review Questions
8.
Name some economic events not related to government policy that could cause aggregate demand to shift.
9.
Name some government policies that could cause aggregate demand to shift.
10.
From a Keynesian point of view, which is more likely to cause a recession: aggregate demand or aggregate supply, and why?
11.
Why do sticky wages and prices increase the impact of an economic downturn on unemployment and recession?
12.
Explain what economists mean by “menu costs.”
13.
What tradeoff does a Phillips curve show?
14.
Would you expect to see long-run data trace out a stable downward-sloping Phillips curve?
15.
What is the Keynesian prescription for recession? For inflation?
16.
How did the Keynesian perspective address the economic market failure of the Great Depression?
12.10: Critical Thinking Questions
17.
In its recent report, The Conference Board’s Global Economic Outlook 2015, updated November 2014 (www.conference-board.org/data...baloutlook.cfm), projects China’s growth between 2015 and 2019 to be about 5.5%. International Business Times (http://www.ibtimes.com/us-exports-ch...decade-1338693) reports that China is the United States’ third largest export market, with exports to China growing 294% over the last ten years. Explain what impact China has on the U.S. economy.
18.
What may happen if growth in China continues or contracts?
19.
Does it make sense that wages would be sticky downwards but not upwards? Why or why not?
20.
Suppose the economy is operating at potential GDP when it experiences an increase in export demand. How might the economy increase production of exports to meet this demand, given that the economy is already at full employment?
21.
Do you think the Phillips curve is a useful tool for analyzing the economy today? Why or why not?
22.
Return to the table from the Economic Report of the President in the earlier Work It Out feature titled “The Phillips Curve for the United States.” How would you expect government spending to have changed over the last six years?
23.
Explain what types of policies the federal government may have implemented to restore aggregate demand and the potential obstacles policymakers may have encountered. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/12%3A_The_Keynesian_Perspective/12.08%3A_Self-Check_Questions.txt |
Figure 13.1 Impact of the Great Recession We can see the impact of the Great Recession in many areas of the economy that impact our daily lives. One of the most visible signs was in the housing market where many people were forced to abandon their homes and other buildings, including ones midway through construction. (Credit: modification of "House" by A McLin/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• The Building Blocks of Neoclassical Analysis
• The Policy Implications of the Neoclassical Perspective
• Balancing Keynesian and Neoclassical Models
Bring It Home
Navigating Uncharted Waters
The Great Recession ended in June 2009 after 18 months, according to the National Bureau of Economic Research (NBER). The NBER examines a variety of measures of economic activity to gauge the economy's overall health. These measures include real income, wholesale and retail sales, employment, and industrial production. In the years since the official end of this historic economic downturn, it has become clear that the Great Recession was two-pronged, hitting the U.S. economy with the collapse of the housing market and the failure of the financial system's credit institutions, further contaminating global economies. While the stock market rapidly lost trillions of dollars of value, consumer spending dried up, and companies began cutting jobs, economic policymakers were struggling with how to best combat and prevent a national, and even global economic collapse. In the end, policymakers used a number of controversial monetary and fiscal policies to support the housing market and domestic industries as well as to stabilize the financial sector. Some of these initiatives included:
• Federal Reserve Bank purchase of both traditional and nontraditional assets off banks' balance sheets. By doing this, the Fed injected money into the banking system and increased the amounts of funds available to lend to the business sector and consumers. This also dropped short-term interest rates to as low as zero percent, which had the effect of devaluing U.S. dollars in the global market and boosting exports.
• The Congress and the President also passed several pieces of legislation that would stabilize the financial market. The Troubled Asset Relief Program (TARP), passed in late 2008, allowed the government to inject cash into troubled banks and other financial institutions and help support General Motors and Chrysler as they faced bankruptcy and threatened job losses throughout their supply chain. The American Recovery and Reinvestment Act in early 2009 provided tax rebates to low- and middle-income households to encourage consumer spending.
Four years after the end of the Great Recession, the economy had yet to return to its pre-recession levels of productivity and growth. Annual productivity increased only 1.9% between 2009 and 2012 compared to its 2.7% annual growth rate between 2000 and 2007, unemployment remained above the natural rate, and real GDP continued to lag behind potential growth. The actions the government took to stabilize the economy were under scrutiny and debate about their effectiveness continues. In this chapter, we will discuss the neoclassical perspective on economics and compare it to the Keynesian perspective, using both the Great Recession and the more recent pandemic-induced recession as examples.
In Chicago, Illinois, the highest recorded temperature was 105° in July 1995, while the lowest recorded temperature was 27° below zero in January 1958. Understanding why these extreme weather patterns occurred would be interesting. However, if you wanted to understand the typical weather pattern in Chicago, instead of focusing on one-time extremes, you would need to look at the entire pattern of data over time.
A similar lesson applies to the study of macroeconomics. It is interesting to study extreme situations, like the 1930s Great Depression, the 2008–2009 Great Recession, or the pandemic-induced recession of 2020. If you want to understand the whole picture, however, you need to look at the long term. Consider the unemployment rate. The unemployment rate has fluctuated from as low as 3.5% in 1969 to as high as 9.7% in 1982 and 8.1% in 2020. Even as the U.S. unemployment rate rose during recessions and declined during expansions, it kept returning to the general neighborhood of 5.0%. When the nonpartisan Congressional Budget Office carried out its long-range economic forecasts in 2010, it assumed that from 2015 to 2020, after the recession has passed, the unemployment rate would be 5.0%. In February 2020, before the COVID-19 pandemic, the unemployment rate reached a historic low of 3.5% and is back to below 5% as of early 2022. From a long-run perspective, the economy seems to keep adjusting back to this rate of unemployment.
As the name “neoclassical” implies, this perspective of how the macroeconomy works is a “new” view of the “old” classical model of the economy. The classical view, the predominant economic philosophy until the Great Depression, was that short-term fluctuations in economic activity would rather quickly, with flexible prices, adjust back to full employment. This view of the economy implied a vertical aggregate supply curve at full employment GDP, and prescribed a “hands off” policy approach. For example, if the economy were to slip into recession (a leftward shift of the aggregate demand curve), it would temporarily exhibit a surplus of goods. Falling prices would eliminate this surplus, and the economy would return to full employment level of GDP. No active fiscal or monetary policy was needed. In fact, the classical view was that expansionary fiscal or monetary policy would only cause inflation, rather than increase GDP. The deep and lasting impact of the Great Depression changed this thinking and Keynesian economics, which prescribed active fiscal policy to alleviate weak aggregate demand, became the more mainstream perspective. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/13%3A_The_Neoclassical_Perspective/13.01%3A_Introduction_to_the_Neoclassical_Perspective.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the importance of potential GDP in the long run
• Analyze the role of flexible prices
• Interpret a neoclassical model of aggregate demand and aggregate supply
• Evaluate different ways for measuring the speed of macroeconomic adjustment
The neoclassical perspective on macroeconomics holds that, in the long run, the economy will fluctuate around its potential GDP and its natural rate of unemployment. This chapter begins with two building blocks of neoclassical economics: (1) potential GDP determines the economy's size and (2) wages and prices will adjust in a flexible manner so that the economy will adjust back to its potential GDP level of output. The key policy implication is this: The government should focus more on long-term growth and on controlling inflation than on worrying about recession or cyclical unemployment. This focus on long-run growth rather than the short-run fluctuations in the business cycle means that neoclassical economics is more useful for long-run macroeconomic analysis and Keynesian economics is more useful for analyzing the macroeconomic short run. Let's consider the two neoclassical building blocks in turn, and how we can embody them in the aggregate demand/aggregate supply model.
The Importance of Potential GDP in the Long Run
Over the long run, the level of potential GDP determines the size of real GDP. When economists refer to “potential GDP” they are referring to that level of output that an economy can achieve when all resources (land, labor, capital, and entrepreneurial ability) are fully employed. While the unemployment rate in labor markets will never be zero, full employment in the labor market refers to zero cyclical unemployment. There will still be some level of unemployment due to frictional or structural unemployment, but when the economy is operating with zero cyclical unemployment, economists say that the economy is at the natural rate of unemployment or at full employment.
Economists benchmark actual or real GDP against the potential GDP to determine how well the economy is performing. As explained in Economic Growth, we can explain GDP growth by increases in investment in physical capital and human capital per person as well as advances in technology. Physical capital per person refers to the amount and kind of machinery and equipment available to help people get work done. Compare, for example, your productivity in typing a term paper on a typewriter to working on your laptop with word processing software. Clearly, you will be able to be more productive using word processing software. The technology and level of capital of your laptop and software has increased your productivity. More broadly, the development of GPS technology and Universal Product Codes (those barcodes on every product we buy) has made it much easier for firms to track shipments, tabulate inventories, and sell and distribute products. These two technological innovations, and many others, have increased a nation's ability to produce goods and services for a given population. Likewise, increasing human capital involves increasing levels of knowledge, education, and skill sets per person through vocational or higher education. Physical and human capital improvements with technological advances will increase overall productivity and, thus, GDP.
To see how these improvements have increased productivity and output at the national level, we should examine evidence from the United States. The United States experienced significant growth in the twentieth century due to phenomenal changes in infrastructure, equipment, and technological improvements in physical capital and human capital. The population more than tripled in the twentieth century, from 76 million in 1900 to over 300 million in 2016. The human capital of modern workers is far higher today because the education and skills of workers have risen dramatically. In 1900, only about one-eighth of the U.S. population had completed high school and just one person in 40 had completed a four-year college degree. By 2010, about 8.5% of Americans age 25 or older had a high school degree and about 28% had a four-year college degree as well. In 2019, 33% of Americans age 25 or older had a four-year college degree. The average amount of physical capital per worker has grown dramatically. The technology available to modern workers is extraordinarily better than a century ago: cars, airplanes, electrical machinery, smartphones, computers, chemical and biological advances, materials science, health care—the list of technological advances could run on and on. More workers, higher skill levels, larger amounts of physical capital per worker, and amazingly better technology, and potential GDP for the U.S. economy has clearly increased a great deal since 1900.
This growth has fallen below its potential GDP and, at times, has exceeded its potential. For example from 2008 to 2009, the U.S. economy tumbled into recession and remained below its potential until 2018. After the pandemic-induced recession of March and April 2020, the economy again fell below potential GDP and remains there as of early 2022. At other times, like in the late 1990s or from 2018 to 2020, the economy ran at potential GDP—or even slightly ahead. Figure 13.2 shows the actual data for the increase in real GDP since 1960. The slightly smoother line shows the potential GDP since 1960 as estimated by the nonpartisan Congressional Budget Office. Most economic recessions and upswings are times when the economy is 1–3% below or above potential GDP in a given year. Clearly, short-run fluctuations around potential GDP do exist, but over the long run, the upward trend of potential GDP determines the size of the economy.
Figure 13.2 Potential and Actual GDP (in 2012 Dollars), 1958–2020 Actual GDP falls below potential GDP during and after recessions, like the recessions of 1980 and 1981–82, 1990–91, 2001, and 2008–2009 and continues below potential GDP until 2019, when it goes slightly above potential. In other cases, actual GDP can be above potential GDP for a time, as in the late 1990s.
In the aggregate demand/aggregate supply model, we show potential GDP as a vertical line. Neoclassical economists who focus on potential GDP as the primary determinant of real GDP argue that the long-run aggregate supply curve is located at potential GDP—that is, we draw the long-run aggregate supply curve as a vertical line at the level of potential GDP, as Figure 13.3 shows. A vertical LRAS curve means that the level of aggregate supply (or potential GDP) will determine the economy's real GDP, regardless of the level of aggregate demand. Over time, increases in the quantity and quality of physical capital, increases in human capital, and technological advancements shift potential GDP and the vertical LRAS curve gradually to the right. Economists often describe this gradual increase in an economy's potential GDP as a nation's long-term economic growth.
Figure 13.3 A Vertical AS Curve In the neoclassical model, we draw the aggregate supply curve as a vertical line at the level of potential GDP. If AS is vertical, then it determines the level of real output, no matter where we draw the aggregate demand curve. Over time, the LRAS curve shifts to the right as productivity increases and potential GDP expands.
The Role of Flexible Prices
How does the macroeconomy adjust back to its level of potential GDP in the long run? What if aggregate demand increases or decreases? Economists base the neoclassical view of how the macroeconomy adjusts on the insight that even if wages and prices are “sticky”, or slow to change, in the short run, they are flexible over time. To understand this better, let's follow the connections from the short-run to the long-run macroeconomic equilibrium.
The aggregate demand and aggregate supply diagram in Figure 13.4 shows two aggregate supply curves. We draw the original upward sloping aggregate supply curve (SRAS0) is a short-run or Keynesian AS curve. The vertical aggregate supply curve (LRASn) is the long-run or neoclassical AS curve, which is located at potential GDP. The original aggregate demand curve, labeled AD0, so that the original equilibrium occurs at point E0, at which point the economy is producing at its potential GDP.
Figure 13.4 The Rebound to Potential GDP after AD Increases The original equilibrium (E0), at an output level of 500 and a price level of 120, happens at the intersection of the aggregate demand curve (AD0) and the short-run aggregate supply curve (SRAS0). The output at E0 is equal to potential GDP. Aggregate demand shifts right from AD0 to AD1. The new equilibrium is E1, with a higher output level of 550 and an increase in the price level to 125. With unemployment rates unsustainably low, eager employers bid up wages, which shifts short-run aggregate supply to the left, from SRAS0 to SRAS1. The new equilibrium (E2) is at the same original level of output, 500, but at a higher price level of 130. Thus, the long-run aggregate supply curve (LRASn), which is vertical at the level of potential GDP, determines the level of real GDP in this economy in the long run.
Now, imagine that some economic event boosts aggregate demand: perhaps a surge of export sales or a rise in business confidence that leads to more investment, perhaps a policy decision like higher government spending, or perhaps a tax cut that leads to additional aggregate demand. The short-run Keynesian analysis is that the rise in aggregate demand will shift the aggregate demand curve out to the right, from AD0 to AD1, leading to a new equilibrium at point E1 with higher output, lower unemployment, and pressure for an inflationary rise in the price level.
In the long-run neoclassical analysis, however, the chain of economic events is just beginning. As economic output rises above potential GDP, the level of unemployment falls. The economy is now above full employment and there is a labor shortage. Eager employers are trying to bid workers away from other companies and to encourage their current workers to exert more effort and to work longer hours. This high demand for labor will drive up wages. Most employers review their workers salaries only once or twice a year, and so it will take time before the higher wages filter through the economy. As wages do rise, it will mean a leftward shift in the short-run Keynesian aggregate supply curve back to SRAS1, because the price of a major input to production has increased. The economy moves to a new equilibrium (E2). The new equilibrium has the same level of real GDP as did the original equilibrium (E0), but there has been an inflationary increase in the price level.
This description of the short-run shift from E0 to E1 and the long-run shift from E1 to E2 is a step-by-step way of making a simple point: the economy cannot sustain production above its potential GDP in the long run. An economy may produce above its level of potential GDP in the short run, under pressure from a surge in aggregate demand. Over the long run, however, that surge in aggregate demand ends up as an increase in the price level, not as a rise in output.
The rebound of the economy back to potential GDP also works in response to a shift to the left in aggregate demand. Figure 13.5 again starts with two aggregate supply curves, with SRAS0 showing the original upward sloping short-run Keynesian AS curve and LRASn showing the vertical long-run neoclassical aggregate supply curve. A decrease in aggregate demand—for example, because of a decline in consumer confidence that leads to less consumption and more saving—causes the original aggregate demand curve AD0 to shift back to AD1. The shift from the original equilibrium (E0) to the new equilibrium (E1) results in a decline in output. The economy is now below full employment and there is a surplus of labor. As output falls below potential GDP, unemployment rises. While a lower price level (i.e., deflation) is rare in the United States, it does happen occasionally during very weak periods of economic activity. For practical purposes, we might consider a lower price level in the AD–AS model as indicative of disinflation, which is a decline in the inflation rate. Thus, the long-run aggregate supply curve LRASn, which is vertical at the level of potential GDP, ultimately determines this economy's real GDP.
Figure 13.5 A Rebound Back to Potential GDP from a Shift to the Left in Aggregate Demand The original equilibrium (E0), at an output level of 500 and a price level of 120, happens at the intersection of the aggregate demand curve (AD0) and the short-run aggregate supply curve (SRAS0). The output at E0 is equal to potential GDP. Aggregate demand shifts left, from AD0 to AD1. The new equilibrium is at E1, with a lower output level of 450 and downward pressure on the price level of 115. With high unemployment rates, wages are held down. Lower wages are an economy-wide decrease in the price of a key input, which shifts short-run aggregate supply to the right, from SRAS0 to SRAS1. The new equilibrium (E2) is at the same original level of output, 500, but at a lower price level of 110.
Again, from the neoclassical perspective, this short-run scenario is only the beginning of the chain of events. The higher level of unemployment means more workers looking for jobs. As a result, employers can hold down on pay increases—or perhaps even replace some of their higher-paid workers with unemployed people willing to accept a lower wage. As wages stagnate or fall, this decline in the price of a key input means that the short-run Keynesian aggregate supply curve shifts to the right from its original (SRAS0 to SRAS1). The overall impact in the long run, as the macroeconomic equilibrium shifts from E0 to E1 to E2, is that the level of output returns to potential GDP, where it started. There is, however, downward pressure on the price level. Thus, in the neoclassical view, changes in aggregate demand can have a short-run impact on output and on unemployment—but only a short-run impact. In the long run, when wages and prices are flexible, potential GDP and aggregate supply determine real GDP's size.
How Fast Is the Speed of Macroeconomic Adjustment?
How long does it take for wages and prices to adjust, and for the economy to rebound to its potential GDP? This subject is highly contentious. Keynesian economists argue that if the adjustment from recession to potential GDP takes a very long time, then neoclassical theory may be more hypothetical than practical. In response to John Maynard Keynes' immortal words, “In the long run we are all dead,” neoclassical economists respond that even if the adjustment takes as long as, say, ten years the neoclassical perspective remains of central importance in understanding the economy.
One subset of neoclassical economists holds that wage and price adjustment in the macroeconomy might be quite rapid. The theory of rational expectations holds that people form the most accurate possible expectations about the future that they can, using all information available to them. In an economy where most people have rational expectations, economic adjustments may happen very quickly.
To understand how rational expectations may affect the speed of price adjustments, think about a situation in the real estate market. Imagine that several events seem likely to push up home values in the neighborhood. Perhaps a local employer announces that it plans to hire many more people or the city announces that it will build a local park or a library in that neighborhood. The theory of rational expectations points out that even though none of the changes will happen immediately, home prices in the neighborhood will rise immediately, because the expectation that homes will be worth more in the future will lead buyers to be willing to pay more in the present. The amount of the immediate increase in home prices will depend on how likely it seems that the announcements about the future will actually happen and on how distant the local jobs and neighborhood improvements are in the future. The key point is that, because of rational expectations, prices do not wait on events, but adjust immediately.
At a macroeconomic level, the theory of rational expectations points out that if the aggregate supply curve is vertical over time, then people should rationally expect this pattern. When a shift in aggregate demand occurs, people and businesses with rational expectations will know that its impact on output and employment will be temporary, while its impact on the price level will be permanent. If firms and workers perceive the outcome of the process in advance, and if all firms and workers know that everyone else is perceiving the process in the same way, then they have no incentive to go through an extended series of short-run scenarios, like a firm first hiring more people when aggregate demand shifts out and then firing those same people when aggregate supply shifts back. Instead, everyone will recognize where this process is heading—toward a change in the price level—and then will act on that expectation. In this scenario, the expected long-run change in the price level may happen very quickly, without a drawn-out zigzag of output and employment first moving one way and then the other.
The theory that people and firms have rational expectations can be a useful simplification, but as a statement about how people and businesses actually behave, the assumption seems too strong. After all, many people and firms are not especially well informed, either about what is happening in the economy or about how the economy works. An alternate assumption is that people and firms act with adaptive expectations: they look at past experience and gradually adapt their beliefs and behavior as circumstances change, but are not perfect synthesizers of information and accurate predictors of the future in the sense of rational expectations theory. If most people and businesses have some form of adaptive expectations, then the adjustment from the short run and long run will be traced out in incremental steps that occur over time.
The empirical evidence on the speed of macroeconomic adjustment of prices and wages is not clear-cut. The speed of macroeconomic adjustment probably varies among different countries and time periods. A reasonable guess is that the initial short-run effect of a shift in aggregate demand might last two to five years, before the adjustments in wages and prices cause the economy to adjust back to potential GDP. Thus, one might think of the short run for applying Keynesian analysis as time periods less than two to five years, and the long run for applying neoclassical analysis as longer than five years. For practical purposes, this guideline is frustratingly imprecise, but when analyzing a complex social mechanism like an economy as it evolves over time, some imprecision seems unavoidable. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/13%3A_The_Neoclassical_Perspective/13.02%3A_The_Building_Blocks_of_Neoclassical_Analysis.txt |
Learning Objectives
By the end of this section, you will be able to:
• Discuss why and how economists measure inflation expectations
• Analyze the impacts of fiscal and monetary policy on aggregate supply and aggregate demand
• Explain the neoclassical Phillips curve, noting its tradeoff between inflation and unemployment
• Identify clear distinctions between neoclassical economics and Keynesian economics
To understand the policy recommendations of the neoclassical economists, it helps to start with the Keynesian perspective. Suppose a decrease in aggregate demand causes the economy to go into recession with high unemployment. The Keynesian response would be to use government policy to stimulate aggregate demand and eliminate the recessionary gap. The neoclassical economists believe that the Keynesian response, while perhaps well intentioned, will not have a good outcome for reasons we will discuss shortly. Since the neoclassical economists believe that the economy will correct itself over time, the only advantage of a Keynesian stabilization policy would be to accelerate the process and minimize the time that the unemployed are out of work. Is that the likely outcome?
Keynesian macroeconomic policy requires some optimism about the government's ability to recognize a situation of too little or too much aggregate demand, and to adjust aggregate demand accordingly with the right level of changes in taxes or spending, all enacted in a timely fashion. After all, neoclassical economists argue, it takes government statisticians months to produce even preliminary estimates of GDP so that politicians know whether a recession is occurring—and those preliminary estimates may be revised substantially later. Moreover, there is the question of timely action. The political process can take more months to enact a tax cut or a spending increase. Political or economic considerations may determine the amount of tax or spending changes. Then the economy will take still more months to put into effect changes in aggregate demand through spending and production. When economists and policy makers consider all of these time lags and political realities, active fiscal policy may fail to address the current problem, and could even make the future economy worse. The average U.S. post-World War II recession has lasted only about a year. By the time government policy activates, the recession will likely be over. As a consequence, the only result of government fine-tuning will be to stimulate the economy when it is already recovering (or to contract the economy when it is already falling). In other words, an active macroeconomic policy is likely to exacerbate the cycles rather than dampen them. Some neoclassical economists believe a large part of the business cycles we observe are due to flawed government policy. To learn about this issue further, read the following Clear It Up feature.
Clear It Up
Why and how do economists measure inflation expectations?
People take expectations about inflation into consideration every time they make a major purchase, such as a house or a car. As inflation fluctuates, so too does the nominal interest rate on loans to buy these goods. The nominal interest rate is comprised of the real rate, plus an expected inflation factor. Expected inflation also tells economists about how the public views the economy's direction. Suppose the public expects inflation to increase. This could be the result of positive demand shock due to an expanding economy and increasing aggregate demand. It could also be the result of a negative supply shock, perhaps from rising energy prices, and decreasing aggregate supply. In either case, the public may expect the central bank to engage in contractionary monetary policy to reduce inflation, and this policy results in higher interest rates. If, however economists expect inflation to decrease, the public may anticipate a recession. In turn, the public may expect expansionary monetary policy, and lower interest rates, in the short run. By monitoring expected inflation, economists garner information about the effectiveness of macroeconomic policies. Additionally, monitoring expected inflation allows for projecting the direction of real interest rates that isolate for the effect of inflation. This information is necessary for making decisions about financing investments.
Expectations about inflation may seem like a highly theoretical concept, but, in fact the Federal Reserve Bank measures, inflation expectations based upon early research conducted by Joseph Livingston, a financial journalist for the Philadelphia Inquirer. In 1946, he started a twice-a-year survey of economists about their expectations of inflation. After Livingston's death in 1969, the Federal Reserve Bank and other economic research agencies such as the Survey Research Center at the University of Michigan, the American Statistical Association, and the National Bureau of Economic Research continued the survey.
Current Federal Reserve research compares these expectations to actual inflation that has occurred, and the results, so far, are mixed. Economists' forecasts, however, have become notably more accurate in the last few decades. Economists are actively researching how inflation expectations and other economic variables form and change.
Link It Up
Visit this website to read “The Federal Reserve Bank of Cleveland’s Economic Commentary: A New Approach to Gauging Inflation Expectations” by Joseph G. Haubrich for more information about how economists forecast expected inflation.
The Neoclassical Phillips Curve Tradeoff
The Keynesian Perspective introduced the Phillips curve and explained how it is derived from the aggregate supply curve. The short run upward sloping aggregate supply curve implies a downward sloping Phillips curve; thus, there is a tradeoff between inflation and unemployment in the short run. By contrast, a neoclassical long-run aggregate supply curve will imply a vertical shape for the Phillips curve, indicating no long run tradeoff between inflation and unemployment. Figure 13.6 (a) shows the vertical AS curve, with three different levels of aggregate demand, resulting in three different equilibria, at three different price levels. At every point along that vertical AS curve, potential GDP and the rate of unemployment remains the same. Assume that for this economy, the natural rate of unemployment is 5%. As a result, the long-run Phillips curve relationship, in Figure 13.6 (b), is a vertical line, rising up from 5% unemployment, at any level of inflation. Read the following Work It Out feature for additional information on how to interpret inflation and unemployment rates.
Figure 13.6 From a Long-Run AS Curve to a Long-Run Phillips Curve (a) With a vertical LRAS curve, shifts in aggregate demand do not alter the level of output but do lead to changes in the price level. Because output is unchanged between the equilibria E0, E1, and E2, all unemployment in this economy will be due to the natural rate of unemployment. (b) If the natural rate of unemployment is 5%, then the Phillips curve will be vertical. That is, regardless of changes in the price level, the unemployment rate remains at 5%.
Work It Out
Tracking Inflation and Unemployment Rates
Suppose that you have collected data for years on inflation and unemployment rates and recorded them in a table, such as Table 13.1. How do you interpret that information?
Year Inflation Rate Unemployment Rate
1970 2% 4%
1975 3% 3%
1980 2% 4%
1985 1% 6%
1990 1% 4%
1995 4% 2%
2000 5% 4%
Table 13.1
Step 1. Plot the data points in a graph with inflation rate on the vertical axis and unemployment rate on the horizontal axis. Your graph will appear similar to Figure 13.7.
Figure 13.7 Inflation Rates
Step 2. What patterns do you see in the data? You should notice that there are years when unemployment falls but inflation rises, and other years where unemployment rises and inflation falls.
Step 3. Can you determine the natural rate of unemployment from the data or from the graph? As you analyze the graph, it appears that the natural rate of unemployment lies at 4%. This is the rate that the economy appears to adjust back to after an apparent change in the economy. For example, in 1975 the economy appeared to have an increase in aggregate demand. The unemployment rate fell to 3% but inflation increased from 2% to 3%. By 1980, the economy had adjusted back to 4% unemployment and the inflation rate had returned to 2%. In 1985, the economy looks to have suffered a recession as unemployment rose to 6% and inflation fell to 1%. This would be consistent with a decrease in aggregate demand. By 1990, the economy recovered back to 4% unemployment, but at a lower inflation rate of 1%. In 1995 the economy again rebounded and unemployment fell to 2%, but inflation increased to 4%, which is consistent with a large increase in aggregate demand. The economy adjusted back to 4% unemployment but at a higher rate of inflation of 5%. Then in 2000, both unemployment and inflation increased to 5% and 4%, respectively.
Step 4. Do you see the Phillips curve(s) in the data? If we trace the downward sloping trend of data points, we could see a short-run Phillips curve that exhibits the inverse tradeoff between higher unemployment and lower inflation rates. If we trace the vertical line of data points, we could see a long-run Phillips curve at the 4% natural rate of unemployment.
The unemployment rate on the long-run Phillips curve will be the natural rate of unemployment. A small inflationary increase in the price level from AD0 to AD1 will have the same natural rate of unemployment as a larger inflationary increase in the price level from AD0 to AD2. The macroeconomic equilibrium along the vertical aggregate supply curve can occur at a variety of different price levels, and the natural rate of unemployment can be consistent with all different rates of inflation. The great economist Milton Friedman (1912–2006) summed up the neoclassical view of the long-term Phillips curve tradeoff in a 1967 speech: “[T]here is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off.”
In the Keynesian perspective, the primary focus is on getting the level of aggregate demand right in relationship to an upward-sloping aggregate supply curve. That is, the government should adjust AD so that the economy produces at its potential GDP, not so low that cyclical unemployment results and not so high that inflation results. In the neoclassical perspective, aggregate supply will determine output at potential GDP, the natural rate of unemployment determines unemployment, and shifts in aggregate demand are the primary determinant of changes in the price level.
Link It Up
Visit this website to read about the effects of economic intervention.
Fighting Unemployment or Inflation?
As we explained in Unemployment, economists divide unemployment into two categories: cyclical unemployment and the natural rate of unemployment, which is the sum of frictional and structural unemployment. Cyclical unemployment results from fluctuations in the business cycle and is created when the economy is producing below potential GDP—giving potential employers less incentive to hire. When the economy is producing at potential GDP, cyclical unemployment will be zero. Because of labor market dynamics, in which people are always entering or exiting the labor force, the unemployment rate never falls to 0%, not even when the economy is producing at or even slightly above potential GDP. Probably the best we can hope for is for the number of job vacancies to equal the number of job seekers. We know that it takes time for job seekers and employers to find each other, and this time is the cause of frictional unemployment. Most economists do not consider frictional unemployment to be a “bad” thing. After all, there will always be workers who are unemployed while looking for a job that is a better match for their skills. There will always be employers that have an open position, while looking for a worker that is a better match for the job. Ideally, these matches happen quickly, but even when the economy is very strong there will be some natural unemployment and this is what the natural rate of unemployment measures.
The neoclassical view of unemployment tends to focus attention away from the cyclical unemployment problem—that is, unemployment caused by recession—while putting more attention on the unemployment rate issue that prevails even when the economy is operating at potential GDP. To put it another way, the neoclassical view of unemployment tends to focus on how the government can adjust public policy to reduce the natural rate of unemployment. Such policy changes might involve redesigning unemployment and welfare programs so that they support those in need, but also offer greater encouragement for job-hunting. It might involve redesigning business rules with an eye to whether they are unintentionally discouraging businesses from taking on new employees. It might involve building institutions to improve the flow of information about jobs and the mobility of workers, to help bring workers and employers together more quickly. For those workers who find that their skills are permanently no longer in demand (for example, the structurally unemployed), economists can design policy to provide opportunities for retraining so that these workers can reenter the labor force and seek employment.
Neoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment; after all, with a vertical aggregate supply curve determining economic output, then aggregate demand has no long-run effect on unemployment. Instead, neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the right—keeping the price level much the same and inflationary pressures low.
If aggregate demand rises rapidly in the neoclassical model, in the long run it leads only to inflationary pressures. Figure 13.8 shows a vertical LRAS curve and three different levels of aggregate demand, rising from AD0 to AD1 to AD2. As the macroeconomic equilibrium rises from E0 to E1 to E2, the price level rises, but real GDP does not budge; nor does the rate of unemployment, which adjusts to its natural rate. Conversely, reducing inflation has no long-term costs, either. Think about Figure 13.8 in reverse, as the aggregate demand curve shifts from AD2 to AD1 to AD0, and the equilibrium moves from E2 to E1 to E0. During this process, the price level falls, but, in the long run, neither real GDP nor the natural unemployment rate changes.
Figure 13.8 How Aggregate Demand Determines the Price Level in the Long Run As aggregate demand shifts to the right, from AD0 to AD1 to AD2, real GDP in this economy and the level of unemployment do not change. However, there is inflationary pressure for a higher price level as the equilibrium changes from E0 to E1 to E2.
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Visit this website to read about how inflation and unemployment are related.
Fighting Recession or Encouraging Long-Term Growth?
Neoclassical economists believe that the economy will rebound out of a recession or eventually contract during an expansion because prices and wage rates are flexible and will adjust either upward or downward to restore the economy to its potential GDP. Thus, the key policy question for neoclassicals is how to promote growth of potential GDP. We know that economic growth ultimately depends on the growth rate of long-term productivity. Productivity measures how effective inputs are at producing outputs. We know that U.S. productivity has grown on average about 2% per year. That means that the same amount of inputs produce 2% more output than the year before. We also know that productivity growth varies a great deal in the short term due to cyclical factors. It also varies somewhat in the long term. From 1953–1972, U.S. labor productivity (as measured by output per hour in the business sector) grew at 3.2% per year. From 1973–1992, productivity growth declined significantly to 1.8% per year. Then, from 1993–2010, productivity growth increased to around 2% per year. In recent years, it has grown less than 2% per year, although it did pick up in 2019 and 2020 to over 2% again. The neoclassical economists believe the underpinnings of long-run productivity growth to be an economy’s investments in human capital, physical capital, and technology, operating together in a market-oriented environment that rewards innovation. Government policy should focus on promoting these factors.
Summary of Neoclassical Macroeconomic Policy Recommendations
Let’s summarize what neoclassical economists recommend for macroeconomic policy. Neoclassical economists do not believe in “fine-tuning” the economy. They believe that a stable economic environment with a low rate of inflation fosters economic growth. Similarly, tax rates should be low and unchanging. In this environment, private economic agents can make the best possible investment decisions, which will lead to optimal investment in physical and human capital as well as research and development to promote improvements in technology.
Summary of Neoclassical Economics versus Keynesian Economics
Table 13.2 summarizes the key differences between the two schools of thought.
Summary Neoclassical Economics Keynesian Economics
Focus: long-term or short term Long-term Short-term
Prices and wages: sticky or flexible? Flexible Sticky
Economic output: Primarily determined by aggregate demand or aggregate supply? Aggregate supply Aggregate demand
Aggregate supply: vertical or upward-sloping? Vertical Upward-sloping
Phillips curve vertical or downward-sloping Vertical Downward sloping
Is aggregate demand a useful tool for controlling inflation? Yes Yes
What should be the primary area of policy emphasis for reducing unemployment? Reform labor market institutions to reduce natural rate of unemployment Increase aggregate demand to eliminate cyclical unemployment
Is aggregate demand a useful tool for ending recession? At best, only in the short-run temporary sense, but may just increase inflation instead Yes
Table 13.2 Neoclassical versus Keynesian Economics | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/13%3A_The_Neoclassical_Perspective/13.03%3A_The_Policy_Implications_of_the_Neoclassical_Perspective.txt |
Learning Objectives
By the end of this section, you will be able to:
• Evaluate how neoclassical economists and Keynesian economists react to recessions
• Analyze the interrelationship between the neoclassical and Keynesian economic models
We can compare finding the balance between Keynesian and Neoclassical models to the challenge of riding two horses simultaneously. When a circus performer stands on two horses, with a foot on each one, much of the excitement for the viewer lies in contemplating the gap between the two. As modern macroeconomists ride into the future on two horses—with one foot on the short-term Keynesian perspective and one foot on the long-term neoclassical perspective—the balancing act may look uncomfortable, but there does not seem to be any way to avoid it. Each approach, Keynesian and neoclassical, has its strengths and weaknesses.
The short-term Keynesian model, built on the importance of aggregate demand as a cause of business cycles and a degree of wage and price rigidity, does a sound job of explaining many recessions and why cyclical unemployment rises and falls. By focusing on the short-run aggregate demand adjustments, Keynesian economics risks overlooking the long-term causes of economic growth or the natural rate of unemployment that exist even when the economy is producing at potential GDP.
The neoclassical model, with its emphasis on aggregate supply, focuses on the underlying determinants of output and employment in markets, and thus tends to put more emphasis on economic growth and how labor markets work. However, the neoclassical view is not especially helpful in explaining why unemployment moves up and down over short time horizons of a few years. Nor is the neoclassical model especially helpful when the economy is mired in an especially deep and long-lasting recession, like the 1930s Great Depression. Keynesian economics tends to view inflation as a price that might sometimes be paid for lower unemployment; neoclassical economics tends to view inflation as a cost that offers no offsetting gains in terms of lower unemployment.
Macroeconomics cannot, however, be summed up as an argument between one group of economists who are pure Keynesians and another group who are pure neoclassicists. Instead, many mainstream economists believe both the Keynesian and neoclassical perspectives. Robert Solow, the Nobel laureate in economics in 1987, described the dual approach in this way:
At short time scales, I think, something sort of ‘Keynesian’ is a good approximation, and surely better than anything straight ‘neoclassical.’ At very long time scales, the interesting questions are best studied in a neoclassical framework, and attention to the Keynesian side of things would be a minor distraction. At the five-to-ten-year time scale, we have to piece things together as best we can, and look for a hybrid model that will do the job.
Many modern macroeconomists spend considerable time and energy trying to construct models that blend the most attractive aspects of the Keynesian and neoclassical approaches. It is possible to construct a somewhat complex mathematical model where aggregate demand and sticky wages and prices matter in the short run, but wages, prices, and aggregate supply adjust in the long run. However, creating an overall model that encompasses both short-term Keynesian and long-term neoclassical models is not easy.
Bring It Home
Navigating Uncharted Waters—The Great Recession and Pandemic-Induced Recession of 2020
Were the policies that the government implemented to stabilize the economy and financial markets during the Great Recession of 2007–2009, and the pandemic-induced recession of 2020 effective? Many economists from both the Keynesian and neoclassical schools have found that they were, although to varying degrees. Regarding the Great Recession, Alan Blinder of Princeton University and Mark Zandi for Moody’s Analytics found that, without fiscal policy, GDP decline would have been significantly more than its 3.3% in 2008 followed by its 0.1% decline in 2009. They also estimated that there would have been 8.5 million more job losses had the government not intervened in the market with the TARP to support the financial industry and key automakers General Motors and Chrysler. Federal Reserve Bank economists Carlos Carvalho, Stefano Eusip, and Christian Grisse found in their study, Policy Initiatives in the Global Recession: What Did Forecasters Expect? that once the government implemented policies, forecasters adapted their expectations to these policies. They were more likely to anticipate increases in investment due to lower interest rates brought on by monetary policy and increased economic growth resulting from fiscal policy.
The neoclassical perspective can also shed light on the country’s experience with policy during the pandemic-induced recession of 2020. It was mentioned earlier that one criticism made by proponents of the neoclassical perspective is that government policy is often too slow to react to a recession. However after the pandemic hit, the federal government quickly responded with aid to state and local governments, increased unemployment insurance, aid to businesses forced to shut down, and stimulus checks to boost spending. There is no doubt that the economic fallout from the pandemic would have been much worse without these policies. Some economists even argue that the government helped too much and that the high inflation the U.S. economy experienced starting mid-2021 is due to the real output growing faster than potential, but it is too early (as of early 2022) to tell if that argument is correct.
By focusing on potential GDP instead of short-run demand, the neoclassical perspective also makes an important point about how the size of the economy determines its ability to grow. Since the pandemic hit, millions of workers have stayed out of the labor market due to early retirement, health and safety concerns, the availability of childcare, and school closures. As mentioned in Unemployment, these changes have caused labor force participation to remain lower than its historical average. The pandemic has also made it harder for future workers to acquire skills they need to be productive in the labor market. The longer these dynamics are at play, the more harm it will do to potential GDP. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/13%3A_The_Neoclassical_Perspective/13.04%3A_Balancing_Keynesian_and_Neoclassical_Models.txt |
adaptive expectations
the theory that people look at past experience and gradually adapt their beliefs and behavior as circumstances change
expected inflation
a future rate of inflation that consumers and firms build into current decision making
neoclassical perspective
the philosophy that, in the long run, the business cycle will fluctuate around the potential, or full-employment, level of output
physical capital per person
the amount and kind of machinery and equipment available to help a person produce a good or service
rational expectations
the theory that people form the most accurate possible expectations about the future that they can, using all information available to them
13.06: Key Concepts and Summary
13.1 The Building Blocks of Neoclassical Analysis
The neoclassical perspective argues that, in the long run, the economy will adjust back to its potential GDP level of output through flexible price levels. Thus, the neoclassical perspective views the long-run AS curve as vertical. A rational expectations perspective argues that people have excellent information about economic events and how the economy works and that, as a result, price and other economic adjustments will happen very quickly. In adaptive expectations theory, people have limited information about economic information and how the economy works, and so price and other economic adjustments can be slow.
13.2 The Policy Implications of the Neoclassical Perspective
Neoclassical economists tend to put relatively more emphasis on long-term growth than on fighting recession, because they believe that recessions will fade in a few years and long-term growth will ultimately determine the standard of living. They tend to focus more on reducing the natural rate of unemployment caused by economic institutions and government policies than the cyclical unemployment caused by recession.
Neoclassical economists also see no social benefit to inflation. With an upward-sloping Keynesian AS curve, inflation can arise because an economy is approaching full employment. With a vertical long-run neoclassical AS curve, inflation does not accompany any rise in output. If aggregate supply is vertical, then aggregate demand does not affect the quantity of output. Instead, aggregate demand can only cause inflationary changes in the price level. A vertical aggregate supply curve, where the quantity of output is consistent with many different price levels, also implies a vertical Phillips curve.
13.3 Balancing Keynesian and Neoclassical Models
The Keynesian perspective considers changes to aggregate demand to be the cause of business cycle fluctuations. Keynesians are likely to advocate that policy makers actively attempt to reverse recessionary and inflationary periods because they are not convinced that the self-correcting economy can easily return to full employment.
The neoclassical perspective places more emphasis on aggregate supply. Neoclassical economists believe that long term productivity growth determines the potential GDP level and that the economy typically will return to full employment after a change in aggregate demand. Skeptical of the effectiveness and timeliness of Keynesian policy, neoclassical economists are more likely to advocate a hands-off, or fairly limited, role for active stabilization policy.
While Keynesians would tend to advocate an acceptable tradeoff between inflation and unemployment when counteracting a recession, neoclassical economists argue that no such tradeoff exists. Any short-term gains in lower unemployment will eventually vanish and the result of active policy will only be inflation. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/13%3A_The_Neoclassical_Perspective/13.05%3A_Key_Terms.txt |
1.
Do rational expectations tend to look back at past experience while adaptive expectations look ahead to the future? Explain your answer.
2.
Legislation proposes that the government should use macroeconomic policy to achieve an unemployment rate of zero percent, by increasing aggregate demand for as much and as long as necessary to accomplish this goal. From a neoclassical perspective, how will this policy affect output and the price level in the short run and in the long run? Sketch an aggregate demand/aggregate supply diagram to illustrate your answer. Hint: revisit Figure 13.4.
3.
Would it make sense to argue that rational expectations economics is an extreme version of neoclassical economics? Explain.
4.
Summarize the Keynesian and Neoclassical models.
13.08: Review Questions
5.
Does neoclassical economics focus on the long term or the short term? Explain your answer.
6.
Does neoclassical economics view prices and wages as sticky or flexible? Why?
7.
What shape is the long-run aggregate supply curve? Why does it have this shape?
8.
What is the difference between rational expectations and adaptive expectations?
9.
A neoclassical economist and a Keynesian economist are studying the economy of Vineland. It appears that Vineland is beginning to experience a mild recession with a decrease in aggregate demand. Which of these two economists would likely advocate that the government of Vineland take active measures to reverse this decline in aggregate demand? Why?
10.
Do neoclassical economists tend to focus more on long term economic growth or on recessions? Explain briefly.
11.
Do neoclassical economists tend to focus more on cyclical unemployment or on inflation? Explain briefly.
12.
Do neoclassical economists see a value in tolerating a little more inflation if it brings additional economic output? Explain your answer.
13.
If aggregate supply is vertical, what role does aggregate demand play in determining output? In determining the price level?
14.
What is the shape of the neoclassical long-run Phillips curve? What assumptions do economists make that lead to this shape?
15.
When the economy is experiencing a recession, why would a neoclassical economist be unlikely to argue for aggressive policy to stimulate aggregate demand and return the economy to full employment? Explain your answer.
16.
If the economy is suffering through a rampant inflationary period, would a Keynesian economist advocate for stabilization policy that involves higher taxes and higher interest rates? Explain your answer.
13.09: Critical Thinking Questions
17.
If most people have rational expectations, how long will recessions last?
18.
Explain why the neoclassical economists believe that the government does not need to do much about unemployment. Do you agree or disagree? Explain.
19.
Economists from all theoretical persuasions criticized the American Recovery and Reinvestment Act. The “Stimulus Package” was arguably a Keynesian measure so why would a Keynesian economist be critical of it? Why would neoclassical economists be critical?
20.
Is it a logical contradiction to be a neoclassical Keynesian? Explain.
13.10: Problems
21.
Use Table 13.3 to answer the following questions.
Price Level Aggregate Supply Aggregate Demand
90 3,000 3,500
95 3,000 3,000
100 3,000 2,500
105 3,000 2,200
110 3,000 2,100
Table 13.3
1. Sketch an aggregate supply and aggregate demand diagram.
2. What is the equilibrium output and price level?
3. If aggregate demand shifts right, what is equilibrium output?
4. If aggregate demand shifts left, what is equilibrium output?
5. In this scenario, would you suggest using aggregate demand to alter the level of output or to control any inflationary increases in the price level? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/13%3A_The_Neoclassical_Perspective/13.07%3A_Self-Check_Questions.txt |
Figure 14.1 Cowrie Shell or Money? Is this an image of a cowrie shell or money? The answer is: Both. For centuries, people used the extremely durable cowrie shell as a medium of exchange in various parts of the world. (Credit: modification of “Cowry Shell (Cypraeidae)” by Silke Baron/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Defining Money by Its Functions
• Measuring Money: Currency, M1, and M2
• The Role of Banks
• How Banks Create Money
Bring It Home
The Many Disguises of Money: From Cowries to Crypto
Here is a trivia question: In the history of the world, what item did people use for money over the broadest geographic area and for the longest period of time? The answer is not gold, silver, or any precious metal. It is the cowrie, a mollusk shell found mainly off the Maldives Islands in the Indian Ocean. Cowries served as money as early as 700 B.C. in China. By the 1500s, they were in widespread use across India and Africa. For several centuries after that, cowries were the means for exchange in markets including southern Europe, western Africa, India, and China: everything from buying lunch or a ferry ride to paying for a shipload of silk or rice. Cowries were still acceptable as a way of paying taxes in certain African nations in the early twentieth century.
What made cowries work so well as money? First, they are extremely durable—lasting a century or more. As the late economic historian Karl Polyani put it, they can be “poured, sacked, shoveled, hoarded in heaps” while remaining “clean, dainty, stainless, polished, and milk-white.” Second, parties could use cowries either by counting shells of a certain size, or—for large purchases—by measuring the weight or volume of the total shells they would exchange. Third, it was impossible to counterfeit a cowrie shell, but dishonest people could counterfeit gold or silver coins by making copies with cheaper metals. Finally, in the heyday of cowrie money, from the 1500s into the 1800s, governments, first the Portuguese, then the Dutch and English, tightly controlled collecting cowries. As a result, the supply of cowries grew quickly enough to serve the needs of commerce, but not so quickly that they were no longer scarce. Money throughout the ages has taken many different forms and continues to evolve even today with the advent of cryptocurrency. What do you think money is?
The discussion of money and banking is a central component in studying macroeconomics. At this point, you should have firmly in mind the main goals of macroeconomics from Welcome to Economics!: economic growth, low unemployment, and low inflation. We have yet to discuss money and its role in helping to achieve our macroeconomic goals.
You should also understand Keynesian and neoclassical frameworks for macroeconomic analysis and how we can embody these frameworks in the aggregate demand/aggregate supply (AD/AS) model. With the goals and frameworks for macroeconomic analysis in mind, the final step is to discuss the two main categories of macroeconomic policy: monetary policy, which focuses on money, banking and interest rates; and fiscal policy, which focuses on government spending, taxes, and borrowing. This chapter discusses what economists mean by money, and how money is closely interrelated with the banking system. Monetary Policy and Bank Regulation furthers this discussion. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/14%3A_Money_and_Banking/14.01%3A_Introduction_to_Money_and_Banking.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the various functions of money
• Contrast commodity money and fiat money
Money for the sake of money is not an end in itself. You cannot eat dollar bills or wear your bank account. Ultimately, the usefulness of money rests in exchanging it for goods or services. As the American writer and humorist Ambrose Bierce (1842–1914) wrote in 1911, money is a “blessing that is of no advantage to us excepting when we part with it.” Money is what people regularly use when purchasing or selling goods and services, and thus both buyers and sellers must widely accept money. This concept of money is intentionally flexible, because money has taken a wide variety of forms in different cultures.
Barter and the Double Coincidence of Wants
To understand the usefulness of money, we must consider what the world would be like without money. How would people exchange goods and services? Economies without money typically engage in the barter system. Barter—literally trading one good or service for another—is highly inefficient for trying to coordinate the trades in a modern advanced economy. In an economy without money, an exchange between two people would involve a double coincidence of wants, a situation in which two people each want some good or service that the other person can provide. For example, if an accountant wants a pair of shoes, this accountant must find someone who has a pair of shoes in the correct size and who is willing to exchange the shoes for some hours of accounting services. Such a trade is likely to be difficult to arrange. Think about the complexity of such trades in a modern economy, with its extensive division of labor that involves thousands upon thousands of different jobs and goods.
Another problem with the barter system is that it does not allow us to easily enter into future contracts for purchasing many goods and services. For example, if the goods are perishable it may be difficult to exchange them for other goods in the future. Imagine a farmer wanting to buy a tractor in six months using a fresh crop of strawberries. Additionally, while the barter system might work adequately in small economies, it will keep these economies from growing. The time that individuals would otherwise spend producing goods and services and enjoying leisure time they spend bartering.
Functions for Money
Money solves the problems that the barter system creates. (We will get to its definition soon.) First, money serves as a medium of exchange, which means that money acts as an intermediary between the buyer and the seller. Instead of exchanging accounting services for shoes, the accountant now exchanges accounting services for money. The accountant then uses this money to buy shoes. To serve as a medium of exchange, people must widely accept money as a method of payment in the markets for goods, labor, and financial capital.
Second, money must serve as a store of value. In a barter system, we saw the example of the shoemaker trading shoes for accounting services. However, she risks having her shoes go out of style, especially if she keeps them in a warehouse for future use—their value will decrease with each season. Shoes are not a good store of value. Holding money is a much easier way of storing value. You know that you do not need to spend it immediately because it will still hold its value the next day, or the next year. This function of money does not require that money is a perfect store of value. In an economy with inflation, money loses some buying power each year, but it remains money.
Third, money serves as a unit of account, which means that it is the ruler by which we measure values. For example, an accountant may charge \$100 to file your tax return. That \$100 can purchase two pair of shoes at \$50 a pair. Money acts as a common denominator, an accounting method that simplifies thinking about trade-offs.
Finally, another function of money is that it must serve as a standard of deferred payment. This means that if money is usable today to make purchases, it must also be acceptable to make purchases today that the purchaser will pay in the future. Loans and future agreements are stated in monetary terms and the standard of deferred payment is what allows us to buy goods and services today and pay in the future. Thus, money serves all of these functions— it is a medium of exchange, store of value, unit of account, and standard of deferred payment.
Commodity versus Fiat Money
Money has taken a wide variety of forms in different cultures. People have used gold, silver, cowrie shells, cigarettes, and even cocoa beans as money. Although we use these items as commodity money, they also have a value from use as something other than money. For example, people have used gold throughout the ages as money although today we do not use it as money but rather value it for its other attributes. Gold is a good conductor of electricity and the electronics and aerospace industry use it. Other industries use gold too, such as to manufacture energy efficient reflective glass for skyscrapers and is used in the medical industry as well. Of course, gold also has value because of its beauty and malleability in creating jewelry.
As commodity money, gold has historically served its purpose as a medium of exchange, a store of value, and as a unit of account. Commodity-backed currencies are dollar bills or other currencies with values backed up by gold or other commodities held at a bank. During much of its history, gold and silver backed the money supply in the United States. Interestingly, antique dollars dated as late as 1957, have “Silver Certificate” printed over the portrait of George Washington, as Figure 14.2 shows. This meant that the holder could take the bill to the appropriate bank and exchange it for a dollar’s worth of silver.
Figure 14.2 A Silver Certificate and a Modern U.S. Bill Until 1958, silver certificates were commodity-backed money—backed by silver, as indicated by the words “Silver Certificate” printed on the bill. Today, The Federal Reserve backs U.S. bills, but as fiat money (inconvertible paper money made legal tender by a government decree). (Credit: "One Dollar Bills" by “The.Comedian”/Flickr Creative Commons, CC BY 2.0)
As economies grew and became more global in nature, the use of commodity monies became more cumbersome. Countries moved towards the use of fiat money. Fiat money has no intrinsic value, but is declared by a government to be a country's legal tender. The United States’ paper money, for example, carries the statement: “THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE.” In other words, by government decree, if you owe a debt, then legally speaking, you can pay that debt with the U.S. currency, even though it is not backed by a commodity. The only backing of our money is universal faith and trust that the currency has value, and nothing more.
Link It Up
Watch this video on the “History of Money.” | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/14%3A_Money_and_Banking/14.02%3A_Defining_Money_by_Its_Functions.txt |
Learning Objectives
By the end of this section, you will be able to:
• Contrast M1 money supply and M2 money supply
• Classify monies as M1 money supply or M2 money supply
Cash in your pocket certainly serves as money; however, what about checks or credit cards? Are they money, too? Rather than trying to state a single way of measuring money, economists offer broader definitions of money based on liquidity. Liquidity refers to how quickly you can use a financial asset to buy a good or service. For example, cash is very liquid. You can use your \$10 bill easily to buy a hamburger at lunchtime. However, \$10 that you have in your savings account is not so easy to use. You must go to the bank or ATM machine and withdraw that cash to buy your lunch. Thus, \$10 in your savings account is less liquid.
The Federal Reserve Bank, which is the central bank of the United States, is a bank regulator and is responsible for monetary policy and defines money according to its liquidity. There are two definitions of money: M1 and M2 money supply. Historically, M1 money supply included those monies that are very liquid such as cash, checkable (demand) deposits, and traveler’s checks, while M2 money supply included those monies that are less liquid in nature; M2 included M1 plus savings and time deposits, certificates of deposits, and money market funds. Beginning in May 2020, the Federal Reserve changed the definition of both M1 and M2. The biggest change is that savings moved to be part of M1. M1 money supply now includes cash, checkable (demand) deposits, and savings. M2 money supply is now measured as M1 plus time deposits, certificates of deposits, and money market funds.
M1 money supply includes coins and currency in circulation—the coins and bills that circulate in an economy that the U.S. Treasury does not hold at the Federal Reserve Bank, or in bank vaults. Closely related to currency are checkable deposits, also known as demand deposits. These are the amounts held in checking accounts. They are called demand deposits or checkable deposits because the banking institution must give the deposit holder his money “on demand” when the customer writes a check or uses a debit card. These items together—currency, and checking accounts in banks—comprise the definition of money known as M1, which the Federal Reserve System measures daily.
As mentioned, M1 now includes savings deposits in banks, which are bank accounts on which you cannot write a check directly, but from which you can easily withdraw the money at an automatic teller machine or bank.
A broader definition of money, M2 includes everything in M1 but also adds other types of deposits. Many banks and other financial institutions also offer a chance to invest in money market funds, where they pool together the deposits of many individual investors and invest them in a safe way, such as short-term government bonds. Another ingredient of M2 are the relatively small (that is, less than about \$100,000) certificates of deposit (CDs) or time deposits, which are accounts that the depositor has committed to leaving in the bank for a certain period of time, ranging from a few months to a few years, in exchange for a higher interest rate. In short, all these types of M2 are money that you can withdraw and spend, but which require a greater effort to do so than the items in M1. Figure 14.3 should help in visualizing the relationship between M1 and M2. Note that M1 is included in the M2 calculation.
Figure 14.3 The Relationship between M1 and M2 Money M1 and M2 money have several definitions, ranging from narrow to broad. M1 = coins and currency in circulation + checkable (demand) deposit + savings deposits. M2 = M1 + money market funds + certificates of deposit + other time deposits.
The Federal Reserve System is responsible for tracking the amounts of M1 and M2 and prepares a weekly release of information about the money supply. To provide an idea of what these amounts sound like, according to the Federal Reserve Bank’s measure of the U.S. money stock, at the end of November 2021, M1 in the United States was \$20.3 trillion, while M2 was \$21.4 trillion. Table 14.1 provides a breakdown of the portion of each type of money that comprised M1 and M2 in November 2021, as provided by the Federal Reserve Bank.
Components of M1 in the U.S. (November 2021, Seasonally Adjusted) \$ billions
Currency \$2,114.6
Demand deposits \$4,764.1
Savings and other liquid deposits \$13,466.3
Total M1 \$20,345 (or \$21.4 trillion)
Components of M2 in the U.S. (November 2021, Seasonally Adjusted) \$ billions
M1 money supply \$19,221
Small-denomination time deposits \$120
Retail money market fund balances \$1,027
Total M2 \$20,368 (or \$20 trillion)
Table 14.1 M1 and M2 Federal Reserve Statistical Release, Money Stock Measures (Source: Federal Reserve Statistical Release, http://www.federalreserve.gov/RELEAS....htm#t2tg1link)
The lines separating M1 and M2 can become a little blurry. Sometimes businesses do not treat elements of M1 alike. For example, some businesses will not accept personal checks for large amounts, but will accept traveler’s checks or cash. Changes in banking practices and technology have made the savings accounts in M2 more similar to the checking accounts in M1. For example, some savings accounts will allow depositors to write checks, use automatic teller machines, and pay bills over the internet, which has made it easier to access savings accounts. As with many other economic terms and statistics, the important point is to know the strengths and limitations of the various definitions of money, not to believe that such definitions are as clear-cut to economists as, say, the definition of nitrogen is to chemists.
Where does “plastic money” like debit cards, credit cards, and smart money fit into this picture? A debit card, like a check, is an instruction to the user’s bank to transfer money directly and immediately from your bank account to the seller. It is important to note that in our definition of money, it is checkable deposits that are money, not the paper check or the debit card. Although you can make a purchase with a credit card, the financial institution does not consider it money but rather a short term loan from the credit card company to you. When you make a credit card purchase, the credit card company immediately transfers money from its checking account to the seller, and at the end of the month, the credit card company sends you a bill for what you have charged that month. Until you pay the credit card bill, you have effectively borrowed money from the credit card company. With a smart card, you can store a certain value of money on the card and then use the card to make purchases. Some “smart cards” used for specific purposes, like long-distance phone calls or making purchases at a campus bookstore and cafeteria, are not really all that smart, because you can only use them for certain purchases or in certain places.
In short, credit cards, debit cards, and smart cards are different ways to move money when you make a purchase. However, having more credit cards or debit cards does not change the quantity of money in the economy, any more than printing more checks increases the amount of money in your checking account.
One key message underlying this discussion of M1 and M2 is that money in a modern economy is not just paper bills and coins. Instead, money is closely linked to bank accounts. The banking system largely conducts macroeconomic policies concerning money. The next section explains how banks function and how a nation’s banking system has the power to create money.
Link It Up
Read a brief article on the monetary challenges in Sweden. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/14%3A_Money_and_Banking/14.03%3A_Measuring_Money-_Currency_M1_and_M2.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how banks act as intermediaries between savers and borrowers
• Evaluate the relationship between banks, savings and loans, and credit unions
• Analyze the causes of bankruptcy and recessions
Somebody once asked the late bank robber named Willie Sutton why he robbed banks. He answered: “That’s where the money is.” While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and consequently, with the broader economy.
Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if everybody had to make all payments in cash. When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.
Banks are a critical intermediary in what we call the payment system, which helps an economy exchange goods and services for money or other financial assets. Also, those with extra money that they would like to save can store their money in a bank rather than look for an individual who is willing to borrow it from them and then repay them at a later date. Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash. Transaction costs are the costs associated with finding a lender or a borrower for this money. Thus, banks lower transactions costs and act as financial intermediaries—they bring savers and borrowers together. Along with making transactions much safer and easier, banks also play a key role in creating money.
Banks as Financial Intermediaries
An “intermediary” is one who stands between two other parties. Banks are a financial intermediary—that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but we will not include them in this discussion because they are not depository institutions, which are institutions that accept money deposits and then use these to make loans. All the deposited funds mingle in one big pool, which the financial institution then lends. Figure 14.4 illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the loans, not to firms that are suffering losses and may be unable to repay.
Figure 14.4 Banks as Financial Intermediaries Banks act as financial intermediaries because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks and repay the loans with interest. In turn, banks return money to savers in the form of withdrawals, which also include interest payments from banks to savers.
Clear It Up
How are banks, savings and loans, and credit unions related?
Banks have a couple of close cousins: savings institutions and credit unions. Banks, as we explained, receive deposits from individuals and businesses and make loans with the money. Savings institutions are also sometimes called “savings and loans” or “thrifts.” They also take loans and make deposits. However, from the 1930s until the 1980s, federal law limited how much interest savings institutions were allowed to pay to depositors. They were also required to make most of their loans in the form of housing-related loans, either to homebuyers or to real-estate developers and builders.
A credit union is a nonprofit financial institution that its members own and run. Members of each credit union decide who is eligible to be a member. Usually, potential members would be everyone in a certain community, or groups of employees, or members of a certain organization. The credit union accepts deposits from members and focuses on making loans back to its members. While there are more credit unions than banks and more banks than savings and loans, the total assets of credit unions are growing.
In 2008, there were 7,085 banks. Due to the bank failures of 2007–2009 and bank mergers, there were 5,571 banks in the United States at the end of the fourth quarter in 2014. By 2020, there were 4,374 commercial banks and 627 savings institutions. According to the National Credit Union Association, as of September 2021 there were 4,990 credit unions with assets totaling \$2.0 trillion. A day of “Transfer Your Money” took place in 2009 out of general public disgust with big bank bailouts. People were encouraged to transfer their deposits to credit unions. This has grown into the ongoing Move Your Money Project. Consequently, some now hold assets with a total value as large as \$111 billion.
A Bank’s Balance Sheet
A balance sheet is an accounting tool that lists assets and liabilities. An asset is something of value that you own and you can use to produce something. For example, you can use the cash you own to pay your tuition. If you own a home, this is also an asset. A liability is a debt or something you owe. Many people borrow money to buy homes. In this case, a home is the asset, but the mortgage is the liability. The net worth is the asset value minus how much is owed (the liability). A bank’s balance sheet operates in much the same way. A bank’s net worth as bank capital. We also refer to a bank has assets such as cash held in its vaults, monies that the bank holds at the Federal Reserve bank (called “reserves”), loans that it makes to customers, and bonds.
Figure 14.5 illustrates a hypothetical and simplified balance sheet for the Safe and Secure Bank. Because of the two-column format of the balance sheet, with the T-shape formed by the vertical line down the middle and the horizontal line under “Assets” and “Liabilities,” we sometimes call it a T-account.
Figure 14.5 A Balance Sheet for the Safe and Secure Bank
The “T” in a T-account separates the assets of a firm, on the left, from its liabilities, on the right. All firms use T-accounts, though most are much more complex. For a bank, the assets are the financial instruments that either the bank is holding (its reserves) or those instruments where other parties owe money to the bank—like loans made by the bank and U.S. Government Securities, such as U.S. treasury bonds purchased by the bank. Liabilities are what the bank owes to others. Specifically, the bank owes any deposits made in the bank to those who have made them. The net worth of the bank is the total assets minus total liabilities. Net worth is included on the liabilities side to have the T account balance to zero. For a healthy business, net worth will be positive. For a bankrupt firm, net worth will be negative. In either case, on a bank’s T-account, assets will always equal liabilities plus net worth.
When bank customers deposit money into a checking account, savings account, or a certificate of deposit, the bank views these deposits as liabilities. After all, the bank owes these deposits to its customers, when the customers wish to withdraw their money. In the example in Figure 14.5, the Safe and Secure Bank holds \$10 million in deposits.
Loans are the first category of bank assets in Figure 14.5. Say that a family takes out a 30-year mortgage loan to purchase a house, which means that the borrower will repay the loan over the next 30 years. This loan is clearly an asset from the bank’s perspective, because the borrower has a legal obligation to make payments to the bank over time. However, in practical terms, how can we measure the value of the mortgage loan that the borrower is paying over 30 years in the present? One way of measuring the value of something—whether a loan or anything else—is by estimating what another party in the market is willing to pay for it. Many banks issue home loans, and charge various handling and processing fees for doing so, but then sell the loans to other banks or financial institutions who collect the loan payments. We call the market where financial institutions make loans to borrowers the primary loan market, while the market in which financial institutions buy and sell these loans is the secondary loan market.
One key factor that affects what financial institutions are willing to pay for a loan, when they buy it in the secondary loan market, is the perceived riskiness of the loan: that is, given the borrower's characteristics, such as income level and whether the local economy is performing strongly, what proportion of loans of this type will the borrower repay? The greater the risk that a borrower will not repay loan, the less that any financial institution will pay to acquire the loan. Another key factor is to compare the interest rate the financial institution charged on the original loan with the current interest rate in the economy. If the original loan requires the borrower to pay a low interest rate, but current interest rates are relatively high, then a financial institution will pay less to acquire the loan. In contrast, if the original loan requires the borrower to pay a high interest rate, while current interest rates are relatively low, then a financial institution will pay more to acquire the loan. For the Safe and Secure Bank in this example, the total value of its loans if they sold them to other financial institutions in the secondary market is \$5 million.
The second category of bank asset is bonds, which are a common mechanism for borrowing, used by the federal and local government, and also private companies, and nonprofit organizations. A bank takes some of the money it has received in deposits and uses the money to buy bonds—typically bonds issued that the U.S. government issues. Government bonds are low-risk because the government is virtually certain to pay off the bond, albeit at a low rate of interest. These bonds are an asset for banks in the same way that loans are an asset: The bank will receive a stream of payments in the future. In our example, the Safe and Secure Bank holds bonds worth a total value of \$4 million.
The final entry under assets is reserves, which is money that the bank keeps on hand, and that it does not lend or invest in bonds—and thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors’ money on “reserve,” which means either in their vaults or at the Federal Reserve Bank. We call this a reserve requirement. (Monetary Policy and Bank Regulation will explain how the level of these required reserves are one policy tool that governments have to influence bank behavior.) Additionally, banks may also want to keep a certain amount of reserves on hand in excess of what is required. The Safe and Secure Bank is holding \$2 million in reserves.
We define net worth of a bank as its total assets minus its total liabilities. For the Safe and Secure Bank in Figure 14.5, net worth is equal to \$1 million; that is, \$11 million in assets minus \$10 million in liabilities. For a financially healthy bank, the net worth will be positive. If a bank has negative net worth and depositors tried to withdraw their money, the bank would not be able to give all depositors their money.
Link It Up
For some concrete examples of what banks do, watch this video from Paul Solman’s “Making Sense of Financial News.”
How Banks Go Bankrupt
A bank that is bankrupt will have a negative net worth, meaning its assets will be worth less than its liabilities. How can this happen? Again, looking at the balance sheet helps to explain.
A well-run bank will assume that a small percentage of borrowers will not repay their loans on time, or at all, and factor these missing payments into its planning. Remember, the calculations of the banks' expenses every year include a factor for loans that borrowers do not repay, and the value of a bank’s loans on its balance sheet assumes a certain level of riskiness because some customers will not repay loans. Even if a bank expects a certain number of loan defaults, it will suffer if the number of loan defaults is much greater than expected, as can happen during a recession. For example, if the Safe and Secure Bank in Figure 14.5 experienced a wave of unexpected defaults, so that its loans declined in value from \$5 million to \$3 million, then the assets of the Safe and Secure Bank would decline so that the bank had negative net worth.
Clear It Up
What led to the 2008–2009 financial crisis?
Many banks make mortgage loans so that people can buy a home, but then do not keep the loans on their books as an asset. Instead, the bank sells the loan. These loans are “securitized,” which means that they are bundled together into a financial security that a financial institution sells to investors. Investors in these mortgage-backed securities receive a rate of return based on the level of payments that people make on all the mortgages that stand behind the security.
Securitization offers certain advantages. If a bank makes most of its loans in a local area, then the bank may be financially vulnerable if the local economy declines, so that many people are unable to make their payments. However, if a bank sells its local loans, and then buys a mortgage-backed security based on home loans in many parts of the country, it can avoid exposure to local financial risks. (In the simple example in the text, banks just own “bonds.” In reality, banks can own a number of financial instruments, as long as these financial investments are safe enough to satisfy the government bank regulators.) From the standpoint of a local homebuyer, securitization offers the benefit that a local bank does not need to have significant extra funds to make a loan, because the bank is only planning to hold that loan for a short time, before selling the loan so that it can pool it into a financial security.
However, securitization also offers one potentially large disadvantage. If a bank plans to hold a mortgage loan as an asset, the bank has an incentive to scrutinize the borrower carefully to ensure that the customer is likely to repay the loan. However, a bank that plans to sell the loan may be less careful in making the loan in the first place. The bank will be more willing to make what we call “subprime loans,” which are loans that have characteristics like low or zero down-payment, little scrutiny of whether the borrower has a reliable income, and sometimes low payments for the first year or two that will be followed by much higher payments. Economists dubbed some of the subprime loans made by financial institutions in the mid-2000s NINJA loans: loans that financial institutions made even though the borrower had demonstrated No Income, No Job, or Assets.
Financial institutions typically sold these subprime loans and turned them into financial securities—but with a twist. The idea was that if losses occurred on these mortgage-backed securities, certain investors would agree to take the first, say, 5% of such losses. Other investors would agree to take, say, the next 5% of losses. By this approach, still other investors would not need to take any losses unless these mortgage-backed financial securities lost 25% or 30% or more of their total value. These complex securities, along with other economic factors, encouraged a large expansion of subprime loans in the mid-2000s.
The economic stage was now set for a banking crisis. Banks thought they were buying only ultra-safe securities, because even though the securities were ultimately backed by risky subprime mortgages, the banks only invested in the part of those securities where they were protected from small or moderate levels of losses. However, as housing prices fell after 2007, and the deepening recession made it harder for many people to make their mortgage payments, many banks found that their mortgage-backed financial assets could be worth much less than they had expected—and so the banks were faced with staring bankruptcy. In the 2008–2011 period, 318 banks failed in the United States.
The risk of an unexpectedly high level of loan defaults can be especially difficult for banks because a bank’s liabilities, namely it customers' deposits. Customers can withdraw funds quickly but many of the bank’s assets like loans and bonds will only be repaid over years or even decades. This asset-liability time mismatch—the ability for customers to withdraw bank’s liabilities in the short term while customers repay its assets in the long term—can cause severe problems for a bank. For example, imagine a bank that has loaned a substantial amount of money at a certain interest rate, but then sees interest rates rise substantially. The bank can find itself in a precarious situation. If it does not raise the interest rate it pays to depositors, then deposits will flow to other institutions that offer the higher interest rates that are now prevailing. However, if the bank raises the interest rates that it pays to depositors, it may end up in a situation where it is paying a higher interest rate to depositors than it is collecting from those past loans that it at lower interest rates. Clearly, the bank cannot survive in the long term if it is paying out more in interest to depositors than it is receiving from borrowers.
How can banks protect themselves against an unexpectedly high rate of loan defaults and against the risk of an asset-liability time mismatch? One strategy is for a bank to diversify its loans, which means lending to a variety of customers. For example, suppose a bank specialized in lending to a niche market—say, making a high proportion of its loans to construction companies that build offices in one downtown area. If that one area suffers an unexpected economic downturn, the bank will suffer large losses. However, if a bank loans both to consumers who are buying homes and cars and also to a wide range of firms in many industries and geographic areas, the bank is less exposed to risk. When a bank diversifies its loans, those categories of borrowers who have an unexpectedly large number of defaults will tend to be balanced out, according to random chance, by other borrowers who have an unexpectedly low number of defaults. Thus, diversification of loans can help banks to keep a positive net worth. However, if a widespread recession occurs that touches many industries and geographic areas, diversification will not help.
Along with diversifying their loans, banks have several other strategies to reduce the risk of an unexpectedly large number of loan defaults. For example, banks can sell some of the loans they make in the secondary loan market, as we described earlier, and instead hold a greater share of assets in the form of government bonds or reserves. Nevertheless, in a lengthy recession, most banks will see their net worth decline because customers will not repay a higher share of loans in tough economic times. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/14%3A_Money_and_Banking/14.04%3A_The_Role_of_Banks.txt |
Learning Objectives
By the end of this section, you will be able to:
• Utilize the money multiplier formulate to determine how banks create money
• Analyze and create T-account balance sheets
• Evaluate the risks and benefits of money and banks
Banks and money are intertwined. It is not just that most money is in the form of bank accounts. The banking system can literally create money through the process of making loans. Let’s see how.
Money Creation by a Single Bank
Start with a hypothetical bank called Singleton Bank. The bank has \$10 million in deposits. The T-account balance sheet for Singleton Bank, when it holds all of the deposits in its vaults, is in Figure 14.6. At this stage, Singleton Bank is simply storing money for depositors and is using these deposits to make loans. In this simplified example, Singleton Bank cannot earn any interest income from these loans and cannot pay its depositors an interest rate either.
Figure 14.6 Singleton Bank’s Balance Sheet: Receives \$10 million in Deposits
The Federal Reserve requires Singleton Bank to keep \$1 million on reserve (10% of total deposits). It will loan out the remaining \$9 million. By loaning out the \$9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank (for now, we will keep it simple and not put interest income on the balance sheet). Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers.
This change in business plan alters Singleton Bank’s balance sheet, as Figure 14.7 shows. Singleton’s assets have changed. It now has \$1 million in reserves and a loan to Hank’s Auto Supply of \$9 million. The bank still has \$10 million in deposits.
Figure 14.7 Singleton Bank’s Balance Sheet: 10% Reserves, One Round of Loans
Singleton Bank lends \$9 million to Hank’s Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that it has made a loan. This loan is an asset, because it will generate interest income for the bank. Of course, the loan officer will not allow let Hank to walk out of the bank with \$9 million in cash. The bank issues Hank’s Auto Supply a cashier’s check for the \$9 million. Hank deposits the loan in his regular checking account with First National. The deposits at First National rise by \$9 million and its reserves also rise by \$9 million, as Figure 14.8 shows. First National must hold 10% of additional deposits as required reserves but is free to loan out the rest
Figure 14.8 First National Balance Sheet
Making loans that are deposited into a demand deposit account increases the M1 money supply. Remember the definition of M1 includes checkable (demand) deposits, which one can easily use as a medium of exchange to buy goods and services. Notice that the money supply is now \$19 million: \$10 million in deposits in Singleton bank and \$9 million in deposits at First National. Obviously as Hank’s Auto Supply writes checks to pay its bills the deposits will draw down. However, the bigger picture is that a bank must hold enough money in reserves to meet its liabilities. The rest the bank loans out. In this example so far, bank lending has expanded the money supply by \$9 million.
Now, First National must hold only 10% as required reserves (\$900,000) but can lend out the other 90% (\$8.1 million) in a loan to Jack’s Chevy Dealership as Figure 14.9 shows.
Figure 14.9 First National Balance Sheet
If Jack’s deposits the loan in its checking account at Second National, the money supply just increased by an additional \$8.1 million, as Figure 14.10 shows.
Figure 14.10 Second National Bank’s Balance Sheet
How is this money creation possible? It is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits, and loans end up deposited in other banks, which increases deposits and, in essence, the money supply.
Link It Up
Watch this video to learn more about how banks create money.
The Money Multiplier and a Multi-Bank System
In a system with multiple banks, Singleton Bank deposited the initial excess reserve amount that it decided to lend to Hank’s Auto Supply into First National Bank, which is free to loan out \$8.1 million. If all banks loan out their excess reserves, the money supply will expand. In a multi-bank system, institutions determine the amount of money that the system can create by using the money multiplier. This tells us by how many times a loan will be “multiplied” as it is spent in the economy and then re-deposited in other banks.
Fortunately, a formula exists for calculating the total of these many rounds of lending in a banking system. The money multiplier formula is:
Work It Out
Using the Money Multiplier Formula
Using the money multiplier for the example in this text:
Step 1. In the case of Singleton Bank, for whom the reserve requirement is 10% (or 0.10), the money multiplier is 1 divided by .10, which is equal to 10.
Step 2. We have identified that the excess reserves are \$9 million, so, using the formula we can determine the total change in the M1 money supply:
$Total Change in the M1 Money Supply=1Reserve Requirement × Excess Requirement=10.10 × 9 million=10 × 9 million=90 millionTotal Change in the M1 Money Supply=1Reserve Requirement × Excess Requirement=10.10 × 9 million=10 × 9 million=90 million$
Step 3. Thus, we can say that, in this example, the total quantity of money generated in this economy after all rounds of lending are completed will be \$90 million.
Cautions about the Money Multiplier
The money multiplier will depend on the proportion of reserves that the Federal Reserve Band requires banks to hold. Additionally, a bank can also choose to hold extra reserves. Banks may decide to vary how much they hold in reserves for two reasons: macroeconomic conditions and government rules. When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that customers are less likely to repay loans when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as Monetary Policy and Bank Regulation will discuss.
The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. All the money in the economy, except for the original reserves, is a result of bank loans that institutions repeatedly re-deposit and loan.
Finally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash, instead of depositing it in banks, and the quantity of loans in an economy will decline. Low-income countries have what economists sometimes refer to as “mattress savings,” or money that people are hiding in their homes because they do not trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline.
Link It Up
Watch a video of Jem Bendell discussing “The Money Myth.”
Money and Banks—Benefits and Dangers
Money and banks are marvelous social inventions that help a modern economy to function. Compared with the alternative of barter, money makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more effective in facilitating exchanges in goods and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the creation of money.
However, the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers. If banks are not working well, it sets off a decline in convenience and safety of transactions throughout the economy. If the banks are under financial stress, because of a widespread decline in the value of their assets, loans may become far less available, which can deal a crushing blow to sectors of the economy that depend on borrowed money like business investment, home construction, and car manufacturing. The 2008–2009 Great Recession illustrated this pattern.
Bring It Home
The Many Disguises of Money: From Cowries to Crypto
The global economy has come a long way since it started using cowrie shells as currency. We have moved away from commodity and commodity-backed paper money to fiat currency. As technology and global integration increases, the need for paper currency is diminishing, too. Every day, we witness the increased use of debit and credit cards.
The latest creation and a new form of money is cryptocurrency. Cryptocurrency is digital currency that is not controlled by any single entity, such as a company or country. In this sense, it is not a fiat currency because it is not issued by a central bank and is not necessarily supported by governments as legal tender. Instead, transactions and ownership are maintained in a decentralized manner, and the value (vis-à-vis, say, the U.S. dollar) is determined primarily by market forces—i.e., supply and demand. Governments can affect the value of a cryptocurrency by regulating its use within their country's boundaries, but in the end, the price of a cryptocurrency comes down to supply and demand. Cryptocurrencies have come a long way since 2009 when Bitcoin was first invented, and the recent two to three years has seen an explosion of different cryptocurrencies being used across the globe.
It is important to note that in order to be considered as money, cryptocurrency still needs to satisfy the three requirements: it needs to be valid as a store of value, it needs to be valid as a unit of account, and it must be able to be used as a medium of exchange. While the first two of these requirements can be satisfied easily by expressing the currency in terms of another, such as the U.S. dollar, and through its secure ownership rules, its use as a medium of exchange—to be used to buy and sell goods and services—is more complicated. While cryptocurrencies are used in many illicit transactions, it is less common to see them accepted as forms of payment for regular things like groceries or your rent.
Bitcoin is the most popular cryptocurrency, and thus the one most likely to be considered real money since it can be used to purchase the most goods and services. Other popular cryptocurrencies as of early 2022 (in terms of trade volume) are Ethereum and Binance Coin. Many other cryptocurrencies exist, but their more widespread adoption as a medium of exchange is yet to be seen. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/14%3A_Money_and_Banking/14.05%3A_How_Banks_Create_Money.txt |
asset
item of value that a firm or an individual owns
asset–liability time mismatch
customers can withdraw a bank’s liabilities in the short term while customers repay its assets in the long term
balance sheet
an accounting tool that lists assets and liabilities
bank capital
a bank’s net worth
barter
literally, trading one good or service for another, without using money
coins and currency in circulation
the coins and bills that circulate in an economy that are not held by the U.S Treasury, at the Federal Reserve Bank, or in bank vaults
commodity money
an item that is used as money, but which also has value from its use as something other than money
commodity-backed currencies
dollar bills or other currencies with values backed up by gold or another commodity
credit card
immediately transfers money from the credit card company’s checking account to the seller, and at the end of the month the user owes the money to the credit card company; a credit card is a short-term loan
debit card
like a check, is an instruction to the user’s bank to transfer money directly and immediately from your bank account to the seller
demand deposit
checkable deposit in banks that is available by making a cash withdrawal or writing a check
depository institution
institution that accepts money deposits and then uses these to make loans
diversify
making loans or investments with a variety of firms, to reduce the risk of being adversely affected by events at one or a few firms
double coincidence of wants
a situation in which two people each want some good or service that the other person can provide
fiat money
has no intrinsic value, but is declared by a government to be the country's legal tender
financial intermediary
an institution that operates between a saver with financial assets to invest and an entity who will borrow those assets and pay a rate of return
liability
any amount or debt that a firm or an individual owes
M1 money supply
a narrow definition of the money supply that includes currency and checking accounts in banks, and to a lesser degree, traveler’s checks.
M2 money supply
a definition of the money supply that includes everything in M1, but also adds savings deposits, money market funds, and certificates of deposit
medium of exchange
whatever is widely accepted as a method of payment
money
whatever serves society in four functions: as a medium of exchange, a store of value, a unit of account, and a standard of deferred payment.
money market fund
the deposits of many investors are pooled together and invested in a safe way like short-term government bonds
money multiplier formula
total money in the economy divided by the original quantity of money, or change in the total money in the economy divided by a change in the original quantity of money
net worth
the excess of the asset value over and above the amount of the liability; total assets minus total liabilities
payment system
helps an economy exchange goods and services for money or other financial assets
reserves
funds that a bank keeps on hand and that it does not loan out or invest in bonds
savings deposit
bank account where you cannot withdraw money by writing a check, but can withdraw the money at a bank—or can transfer it easily to a checking account
smart card
stores a certain value of money on a card and then one can use the card to make purchases
standard of deferred payment
money must also be acceptable to make purchases today that will be paid in the future
store of value
something that serves as a way of preserving economic value that one can spend or consume in the future
T-account
a balance sheet with a two-column format, with the T-shape formed by the vertical line down the middle and the horizontal line under the column headings for “Assets” and “Liabilities”
time deposit
account that the depositor has committed to leaving in the bank for a certain period of time, in exchange for a higher rate of interest; also called certificate of deposit
transaction costs
the costs associated with finding a lender or a borrower for money
unit of account
the common way in which we measure market values in an economy | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/14%3A_Money_and_Banking/14.06%3A_Key_Terms.txt |
14.1 Defining Money by Its Functions
Money is what people in a society regularly use when purchasing or selling goods and services. If money were not available, people would need to barter with each other, meaning that each person would need to identify others with whom they have a double coincidence of wants—that is, each party has a specific good or service that the other desires. Money serves several functions: a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. There are two types of money: commodity money, which is an item used as money, but which also has value from its use as something other than money; and fiat money, which has no intrinsic value, but is declared by a government to be the country's legal tender.
14.2 Measuring Money: Currency, M1, and M2
We measure money with several definitions: M1 includes currency and money in checking accounts (demand deposits). Traveler’s checks are also a component of M1, but are declining in use. M2 includes all of M1, plus savings deposits, time deposits like certificates of deposit, and money market funds.
14.3 The Role of Banks
Banks facilitate using money for transactions in the economy because people and firms can use bank accounts when selling or buying goods and services, when paying a worker or receiving payment, and when saving money or receiving a loan. In the financial capital market, banks are financial intermediaries; that is, they operate between savers who supply financial capital and borrowers who demand loans. A balance sheet (sometimes called a T-account) is an accounting tool which lists assets in one column and liabilities in another. The bank's liabilities are its deposits. The bank's assets include its loans, its ownership of bonds, and its reserves (which it does not loan out). We calculate a bank's net worth by subtracting its liabilities from its assets. Banks run a risk of negative net worth if the value of their assets declines. The value of assets can decline because of an unexpectedly high number of defaults on loans, or if interest rates rise and the bank suffers an asset-liability time mismatch in which the bank is receiving a low interest rate on its long-term loans but must pay the currently higher market interest rate to attract depositors. Banks can protect themselves against these risks by choosing to diversify their loans or to hold a greater proportion of their assets in bonds and reserves. If banks hold only a fraction of their deposits as reserves, then the process of banks’ lending money, re-depositing those loans in banks, and the banks making additional loans will create money in the economy.
14.4 How Banks Create Money
We define the money multiplier as the quantity of money that the banking system can generate from each \$1 of bank reserves. The formula for calculating the multiplier is 1/reserve ratio, where the reserve ratio is the fraction of deposits that the bank wishes to hold as reserves. The quantity of money in an economy and the quantity of credit for loans are inextricably intertwined. The network of banks making loans, people making deposits, and banks making more loans creates much of the money in an economy.
Given the macroeconomic dangers of a malfunctioning banking system, Monetary Policy and Bank Regulation will discuss government policies for controlling the money supply and for keeping the banking system safe. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/14%3A_Money_and_Banking/14.07%3A_Key_Concepts_and_Summary.txt |
1.
In many casinos, a person buys chips to use for gambling. Within the casino's walls, customers often can use these chips to buy food and drink or even a hotel room. Do chips in a gambling casino serve all three functions of money?
2.
Can you name some item that is a store of value, but does not serve the other functions of money?
3.
If you are out shopping for clothes and books, what is easiest and most convenient for you to spend: M1 or M2? Explain your answer.
4.
For the following list of items, indicate if they are in M1, M2, or neither:
1. Your \$5,000 line of credit on your Bank of America card
2. \$50 dollars’ worth of traveler’s checks you have not used yet
3. \$1 in quarters in your pocket
4. \$1200 in your checking account
5. \$2000 you have in a money market account
5.
Explain why the money listed under assets on a bank balance sheet may not actually be in the bank?
6.
Imagine that you are in the position of buying loans in the secondary market (that is, buying the right to collect the payments on loans) for a bank or other financial services company. Explain why you would be willing to pay more or less for a given loan if:
1. The borrower has been late on a number of loan payments
2. Interest rates in the economy as a whole have risen since the bank made the loan
3. The borrower is a firm that has just declared a high level of profits
4. Interest rates in the economy as a whole have fallen since the bank made the loan
14.09: Review Questions
7.
What are the four functions that money serves?
8.
How does the existence of money simplify the process of buying and selling?
9.
What is the double-coincidence of wants?
10.
What components of money do we count as part of M1?
11.
What components of money do we count in M2?
12.
Why do we call a bank a financial intermediary?
13.
What does a balance sheet show?
14.
What are a bank's assets? What are its liabilities?
15.
How do you calculate a bank's net worth?
16.
How can a bank end up with negative net worth?
17.
What is the asset-liability time mismatch that all banks face?
18.
What is the risk if a bank does not diversify its loans?
19.
How do banks create money?
20.
What is the formula for the money multiplier?
14.10: Critical Thinking Questions
21.
The Bring it Home Feature discusses the use of cowrie shells as money. Although we no longer use cowrie shells as money, do you think other forms of commodity monies are possible? What role might technology play in our definition of money?
22.
Imagine that you are a barber in a world without money. Explain why it would be tricky to obtain groceries, clothing, and a place to live.
23.
Explain why you think the Federal Reserve Bank tracks M1 and M2.
24.
The total amount of U.S. currency in circulation divided by the U.S. population comes out to about \$3,500 per person. That is more than most of us carry. Where is all the cash?
25.
Explain the difference between how you would characterize bank deposits and loans as assets and liabilities on your own personal balance sheet and how a bank would characterize deposits and loans as assets and liabilities on its balance sheet.
26.
Should banks have to hold 100% of their deposits? Why or why not?
27.
Explain what will happen to the money multiplier process if there is an increase in the reserve requirement?
28.
What do you think the Federal Reserve Bank did to the reserve requirement during the 2008–2009 Great Recession?
14.11: Problems
29.
If you take \$100 out of your piggy bank and deposit it in your checking account, how did M1 change? Did M2 change?
30.
A bank has deposits of \$400. It holds reserves of \$50. It has purchased government bonds worth \$70. It has made loans of \$500. Set up a T-account balance sheet for the bank, with assets and liabilities, and calculate the bank’s net worth.
31.
Humongous Bank is the only bank in the economy. The people in this economy have \$20 million in money, and they deposit all their money in Humongous Bank.
1. Humongous Bank decides on a policy of holding 100% reserves. Draw a T-account for the bank.
2. Humongous Bank is required to hold 5% of its existing \$20 million as reserves, and to loan out the rest. Draw a T-account for the bank after it has made its first round of loans.
3. Assume that Humongous bank is part of a multibank system. How much will money supply increase with that original \$19 million loan? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/14%3A_Money_and_Banking/14.08%3A_Self-Check_Questions.txt |
Figure 15.1 Marriner S. Eccles Federal Reserve Headquarters, Washington D.C. Some of the most influential decisions regarding monetary policy in the United States are made behind these doors. (Credit: modification of work by “Marriner S. Eccles Federal Reserve” by LunchboxLarry/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• The Federal Reserve Banking System and Central Banks
• Bank Regulation
• How a Central Bank Executes Monetary Policy
• Monetary Policy and Economic Outcomes
• Pitfalls for Monetary Policy
Bring It Home
The Problem of the Zero Percent Interest Rate Lower Bound
Most economists believe that monetary policy (the manipulation of interest rates and credit conditions by a nation’s central bank) has a powerful influence on a nation’s economy. Monetary policy works when the central bank reduces interest rates and makes credit more available. As a result, business investment and other types of spending increase, causing GDP and employment to grow.
However, what if the interest rates banks pay are close to zero already? They cannot be made negative, can they? That would mean that lenders pay borrowers for the privilege of taking their money. Yet, this was the situation the U.S. Federal Reserve found itself in both at the end of the 2008–2009 recession and during the COVID-19 recession of 2020. The federal funds rate, which is the interest rate for banks that the Federal Reserve targets with its monetary policy, was slightly above 5% in 2007. By 2009, it had fallen to 0.16%. It then fell again from over 2% to 0.05% in March 2020.
During the Great Recession, the Federal Reserve’s situation was further complicated because fiscal policy, the other major tool for managing the economy, was constrained by fears that the federal budget deficit and the public debt were already too high. What were the Federal Reserve’s options? How could the Federal Reserve use monetary policy to stimulate the economy? And while fiscal policy was more aggressive in 2020, the economic situation has in some cases been more severe and additional financial support was necessary. The solution to the problem of the lower bound in both recessions, as we will see in this chapter, was to change the rules of the game.
Money, loans, and banks are all interconnected. Money is deposited in bank accounts, which is then loaned to businesses, individuals, and other banks. When the interlocking system of money, loans, and banks works well, economic transactions smoothly occur in goods and labor markets and savers are connected with borrowers. If the money and banking system does not operate smoothly, the economy can either fall into recession or suffer prolonged inflation.
The government of every country has public policies that support the system of money, loans, and banking. However, these policies do not always work perfectly. This chapter discusses how monetary policy works and what may prevent it from working perfectly.
15.02: The Federal Reserve Banking System and Central Banks
Learning Objectives
By the end of this section, you will be able to:
• Explain the structure and organization of the U.S. Federal Reserve
• Discuss how central banks impact monetary policy, promote financial stability, and provide banking services
In making decisions about the money supply, a central bank decides whether to raise or lower interest rates and, in this way, to influence macroeconomic policy, whose goal is low unemployment and low inflation. The central bank is also responsible for regulating all or part of the nation’s banking system to protect bank depositors and insure the health of the bank’s balance sheet.
We call the organization responsible for conducting monetary policy and ensuring that a nation’s financial system operates smoothly the central bank. Most nations have central banks or currency boards. Some prominent central banks around the world include the European Central Bank, the Bank of Japan, and the Bank of England. In the United States, we call the central bank the Federal Reserve—often abbreviated as just “the Fed.” This section explains the U.S. Federal Reserve's organization and identifies the major central bank's responsibilities.
Structure/Organization of the Federal Reserve
Unlike most central banks, the Federal Reserve is semi-decentralized, mixing government appointees with representation from private-sector banks. At the national level, it is run by a Board of Governors, consisting of seven members appointed by the President of the United States and confirmed by the Senate. Appointments are for 14-year terms and they are arranged so that one term expires January 31 of every even-numbered year. The purpose of the long and staggered terms is to insulate the Board of Governors as much as possible from political pressure so that governors can make policy decisions based only on their economic merits. Additionally, except when filling an unfinished term, each member only serves one term, further insulating decision-making from politics. The Fed's policy decisions do not require congressional approval, and the President cannot ask for a Federal Reserve Governor to resign as the President can with cabinet positions.
One member of the Board of Governors is designated as the Chair. For example, from 1987 until early 2006, the Chair was Alan Greenspan. From 2006 until 2014, Ben Bernanke held the post. From 2014 to 2018, Janet Yellen was the Chair. The current Chair is Jerome Powell. See the following Clear It Up feature to find out more about the former and current Chair.
Clear It Up
Who has the most immediate economic power in the world?
Figure 15.2 Chair of the Federal Reserve Board Jerome H. Powell (Credit: “_NZ79221” by Board of Governors of the Federal Reserve System/Flickr, Public Domain)
What individual can make a financial market crash or soar just by making a public statement? It is not Bill Gates or Warren Buffett. It is not even the President of the United States. The answer is the Chair of the Federal Reserve Board of Governors. In 2018, President Donald Trump appointed Jerome H. Powell to a 4-year term as chair of the Federal Reserve, replacing Janet Yellen, who served as the first female chair of the Federal Reserve from 2014–2018 and who now serves as the Treasury Secretary in the Biden administration. In November 2021, Powell was nominated for a second term by President Biden; this appointment was confirmed in early-2022.
Powell played a pivotal role during the COVID-19 recession and its aftermath; in March 2020, under his leadership the Fed acted quickly to reduce the effective federal funds rate and expand its lending and bond-buying actions, similar to what Ben Bernanke did during the Great Recession. A centrist at heart, Powell has been criticized for fueling asset prices, even though in his many speeches and testimony before Congress he has consistently emphasized low unemployment rates and has been more tolerant of inflation than others on the Federal Reserve Board. Powell is not an academic economist by training or career—he has a J.D. from Georgetown Law and worked for many years at investment banks and on corporate boards—but this lack of "ivory tower" influences has helped guide a practical approach to economic problems, for which he is best known.
The Fed Chair is first among equals on the Board of Governors. While they have only one vote, the Chair controls the agenda, and is the Fed's public voice, so they have more power and influence than one might expect.
Link It Up
Visit this website to see who the current members of the Federal Reserve Board of Governors are. You can follow the links provided for each board member to learn more about their backgrounds, experiences, and when their terms on the board will end.
The Federal Reserve is more than the Board of Governors. The Fed also includes 12 regional Federal Reserve banks, each of which is responsible for supporting the commercial banks and economy generally in its district. Figure 15.3 shows the Federal Reserve districts and the cities where their regional headquarters are located. The commercial banks in each district elect a Board of Directors for each regional Federal Reserve bank, and that board chooses a president for each regional Federal Reserve district. Thus, the Federal Reserve System includes both federally and private-sector appointed leaders.
Figure 15.3 The Twelve Federal Reserve Districts There are twelve regional Federal Reserve banks, each with its district.
What Does a Central Bank Do?
The Federal Reserve, like most central banks, is designed to perform three important functions:
1. To conduct monetary policy
2. To promote stability of the financial system
3. To provide banking services to commercial banks and other depository institutions, and to provide banking services to the federal government.
The first two functions are sufficiently important that we will discuss them in their own modules. The third function we will discuss here.
The Federal Reserve provides many of the same services to banks as banks provide to their customers. For example, all commercial banks have an account at the Fed where they deposit reserves. Similarly, banks can obtain loans from the Fed through the “discount window” facility, which we will discuss in more detail later. The Fed is also responsible for check processing. When you write a check, for example, to buy groceries, the grocery store deposits the check in its bank account. Then, the grocery store's bank returns the physical check (or an image of that actual check) to your bank, after which it transfers funds from your bank account to the grocery store's account. The Fed is responsible for each of these actions.
On a more mundane level, the Federal Reserve ensures that enough currency and coins are circulating through the financial system to meet public demands. For example, each year the Fed increases the amount of currency available in banks around the Christmas shopping season and reduces it again in January.
Finally, the Fed is responsible for assuring that banks are in compliance with a wide variety of consumer protection laws. For example, banks are forbidden from discriminating on the basis of age, race, sex, or marital status. Banks are also required to disclose publicly information about the loans they make for buying houses and how they distribute the loans geographically, as well as by sex and race of the loan applicants. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/15%3A_Monetary_Policy_and_Bank_Regulation/15.01%3A_Introduction_to_Monetary_Policy_and_Bank_Regulation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Discuss the relationship between bank regulation and monetary policy
• Explain bank supervision
• Explain how deposit insurance and lender of last resort are two strategies to protect against bank runs
A safe and stable national financial system is a critical concern of the Federal Reserve. The goal is not only to protect individuals’ savings, but to protect the integrity of the financial system itself. This esoteric task is usually behind the scenes, but came into view during the 2008–2009 financial crisis, when for a brief period of time, critical parts of the financial system failed and firms became unable to obtain financing for ordinary parts of their business. Imagine if suddenly you were unable to access the money in your bank accounts because your checks were not accepted for payment and your debit cards were declined. This gives an idea of a failure of the payments/financial system.
Bank regulation is intended to maintain banks' solvency by avoiding excessive risk. Regulation falls into a number of categories, including reserve requirements, capital requirements, and restrictions on the types of investments banks may make. In Money and Banking, we learned that banks are required to hold a minimum percentage of their deposits on hand as reserves. “On hand” is a bit of a misnomer because, while a portion of bank reserves are held as cash in the bank, the majority are held in the bank’s account at the Federal Reserve, and their purpose is to cover desired withdrawals by depositors. Another part of bank regulation is restrictions on the types of investments banks are allowed to make. Banks are permitted to make loans to businesses, individuals, and other banks. They can purchase U.S. Treasury securities but, to protect depositors, they are not permitted to invest in the stock market or other assets that are perceived as too risky.
Bank capital is the difference between a bank’s assets and its liabilities. In other words, it is a bank’s net worth. A bank must have positive net worth; otherwise it is insolvent or bankrupt, meaning it would not have enough assets to pay back its liabilities. Regulation requires that banks maintain a minimum net worth, usually expressed as a percent of their assets, to protect their depositors and other creditors.
Link It Up
Visit this website to read the brief article, “Stop Confusing Monetary Policy and Bank Regulation.”
Bank Supervision
Several government agencies monitor banks' balance sheets to make sure they have positive net worth and are not taking too high a level of risk. Within the U.S. Department of the Treasury, the Office of the Comptroller of the Currency has a national staff of bank examiners who conduct on-site reviews of the 1,500 or so of the largest national banks. The bank examiners also review any foreign banks that have branches in the United States. The Office of the Comptroller of the Currency also monitors and regulates about 800 savings and loan institutions.
The National Credit Union Administration (NCUA) supervises credit unions, which are nonprofit banks that their members run and own. There are about 5,000 credit unions in the U.S. economy today, although the typical credit union is small compared to most banks.
The Federal Reserve also has some responsibility for supervising financial institutions. For example, we call conglomerate firms that own banks and other businesses “bank holding companies.” While other regulators like the Office of the Comptroller of the Currency supervises the banks, the Federal Reserve supervises the holding companies.
When bank supervision (and bank-like institutions such as savings and loans and credit unions) works well, most banks will remain financially healthy most of the time. If the bank supervisors find that a bank has low or negative net worth, or is making too high a proportion of risky loans, they can require that the bank change its behavior—or, in extreme cases, even force the bank to close or be sold to a financially healthy bank.
Bank supervision can run into both practical and political questions. The practical question is that measuring the value of a bank’s assets is not always straightforward. As we discussed in Money and Banking, a bank’s assets are its loans, and the value of these assets depends on estimates about the risk that customers will not repay these loans. These issues can become even more complex when a bank makes loans to banks or firms in other countries, or arranges financial deals that are much more complex than a basic loan.
The political question arises because a bank supervisor's decision to require a bank to close or to change its financial investments is often controversial, and the bank supervisor often comes under political pressure from the bank's owners and the local politicians to keep quiet and back off.
For example, many observers have pointed out that Japan’s banks were in deep financial trouble through most of the 1990s; however, nothing substantial had been done about it by the early 2000s. A similar unwillingness to confront problems with struggling banks is visible across the rest of the world, in East Asia, Latin America, Eastern Europe, Russia, and elsewhere.
In the United States, the government passed laws in the 1990s requiring that bank supervisors make their findings open and public, and that they act as soon as they identify a problem. However, as many U.S. banks were staggered by the 2008-2009 recession, critics of the bank regulators asked pointed questions about why the regulators had not foreseen the banks' financial shakiness earlier, before such large losses had a chance to accumulate.
Bank Runs
Back in the nineteenth century and during the first few decades of the twentieth century (around and during the Great Depression), putting your money in a bank could be nerve-wracking. Imagine that the net worth of your bank became negative, so that the bank’s assets were not enough to cover its liabilities. In this situation, whoever withdrew their deposits first received all of their money, and those who did not rush to the bank quickly enough, lost their money. We call depositors racing to the bank to withdraw their deposits, as Figure 15.4 shows a bank run. In the movie It’s a Wonderful Life, the bank manager, played by Jimmy Stewart, faces a mob of worried bank depositors who want to withdraw their money, but manages to allay their fears by allowing some of them to withdraw a portion of their deposits—using the money from his own pocket that was supposed to pay for his honeymoon.
Figure 15.4 A Run on the Bank Bank runs during the Great Depression only served to worsen the economic situation. (Credit: “Depression: "Runs on Banks” by National Archives and Records Administration, Public Domain)
The risk of bank runs created instability in the banking system. Even a rumor that a bank might experience negative net worth could trigger a bank run and, in a bank run, even healthy banks could be destroyed. Because a bank loans out most of the money it receives, and because it keeps only limited reserves on hand, a bank run of any size would quickly drain any of the bank’s available cash. When the bank had no cash remaining, it only intensified the fears of remaining depositors that they could lose their money. Moreover, a bank run at one bank often triggered a chain reaction of runs on other banks. In the late nineteenth and early twentieth century, bank runs were typically not the original cause of a recession—but they could make a recession much worse.
Deposit Insurance
To protect against bank runs, Congress has put two strategies into place: deposit insurance and the lender of last resort. Deposit insurance is an insurance system that makes sure depositors in a bank do not lose their money, even if the bank goes bankrupt. About 70 countries around the world, including all of the major economies, have deposit insurance programs. In the United States, the Federal Deposit Insurance Corporation (FDIC) is responsible for deposit insurance. Banks pay an insurance premium to the FDIC. The insurance premium is based on the bank’s level of deposits, and then adjusted according to the riskiness of a bank’s financial situation. In 2009, for example, a fairly safe bank with a high net worth might have paid 10–20 cents in insurance premiums for every \$100 in bank deposits, while a risky bank with very low net worth might have paid 50–60 cents for every \$100 in bank deposits.
Bank examiners from the FDIC evaluate the banks' balance sheets, looking at the asset and liability values to determine the risk level. The FDIC provides deposit insurance for about 4,914 banks (as of the third quarter of 2021). Even if a bank fails, the government guarantees that depositors will receive up to \$250,000 of their money in each account, which is enough for almost all individuals, although not sufficient for many businesses. Since the United States enacted deposit insurance in the 1930s, no one has lost any of their insured deposits. Bank runs no longer happen at insured banks.
Lender of Last Resort
The problem with bank runs is not that insolvent banks will fail; they are, after all, bankrupt and need to be shut down. The problem is that bank runs can cause solvent banks to fail and spread to the rest of the financial system. To prevent this, the Fed stands ready to lend to banks and other financial institutions when they cannot obtain funds from anywhere else. This is known as the lender of last resort role. For banks, the central bank acting as a lender of last resort helps to reinforce the effect of deposit insurance and to reassure bank customers that they will not lose their money.
The lender of last resort task can arise in other financial crises, as well. During the 1987 stock market crash panic, when U.S. stock values fell by 25% in a single day, the Federal Reserve made a number of short-term emergency loans so that the financial system could keep functioning. During the 2008-2009 recession, we can interpret the Fed's “quantitative easing” policies (discussed below) as a willingness to make short-term credit available as needed in a time when the banking and financial system was under stress. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/15%3A_Monetary_Policy_and_Bank_Regulation/15.03%3A_Bank_Regulation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the reason for open market operations
• Evaluate reserve requirements and discount rates
• Interpret and show bank activity through balance sheets
The Federal Reserve's most important function is to conduct the nation’s monetary policy. Article I, Section 8 of the U.S. Constitution gives Congress the power “to coin money” and “to regulate the value thereof.” As part of the 1913 legislation that created the Federal Reserve, Congress delegated these powers to the Fed. Monetary policy involves managing interest rates and credit conditions, which influences the level of economic activity, as we describe in more detail below.
A central bank has three traditional tools to implement monetary policy in the economy:
• Open market operations
• Changing reserve requirements
• Changing the discount rate
In discussing how these three tools work, it is useful to think of the central bank as a “bank for banks”—that is, each private-sector bank has its own account at the central bank. We will discuss each of these monetary policy tools in the sections below.
Open Market Operations
Since the early 1920s, the most common monetary policy tool in the U.S. has been open market operations. These take place when the central bank sells or buys U.S. Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates. The specific interest rate targeted in open market operations is the federal funds rate. The name is a bit of a misnomer since the federal funds rate is the interest rate that commercial banks charge making overnight loans to other banks. As such, it is a very short term interest rate, but one that reflects credit conditions in financial markets very well.
The Federal Open Market Committee (FOMC) makes the decisions regarding these open market operations. The FOMC comprises seven members of the Federal Reserve’s Board of Governors. It also includes five voting members who the Board draws, on a rotating basis, from the regional Federal Reserve Banks. The New York district president is a permanent FOMC voting member and the Board fills other four spots on a rotating, annual basis, from the other 11 districts. The FOMC typically meets every six weeks, but it can meet more frequently if necessary. The FOMC tries to act by consensus; however, the Federal Reserve's chairman has traditionally played a very powerful role in defining and shaping that consensus. For the Federal Reserve, and for most central banks, open market operations have, over the last few decades, been the most commonly used tool of monetary policy.
Link It Up
Visit this website for the Federal Reserve to learn more about current monetary policy.
To understand how open market operations affect the money supply, consider the balance sheet of Happy Bank, displayed in Figure 15.5. Figure 15.5 (a) shows that Happy Bank starts with \$460 million in assets, divided among reserves, bonds and loans, and \$400 million in liabilities in the form of deposits, with a net worth of \$60 million. When the central bank purchases \$20 million in bonds from Happy Bank, the bond holdings of Happy Bank fall by \$20 million and the bank’s reserves rise by \$20 million, as Figure 15.5 (b) shows. However, Happy Bank only wants to hold \$40 million in reserves (the quantity of reserves with which it started in Figure 15.5) (a), so the bank decides to loan out the extra \$20 million in reserves and its loans rise by \$20 million, as Figure 15.5(c) shows. The central bank's open market operation causes Happy Bank to make loans instead of holding its assets in the form of government bonds, which expands the money supply. As the new loans are deposited in banks throughout the economy, these banks will, in turn, loan out some of the deposits they receive, triggering the money multiplier that we discussed in Money and Banking.
Figure 15.5
Where did the Federal Reserve get the \$20 million that it used to purchase the bonds? A central bank has the power to create money. In practical terms, the Federal Reserve would write a check to Happy Bank, so that Happy Bank can have that money credited to its bank account at the Federal Reserve. In truth, the Federal Reserve created the money to purchase the bonds out of thin air—or with a few clicks on some computer keys.
Open market operations can also reduce the quantity of money and loans in an economy. Figure 15.6 (a) shows the balance sheet of Happy Bank before the central bank sells bonds in the open market. When Happy Bank purchases \$30 million in bonds, Happy Bank sends \$30 million of its reserves to the central bank, but now holds an additional \$30 million in bonds, as Figure 15.6 (b) shows. However, Happy Bank wants to hold \$40 million in reserves, as in Figure 15.6 (a), so it will adjust down the quantity of its loans by \$30 million, to bring its reserves back to the desired level, as Figure 15.6 (c) shows. In practical terms, a bank can easily reduce its quantity of loans. At any given time, a bank is receiving payments on loans that it made previously and also making new loans. If the bank just slows down or briefly halts making new loans, and instead adds those funds to its reserves, then its overall quantity of loans will decrease. A decrease in the quantity of loans also means fewer deposits in other banks, and other banks reducing their lending as well, as the money multiplier that we discussed in Money and Banking takes effect. What about all those bonds? How do they affect the money supply? Read the following Clear It Up feature for the answer.
Figure 15.6
Clear It Up
Does selling or buying bonds increase the money supply?
Is it a sale of bonds by the central bank which increases bank reserves and lowers interest rates or is it a purchase of bonds by the central bank? The easy way to keep track of this is to treat the central bank as being outside the banking system. When a central bank buys bonds, money is flowing from the central bank to individual banks in the economy, increasing the money supply in circulation. When a central bank sells bonds, then money from individual banks in the economy is flowing into the central bank—reducing the quantity of money in the economy.
The Federal Reserve was founded in the aftermath of the 1907 Financial Panic when many banks failed as a result of bank runs. As mentioned earlier, since banks make profits by lending out their deposits, no bank, even those that are not bankrupt, can withstand a bank run. As a result of the Panic, the Federal Reserve was founded to be the “lender of last resort.” In the event of a bank run, sound banks, (banks that were not bankrupt) could borrow as much cash as they needed from the Fed’s discount “window” to quell the bank run. We call the interest rate banks pay for such loans the discount rate. (They are so named because the bank makes loans against its outstanding loans “at a discount” of their face value.) Once depositors became convinced that the bank would be able to honor their withdrawals, they no longer had a reason to make a run on the bank. In short, the Federal Reserve was originally intended to provide credit passively, but in the years since its founding, the Fed has taken on a more active role with monetary policy.
The second traditional method for conducting monetary policy is to raise or lower the discount rate. If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed, and instead call in loans to replace those reserves. Since fewer loans are available, the money supply falls and market interest rates rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse.
In recent decades, the Federal Reserve has made relatively few discount loans. Before a bank borrows from the Federal Reserve to fill out its required reserves, the bank is expected to first borrow from other available sources, like other banks. This is encouraged by the Fed charging a higher discount rate than the federal funds rate. Given that most banks borrow little at the discount rate, changing the discount rate up or down has little impact on their behavior. More importantly, the Fed has found from experience that open market operations are a more precise and powerful means of executing any desired monetary policy.
Changing Reserve Requirements
A potential third method of conducting monetary policy is for the central bank to raise or lower the reserve requirement, which, as we noted earlier, is the percentage of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank. If banks are required to hold a greater amount in reserves, they have less money available to lend out. If banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out.
Until very recently, the Federal Reserve required banks to hold reserves equal to 0% of the first \$14.5 million in deposits, then to hold reserves equal to 3% of the deposits up to \$103.6 million, and 10% of any amount above \$103.6 million. The Fed makes small changes in the reserve requirements almost every year. For example, the \$103.6 million dividing line is sometimes bumped up or down by a few million dollars. Today, these rates are no longer in effect; as of March 2020 (when the pandemic-induced recession hit), the 10% and 3% requirements were reduced to 0%, effectively eliminating the reserve requirement for all depository institutions.
The Fed rarely uses large changes in reserve requirements to execute monetary policy; the pandemic was an exception for obvious reasons. Also, a sudden demand that all banks increase their reserves would be extremely disruptive and difficult for them to comply. While loosening requirements too much might create a danger of banks’ inability to meet withdrawal demands, the benefits of reducing the reserve requirements in March 2020 exceeded the risks.
Changing the Discount Rate
In the Federal Reserve Act, the phrase “...to afford means of rediscounting commercial paper” is contained in its long title. This was the main tool for monetary policy when the Fed was initially created. Today, the Federal Reserve has even more tools at its disposal, including quantitative easing, overnight repurchase agreements, and interest on excess reserves. This illustrates how monetary policy has evolved and how it continues to do so.
Link It Up
While these topics are beyond the scope of an introductory textbook, if you’re interested in learning more about the Federal Reserve’s newest policy tools, visit the Federal Reserve Bank of New York's page on large-scale asset purchases and the Federal Reserve Bank of St. Louis' FRED Blog post on fixing the textbook lag to learn more. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/15%3A_Monetary_Policy_and_Bank_Regulation/15.04%3A_How_a_Central_Bank_Executes_Monetary_Policy.txt |
Learning Objectives
By the end of this section, you will be able to:
• Contrast expansionary monetary policy and contractionary monetary policy
• Explain how monetary policy impacts interest rates and aggregate demand
• Evaluate Federal Reserve decisions over the last forty years
• Explain the significance of quantitative easing (QE)
A monetary policy that lowers interest rates and stimulates borrowing is an expansionary monetary policy or loose monetary policy. Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy or tight monetary policy. This module will discuss how expansionary and contractionary monetary policies affect interest rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation. We will conclude with a look at the Fed’s monetary policy practice in recent decades.
The Effect of Monetary Policy on Interest Rates
Consider the market for loanable bank funds in Figure 15.7. The original equilibrium (E0) occurs at an 8% interest rate and a quantity of funds loaned and borrowed of \$10 billion. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to S1, leading to an equilibrium (E1) with a lower 6% interest rate and a quantity \$14 billion in loaned funds. Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to S2, leading to an equilibrium (E2) with a higher 10% interest rate and a quantity of \$8 billion in loaned funds.
Figure 15.7 Monetary Policy and Interest Rates The original equilibrium occurs at E0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to the new supply curve (S1) and to a new equilibrium of E1, reducing the interest rate from 8% to 6%. A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to the new supply (S2), and raise the interest rate from 8% to 10%.
How does a central bank “raise” interest rates? When describing the central bank's monetary policy actions, it is common to hear that the central bank “raised interest rates” or “lowered interest rates.” We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds. As a result, Figure 15.7 shows that interest rates change. If they do not meet the Fed’s target, the Fed can supply more or less reserves until interest rates do.
Recall that the specific interest rate the Fed targets is the federal funds rate. The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations.
Of course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that they must repay over different periods of time. In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise. However, a fall or rise of one percentage point in the federal funds rate—which remember is for borrowing overnight—will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car. Monetary policy can push the entire spectrum of interest rates higher or lower, but the forces of supply and demand in those specific markets for lending and borrowing set the specific interest rates.
The Effect of Monetary Policy on Aggregate Demand
Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars. Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items.
If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. Figure 15.8 (a) illustrates this situation. This example uses a short-run upward-sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a recession of E0 occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD0) to shift right to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700.
Figure 15.8 Expansionary or Contractionary Monetary Policy (a) The economy is originally in a recession with the equilibrium output and price shown at E0. Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from AD0 to AD1, leading to the new equilibrium (E1) at the potential GDP level of output with a relatively small rise in the price level. (b) The economy is originally producing above the potential GDP level of output at the equilibrium E0 and is experiencing pressures for an inflationary rise in the price level. Contractionary monetary policy will shift aggregate demand to the left from AD0 to AD1, thus leading to a new equilibrium (E1) at the potential GDP level of output.
Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In Figure 15.8 (b), the original equilibrium (E0) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD0) to shift left to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700.
These examples suggest that monetary policy should be countercyclical; that is, it should act to counterbalance the business cycles of economic downturns and upswings. The Fed should loosen monetary policy when a recession has caused unemployment to increase and tighten it when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. Figure 15.9 (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level.
Figure 15.9 The Pathways of Monetary Policy (a) In expansionary monetary policy the central bank causes the supply of money and loanable funds to increase, which lowers the interest rate, stimulating additional borrowing for investment and consumption, and shifting aggregate demand right. The result is a higher price level and, at least in the short run, higher real GDP. (b) In contractionary monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower price level and, at least in the short run, lower real GDP.
Federal Reserve Actions Over Last Four Decades
For the period from 1970 through 2020, we can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market operations.
Of course, telling the story of the U.S. economy since 1970 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic growth, and inflation over this time. The ten episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U.S. economy is probably the Federal Reserve chairperson.
Figure 15.10 shows how the Federal Reserve has carried out monetary policy by targeting the federal funds interest rate in the last few decades. The graph shows the federal funds interest rate (remember, this interest rate is set through open market operations), the unemployment rate, and the inflation rate since 1970. Different episodes of monetary policy during this period are indicated in the figure.
Figure 15.10 Monetary Policy, Unemployment, and Inflation Through the episodes here, the Federal Reserve typically reacted to higher inflation with a contractionary monetary policy and a higher interest rate, and reacted to higher unemployment with an expansionary monetary policy and a lower interest rate.
Episode 1
Consider Episode 1 in the late 1970s. The rate of inflation was very high, exceeding 10% in 1979 and 1980, so the Federal Reserve used tight monetary policy to raise interest rates, with the federal funds rate rising from 5.5% in 1977 to 16.4% in 1981. By 1983, inflation was down to 3.2%, but aggregate demand contracted sharply enough that back-to-back recessions occurred in 1980 and in 1981–1982, and the unemployment rate rose from 5.8% in 1979 to 9.7% in 1982.
Episode 2
In Episode 2, when economists persuaded the Federal Reserve in the early 1980s that inflation was declining, the Fed began slashing interest rates to reduce unemployment. The federal funds interest rate fell from 16.4% in 1981 to 6.8% in 1986. By 1986 or so, inflation had fallen to about 2% and the unemployment rate had come down to 7%, and was still falling.
Episode 3
However, in Episode 3 in the late 1980s, inflation appeared to be creeping up again, rising from 2% in 1986 up toward 5% by 1989. In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6.6% in 1987 to 9.2% in 1989. The tighter monetary policy stopped inflation, which fell from above 5% in 1990 to under 3% in 1992, but it also helped to cause the 1990-1991 recession, and the unemployment rate rose from 5.3% in 1989 to 7.5% by 1992.
Episode 4
In Episode 4, in the early 1990s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.1% in 1990 to 3.5% in 1992. As the economy expanded, the unemployment rate declined from 7.5% in 1992 to less than 5% by 1997.
Episodes 5 and 6
In Episodes 5 and 6, the Federal Reserve perceived a risk of inflation and raised the federal funds rate from 3% to 5.8% from 1993 to 1995. Inflation did not rise, and the period of economic growth during the 1990s continued. Then in 1999 and 2000, the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4.6% in December 1998 to 6.5% in June 2000. By early 2001, inflation was declining again, but a recession occurred in 2001. Between 2000 and 2002, the unemployment rate rose from 4.0% to 5.8%.
Episodes 7 and 8
In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6.2% in 2000 to just 1.7% in 2002, and then again to 1% in 2003. They actually did this because of fear of Japan-style deflation. This persuaded them to lower the Fed funds further than they otherwise would have. The recession ended, but, unemployment rates were slow to decline in the early 2000s. Finally, in 2004, the unemployment rate declined and the Federal Reserve began to raise the federal funds rate until it reached 5% by 2007.
Episode 9
In Episode 9, as the Great Recession took hold in 2008, the Federal Reserve was quick to slash interest rates, taking them down to 2% in 2008 and to nearly 0% in 2009. When the Fed had taken interest rates down to near-zero, the economy was still deep in recession. Open market operations could not make the interest rate turn negative. The Federal Reserve had to think “outside the box.”
Episode 10
In Episode 10, which started in March 2020, the Fed cut interest rates again, reducing the target federal funds rate from 2% to between 0–1/4% in a matter of weeks. Limited by the zero lower bound, the Fed once again had to think “outside the box” in order to further support the financial system.
Quantitative Easing
The most powerful and commonly used of the three traditional tools of monetary policy—open market operations—works by expanding or contracting the money supply in a way that influences the interest rate. In late 2008, as the U.S. economy struggled with recession, the Federal Reserve had already reduced the interest rate to near-zero. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing (QE). This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand.
Quantitative easing differed from traditional monetary policy in several key ways. First, it involved the Fed purchasing long term Treasury bonds, rather than short term Treasury bills. In 2008, however, it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get. (Read the closing Bring it Home feature for more on this.) Therefore, Chairman Bernanke sought to lower long-term rates utilizing quantitative easing.
This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed “toxic assets,” because when the housing market collapsed, no one knew what these securities were worth, which put the financial institutions which were holding those securities on very shaky ground. By offering to purchase mortgage-backed securities, the Fed was both pushing long term interest rates down and also removing possibly “toxic assets” from the balance sheets of private financial firms, which would strengthen the financial system.
Quantitative easing (QE) occurred in three episodes:
1. During QE1, which began in November 2008, the Fed purchased \$600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac.
2. In November 2010, the Fed began QE2, in which it purchased \$600 billion in U.S. Treasury bonds.
3. QE3, began in September 2012 when the Fed commenced purchasing \$40 billion of additional mortgage-backed securities per month. This amount was increased in December 2012 to \$85 billion per month. The Fed stated that, when economic conditions permit, it will begin tapering (or reducing the monthly purchases). By October 2014, the Fed had announced the final \$15 billion bond purchase, ending Quantitative Easing.
We usually think of the quantitative easing policies that the Federal Reserve adopted (as did other central banks around the world) as temporary emergency measures. If these steps are to be temporary, then the Federal Reserve will need to stop making these additional loans and sell off the financial securities it has accumulated. The concern is that the process of quantitative easing may prove more difficult to reverse than it was to enact. The evidence suggests that QE1 was somewhat successful, but that QE2 and QE3 have been less so.
Fast forward to March 2020, when the Fed under the leadership of Jerome Powell promised another round of asset purchases which was dubbed by some as “QE4,” intended once again to provide liquidity to a distressed financial system in the wake of the pandemic. This round was much faster, increasing Fed assets by \$2 trillion in just a few months. Recently, the Fed has begun to slow down the purchase of these assets once again through a taper, and the pace of the tapering is expected to increase through 2022. But as of the end of 2021, total Fed assets exceed \$8 trillion, compared to \$4 trillion in February 2020. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/15%3A_Monetary_Policy_and_Bank_Regulation/15.05%3A_Monetary_Policy_and_Economic_Outcomes.txt |
Learning Objectives
By the end of this section, you will be able to:
• Analyze whether monetary policy decisions should be made more democratically
• Calculate the velocity of money
• Evaluate the central bank’s influence on inflation, unemployment, asset bubbles, and leverage cycles
• Calculate the effects of monetary stimulus
In the real world, effective monetary policy faces a number of significant hurdles. Monetary policy affects the economy only after a time lag that is typically long and of variable length. Remember, monetary policy involves a chain of events: the central bank must perceive a situation in the economy, hold a meeting, and make a decision to react by tightening or loosening monetary policy. The change in monetary policy must percolate through the banking system, changing the quantity of loans and affecting interest rates. When interest rates change, businesses must change their investment levels and consumers must change their borrowing patterns when purchasing homes or cars. Then it takes time for these changes to filter through the rest of the economy.
As a result of this chain of events, monetary policy has little effect in the immediate future. Instead, its primary effects are felt perhaps one to three years in the future. The reality of long and variable time lags does not mean that a central bank should refuse to make decisions. It does mean that central banks should be humble about taking action, because of the risk that their actions can create as much or more economic instability as they resolve.
Excess Reserves
Banks are legally required to hold a minimum level of reserves, but no rule prohibits them from holding additional excess reserves above the legally mandated limit. For example, during a recession banks may be hesitant to lend, because they fear that when the economy is contracting, a high proportion of loan applicants become less likely to repay their loans.
When many banks are choosing to hold excess reserves, expansionary monetary policy may not work well. This may occur because the banks are concerned about a deteriorating economy, while the central bank is trying to expand the money supply. If the banks prefer to hold excess reserves above the legally required level, the central bank cannot force individual banks to make loans. Similarly, sensible businesses and consumers may be reluctant to borrow substantial amounts of money in a recession, because they recognize that firms’ sales and employees’ jobs are more insecure in a recession, and they do not want to face the need to make interest payments. The result is that during an especially deep recession, an expansionary monetary policy may have little effect on either the price level or the real GDP.
Japan experienced this situation in the 1990s and early 2000s. Japan’s economy entered a period of very slow growth, dipping in and out of recession, in the early 1990s. By February 1999, the Bank of Japan had lowered the equivalent of its federal funds rate to 0%. It kept it there most of the time through 2003. Moreover, in the two years from March 2001 to March 2003, the Bank of Japan also expanded the country's money supply by about 50%—an enormous increase. Even this highly expansionary monetary policy, however, had no substantial effect on stimulating aggregate demand. Japan’s economy continued to experience extremely slow growth into the mid-2000s.
Clear It Up
Should monetary policy decisions be made more democratically?
Should a nation’s Congress or legislature comprised of elected representatives conduct monetary policy or should a politically appointed central bank that is more independent of voters take charge? Here are some of the arguments.
The Case for Greater Democratic Control of Monetary Policy
Elected representatives pass taxes and spending bills to conduct fiscal policy by passing tax and spending bills. They could handle monetary policy in the same way. They will sometimes make mistakes, but in a democracy, it is better to have elected officials who are accountable to voters make mistakes instead of political appointees. After all, the people appointed to the top governing positions at the Federal Reserve—and to most central banks around the world—are typically bankers and economists. They are not representatives of borrowers like small businesses or farmers nor are they representatives of labor unions. Central banks might not be so quick to raise interest rates if they had to pay more attention to firms and people in the real economy.
The Case for an Independent Central Bank
Because the central bank has some insulation from day-to-day politics, its members can take a nonpartisan look at specific economic situations and make tough, immediate decisions when necessary. The idea of giving a legislature the ability to create money and hand out loans is likely to end up badly, sooner or later. It is simply too tempting for lawmakers to expand the money supply to fund their projects. The long term result will be rampant inflation. Also, a central bank, acting according to the laws passed by elected officials, can respond far more quickly than a legislature. For example, the U.S. budget takes months to debate, pass, and sign into law, but monetary policy decisions happen much more rapidly. Day-to-day democratic control of monetary policy is impractical and seems likely to lead to an overly expansionary monetary policy and higher inflation.
The problem of excess reserves does not affect contractionary policy. Central bankers have an old saying that monetary policy can be like pulling and pushing on a string: when the central bank pulls on the string and uses contractionary monetary policy, it can definitely raise interest rates and reduce aggregate demand. However, when the central bank tries to push on the string of expansionary monetary policy, the string may sometimes just fold up limp and have little effect, because banks decide not to loan out their excess reserves. Do not take this analogy too literally—expansionary monetary policy usually does have real effects, after that inconveniently long and variable lag. There are also times, like Japan’s economy in the late 1990s and early 2000s, when expansionary monetary policy has been insufficient to lift a recession-prone economy.
Unpredictable Movements of Velocity
Velocity is a term that economists use to describe how quickly money circulates through the economy. We define the velocity of money in a year as:
$Velocity = nominal GDPmoney supplyVelocity = nominal GDPmoney supply$
Specific measurements of velocity depend on the definition of the money supply used. Consider the velocity of M1, the total amount of currency in circulation and checking account balances. In 2009, for example, M1 was \$1.7 trillion and nominal GDP was \$14.3 trillion, so the velocity of M1 was 8.4 (which is \$14.3 trillion/\$1.7 trillion). A higher velocity of money means that the average dollar circulates more times in a year. A lower velocity means that the average dollar circulates fewer times in a year.
See the following Clear It Up feature for a discussion of how deflation could affect monetary policy.
Clear It Up
What happens during episodes of deflation?
Deflation occurs when the rate of inflation is negative; that is, instead of money having less purchasing power over time, as occurs with inflation, money is worth more. Deflation can make it very difficult for monetary policy to address a recession.
Remember that the real interest rate is the nominal interest rate minus the rate of inflation. If the nominal interest rate is 7% and the rate of inflation is 3%, then the borrower is effectively paying a 4% real interest rate. If the nominal interest rate is 7% and there is deflation of 2%, then the real interest rate is actually 9%. In this way, an unexpected deflation raises the real interest payments for borrowers. It can lead to a situation where borrowers do not repay an unexpectedly high number of loans, and banks find that their net worth is decreasing or negative. When banks are suffering losses, they become less able and eager to make new loans. Aggregate demand declines, which can lead to recession.
Then the double-whammy: After causing a recession, deflation can make it difficult for monetary policy to work. Say that the central bank uses expansionary monetary policy to reduce the nominal interest rate all the way to zero—but the economy has 5% deflation. As a result, the real interest rate is 5%, and because a central bank cannot make the nominal interest rate negative, expansionary policy cannot reduce the real interest rate further.
In the U.S. economy during the early 1930s, deflation was 6.7% per year from 1930–1933, which caused many borrowers to default on their loans and many banks to end up bankrupt, which in turn contributed substantially to the Great Depression. Not all episodes of deflation, however, end in economic depression. Japan, for example, experienced deflation of slightly less than 1% per year from 1999–2002, which hurt the Japanese economy, but it still grew by about 0.9% per year over this period. There is at least one historical example of deflation coexisting with rapid growth. The U.S. economy experienced deflation of about 1.1% per year over the quarter-century from 1876–1900, but real GDP also expanded at a rapid clip of 4% per year over this time, despite some occasional severe recessions.
The central bank should be on guard against deflation and, if necessary, use expansionary monetary policy to prevent any long-lasting or extreme deflation from occurring. Except in severe cases like the Great Depression, deflation does not guarantee economic disaster.
Changes in velocity can cause problems for monetary policy. To understand why, rewrite the definition of velocity so that the money supply is on the left-hand side of the equation. That is:
$Money supply × velocity = Nominal GDPMoney supply × velocity = Nominal GDP$
Recall from The Macroeconomic Perspective that
$Nominal GDP = Price Level (or GDP Deflator) × Real GDP.Nominal GDP = Price Level (or GDP Deflator) × Real GDP.$
Therefore,
$Money Supply × velocity = Nominal GDP = Price Level × Real GDP.Money Supply × velocity = Nominal GDP = Price Level × Real GDP.$
We sometimes call this equation the basic quantity equation of money but, as you can see, it is just the definition of velocity written in a different form. This equation must hold true, by definition.
If velocity is constant over time, then a certain percentage rise in the money supply on the left-hand side of the basic quantity equation of money will inevitably lead to the same percentage rise in nominal GDP—although this change could happen through an increase in inflation, or an increase in real GDP, or some combination of the two. If velocity is changing over time but in a constant and predictable way, then changes in the money supply will continue to have a predictable effect on nominal GDP. If velocity changes unpredictably over time, however, then the effect of changes in the money supply on nominal GDP becomes unpredictable.
Figure 15.11 illustrates the actual velocity of money in the U.S. economy as measured by using M1, the most common definition of the money supply. From 1960 up to about 1980, velocity appears fairly predictable; that is, it is increasing at a fairly constant rate. In the early 1980s, however, velocity as calculated with M1 becomes more variable. The reasons for these sharp changes in velocity remain a puzzle. Economists suspect that the changes in velocity are related to innovations in banking and finance which have changed how we are using money in making economic transactions: for example, the growth of electronic payments; a rise in personal borrowing and credit card usage; and accounts that make it easier for people to hold money in savings accounts, where it is counted as M2, right up to the moment that they want to write a check on the money and transfer it to M1. So far at least, it has proven difficult to draw clear links between these kinds of factors and the specific up-and-down fluctuations in M1. Given many changes in banking and the prevalence of electronic banking, economists now favor M2 as a measure of money rather than the narrower M1.
Figure 15.11 Velocity Calculated Using M1 Velocity is the nominal GDP divided by the money supply for a given year. We can calculate different measures of velocity by using different measures of the money supply. Velocity, as calculated by using M1, has lacked a steady trend since the 1980s, instead bouncing up and down. Note also that the redefinition of M1 to include savings deposits in 2020 (see Money and Banking) drastically increased M1 in 2020, causing velocity to plummet. (credit: Federal Reserve Bank of St. Louis)
Velocity Calculated Using M1
In the 1970s, when velocity as measured by M1 seemed predictable, a number of economists, led by Nobel laureate Milton Friedman (1912–2006), argued that the best monetary policy was for the central bank to increase the money supply at a constant growth rate. These economists argued that with the long and variable lags of monetary policy, and the political pressures on central bankers, central bank monetary policies were as likely to have undesirable as to have desirable effects. Thus, these economists believed that the monetary policy should seek steady growth in the money supply of 3% per year. They argued that a steady monetary growth rate would be correct over longer time periods, since it would roughly match the growth of the real economy. In addition, they argued that giving the central bank less discretion to conduct monetary policy would prevent an overly activist central bank from becoming a source of economic instability and uncertainty. In this spirit, Friedman wrote in 1967: “The first and most important lesson that history teaches about what monetary policy can do—and it is a lesson of the most profound importance—is that monetary policy can prevent money itself from being a major source of economic disturbance.”
As the velocity of M1 began to fluctuate in the 1980s, having the money supply grow at a predetermined and unchanging rate seemed less desirable, because as the quantity theory of money shows, the combination of constant growth in the money supply and fluctuating velocity would cause nominal GDP to rise and fall in unpredictable ways. The jumpiness of velocity in the 1980s caused many central banks to focus less on the rate at which the quantity of money in the economy was increasing, and instead to set monetary policy by reacting to whether the economy was experiencing or in danger of higher inflation or unemployment.
Unemployment and Inflation
If you were to survey central bankers around the world and ask them what they believe should be the primary task of monetary policy, the most popular answer by far would be fighting inflation. Most central bankers believe that the neoclassical model of economics accurately represents the economy over the medium to long term. Remember that in the neoclassical model of the economy, we draw the aggregate supply curve as a vertical line at the level of potential GDP, as Figure 15.12 shows. In the neoclassical model, economists determine the level of potential GDP (and the natural rate of unemployment that exists when the economy is producing at potential GDP) by real economic factors. If the original level of aggregate demand is AD0, then an expansionary monetary policy that shifts aggregate demand to AD1 only creates an inflationary increase in the price level, but it does not alter GDP or unemployment. From this perspective, all that monetary policy can do is to lead to low inflation or high inflation—and low inflation provides a better climate for a healthy and growing economy. After all, low inflation means that businesses making investments can focus on real economic issues, not on figuring out ways to protect themselves from the costs and risks of inflation. In this way, a consistent pattern of low inflation can contribute to long-term growth.
Figure 15.12 Monetary Policy in a Neoclassical Model In a neoclassical view, monetary policy affects only the price level, not the level of output in the economy. For example, an expansionary monetary policy causes aggregate demand to shift from the original AD0 to AD1. However, the adjustment of the economy from the original equilibrium (E0) to the new equilibrium (E1) represents an inflationary increase in the price level from P0 to P1, but has no effect in the long run on output or the unemployment rate. In fact, no shift in AD will affect the equilibrium quantity of output in this model.
This vision of focusing monetary policy on a low rate of inflation is so attractive that many countries have rewritten their central banking laws since in the 1990s to have their bank practice inflation targeting, which means that the central bank is legally required to focus primarily on keeping inflation low. By 2014, central banks in 28 countries, including Austria, Brazil, Canada, Israel, Korea, Mexico, New Zealand, Spain, Sweden, Thailand, and the United Kingdom faced a legal requirement to target the inflation rate. A notable exception is the Federal Reserve in the United States, which does not practice inflation-targeting. Instead, the law governing the Federal Reserve requires it to take both unemployment and inflation into account.
Economists have no final consensus on whether a central bank should be required to focus only on inflation or should have greater discretion. For those who subscribe to the inflation targeting philosophy, the fear is that politicians who are worried about slow economic growth and unemployment will constantly pressure the central bank to conduct a loose monetary policy—even if the economy is already producing at potential GDP. In some countries, the central bank may lack the political power to resist such pressures, with the result of higher inflation, but no long-term reduction in unemployment. The U.S. Federal Reserve has a tradition of independence, but central banks in other countries may be under greater political pressure. For all of these reasons—long and variable lags, excess reserves, unstable velocity, and controversy over economic goals—monetary policy in the real world is often difficult. The basic message remains, however, that central banks can affect aggregate demand through the conduct of monetary policy and in that way influence macroeconomic outcomes.
Asset Bubbles and Leverage Cycles
One long-standing concern about having the central bank focus on inflation and unemployment is that it may be overlooking certain other economic problems that are coming in the future. For example, from 1994 to 2000 during what was known as the “dot-com” boom, the U.S. stock market, which the Dow Jones Industrial Index measures (which includes 30 very large companies from across the U.S. economy), nearly tripled in value. The Nasdaq index, which includes many smaller technology companies, increased in value by a multiple of five from 1994 to 2000. These rates of increase were clearly not sustainable. Stock values as measured by the Dow Jones were almost 20% lower in 2009 than they had been in 2000. Stock values in the Nasdaq index were 50% lower in 2009 than they had been in 2000. The drop-off in stock market values contributed to the 2001 recession and the higher unemployment that followed.
We can tell a similar story about housing prices in the mid-2000s. During the 1970s, 1980s, and 1990s, housing prices increased at about 6% per year on average. During what came to be known as the “housing bubble” from 2003 to 2005, housing prices increased at almost double this annual rate. These rates of increase were clearly not sustainable. When housing prices fell in 2007 and 2008, many banks and households found that their assets were worth less than they expected, which contributed to the recession that started in 2007.
At a broader level, some economists worry about a leverage cycle, where “leverage” is a term financial economists use to mean “borrowing.” When economic times are good, banks and the financial sector are eager to lend, and people and firms are eager to borrow. Remember that a money multiplier determines the amount of money and credit in an economy —a process of loans made, money deposited, and more loans made. In good economic times, this surge of lending exaggerates the episode of economic growth. It can even be part of what lead prices of certain assets—like stock prices or housing prices—to rise at unsustainably high annual rates. At some point, when economic times turn bad, banks and the financial sector become much less willing to lend, and credit becomes expensive or unavailable to many potential borrowers. The sharp reduction in credit, perhaps combined with the deflating prices of a dot-com stock price bubble or a housing bubble, makes the economic downturn worse than it would otherwise be.
Thus, some economists have suggested that the central bank should not just look at economic growth, inflation, and unemployment rates, but should also keep an eye on asset prices and leverage cycles. Such proposals are quite controversial. If a central bank had announced in 1997 that stock prices were rising “too fast” or in 2004 that housing prices were rising “too fast,” and then taken action to hold down price increases, many people and their elected political representatives would have been outraged. Neither the Federal Reserve nor any other central banks want to take the responsibility of deciding when stock prices and housing prices are too high, too low, or just right. As further research explores how asset price bubbles and leverage cycles can affect an economy, central banks may need to think about whether they should conduct monetary policy in a way that would seek to moderate these effects.
Let’s end this chapter with a Work it Out exercise in how the Fed—or any central bank—would stir up the economy by increasing the money supply.
Work It Out
Calculating the Effects of Monetary Stimulus
Suppose that the central bank wants to stimulate the economy by increasing the money supply. The bankers estimate that the velocity of money is 3, and that the price level will increase from 100 to 110 due to the stimulus. Using the quantity equation of money, what will be the impact of an \$800 billion dollar increase in the money supply on the quantity of goods and services in the economy given an initial money supply of \$4 trillion?
Step 1. We begin by writing the quantity equation of money: MV = PQ. We know that initially V = 3, M = 4,000 (billion) and P = 100. Substituting these numbers in, we can solve for Q:
$MV = PQ4,000 × 3 = 100 × QQ = 120MV = PQ4,000 × 3 = 100 × QQ = 120$
Step 2. Now we want to find the effect of the addition \$800 billion in the money supply, together with the increase in the price level. The new equation is:
$MV = PQ4,800 × 3 = 110 × QQ = 130.9MV = PQ4,800 × 3 = 110 × QQ = 130.9$
Step 3. If we take the difference between the two quantities, we find that the monetary stimulus increased the quantity of goods and services in the economy by 10.9 billion.
The discussion in this chapter has focused on domestic monetary policy; that is, the view of monetary policy within an economy. Exchange Rates and International Capital Flows explores the international dimension of monetary policy, and how monetary policy becomes involved with exchange rates and international flows of financial capital.
Bring It Home
The Problem of the Zero Percent Interest Rate Lower Bound
In 2008, the U.S. Federal Reserve found itself in a difficult position. The federal funds rate was on its way to near zero, which meant that traditional open market operations, by which the Fed purchases U.S. Treasury Bills to lower short term interest rates, was no longer viable. This so called “zero bound problem,” prompted the Fed, under then Chair Ben Bernanke, to attempt some unconventional policies, collectively called quantitative easing. By early 2014, quantitative easing nearly quintupled the amount of bank reserves. This likely contributed to the U.S. economy’s recovery, but the impact was muted, probably due to some of the hurdles mentioned in the last section of this module. The unprecedented increase in bank reserves also led to fears of inflation, which never bore out. Throughout the 2010s there have been no serious signs of inflation with core inflation around a stable 1.5–2%. As of early 2015, however, there have been no serious signs of a boom, with core inflation around a stable 1.7%.
The Zero Lower Bound was encountered again in 2020 due to the pandemic, when the target federal funds rate dropped by over two percentage points in a matter of weeks. The Fed further responded by increasing asset purchases by an even greater amount, and at a faster rate, than in 2009. When the U.S. started experiencing higher-than-average inflation in 2021, the Fed chair Jerome Powell responded to criticisms by saying that the Fed was poised to consider rate increases and start tapering the rate of asset purchases into 2022. It remains to be seen whether inflation can be tamed moving forward, or if more aggressive policy measures will be required. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/15%3A_Monetary_Policy_and_Bank_Regulation/15.06%3A_Pitfalls_for_Monetary_Policy.txt |
bank run
when depositors race to the bank to withdraw their deposits for fear that otherwise they would be lost
basic quantity equation of money
money supply × velocity = nominal GDP
central bank
institution which conducts a nation’s monetary policy and regulates its banking system
contractionary monetary policy
a monetary policy that reduces the supply of money and loans
countercyclical
moving in the opposite direction of the business cycle of economic downturns and upswings
deposit insurance
an insurance system that makes sure depositors in a bank do not lose their money, even if the bank goes bankrupt
discount rate
the interest rate charged by the central bank on the loans that it gives to other commercial banks
excess reserves
reserves banks hold that exceed the legally mandated limit
expansionary monetary policy
a monetary policy that increases the supply of money and the quantity of loans
federal funds rate
the interest rate at which one bank lends funds to another bank overnight
inflation targeting
a rule that the central bank is required to focus only on keeping inflation low
lender of last resort
an institution that provides short-term emergency loans in conditions of financial crisis
loose monetary policy
see expansionary monetary policy
open market operations
the central bank selling or buying Treasury bonds to influence the quantity of money and the level of interest rates
quantitative easing (QE)
the purchase of long term government and private mortgage-backed securities by central banks to make credit available in hopes of stimulating aggregate demand
reserve requirement
the percentage amount of its total deposits that a bank is legally obligated to either hold as cash in their vault or deposit with the central bank
tight monetary policy
see contractionary monetary policy
velocity
the speed with which money circulates through the economy; calculated as the nominal GDP divided by the money supply
15.08: Key Concepts and Summary
15.1 The Federal Reserve Banking System and Central Banks
The most prominent task of a central bank is to conduct monetary policy, which involves changes to interest rates and credit conditions, affecting the amount of borrowing and spending in an economy. Some prominent central banks around the world include the U.S. Federal Reserve, the European Central Bank, the Bank of Japan, and the Bank of England.
15.2 Bank Regulation
A bank run occurs when there are rumors (possibly true, possibly false) that a bank is at financial risk of having negative net worth. As a result, depositors rush to the bank to withdraw their money and put it someplace safer. Even false rumors, if they cause a bank run, can force a healthy bank to lose its deposits and be forced to close. Deposit insurance guarantees bank depositors that, even if the bank has negative net worth, their deposits will be protected. In the United States, the Federal Deposit Insurance Corporation (FDIC) collects deposit insurance premiums from banks and guarantees bank deposits up to \$250,000. Bank supervision involves inspecting the balance sheets of banks to make sure that they have positive net worth and that their assets are not too risky. In the United States, the Office of the Comptroller of the Currency (OCC) is responsible for supervising banks and inspecting savings and loans and the National Credit Union Administration (NCUA) is responsible for inspecting credit unions. The FDIC and the Federal Reserve also play a role in bank supervision.
When a central bank acts as a lender of last resort, it makes short-term loans available in situations of severe financial panic or stress. The failure of a single bank can be treated like any other business failure. Yet if many banks fail, it can reduce aggregate demand in a way that can bring on or deepen a recession. The combination of deposit insurance, bank supervision, and lender of last resort policies help to prevent weaknesses in the banking system from causing recessions.
15.3 How a Central Bank Executes Monetary Policy
A central bank has three traditional tools to conduct monetary policy: open market operations, which involves buying and selling government bonds with banks; reserve requirements, which determine what level of reserves a bank is legally required to hold; and discount rates, which is the interest rate charged by the central bank on the loans that it gives to other commercial banks. The most commonly used tool is open market operations.
15.4 Monetary Policy and Economic Outcomes
An expansionary (or loose) monetary policy raises the quantity of money and credit above what it otherwise would have been and reduces interest rates, boosting aggregate demand, and thus countering recession. A contractionary monetary policy, also called a tight monetary policy, reduces the quantity of money and credit below what it otherwise would have been and raises interest rates, seeking to hold down inflation. During the 2008–2009 recession, central banks around the world also used quantitative easing to expand the supply of credit.
15.5 Pitfalls for Monetary Policy
Monetary policy is inevitably imprecise, for a number of reasons: (a) the effects occur only after long and variable lags; (b) if banks decide to hold excess reserves, monetary policy cannot force them to lend; and (c) velocity may shift in unpredictable ways. The basic quantity equation of money is MV = PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q is the real output of the economy. Some central banks, like the European Central Bank, practice inflation targeting, which means that the only goal of the central bank is to keep inflation within a low target range. Other central banks, such as the U.S. Federal Reserve, are free to focus on either reducing inflation or stimulating an economy that is in recession, whichever goal seems most important at the time. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/15%3A_Monetary_Policy_and_Bank_Regulation/15.07%3A_Key_Terms.txt |
1.
Why is it important for the members of the Board of Governors of the Federal Reserve to have longer terms in office than elected officials, like the President?
2.
Given the danger of bank runs, why do banks not keep the majority of deposits on hand to meet the demands of depositors?
3.
Bank runs are often described as “self-fulfilling prophecies.” Why is this phrase appropriate to bank runs?
4.
If the central bank sells \$500 in bonds to a bank that has issued \$10,000 in loans and is exactly meeting the reserve requirement of 10%, what will happen to the amount of loans and to the money supply in general?
5.
What would be the effect of increasing the banks' reserve requirements on the money supply?
6.
Why does contractionary monetary policy cause interest rates to rise?
7.
Why does expansionary monetary policy causes interest rates to drop?
8.
Why might banks want to hold excess reserves in time of recession?
9.
Why might the velocity of money change unexpectedly?
15.10: Review Questions
10.
How is a central bank different from a typical commercial bank?
11.
List the three traditional tools that a central bank has for controlling the money supply.
12.
How is bank regulation linked to the conduct of monetary policy?
13.
What is a bank run?
14.
In a program of deposit insurance as it is operated in the United States, what is being insured and who pays the insurance premiums?
15.
In government programs of bank supervision, what is being supervised?
16.
What is the lender of last resort?
17.
Name and briefly describe the responsibilities of each of the following agencies: FDIC, NCUA, and OCC.
18.
Explain how to use an open market operation to expand the money supply.
19.
Explain how to use the reserve requirement to expand the money supply.
20.
Explain how to use the discount rate to expand the money supply.
21.
How do the expansionary and contractionary monetary policy affect the quantity of money?
22.
How do tight and loose monetary policy affect interest rates?
23.
How do expansionary, tight, contractionary, and loose monetary policy affect aggregate demand?
24.
Which kind of monetary policy would you expect in response to high inflation: expansionary or contractionary? Why?
25.
Explain how to use quantitative easing to stimulate aggregate demand.
26.
Which kind of monetary policy would you expect in response to recession: expansionary or contractionary? Why?
27.
How might each of the following factors complicate the implementation of monetary policy: long and variable lags, excess reserves, and movements in velocity?
28.
Define the velocity of the money supply.
29.
What is the basic quantity equation of money?
30.
How does a monetary policy of inflation target work?
15.11: Critical Thinking Questions
31.
Why do presidents typically reappoint Chairs of the Federal Reserve Board even when they were originally appointed by a president of a different political party?
32.
In what ways might monetary policy be superior to fiscal policy? In what ways might it be inferior?
33.
The term “moral hazard” describes increases in risky behavior resulting from efforts to make that behavior safer. How does the concept of moral hazard apply to deposit insurance and other bank regulations?
34.
Explain what would happen if banks were notified they had to increase their required reserves by one percentage point from, say, 9% to10% of deposits. What would their options be to come up with the cash?
35.
A well-known economic model called the Phillips Curve (discussed in The Keynesian Perspective chapter) describes the short run tradeoff typically observed between inflation and unemployment. Based on the discussion of expansionary and contractionary monetary policy, explain why one of these variables usually falls when the other rises.
36.
How does rule-based monetary policy differ from discretionary monetary policy (that is, monetary policy not based on a rule)? What are some of the arguments for each?
37.
Is it preferable for central banks to primarily target inflation or unemployment? Why?
15.12: Problems
38.
Suppose the Fed conducts an open market purchase by buying \$10 million in Treasury bonds from Acme Bank. Sketch out the balance sheet changes that will occur as Acme converts the bond sale proceeds to new loans. The initial Acme bank balance sheet contains the following information: Assets – reserves 30, bonds 50, and loans 50; Liabilities – deposits 100 and equity 30.
39.
Suppose the Fed conducts an open market sale by selling \$10 million in Treasury bonds to Acme Bank. Sketch out the balance sheet changes that will occur as Acme restores its required reserves (10% of deposits) by reducing its loans. The initial balance sheet for Acme Bank contains the following information: Assets – reserves 30, bonds 50, and loans 250; Liabilities – deposits 300 and equity 30.
40.
All other things being equal, by how much will nominal GDP expand if the central bank increases the money supply by \$100 billion, and the velocity of money is 3? (Use this information as necessary to answer the following 4 questions.)
41.
Suppose now that economists expect the velocity of money to increase by 50% as a result of the monetary stimulus. What will be the total increase in nominal GDP?
42.
If GDP is 1,500 and the money supply is 400, what is velocity?
43.
If GDP now rises to 1,600, but the money supply does not change, how has velocity changed?
44.
If GDP now falls back to 1,500 and the money supply falls to 350, what is velocity? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/15%3A_Monetary_Policy_and_Bank_Regulation/15.09%3A_Self-Check_Questions.txt |
Figure 16.1 Trade Around the World Is a trade deficit between the United States and the European Union good or bad for the U.S. economy? (Credit: modification of “US Dollar banknotes” by Milad Mosapoor/Wikimedia Commons, Public Domain)
Chapter Objectives
In this chapter, you will learn about:
• How the Foreign Exchange Market Works
• Demand and Supply Shifts in Foreign Exchange Markets
• Macroeconomic Effects of Exchange Rates
• Exchange Rate Policies
Bring It Home
Is a Stronger Dollar Good for the U.S. Economy?
From 2002 to 2008, the U.S. dollar lost more than a quarter of its value in foreign currency markets. On January 1, 2002, one dollar was worth 1.11 euros. On April 24, 2008 it hit its lowest point with a dollar being worth 0.64 euros. During this period, the trade deficit between the United States and the European Union grew from a yearly total of approximately 85.7 billion dollars in 2002 to 95.8 billion dollars in 2008. Was this a good thing or a bad thing for the U.S. economy?
We live in a global world. U.S. consumers buy trillions of dollars worth of imported goods and services each year, not just from the European Union, but from all over the world. U.S. businesses sell trillions of dollars’ worth of exports. U.S. citizens, businesses, and governments invest trillions of dollars abroad every year. Foreign investors, businesses, and governments invest trillions of dollars in the United States each year. Indeed, foreigners are a major buyer of U.S. federal debt.
Many people feel that a weaker dollar is bad for America, that it’s an indication of a weak economy, but is it? This chapter will help answer that question.
The world has over 150 different currencies, from the Afghanistan afghani and the Albanian lek all the way through the alphabet to the Zambian kwacha and the Zimbabwean dollar. For international economic transactions, households or firms will wish to exchange one currency for another. Perhaps the need for exchanging currencies will come from a German firm that exports products to Russia, but then wishes to exchange the Russian rubles it has earned for euros, so that the firm can pay its workers and suppliers in Germany. Perhaps it will be a South African firm that wishes to purchase a mining operation in Angola, but to make the purchase it must convert South African rand to Angolan kwanza. Perhaps it will be an American tourist visiting China, who wishes to convert U.S. dollars to Chinese yuan to pay the hotel bill.
Exchange rates can sometimes change very swiftly. For example, in the United Kingdom the pound was worth about \$1.50 just before the nation voted to leave the European Union (also known as the Brexit vote), in June 2016; the pound fell to \$1.37 just after the vote and continued falling to reach 30-year lows a few months later. For firms engaged in international buying, selling, lending, and borrowing, these swings in exchange rates can have an enormous effect on profits.
This chapter discusses the international dimension of money, which involves conversions from one currency to another at an exchange rate. An exchange rate is nothing more than a price—that is, the price of one currency in terms of another currency—and so we can analyze it with the tools of supply and demand. The first module of this chapter begins with an overview of foreign exchange markets: their size, their main participants, and the vocabulary for discussing movements of exchange rates. The following module uses demand and supply graphs to analyze some of the main factors that cause shifts in exchange rates. A final module then brings the central bank and monetary policy back into the picture. Each country must decide whether to allow the market to determine its exchange rate, or have the central bank intervene. All the choices for exchange rate policy involve distinctive tradeoffs and risks. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/16%3A_Exchange_Rates_and_International_Capital_Flows/16.01%3A_Introduction_to_Exchange_Rates_and_International_Capital_Flows.txt |
Learning Objectives
By the end of this section, you will be able to:
• Define "foreign exchange market"
• Describe different types of investments like foreign direct investments (FDI), portfolio investments, and hedging
• Explain how appreciating or depreciating currency affects exchange rates
• Identify who benefits from a stronger currency and benefits from a weaker currency
Most countries have different currencies, but not all. Sometimes small economies use an economically larger neighbor's currency. For example, Ecuador, El Salvador, and Panama have decided to dollarize—that is, to use the U.S. dollar as their currency. Sometimes nations share a common currency. A large-scale example of a common currency is the decision by 17 European nations—including some very large economies such as France, Germany, and Italy—to replace their former currencies with the euro at the start of 1999. With these exceptions, most of the international economy takes place in a situation of multiple national currencies in which both people and firms need to convert from one currency to another when selling, buying, hiring, borrowing, traveling, or investing across national borders. We call the market in which people or firms use one currency to purchase another currency the foreign exchange market.
You have encountered the basic concept of exchange rates in earlier chapters. In The International Trade and Capital Flows, for example, we discussed how economists use exchange rates to compare GDP statistics from countries where they measure GDP in different currencies. These earlier examples, however, took the actual exchange rate as given, as if it were a fact of nature. In reality, the exchange rate is a price—the price of one currency expressed in terms of units of another currency. The key framework for analyzing prices, whether in this course, any other economics course, in public policy, or business examples, is the operation of supply and demand in markets.
Link It Up
Visit this website for an exchange rate calculator.
The Extraordinary Size of the Foreign Exchange Markets
If you travel to a foreign country that uses a different currency, you will undoubtedly need to make a trip to a bank or foreign currency office to exchange whatever currency you’re holding for that country’s currency. Even though this is a simple transaction, it is part of a very large market. The quantities traded in foreign exchange markets are breathtaking. A 2019 Bank of International Settlements survey found that \$5.3 trillion per day was traded on foreign exchange markets, which makes the foreign exchange market the largest market in the world economy. In contrast, 2019 U.S. real GDP was \$21.4 trillion per year.
Your transaction is simple enough. Suppose you carry a \$100 bill. You bring it into the foreign currency office and look up, and you see a bunch of different numbers on a digital board. For example, if you are traveling to Turkey, whose national currency is the Turkish Lira, one line of the board might read: “U.S. DOLLARS: BUY 5.50; SELL 5.80.” This means that the office will give you 5.50 Turkish Lira in exchange for 1 U.S. dollar. If you have \$100, the office will give you 550 Turkish Lira. If you want to sell Turkish Lira for U.S. dollars, the office will surely buy them from you, but not at the same exchange rate, since the office will make some money on the exchange. So if you bring 550 Turkish Lira and ask for U.S. dollars, it will not give you 100 dollars, but instead about \$95. The important point is that this one transaction, when repeated all over the world for all sorts of different transactions, ends up totaling \$6.6 trillion worth of exchanges per day.
Table 16.1 shows the currencies most commonly traded on foreign exchange markets. The U.S. dollar dominates the foreign exchange market, being on one side of 88.3% of all foreign exchange transactions. The U.S. dollar is followed by the euro, the British pound, the Australian dollar, and the Japanese yen.
Currency % Daily Share
U.S. dollar 88.3%
Euro 32.3%
Japanese yen 16.8%
British pound 12.8%
Australian dollar 6.8%
Canadian dollar 5.0%
Swiss franc 5.0%
Chinese yuan 4.3%
Table 16.1 Currencies Traded Most on Foreign Exchange Markets as of September, 2019 The “% Daily Share” shows the percentage of transactions where the currency is on one side of the exchange. (Source: https://www.bis.org/statistics/rpfx19_fx.pdf)
Demanders and Suppliers of Currency in Foreign Exchange Markets
In foreign exchange markets, demand and supply become closely interrelated, because a person or firm who demands one currency must at the same time supply another currency—and vice versa. To get a sense of this, it is useful to consider four groups of people or firms who participate in the market: (1) firms that are involved in international trade of goods and services; (2) tourists visiting other countries; (3) international investors buying ownership (or part-ownership) of a foreign firm; (4) international investors making financial investments that do not involve ownership. Let’s consider these categories in turn.
Firms that buy and sell on international markets find that their costs for workers, suppliers, and investors are measured in the currency of the nation where their production occurs, but their revenues from sales are measured in the currency of the different nation where their sales happened. Thus, a Chinese firm exporting abroad will earn some other currency—say, U.S. dollars—but will need Chinese yuan to pay the workers, suppliers, and investors who are based in China. In the foreign exchange markets, this firm will be a supplier of U.S. dollars and a demander of Chinese yuan.
International tourists will supply their home currency to receive the currency of the country they are visiting. For example, an American tourist who is visiting China will supply U.S. dollars into the foreign exchange market and demand Chinese yuan.
We often divide financial investments that cross international boundaries, and require exchanging currency into two categories. Foreign direct investment (FDI) refers to purchasing a firm (at least ten percent) in another country or starting up a new enterprise in a foreign country For example, in 2008 the Belgian beer-brewing company InBev bought the U.S. beer-maker Anheuser-Busch for \$52 billion. To make this purchase, InBev would have to supply euros (the currency of Belgium) to the foreign exchange market and demand U.S. dollars.
The other kind of international financial investment, portfolio investment, involves a purely financial investment that does not entail any management responsibility. An example would be a U.S. financial investor who purchased U.K. government bonds, or deposited money in a British bank. To make such investments, the American investor would supply U.S. dollars in the foreign exchange market and demand British pounds.
Business people often link portfolio investment to expectations about how exchange rates will shift. Look at a U.S. financial investor who is considering purchasing U.K. issued bonds. For simplicity, ignore any bond interest payment (which will be small in the short run anyway) and focus on exchange rates. Say that a British pound is currently worth \$1.50 in U.S. currency. However, the investor believes that in a month, the British pound will be worth \$1.60 in U.S. currency. Thus, as Figure 16.2 (a) shows, this investor would change \$24,000 for 16,000 British pounds. In a month, if the pound is worth \$1.60, then the portfolio investor can trade back to U.S. dollars at the new exchange rate, and have \$25,600—a nice profit. A portfolio investor who believes that the foreign exchange rate for the pound will work in the opposite direction can also invest accordingly. Say that an investor expects that the pound, now worth \$1.50 in U.S. currency, will decline to \$1.40. Then, as Figure 16.2 (b) shows, that investor could start off with £20,000 in British currency (borrowing the money if necessary), convert it to \$30,000 in U.S. currency, wait a month, and then convert back to approximately £21,429 in British currency—again making a nice profit. Of course, this kind of investing comes without guarantees, and an investor will suffer losses if the exchange rates do not move as predicted.
Figure 16.2 A Portfolio Investor Trying to Benefit from Exchange Rate Movements Expectations of a currency's future value can drive its demand and supply in foreign exchange markets.
Many portfolio investment decisions are not as simple as betting that the currency's value will change in one direction or the other. Instead, they involve firms trying to protect themselves from movements in exchange rates. Imagine you are running a U.S. firm that is exporting to France. You have signed a contract to deliver certain products and will receive 1 million euros a year from now. However, you do not know how much this contract will be worth in U.S. dollars, because the dollar/euro exchange rate can fluctuate in the next year. Let’s say you want to know for sure what the contract will be worth, and not take a risk that the euro will be worth less in U.S. dollars than it currently is. You can hedge, which means using a financial transaction to protect yourself against a risk from one of your investments (in this case, currency risk from the contract). Specifically, you can sign a financial contract and pay a fee that guarantees you a certain exchange rate one year from now—regardless of what the market exchange rate is at that time. Now, it is possible that the euro will be worth more in dollars a year from now, so your hedging contract will be unnecessary, and you will have paid a fee for nothing. However, if the value of the euro in dollars declines, then you are protected by the hedge. When parties wish to enter financial contracts like hedging, they normally rely on a financial institution or brokerage company to handle the hedging. These companies either take a fee or create a spread in the exchange rate in order to earn money through the service they provide.
Both foreign direct investment and portfolio investment involve an investor who supplies domestic currency and demands a foreign currency. With portfolio investment, the client purchases less than ten percent of a company. As such, business players often get involved with portfolio investment with a short term focus. With foreign direct investment the investor purchases more than ten percent of a company and the investor typically assumes some managerial responsibility. Thus, foreign direct investment tends to have a more long-run focus. As a practical matter, an investor can withdraw portfolio investments from a country much more quickly than foreign direct investments. A U.S. portfolio investor who wants to buy or sell U.K. government bonds can do so with a phone call or a few computer keyboard clicks. However, a U.S. firm that wants to buy or sell a company, such as one that manufactures automobile parts in the United Kingdom, will find that planning and carrying out the transaction takes a few weeks, even months. Table 16.2 summarizes the main categories of currency demanders and suppliers.
Demand for the U.S. Dollar Comes from… Supply of the U.S. Dollar Comes from…
A U.S. exporting firm that earned foreign currency and is trying to pay U.S.-based expenses A foreign firm that has sold imported goods in the United States, earned U.S. dollars, and is trying to pay expenses incurred in its home country
Foreign tourists visiting the United States U.S. tourists leaving to visit other countries
Foreign investors who wish to make direct investments in the U.S. economy U.S. investors who want to make foreign direct investments in other countries
Foreign investors who wish to make portfolio investments in the U.S. economy U.S. investors who want to make portfolio investments in other countries
Table 16.2 The Demand and Supply Line-ups in Foreign Exchange Markets
Participants in the Exchange Rate Market
The foreign exchange market does not involve the ultimate suppliers and demanders of foreign exchange literally seeking each other. If Martina decides to leave her home in Venezuela and take a trip in the United States, she does not need to find a U.S. citizen who is planning to take a vacation in Venezuela and arrange a person-to-person currency trade. Instead, the foreign exchange market works through financial institutions, and it operates on several levels.
Most people and firms who are exchanging a substantial quantity of currency go to a bank, and most banks provide foreign exchange as a service to customers. These banks (and a few other firms), known as dealers, then trade the foreign exchange. This is called the interbank market.
In the world economy, roughly 2,000 firms are foreign exchange dealers. The U.S. economy has less than 100 foreign exchange dealers, but the largest 12 or so dealers carry out more than half the total transactions. The foreign exchange market has no central location, but the major dealers keep a close watch on each other at all times.
The foreign exchange market is huge not because of the demands of tourists, firms, or even foreign direct investment, but instead because of portfolio investment and the actions of interlocking foreign exchange dealers. International tourism is a very large industry, involving about \$1 trillion per year. Global exports are about 23.5% of global GDP or about \$19 trillion per year. Foreign direct investment totaled about \$870 billion in the end of 2021. These quantities are dwarfed, however, by the \$6.6 trillion per day traded in foreign exchange markets. Most transactions in the foreign exchange market are for portfolio investment—relatively short-term movements of financial capital between currencies—and because of the large foreign exchange dealers' actions as they constantly buy and sell with each other.
Strengthening and Weakening Currency
When the prices of most goods and services change, the price "rises or "falls". For exchange rates, the terminology is different. When the exchange rate for a currency rises, so that the currency exchanges for more of other currencies, we refer to it as appreciating or “strengthening.” When the exchange rate for a currency falls, so that a currency trades for less of other currencies, we refer to it as depreciating or “weakening.”
To illustrate the use of these terms, consider the exchange rate between the U.S. dollar and the Canadian dollar since 1980, in Figure 16.3 (a). The vertical axis in Figure 16.3 (a) shows the price of \$1 in U.S. currency, measured in terms of Canadian currency. Clearly, exchange rates can move up and down substantially. A U.S. dollar traded for \$1.17 Canadian in 1980. The U.S. dollar appreciated or strengthened to \$1.39 Canadian in 1986, depreciated or weakened to \$1.15 Canadian in 1991, and then appreciated or strengthened to \$1.60 Canadian by early in 2002, fell to roughly \$1.20 Canadian in 2009, and then had a sharp spike up and decline in 2009 and 2010. In August 2022, the U.S. dollar stood at \$1.28 Canadian. The units in which we measure exchange rates can be confusing, because we measure the exchange rate of the U.S. dollar exchange using a different currency—the Canadian dollar. However, exchange rates always measure the price of one unit of currency by using a different currency.
Figure 16.3 Strengthen or Appreciate vs. Weaken or Depreciate Exchange rates tend to fluctuate substantially, even between bordering companies such as the United States and Canada. By looking closely at the time values (the years vary slightly on these graphs), it is clear that the values in part (a) are a mirror image of part (b), which demonstrates that the depreciation of one currency correlates to the appreciation of the other and vice versa. This means that when comparing the exchange rates between two countries (in this case, the United States and Canada), the depreciation (or weakening) of one country (the U.S. dollar for this example) indicates the appreciation (or strengthening) of the other currency (which in this example is the Canadian dollar). (Source: Federal Reserve Economic Data (FRED) https://research.stlouisfed.org/fred2/series/EXCAUS)
In looking at the exchange rate between two currencies, the appreciation or strengthening of one currency must mean the depreciation or weakening of the other. Figure 16.3 (b) shows the exchange rate for the Canadian dollar, measured in terms of U.S. dollars. The exchange rate of the U.S. dollar measured in Canadian dollars, in Figure 16.3 (a), is a perfect mirror image with the Canadian dollar exchange rate measured in U.S. dollars, in Figure 16.3 (b). A fall in the Canada \$/U.S. \$ ratio means a rise in the U.S. \$/Canada \$ ratio, and vice versa.
Canadian Dollars per 1 U.S. Dollar.
With the price of a typical good or service, it is clear that higher prices benefit sellers and hurt buyers, while lower prices benefit buyers and hurt sellers. In the case of exchange rates, where the buyers and sellers are not always intuitively obvious, it is useful to trace how a stronger or weaker currency will affect different market participants. Consider, for example, the impact of a stronger U.S. dollar on six different groups of economic actors, as Figure 16.4 shows: (1) U.S. exporters selling abroad; (2) foreign exporters (that is, firms selling imports in the U.S. economy); (3) U.S. tourists abroad; (4) foreign tourists visiting the United States; (5) U.S. investors (either foreign direct investment or portfolio investment) considering opportunities in other countries; (6) and foreign investors considering opportunities in the U.S. economy.
Figure 16.4 How Do Exchange Rate Movements Affect Each Group? Exchange rate movements affect exporters, tourists, and international investors in different ways.
For a U.S. firm selling abroad, a stronger U.S. dollar is a curse. A strong U.S. dollar means that foreign currencies are correspondingly weak. When this exporting firm earns foreign currencies through its export sales, and then converts them back to U.S. dollars to pay workers, suppliers, and investors, the stronger dollar means that the foreign currency buys fewer U.S. dollars than if the currency had not strengthened, and that the firm’s profits (as measured in dollars) fall. As a result, the firm may choose to reduce its exports, or it may raise its selling price, which will also tend to reduce its exports. In this way, a stronger currency reduces a country’s exports.
Conversely, for a foreign firm selling in the U.S. economy, a stronger dollar is a blessing. Each dollar earned through export sales, when traded back into the exporting firm's home currency, will now buy more home currency than expected before the dollar had strengthened. As a result, the stronger dollar means that the importing firm will earn higher profits than expected. The firm will seek to expand its sales in the U.S. economy, or it may reduce prices, which will also lead to expanded sales. In this way, a stronger U.S. dollar means that consumers will purchase more from foreign producers, expanding the country’s level of imports.
For a U.S. tourist abroad, who is exchanging U.S. dollars for foreign currency as necessary, a stronger U.S. dollar is a benefit. The tourist receives more foreign currency for each U.S. dollar, and consequently the cost of the trip in U.S. dollars is lower. When a country’s currency is strong, it is a good time for citizens of that country to tour abroad. Imagine a U.S. tourist who has saved up \$5,000 for a trip to South Africa. In February 2018, \$1 bought 11.9 South African rand, so the tourist had 59,500 rand to spend. By 2018, \$1 bought 14.5 rand, which for the tourist translates to 72,500 rand. For foreign visitors to the United States, the opposite pattern holds true. A relatively stronger U.S. dollar means that their own currencies are relatively weaker, so that as they shift from their own currency to U.S. dollars, they have fewer U.S. dollars than previously. When a country’s currency is strong, it is not an especially good time for foreign tourists to visit.
A stronger dollar injures the prospects of a U.S. financial investor who has already invested money in another country. A U.S. financial investor abroad must first convert U.S. dollars to a foreign currency, invest in a foreign country, and then later convert that foreign currency back to U.S. dollars. If in the meantime the U.S. dollar becomes stronger and the foreign currency becomes weaker, then when the investor converts back to U.S. dollars, the rate of return on that investment will be less than originally expected at the time it was made.
However, a stronger U.S. dollar boosts the returns of a foreign investor putting money into a U.S. investment. That foreign investor converts from the home currency to U.S. dollars and seeks a U.S. investment, while later planning to switch back to the home currency. If, in the meantime, the dollar grows stronger, then when the time comes to convert from U.S. dollars back to the foreign currency, the investor will receive more foreign currency than expected at the time the original investment was made.
The preceding paragraphs all focus on the case where the U.S. dollar becomes stronger. The first column in Figure 16.4 illustrates the corresponding happy or unhappy economic reactions. The following Work It Out feature centers the analysis on the opposite: a weaker dollar.
Work It Out
Effects of a Weaker Dollar
Let’s work through the effects of a weaker dollar on a U.S. exporter, a foreign exporter into the United States, a U.S. tourist going abroad, a foreign tourist coming to the United States, a U.S. investor abroad, and a foreign investor in the United States.
Step 1. Note that the demand for U.S. exports is a function of the price of those exports, which depends on the dollar price of those goods and the exchange rate of the dollar in terms of foreign currency. For example, a Ford pickup truck costs \$25,000 in the United States. When it is sold in the United Kingdom, the price is \$25,000 / \$1.30 per British pound, or £19,231. The dollar affects the price foreigners face who may purchase U.S. exports.
Step 2. Consider that, if the dollar weakens, the pound rises in value. If the pound rises to \$2.00 per pound, then the price of a Ford pickup is now \$25,000 / \$2.00 = £12,500. A weaker dollar means the foreign currency buys more dollars, which means that U.S. exports appear less expensive.
Step 3. Summarize that a weaker U.S. dollar leads to an increase in U.S. exports. For a foreign exporter, the outcome is just the opposite.
Step 4. Suppose a brewery in England is interested in selling its Bass Ale to a grocery store in the United States. If the price of a six pack of Bass Ale is £6.00 and the exchange rate is \$1.30 per British pound, the price for the grocery store is 6.00 × \$1.30 = \$7.80 per six pack. If the dollar weakens to \$2.00 per pound, the price of Bass Ale is now 6.00 × \$2.00 = \$12.
Step 5. Summarize that, from the perspective of U.S. purchasers, a weaker dollar means that foreign currency is more expensive, which means that foreign goods are more expensive also. This leads to a decrease in U.S. imports, which is bad for the foreign exporter.
Step 6. Consider U.S. tourists going abroad. They face the same situation as a U.S. importer—they are purchasing a foreign trip. A weaker dollar means that their trip will cost more, since a given expenditure of foreign currency (e.g., hotel bill) will take more dollars. The result is that the tourist may not stay as long abroad, and some may choose not to travel at all.
Step 7. Consider that, for the foreign tourist to the United States, a weaker dollar is a boon. It means their currency goes further, so the cost of a trip to the United States will be less. Foreigners may choose to take longer trips to the United States, and more foreign tourists may decide to take U.S. trips.
Step 8. Note that a U.S. investor abroad faces the same situation as a U.S. importer—they are purchasing a foreign asset. A U.S. investor will see a weaker dollar as an increase in the “price” of investment, since the same number of dollars will buy less foreign currency and thus less foreign assets. This should decrease the amount of U.S. investment abroad.
Step 9. Note also that foreign investors in the Unites States will have the opposite experience. Since foreign currency buys more dollars, they will likely invest in more U.S. assets.
At this point, you should have a good sense of the major players in the foreign exchange market: firms involved in international trade, tourists, international financial investors, banks, and foreign exchange dealers. The next module shows how players can use the tools of demand and supply in foreign exchange markets to explain the underlying causes of stronger and weaker currencies (we address “stronger” and “weaker” more in the following Clear It Up feature).
Clear It Up
Why is a stronger currency not necessarily better?
One common misunderstanding about exchange rates is that a “stronger” or “appreciating” currency must be better than a “weaker” or “depreciating” currency. After all, is it not obvious that “strong” is better than “weak”? Do not let the terminology confuse you. When a currency becomes stronger, so that it purchases more of other currencies, it benefits some in the economy and injures others. Stronger currency is not necessarily better, it is just different. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/16%3A_Exchange_Rates_and_International_Capital_Flows/16.02%3A_How_the_Foreign_Exchange_Market_Works.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain supply and demand for exchange rates
• Define arbitrage
• Explain purchasing power parity's importance when comparing countries.
The foreign exchange market involves firms, households, and investors who demand and supply currencies coming together through their banks and the key foreign exchange dealers. Figure 16.5 (a) offers an example for the exchange rate between the U.S. dollar and the Mexican peso. The vertical axis shows the exchange rate for U.S. dollars, which in this case is measured in pesos. The horizontal axis shows the quantity of U.S. dollars traded in the foreign exchange market each day. The demand curve (D) for U.S. dollars intersects with the supply curve (S) of U.S. dollars at the equilibrium point (E), which is an exchange rate of 10 pesos per dollar and a total volume of \$8.5 billion.
Figure 16.5 Demand and Supply for the U.S. Dollar and Mexican Peso Exchange Rate (a) The quantity measured on the horizontal axis is in U.S. dollars, and the exchange rate on the vertical axis is the price of U.S. dollars measured in Mexican pesos. (b) The quantity measured on the horizontal axis is in Mexican pesos, while the price on the vertical axis is the price of pesos measured in U.S. dollars. In both graphs, the equilibrium exchange rate occurs at point E, at the intersection of the demand curve (D) and the supply curve (S).
Figure 16.5 (b) presents the same demand and supply information from the perspective of the Mexican peso. The vertical axis shows the exchange rate for Mexican pesos, which is measured in U.S. dollars. The horizontal axis shows the quantity of Mexican pesos traded in the foreign exchange market. The demand curve (D) for Mexican pesos intersects with the supply curve (S) of Mexican pesos at the equilibrium point (E), which is an exchange rate of 10 cents in U.S. currency for each Mexican peso and a total volume of 85 billion pesos. Note that the two exchange rates are inverses: 10 pesos per dollar is the same as 10 cents per peso (or \$0.10 per peso). In the actual foreign exchange market, almost all of the trading for Mexican pesos is for U.S. dollars. What factors would cause the demand or supply to shift, thus leading to a change in the equilibrium exchange rate? We discuss the answer to this question in the following section.
Expectations about Future Exchange Rates
One reason to demand a currency on the foreign exchange market is the belief that the currency's value is about to increase. One reason to supply a currency—that is, sell it on the foreign exchange market—is the expectation that the currency's value is about to decline. For example, imagine that a leading business newspaper, like the Wall Street Journal or the Financial Times, runs an article predicting that the Mexican peso will appreciate in value. Figure 16.6 illustrates the likely effects of such an article. Demand for the Mexican peso shifts to the right, from D0 to D1, as investors become eager to purchase pesos. Conversely, the supply of pesos shifts to the left, from S0 to S1, because investors will be less willing to give them up. The result is that the equilibrium exchange rate rises from 10 cents/peso to 12 cents/peso and the equilibrium exchange rate rises from 85 billion to 90 billion pesos as the equilibrium moves from E0 to E1.
Figure 16.6 Exchange Rate Market for Mexican Peso Reacts to Expectations about Future Exchange Rates An announcement that the peso exchange rate is likely to strengthen in the future will lead to greater demand for the peso in the present from investors who wish to benefit from the appreciation. Similarly, it will make investors less likely to supply pesos to the foreign exchange market. Both the shift of demand to the right and the shift of supply to the left cause an immediate appreciation in the exchange rate.
Figure 16.6 also illustrates some peculiar traits of supply and demand diagrams in the foreign exchange market. In contrast to all the other cases of supply and demand you have considered, in the foreign exchange market, supply and demand typically both move at the same time. Groups of participants in the foreign exchange market like firms and investors include some who are buyers and some who are sellers. An expectation of a future shift in the exchange rate affects both buyers and sellers—that is, it affects both demand and supply for a currency.
The shifts in demand and supply curves both cause the exchange rate to shift in the same direction. In this example, they both make the peso exchange rate stronger. However, the shifts in demand and supply work in opposing directions on the quantity traded. In this example, the rising demand for pesos is causing the quantity to rise while the falling supply of pesos is causing quantity to fall. In this specific example, the result is a higher quantity. However, in other cases, the result could be that quantity remains unchanged or declines.
This example also helps to explain why exchange rates often move quite substantially in a short period of a few weeks or months. When investors expect a country’s currency to strengthen in the future, they buy the currency and cause it to appreciate immediately. The currency's appreciation can lead other investors to believe that future appreciation is likely—and thus lead to even further appreciation. Similarly, a fear that a currency might weaken quickly leads to an actual weakening of the currency, which often reinforces the belief that the currency will weaken further. Thus, beliefs about the future path of exchange rates can be self-reinforcing, at least for a time, and a large share of the trading in foreign exchange markets involves dealers trying to outguess each other on what direction exchange rates will move next.
Differences across Countries in Rates of Return
The motivation for investment, whether domestic or foreign, is to earn a return. If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. Conversely, if rates of return in a country look relatively low, then funds will tend to flee to other economies. Changes in the expected rate of return will shift demand and supply for a currency. For example, imagine that interest rates rise in the United States as compared with Mexico. Thus, financial investments in the United States promise a higher return than previously. As a result, more investors will demand U.S. dollars so that they can buy interest-bearing assets and fewer investors will be willing to supply U.S. dollars to foreign exchange markets. Demand for the U.S. dollar will shift to the right, from D0 to D1, and supply will shift to the left, from S0 to S1, as Figure 16.7 shows. The new equilibrium (E1), will occur at an exchange rate of nine pesos/dollar and the same quantity of \$8.5 billion. Thus, a higher interest rate or rate of return relative to other countries leads a nation’s currency to appreciate or strengthen, and a lower interest rate relative to other countries leads a nation’s currency to depreciate or weaken. Since a nation’s central bank can use monetary policy to affect its interest rates, a central bank can also cause changes in exchange rates—a connection that we will discuss in more detail later in this chapter.
Figure 16.7 Exchange Rate Market for U.S. Dollars Reacts to Higher Interest Rates A higher rate of return for U.S. dollars makes holding dollars more attractive. Thus, the demand for dollars in the foreign exchange market shifts to the right, from D0 to D1, while the supply of dollars shifts to the left, from S0 to S1. The new equilibrium (E1) has a stronger exchange rate than the original equilibrium (E0), but in this example, the equilibrium quantity traded does not change.
Relative Inflation
If a country experiences a relatively high inflation rate compared with other economies, then the buying power of its currency is eroding, which will tend to discourage anyone from wanting to acquire or to hold the currency. Figure 16.8 shows an example based on an actual episode concerning the Mexican peso. In 1986–87, Mexico experienced an inflation rate of over 200%. Not surprisingly, as inflation dramatically decreased the peso's purchasing power in Mexico. The peso's exchange rate value declined as well. Figure 16.8 shows that the demand for the peso on foreign exchange markets decreased from D0 to D1, while the peso's supply increased from S0 to S1. The equilibrium exchange rate fell from \$2.50 per peso at the original equilibrium (E0) to \$0.50 per peso at the new equilibrium (E1). In this example, the quantity of pesos traded on foreign exchange markets remained the same, even as the exchange rate shifted.
Figure 16.8 Exchange Rate Markets React to Higher Inflation If a currency is experiencing relatively high inflation, then its buying power is decreasing and international investors will be less eager to hold it. Thus, a rise in inflation in the Mexican peso would lead demand to shift from D0 to D1, and supply to increase from S0 to S1. Both movements in demand and supply would cause the currency to depreciate. Here, we draw no effect on the quantity traded, but in truth it could be an increase or a decrease, depending on the actual movements of demand and supply.
Link It Up
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Purchasing Power Parity
Over the long term, exchange rates must bear some relationship to the currency's buying power in terms of internationally traded goods. If at a certain exchange rate it was much cheaper to buy internationally traded goods—such as oil, steel, computers, and cars—in one country than in another country, businesses would start buying in the cheap country, selling in other countries, and pocketing the profits.
For example, if a U.S. dollar is worth \$1.30 in Canadian currency, then a car that sells for \$20,000 in the United States should sell for \$26,000 in Canada. If the price of cars in Canada were much lower than \$26,000, then at least some U.S. car-buyers would convert their U.S. dollars to Canadian dollars and buy their cars in Canada. If the price of cars were much higher than \$26,000 in this example, then at least some Canadian buyers would convert their Canadian dollars to U.S. dollars and go to the United States to purchase their cars. This is known as arbitrage, the process of buying and selling goods or currencies across international borders at a profit. It may occur slowly, but over time, it will force prices and exchange rates to align so that the price of internationally traded goods is similar in all countries.
We call the exchange rate that equalizes the prices of internationally traded goods across countries the purchasing power parity (PPP) exchange rate. A group of economists at the International Comparison Program, run by the World Bank, have calculated the PPP exchange rate for all countries, based on detailed studies of the prices and quantities of internationally tradable goods.
The purchasing power parity exchange rate has two functions. First, economists often use PPP exchange rates for international comparison of GDP and other economic statistics. Imagine that you are preparing a table showing the size of GDP in many countries in several recent years, and for ease of comparison, you are converting all the values into U.S. dollars. When you insert the value for Japan, you need to use a yen/dollar exchange rate. However, should you use the market exchange rate or the PPP exchange rate? Market exchange rates bounce around. In 2014, the exchange rate was 105 yen/dollar, but in late 2015 the U.S. dollar exchange rate versus the yen was 121 yen/dollar. For simplicity, say that Japan’s GDP was ¥500 trillion in both 2014 and 2015. If you use the market exchange rates, then Japan’s GDP will be \$4.8 trillion in 2014 (that is, ¥500 trillion /(¥105/dollar)) and \$4.1 trillion in 2015 (that is, ¥500 trillion /(¥121/dollar)).
The misleading appearance of a changing Japanese economy occurs only because we used the market exchange rate, which often has short-run rises and falls. However, PPP exchange rates stay fairly constant and change only modestly, if at all, from year to year.
The second function of PPP is that exchanges rates will often get closer to it as time passes. It is true that in the short and medium run, as exchange rates adjust to relative inflation rates, rates of return, and to expectations about how interest rates and inflation will shift, the exchange rates will often move away from the PPP exchange rate for a time. However, knowing the PPP will allow you to track and predict exchange rate relationships. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/16%3A_Exchange_Rates_and_International_Capital_Flows/16.03%3A_Demand_and_Supply_Shifts_in_Foreign_Exchange_Markets.txt |
Learning Objectives
By the end of this section you will be able to:
• Explain how exchange rate shifting influences aggregate demand and supply
• Explain how shifting exchange rates also can influence loans and banks
A central bank will be concerned about the exchange rate for multiple reasons: (1) Movements in the exchange rate will affect the quantity of aggregate demand in an economy; (2) frequent substantial fluctuations in the exchange rate can disrupt international trade and cause problems in a nation’s banking system–this may contribute to an unsustainable balance of trade and large inflows of international financial capital, which can set up the economy for a deep recession if international investors decide to move their money to another country. Let’s discuss these scenarios in turn.
Exchange Rates, Aggregate Demand, and Aggregate Supply
Foreign trade in goods and services typically involves incurring the costs of production in one currency while receiving revenues from sales in another currency. As a result, movements in exchange rates can have a powerful effect on incentives to export and import, and thus on aggregate demand in the economy as a whole.
For example, in 1999, when the euro first became a currency, its value measured in U.S. currency was \$1.16/euro, which dropped to a low of about \$0.83/euro in 2000. By the end of 2013, the euro had risen (and the U.S. dollar had correspondingly weakened) to \$1.37/euro. However, by the beginning of 2021, the exchange rate was down to \$1.12/euro. Consider the situation of a French firm that each year incurs €10 million in costs, and sells its products in the United States for \$10 million. At a time in 1999, when this firm converted \$10 million back to euros at the exchange rate of \$1.06/euro (that is, \$10 million × [€1/\$1.06]), it received €9.4 million, and suffered a loss. In 2013, when this same firm converted \$10 million back to euros at the exchange rate of \$1.37/euro (that is, \$10 million × [€1 euro/\$1.37]), it received approximately €7.3 million and an even larger loss. In the beginning of 2021, with the exchange rate back at \$1.12/euro the firm would suffer a loss once again. This example shows how a stronger euro discourages exports by the French firm, because it makes the costs of production in the domestic currency higher relative to the sales revenues earned in another country. From the point of view of the U.S. economy, the example also shows how a weaker U.S. dollar encourages exports.
Since an increase in exports results in more dollars flowing into the economy, and an increase in imports means more dollars are flowing out, it is easy to conclude that exports are “good” for the economy and imports are “bad,” but this overlooks the role of exchange rates. If an American consumer buys a Japanese car for \$20,000 instead of an American car for \$30,000, it may be tempting to argue that the American economy has lost out. However, the Japanese company will have to convert those dollars to yen to pay its workers and operate its factories. Whoever buys those dollars will have to use them to purchase American goods and services, so the money comes right back into the American economy. At the same time, the consumer saves money by buying a less expensive import, and can use the extra money for other purposes.
Fluctuations in Exchange Rates
Exchange rates can fluctuate a great deal in the short run. As yet one more example, the Indian rupee moved from 39 rupees/dollar in February 2008 to 51 rupees/dollar in March 2009, a decline of more than one-fourth in the value of the rupee on foreign exchange markets. Figure 16.9 earlier showed that even two economically developed neighboring economies like the United States and Canada can see significant movements in exchange rates over a few years. For firms that depend on export sales, or firms that rely on imported inputs to production, or even purely domestic firms that compete with firms tied into international trade—which in many countries adds up to half or more of a nation’s GDP—sharp movements in exchange rates can lead to dramatic changes in profits and losses. A central bank may desire to keep exchange rates from moving too much as part of providing a stable business climate, where firms can focus on productivity and innovation, not on reacting to exchange rate fluctuations.
One of the most economically destructive effects of exchange rate fluctuations can happen through the banking system. Financial institutions measure most international loans are measured in a few large currencies, like U.S. dollars, European euros, and Japanese yen. In countries that do not use these currencies, banks often borrow funds in the currencies of other countries, like U.S. dollars, but then lend in their own domestic currency. The left-hand chain of events in Figure 16.9 shows how this pattern of international borrowing can work. A bank in Thailand borrows one million in U.S. dollars. Then the bank converts the dollars to its domestic currency—in the case of Thailand, the currency is the baht—at a rate of 40 baht/dollar. The bank then lends the baht to a firm in Thailand. The business repays the loan in baht, and the bank converts it back to U.S. dollars to pay off its original U.S. dollar loan.
Figure 16.9 International Borrowing The scenario of international borrowing that ends on the left is a success story, but the scenario that ends on the right shows what happens when the exchange rate weakens.
This process of borrowing in a foreign currency and lending in a domestic currency can work just fine, as long as the exchange rate does not shift. In the scenario outlined, if the dollar strengthens and the baht weakens, a problem arises. The right-hand chain of events in Figure 16.9 illustrates what happens when the baht unexpectedly weakens from 40 baht/dollar to 50 baht/dollar. The Thai firm still repays the loan in full to the bank. However, because of the shift in the exchange rate, the bank cannot repay its loan in U.S. dollars. (Of course, if the exchange rate had changed in the other direction, making the Thai currency stronger, the bank could have realized an unexpectedly large profit.)
In 1997–1998, countries across eastern Asia, like Thailand, Korea, Malaysia, and Indonesia, experienced a sharp depreciation of their currencies, in some cases 50% or more. These countries had been experiencing substantial inflows of foreign investment capital, with bank lending increasing by 20% to 30% per year through the mid-1990s. When their exchange rates depreciated, the banking systems in these countries were bankrupt. Argentina experienced a similar chain of events in 2002. When the Argentine peso depreciated, Argentina’s banks found themselves unable to pay back what they had borrowed in U.S. dollars.
Banks play a vital role in any economy in facilitating transactions and in making loans to firms and consumers. When most of a country’s largest banks become bankrupt simultaneously, a sharp decline in aggregate demand and a deep recession results. Since the main responsibilities of a central bank are to control the money supply and to ensure that the banking system is stable, a central bank must be concerned about whether large and unexpected exchange rate depreciation will drive most of the country’s existing banks into bankruptcy. For more on this concern, return to the chapter on The International Trade and Capital Flows.
Summing Up Public Policy and Exchange Rates
Every nation would prefer a stable exchange rate to facilitate international trade and reduce the degree of risk and uncertainty in the economy. However, a nation may sometimes want a weaker exchange rate to stimulate aggregate demand and reduce a recession, or a stronger exchange rate to fight inflation. The country must also be concerned that rapid movements from a weak to a strong exchange rate may hurt its export industries, while rapid movements from a strong to a weak exchange rate can hurt its banking sector. In short, every choice of an exchange rate—whether it should be stronger or weaker, or fixed or changing—represents potential tradeoffs. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/16%3A_Exchange_Rates_and_International_Capital_Flows/16.04%3A_Macroeconomic_Effects_of_Exchange_Rates.txt |
Learning Objectives
By the end of this section, you will be able to:
• Differentiate among a floating exchange rate, a soft peg, a hard peg, and a merged currency
• Identify the tradeoffs that come with a floating exchange rate, a soft peg, a hard peg, and a merged currency
Exchange rate policies come in a range of different forms listed in Figure 16.10: let the foreign exchange market determine the exchange rate; let the market set the value of the exchange rate most of the time, but have the central bank sometimes intervene to prevent fluctuations that seem too large; have the central bank guarantee a specific exchange rate; or share a currency with other countries. Let’s discuss each type of exchange rate policy and its tradeoffs.
Figure 16.10 A Spectrum of Exchange Rate Policies A nation may adopt one of a variety of exchange rate regimes, from floating rates in which the foreign exchange market determines the rates to pegged rates where governments intervene to manage the exchange rate's value, to a common currency where the nation adopts another country or group of countries' currency.
Floating Exchange Rates
We refer to a policy which allows the foreign exchange market to set exchange rates as a floating exchange rate. The U.S. dollar is a floating exchange rate, as are the currencies of about 40% of the countries in the world economy. The major concern with this policy is that exchange rates can move a great deal in a short time.
Consider the U.S. exchange rate expressed in terms of another fairly stable currency, the Japanese yen, as Figure 16.11 shows. On January 1, 2002, the exchange rate was 133 yen/dollar. On January 1, 2005, it was 103 yen/dollar. On June 1, 2007, it was 122 yen/dollar, on January 1, 2012, it was 77 yen per dollar, and on March 1, 2015, it was 120 yen per dollar. Since 2015, it has dropped again; by the end of December 2020, the exchange rate stood at 103 yen per dollar. As investor sentiment swings back and forth, driving exchange rates up and down, exporters, importers, and banks involved in international lending are all affected. At worst, large movements in exchange rates can drive companies into bankruptcy or trigger a nationwide banking collapse. However, even in the moderate case of the yen/dollar exchange rate, these movements of roughly 30 percent back and forth impose stress on both economies as firms must alter their export and import plans to take the new exchange rates into account. Especially in smaller countries where international trade is a relatively large share of GDP, exchange rate movements can rattle their economies.
Figure 16.11 U.S. Dollar Exchange Rate in Japanese Yen Even seemingly stable exchange rates such as the Japanese Yen to the U.S. Dollar can vary when closely examined over time. This figure shows a relatively stable rate between 2011 and 2013. In 2013, there was a drastic depreciation of the Yen (relative to the U.S. Dollar) by about 14% and again at the end of the year in 2014 also by about 14%. Since then, between 2016 and 2020 there was an appreciation of about 13% from 118 yen per dollar to 103 yen per dollar. (Source: Federal Reserve Economic Data (FRED) https://research.stlouisfed.org/fred2/series/DEXJPUS)
However, movements of floating exchange rates have advantages, too. After all, prices of goods and services rise and fall throughout a market economy, as demand and supply shift. If an economy experiences strong inflows or outflows of international financial capital, or has relatively high inflation, or if it experiences strong productivity growth so that purchasing power changes relative to other economies, then it makes economic sense for the exchange rate to shift as well.
Floating exchange rate advocates often argue that if government policies were more predictable and stable, then inflation rates and interest rates would be more predictable and stable. Exchange rates would bounce around less, too. The economist Milton Friedman (1912–2006), for example, wrote a defense of floating exchange rates in 1962 in his book Capitalism and Freedom:
Being in favor of floating exchange rates does not mean being in favor of unstable exchange rates. When we support a free price system [for goods and services] at home, this does not imply that we favor a system in which prices fluctuate wildly up and down. What we want is a system in which prices are free to fluctuate but in which the forces determining them are sufficiently stable so that in fact prices move within moderate ranges. This is equally true in a system of floating exchange rates. The ultimate objective is a world in which exchange rates, while free to vary, are, in fact, highly stable because basic economic policies and conditions are stable.
Advocates of floating exchange rates admit that, yes, exchange rates may sometimes fluctuate. They point out, however, that if a central bank focuses on preventing either high inflation or deep recession, with low and reasonably steady interest rates, then exchange rates will have less reason to vary.
Using Soft Pegs and Hard Pegs
When a government intervenes in the foreign exchange market so that the currency's exchange rate is different from what the market would have produced, it establishes a “peg” for its currency. A soft peg is the name for an exchange rate policy where the government usually allows the market to set exchange rate, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene in the market. With a hard peg exchange rate policy, the central bank sets a fixed and unchanging value for the exchange rate. A central bank can implement soft peg and hard peg policies.
Suppose the market exchange rate for the Brazilian currency, the real, would be 35 cents/real with a daily quantity of 15 billion real traded in the market, as the equilibrium E0 in Figure 16.12 (a) and Figure 16.12 (b) show. However, Brazil's government decides that the exchange rate should be 30 cents/real, as Figure 16.12 (a) shows. Perhaps Brazil sets this lower exchange rate to benefit its export industries. Perhaps it is an attempt to stimulate aggregate demand by stimulating exports. Perhaps Brazil believes that the current market exchange rate is higher than the long-term purchasing power parity value of the real, so it is minimizing fluctuations in the real by keeping it at this lower rate. Perhaps the government set the target exchange rate sometime in the past, and it is now maintaining it for the sake of stability. Whatever the reason, if Brazil’s central bank wishes to keep the exchange rate below the market level, it must face the reality that at this weaker exchange rate of 30 cents/real, the quantity demanded of its currency at 17 billion reals is greater than the quantity supplied of 13 billion reals in the foreign exchange market.
Figure 16.12 Pegging an Exchange Rate (a) If an exchange rate is pegged below what would otherwise be the equilibrium, then the currency's quantity demanded will exceed the quantity supplied. (b) If an exchange rate is pegged above what would otherwise be the equilibrium, then the currency's quantity supplied exceeds the quantity demanded.
The Brazilian central bank could weaken its exchange rate in two ways. One approach is to use an expansionary monetary policy that leads to lower interest rates. In foreign exchange markets, the lower interest rates will reduce demand and increase supply of the real and lead to depreciation. Central banks do not use this technique often because lowering interest rates to weaken the currency may be in conflict with the country’s monetary policy goals. Alternatively, Brazil’s central bank could trade directly in the foreign exchange market. The central bank can expand the money supply by creating reals, use the reals to purchase foreign currencies, and avoid selling any of its own currency. In this way, it can fill the gap between quantity demanded and quantity supplied of its currency.
Figure 16.12 (b) shows the opposite situation. Here, the Brazilian government desires a stronger exchange rate of 40 cents/real than the market rate of 35 cents/real. Perhaps Brazil desires the stronger currency to reduce aggregate demand and to fight inflation, or perhaps Brazil believes that that current market exchange rate is temporarily lower than the long-term rate. Whatever the reason, at the higher desired exchange rate, the quantity supplied of 16 billion reals exceeds the quantity demanded of 14 billion reals.
Brazil’s central bank can use a contractionary monetary policy to raise interest rates, which will increase demand and reduce currency supply on foreign exchange markets, and lead to an appreciation. Alternatively, Brazil’s central bank can trade directly in the foreign exchange market. In this case, with an excess supply of its own currency in foreign exchange markets, the central bank must use reserves of foreign currency, like U.S. dollars, to demand its own currency and thus cause an appreciation of its exchange rate.
Both a soft peg and a hard peg policy require that the central bank intervene in the foreign exchange market. However, a hard peg policy attempts to preserve a fixed exchange rate at all times. A soft peg policy typically allows the exchange rate to move up and down by relatively small amounts in the short run of several months or a year, and to move by larger amounts over time, but seeks to avoid extreme short-term fluctuations.
Tradeoffs of Soft Pegs and Hard Pegs
When a country decides to alter the market exchange rate, it faces a number of tradeoffs. If it uses monetary policy to alter the exchange rate, it then cannot at the same time use monetary policy to address issues of inflation or recession. If it uses direct purchases and sales of foreign currencies in exchange rates, then it must face the issue of how it will handle its reserves of foreign currency. Finally, a pegged exchange rate can even create additional movements of the exchange rate. For example, even the possibility of government intervention in exchange rate markets will lead to rumors about whether and when the government will intervene, and dealers in the foreign exchange market will react to those rumors. Let’s consider these issues in turn.
One concern with pegged exchange rate policies is that they imply a country’s monetary policy is no longer focused on controlling inflation or shortening recessions, but now must also take the exchange rate into account. For example, when a country pegs its exchange rate, it will sometimes face economic situations where it would like to have an expansionary monetary policy to fight recession—but it cannot do so because that policy would depreciate its exchange rate and break its hard peg. With a soft peg exchange rate policy, the central bank can sometimes ignore the exchange rate and focus on domestic inflation or recession—but in other cases the central bank may ignore inflation or recession and instead focus on its soft peg exchange rate. With a hard peg policy, domestic monetary policy is effectively no longer determined by domestic inflation or unemployment, but only by what monetary policy is needed to keep the exchange rate at the hard peg.
Another issue arises when a central bank intervenes directly in the exchange rate market. If a central bank ends up in a situation where it is perpetually creating and selling its own currency on foreign exchange markets, it will be buying the currency of other countries, like U.S. dollars or euros, to hold as reserves. Holding large reserves of other currencies has an opportunity cost, and central banks will not wish to boost such reserves without limit.
In addition, a central bank that causes a large increase in the supply of money is also risking an inflationary surge in aggregate demand. Conversely, when a central bank wishes to buy its own currency, it can do so by using its reserves of international currency like the U.S. dollar or the euro. However, if the central bank runs out of such reserves, it can no longer use this method to strengthen its currency. Thus, buying foreign currencies in exchange rate markets can be expensive and inflationary, while selling foreign currencies can work only until a central bank runs out of reserves.
Yet another issue is that when a government pegs its exchange rate, it may unintentionally create another reason for additional fluctuation. With a soft peg policy, foreign exchange dealers and international investors react to every rumor about how or when the central bank is likely to intervene to influence the exchange rate, and as they react to rumors the exchange rate will shift up and down. Thus, even though the goal of a soft peg policy is to reduce short-term fluctuations of the exchange rate, the existence of the policy—when anticipated in the foreign exchange market—may sometimes increase short-term fluctuations as international investors try to anticipate how and when the central bank will act. The following Clear It Up feature discusses the effects of international capital flows—capital that flows across national boundaries as either portfolio investment or direct investment.
Clear It Up
How do Tobin taxes control the flow of capital?
Some countries like Chile and Malaysia have sought to reduce movements in exchange rates by limiting international financial capital inflows and outflows. The government can enact this policy either through targeted taxes or by regulations.
Taxes on international capital flows are sometimes known as Tobin taxes, named after James Tobin, the 1981 Nobel laureate in economics who proposed such a tax in a 1972 lecture. For example, a government might tax all foreign exchange transactions, or attempt to tax short-term portfolio investment while exempting long-term foreign direct investment. Countries can also use regulation to forbid certain kinds of foreign investment in the first place or to make it difficult for international financial investors to withdraw their funds from a country.
The goal of such policies is to reduce international capital flows, especially short-term portfolio flows, in the hope that doing so will reduce the chance of large movements in exchange rates that can bring macroeconomic disaster.
However, proposals to limit international financial flows have severe practical difficulties. National governments impose taxes, not international ones. If one government imposes a Tobin tax on exchange rate transactions carried out within its territory, a firm based someplace like the Grand Caymans, an island nation in the Caribbean well-known for allowing some financial wheeling and dealing might easily operate the exchange rate market. In an interconnected global economy, if goods and services are allowed to flow across national borders, then payments need to flow across borders, too. It is very difficult—in fact close to impossible—for a nation to allow only the flows of payments that relate to goods and services, while clamping down or taxing other flows of financial capital. If a nation participates in international trade, it must also participate in international capital movements.
Finally, countries all over the world, especially low-income countries, are crying out for foreign investment to help develop their economies. Policies that discourage international financial investment may prevent some possible harm, but they rule out potentially substantial economic benefits as well.
A hard peg exchange rate policy will not allow short-term fluctuations in the exchange rate. If the government first announces a hard peg and then later changes its mind—perhaps the government becomes unwilling to keep interest rates high or to hold high levels of foreign exchange reserves—then the result of abandoning a hard peg could be a dramatic shift in the exchange rate.
In the mid-2000s, about one-third of the countries in the world used a soft peg approach and about one-quarter used a hard peg approach. The general trend in the 1990s was to shift away from a soft peg approach in favor of either floating rates or a hard peg. The concern is that a successful soft peg policy may, for a time, lead to very little variation in exchange rates, so that firms and banks in the economy begin to act as if a hard peg exists. When the exchange rate does move, the effects are especially painful because firms and banks have not planned and hedged against a possible change. Thus, the argument went, it is better either to be clear that the exchange rate is always flexible, or that it is fixed, but choosing an in-between soft peg option may end up being worst of all.
A Merged Currency
A final approach to exchange rate policy is for a nation to choose a common currency shared with one or more nations is also called a merged currency. A merged currency approach eliminates foreign exchange risk altogether. Just as no one worries about exchange rate movements when buying and selling between New York and California, Europeans know that the value of the euro will be the same in Germany and France and other European nations that have adopted the euro.
However, a merged currency also poses problems. Like a hard peg, a merged currency means that a nation has given up altogether on domestic monetary policy, and instead has put its interest rate policies in other hands. When Ecuador uses the U.S. dollar as its currency, it has no voice in whether the Federal Reserve raises or lowers interest rates. The European Central Bank that determines monetary policy for the euro has representatives from all the euro nations. However, from the standpoint of, say, Portugal, there will be times when the decisions of the European Central Bank about monetary policy do not match the decisions that a Portuguese central bank would have made.
The lines between these four different exchange rate policies can blend into each other. For example, a soft peg exchange rate policy in which the government almost never acts to intervene in the exchange rate market will look a great deal like a floating exchange rate. Conversely, a soft peg policy in which the government intervenes often to keep the exchange rate near a specific level will look a lot like a hard peg. A decision to merge currencies with another country is, in effect, a decision to have a permanently fixed exchange rate with those countries, which is like a very hard exchange rate peg. Table 16.3 summarizes the range of exchange rates policy choices, with their advantages and disadvantages.
Situation Floating Exchange Rates Soft Peg Hard Peg Merged Currency
Large short-run fluctuations in exchange rates? Often considerable in the short term Maybe less in the short run, but still large changes over time None, unless a change in the fixed rate None
Large long-term fluctuations in exchange rates? Can often happen Can often happen Cannot happen unless hard peg changes, in which case substantial volatility can occur Cannot happen
Power of central bank to conduct countercyclical monetary policy? Flexible exchange rates make monetary policy stronger Some power, although conflicts may arise between exchange rate policy and countercyclical policy Very little; central bank must keep exchange rate fixed None; nation does not have its own currency
Costs of holding foreign exchange reserves? Do not need to hold reserves Hold moderate reserves that rise and fall over time Hold large reserves No need to hold reserves
Risk of ending up with an exchange rate that causes a large trade imbalance and very high inflows or outflows of financial capital? Adjusts often Adjusts over the medium term, if not the short term May end up over time either far above or below the market level Cannot adjust
Table 16.3 Tradeoffs of Exchange Rate Policies
Global macroeconomics would be easier if the whole world had one currency and one central bank. The exchange rates between different currencies complicate the picture. If financial markets solely set exchange rates, they fluctuate substantially as short-term portfolio investors try to anticipate tomorrow’s news. If the government attempts to intervene in exchange rate markets through soft pegs or hard pegs, it gives up at least some of the power to use monetary policy to focus on domestic inflations and recessions, and it risks causing even greater fluctuations in foreign exchange markets.
There is no consensus among economists about which exchange rate policies are best: floating, soft peg, hard peg, or merged currencies. The choice depends both on how well a nation’s central bank can implement a specific exchange rate policy and on how well a nation’s firms and banks can adapt to different exchange rate policies. A national economy that does a fairly good job at achieving the four main economic goals of growth, low inflation, low unemployment, and a sustainable balance of trade will probably do just fine most of the time with any exchange rate policy. Conversely, no exchange rate policy is likely to save an economy that consistently fails at achieving these goals. Alternatively, a merged currency applied across wide geographic and cultural areas carries with it its own set of problems, such as the ability for countries to conduct their own independent monetary policies.
Bring It Home
Is a Stronger Dollar Good for the U.S. Economy?
The foreign exchange value of the dollar is a price and whether a higher price is good or bad depends on where you are standing: sellers benefit from higher prices and buyers are harmed. A stronger dollar is good for U.S. imports (and people working for U.S. importers) and U.S. investment abroad. It is also good for U.S. tourists going to other countries, since their dollar goes further. However, a stronger dollar is bad for U.S. exports (and people working in U.S. export industries); it is bad for foreign investment in the United States (leading, for example, to higher U.S. interest rates); and it is bad for foreign tourists (as well as U.S hotels, restaurants, and others in the tourist industry). In short, whether the U.S. dollar is good or bad is a more complex question than you may have thought. The economic answer is “it depends.” | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/16%3A_Exchange_Rates_and_International_Capital_Flows/16.05%3A_Exchange_Rate_Policies.txt |
appreciating
when a currency is worth more in terms of other currencies; also called “strengthening”
arbitrage
the process of buying a good and selling goods across borders to take advantage of international price differences
depreciating
when a currency is worth less in terms of other currencies; also called “weakening”
dollarize
a country that is not the United States uses the U.S. dollar as its currency
floating exchange rate
a country lets the exchange rate market determine its currency's value
foreign direct investment (FDI)
purchasing more than ten percent of a firm or starting a new enterprise in another country
foreign exchange market
the market in which people use one currency to buy another currency
hard peg
an exchange rate policy in which the central bank sets a fixed and unchanging value for the exchange rate
hedge
using a financial transaction as protection against risk
international capital flows
flow of financial capital across national boundaries either as portfolio investment or direct investment
merged currency
when a nation chooses to use another nation's currency
portfolio investment
an investment in another country that is purely financial and does not involve any management responsibility
purchasing power parity (PPP)
the exchange rate that equalizes the prices of internationally traded goods across countries
soft peg
an exchange rate policy in which the government usually allows the market to set the exchange rate, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene
Tobin taxes
see international capital flows
16.07: Key Concepts and Summary
16.1 How the Foreign Exchange Market Works
In the foreign exchange market, people and firms exchange one currency to purchase another currency. The demand for dollars comes from those U.S. export firms seeking to convert their earnings in foreign currency back into U.S. dollars; foreign tourists converting their earnings in a foreign currency back into U.S. dollars; and foreign investors seeking to make financial investments in the U.S. economy. On the supply side of the foreign exchange market for the trading of U.S. dollars are foreign firms that have sold imports in the U.S. economy and are seeking to convert their earnings back to their home currency; U.S. tourists abroad; and U.S. investors seeking to make financial investments in foreign economies. When currency A can buy more of currency B, then currency A has strengthened or appreciated relative to B. When currency A can buy less of currency B, then currency A has weakened or depreciated relative to B. If currency A strengthens or appreciates relative to currency B, then currency B must necessarily weaken or depreciate with regard to currency A. A stronger currency benefits those who are buying with that currency and injures those who are selling. A weaker currency injures those, like importers, who are buying with that currency and benefits those who are selling with it, like exporters.
16.2 Demand and Supply Shifts in Foreign Exchange Markets
In the extreme short run, ranging from a few minutes to a few weeks, speculators who are trying to invest in currencies that will grow stronger, and to sell currencies that will grow weaker influence exchange rates. Such speculation can create a self-fulfilling prophecy, at least for a time, where an expected appreciation leads to a stronger currency and vice versa. In the relatively short run, differences in rates of return influence exchange rate markets. Countries with relatively high real rates of return (for example, high interest rates) will tend to experience stronger currencies as they attract money from abroad, while countries with relatively low rates of return will tend to experience weaker exchange rates as investors convert to other currencies.
In the medium run of a few months or a few years, inflation rates influence exchange rate markets. Countries with relatively high inflation will tend to experience less demand for their currency than countries with lower inflation, and thus currency depreciation. Over long periods of many years, exchange rates tend to adjust toward the purchasing power parity (PPP) rate, which is the exchange rate such that the prices of internationally tradable goods in different countries, when converted at the PPP exchange rate to a common currency, are similar in all economies.
16.3 Macroeconomic Effects of Exchange Rates
A central bank will be concerned about the exchange rate for several reasons. Exchange rates will affect imports and exports, and thus affect aggregate demand in the economy. Fluctuations in exchange rates may cause difficulties for many firms, but especially banks. The exchange rate may accompany unsustainable flows of international financial capital.
16.4 Exchange Rate Policies
In a floating exchange rate policy, a government determines its country’s exchange rate in the foreign exchange market. In a soft peg exchange rate policy, the foreign exchange market usually determines a country's exchange rate, but the government sometimes intervenes to strengthen or weaken it. In a hard peg exchange rate policy, the government chooses an exchange rate. A central bank can intervene in exchange markets in two ways. It can raise or lower interest rates to make the currency stronger or weaker. It also can directly purchase or sell its currency in foreign exchange markets. All exchange rates policies face tradeoffs. A hard peg exchange rate policy will reduce exchange rate fluctuations, but means that a country must focus its monetary policy on the exchange rate, not on fighting recession or controlling inflation. When a nation merges its currency with another nation, it gives up on nationally oriented monetary policy altogether.
A soft peg exchange rate may create additional volatility as exchange rate markets try to anticipate when and how the government will intervene. A flexible exchange rate policy allows monetary policy to focus on inflation and unemployment, and allows the exchange rate to change with inflation and rates of return, but also raises a risk that exchange rates may sometimes make large and abrupt movements. The spectrum of exchange rate policies includes: (a) a floating exchange rate, (b) a pegged exchange rate, soft or hard, and (c) a merged currency. Monetary policy can focus on a variety of goals: (a) inflation; (b) inflation or unemployment, depending on which is the most dangerous obstacle; and (c) a long-term rule based policy designed to keep the money supply stable and predictable. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/16%3A_Exchange_Rates_and_International_Capital_Flows/16.06%3A_Key_Terms.txt |
1.
How will a stronger euro affect the following economic agents?
1. A British exporter to Germany.
2. A Dutch tourist visiting Chile.
3. A Greek bank investing in a Canadian government bond.
4. A French exporter to Germany.
2.
Suppose that political unrest in Egypt leads financial markets to anticipate a depreciation in the Egyptian pound. How will that affect the demand for pounds, supply of pounds, and exchange rate for pounds compared to, say, U.S. dollars?
3.
Suppose U.S. interest rates decline compared to the rest of the world. What would be the likely impact on the demand for dollars, supply of dollars, and exchange rate for dollars compared to, say, euros?
4.
Suppose Argentina gets inflation under control and the Argentine inflation rate decreases substantially. What would likely happen to the demand for Argentine pesos, the supply of Argentine pesos, and the peso/U.S. dollar exchange rate?
5.
This chapter has explained that “one of the most economically destructive effects of exchange rate fluctuations can happen through the banking system,” if banks borrow from abroad to lend domestically. Why is this less likely to be a problem for the U.S. banking system?
6.
A booming economy can attract financial capital inflows, which promote further growth. However, capital can just as easily flow out of the country, leading to economic recession. Is a country whose economy is booming because it decided to stimulate consumer spending more or less likely to experience capital flight than an economy whose boom is caused by economic investment expenditure?
7.
How would a contractionary monetary policy affect the exchange rate, net exports, aggregate demand, and aggregate supply?
8.
A central bank can allow its currency to fall indefinitely, but it cannot allow its currency to rise indefinitely. Why not?
9.
Is a country for which imports and exports comprise a large fraction of the GDP more likely to adopt a flexible exchange rate or a fixed (hard peg) exchange rate?
16.09: Review Questions
10.
What is the foreign exchange market?
11.
Describe some buyers and some sellers in the market for U.S. dollars.
12.
What is the difference between foreign direct investment and portfolio investment?
13.
What does it mean to hedge a financial transaction?
14.
What does it mean to say that a currency appreciates? Depreciates? Becomes stronger? Becomes weaker?
15.
Does an expectation of a stronger exchange rate in the future affect the exchange rate in the present? If so, how?
16.
Does a higher rate of return in a nation’s economy, all other things being equal, affect the exchange rate of its currency? If so, how?
17.
Does a higher inflation rate in an economy, other things being equal, affect the exchange rate of its currency? If so, how?
18.
What is the purchasing power parity exchange rate?
19.
What are some of the reasons a central bank is likely to care, at least to some extent, about the exchange rate?
20.
How can an unexpected fall in exchange rates injure the financial health of a nation’s banks?
21.
What is the difference between a floating exchange rate, a soft peg, a hard peg, and dollarization?
22.
List some advantages and disadvantages of the different exchange rate policies.
16.10: Critical Thinking Questions
23.
Why would a nation “dollarize”—that is, adopt another country’s currency instead of having its own?
24.
Can you think of any major disadvantages to dollarization? How would a central bank work in a country that has dollarized?
25.
If a country’s currency is expected to appreciate in value, what would you think will be the impact of expected exchange rates on yields (e.g., the interest rate paid on government bonds) in that country? Hint: Think about how expected exchange rate changes and interest rates affect a currency's demand and supply.
26.
Do you think that a country experiencing hyperinflation is more or less likely to have an exchange rate equal to its purchasing power parity value when compared to a country with a low inflation rate?
27.
Suppose a country has an overall balance of trade so that exports of goods and services equal imports of goods and services. Does that imply that the country has balanced trade with each of its trading partners?
28.
We learned that changes in exchange rates and the corresponding changes in the balance of trade amplify monetary policy. From the perspective of a nation’s central bank, is this a good thing or a bad thing?
29.
If a developing country needs foreign capital inflows, management expertise, and technology, how can it encourage foreign investors while at the same time protect itself against capital flight and banking system collapse, as happened during the Asian financial crisis?
30.
Many developing countries, like Mexico, have moderate to high rates of inflation. At the same time, international trade plays an important role in their economies. What type of exchange rate regime would be best for such a country’s currency vis à vis the U.S. dollar?
31.
What would make a country decide to change from a common currency, like the euro, back to its own currency?
16.11: Problems
32.
A British pound cost \$2.00 in U.S. dollars in 2008, but \$1.27 in U.S. dollars in 2017. Was the pound weaker or stronger against the dollar? Did the dollar appreciate or depreciate versus the pound? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/16%3A_Exchange_Rates_and_International_Capital_Flows/16.08%3A_Self-Check_Questions.txt |
Figure 17.1 Shut Downs and Parks Yellowstone National Park is one of the many national parks forced to close operations during the government shut down in 2013 and 2018–2019. (Credit: modification of “Close up of sign” by David Fulmer/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Government Spending
• Taxation
• Federal Deficits and the National Debt
• Using Fiscal Policy to Fight Recessions, Unemployment, and Inflation
• Automatic Stabilizers
• Practical Problems with Discretionary Fiscal Policy
• The Question of a Balanced Budget
Bring It Home
No Yellowstone Park?
You had trekked all the way to see Yellowstone National Park in the beautiful month of October 2013, only to find it… closed. Closed! Why?
For two weeks in October 2013, the U.S. federal government shut down. Many federal services, like the national parks, closed and 800,000 federal employees were furloughed. Tourists were shocked and so was the rest of the world: Congress and the President could not agree on a budget. Inside the Capitol, Republicans and Democrats argued about spending priorities and whether to increase the national debt limit. Each year's budget, which is over \$3 trillion of spending, must be approved by Congress and signed by the President. Two thirds of the budget are entitlements and other mandatory spending which occur without congressional or presidential action once the programs are established. Tied to the budget debate was the issue of increasing the debt ceiling—how high the U.S. government's national debt can be. The House of Representatives refused to sign on to the bills to fund the government unless they included provisions to stop or change the Affordable Health Care Act (more colloquially known as Obamacare). As the days progressed, the United States came very close to defaulting on its debt.
October 2013 was not the first time the government shut down, and it was not the last. Several brief shutdowns occurred in the early 1980s, and they occurred periodically in the following years. The longest shutdown took place between December 2018 and January 2019, when funding a border wall was a core disagreement.
Why does the federal budget create such intense debates? What would happen if the United States actually defaulted on its debt? In this chapter, we will examine the federal budget, taxation, and fiscal policy. We will also look at the annual federal budget deficits and the national debt.
All levels of government—federal, state, and local—have budgets that show how much revenue the government expects to receive in taxes and other income and how the government plans to spend it. Budgets, however, can shift dramatically within a few years, as policy decisions and unexpected events disrupt earlier tax and spending plans.
In this chapter, we revisit fiscal policy, which we first covered in Welcome to Economics! Fiscal policy is one of two policy tools for fine tuning the economy (the other is monetary policy). While policymakers at the Federal Reserve make monetary policy, Congress and the President make fiscal policy.
The discussion of fiscal policy focuses on how federal government taxing and spending affects aggregate demand. All government spending and taxes affect the economy, but fiscal policy focuses strictly on federal government policies. We begin with an overview of U.S. government spending and taxes. We then discuss fiscal policy from a short-run perspective; that is, how government uses tax and spending policies to address recession, unemployment, and inflation; how periods of recession and growth affect government budgets; and the merits of balanced budget proposals. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.01%3A_Introduction_to_Government_Budgets_and_Fiscal_Policy.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify U.S. budget deficit and surplus trends over the past five decades
• Explain the differences between the U.S. federal budget, and state and local budgets
Government spending covers a range of services that the federal, state, and local governments provide. When the federal government spends more money than it receives in taxes in a given year, it runs a budget deficit. Conversely, when the government receives more money in taxes than it spends in a year, it runs a budget surplus. If government spending and taxes are equal, it has a balanced budget. For example, in 2020, the U.S. government experienced its largest budget deficit ever, as the federal government spent \$3.1 trillion more than it collected in taxes. This deficit was about 15% of the size of the U.S. GDP in 2020, making it by far the largest budget deficit relative to GDP since the mammoth borrowing the government used to finance World War II. To put it into perspective, the previous record deficits were experienced during the Great Recession of 2007–2009, when the deficit reached 9.6% of GDP.
This section presents an overview of government spending in the United States.
Total U.S. Government Spending
Federal spending in nominal dollars (that is, dollars not adjusted for inflation) has grown by a multiple of more than 38 over the last four decades, from \$93.4 billion in 1960 to \$6.8 trillion in 2020. Comparing spending over time in nominal dollars is misleading because it does not take into account inflation or growth in population and the real economy. A more useful method of comparison is to examine government spending as a percent of GDP over time.
The top line in Figure 17.2 shows the federal spending level since 1960, expressed as a share of GDP. Despite a widespread sense among many Americans that the federal government has been growing steadily larger, the graph shows that federal spending has hovered in a range from 18% to 22% of GDP most of the time since 1960. For example, throughout the latter part of the 2010s, government expenditures were around 20% of GDP. The other lines in Figure 17.2 show the major federal spending categories: national defense, Social Security, health programs, and interest payments. From the graph, we see that national defense spending as a share of GDP has generally declined since the 1960s, although there were some upward bumps in the 1980s buildup under President Ronald Reagan and in the aftermath of the terrorist attacks on September 11, 2001. In contrast, Social Security and healthcare have grown steadily as a percent of GDP. Healthcare expenditures include both payments for senior citizens (Medicare), and payments for low-income Americans (Medicaid). State governments also partially fund Medicaid. Interest payments are the final main category of government spending in Figure 30.2.
Figure 17.2 Federal Spending, 1960–2020 Since 1960, total federal spending has ranged from about 18% to 22% of GDP. It climbed above that level in 2009, quickly dropped back down to that level by 2013, and again climbed above that level in 2020. The share that the government has spent on national defense has generally declined, while the share it has spent on Social Security and on healthcare expenses (mainly Medicare and Medicaid) has increased. (Source: Economic Report of the President, 2021, Table B47, https://www.govinfo.gov/app/collection/erp/2021)
Each year, the government borrows funds from U.S. citizens and foreigners to cover its budget deficits. It does this by selling securities (Treasury bonds, notes, and bills)—in essence borrowing from the public and promising to repay with interest in the future. From 1961 to 1997, the U.S. government has run budget deficits, and thus borrowed funds, in almost every year. It had budget surpluses from 1998 to 2001, and then returned to deficits.
The interest payments on past federal government borrowing were typically 1–2% of GDP in the 1960s and 1970s but then climbed above 3% of GDP in the 1980s and stayed there until the late 1990s. The government was able to repay some of its past borrowing by running surpluses from 1998 to 2001 and, with help from low interest rates, the interest payments on past federal government borrowing had fallen back to 1.6% of GDP by 2020.
We investigate the government borrowing and debt patterns in more detail later in this chapter, but first we need to clarify the difference between the deficit and the debt. The deficit is not the debt. The difference between the deficit and the debt lies in the time frame. The government deficit (or surplus) refers to what happens with the federal government budget each year. The government debt is accumulated over time. It is the sum of all past deficits and surpluses. If you borrow \$10,000 per year for each of the four years of college, you might say that your annual deficit was \$10,000, but your accumulated debt over the four years is \$40,000.
These four categories—national defense, Social Security, healthcare, and interest payments—generally account for roughly 60% of all federal spending, as Figure 17.3 shows. (Due to the large amount of one-time expenditures by the federal government in 2020 due to the pandemic, the 2019 statistics are presented here.) The remaining 40% wedge of the pie chart covers all other categories of federal government spending: international affairs; science and technology; natural resources and the environment; transportation; housing; education; income support for people in poverty; community and regional development; law enforcement and the judicial system; and the administrative costs of running the government.
Figure 17.3 Slices of Federal Spending, 2019 About 60% of government spending goes to four major areas: national defense, Social Security, healthcare, and interest payments on past borrowing. This leaves about 40% of federal spending for all other functions of the U.S. government. (Source: www.whitehouse.gov/omb/budget/Historicals/)
State and Local Government Spending
Although federal government spending often gets most of the media attention, state and local government spending is also substantial—at about \$3.3 trillion in 2021. Figure 17.4 shows that state and local government spending has increased during the last four decades from around 8% to around 14% today. The single biggest item is education, which accounts for about one-third of the total. The rest covers programs like highways, libraries, hospitals and healthcare, parks, and police and fire protection. Unlike the federal government, all states (except Vermont) have balanced budget laws, which means any gaps between revenues and spending must be closed by higher taxes, lower spending, drawing down their previous savings, or some combination of all of these.
Figure 17.4 State and Local Spending, 1960–2020 Spending by state and local government increased from about 10% of GDP in the early 1960s to 14–16% by the mid-1970s. It has remained at roughly that level since. The single biggest spending item is education, including both K–12 spending and support for public colleges and universities, which has been about 4–5% of GDP in recent decades. Source: (Source: Bureau of Economic Analysis, https://apps.bea.gov/iTable/index_nipa.cfm.)
U.S. presidential candidates often run for office pledging to improve the public schools or to get tough on crime. However, in the U.S. government system, these tasks are primarily state and local government responsibilities. In fiscal year 2020 state and local governments spent about \$970 billion per year on education (including K–12 and college and university education), compared to only \$100 billion by the federal government. In other words, about 90 cents of every dollar spent on education happens at the state and local level. A politician who really wants hands-on responsibility for reforming education or reducing crime might do better to run for mayor of a large city or for state governor rather than for president of the United States.
Taxes are paid by most, but not all, people who work. Even if you are part of the so-called “1099” or “gig” economy, you are considered an independent contractor and must pay taxes on the income you earn in those occupations. Taxes are also paid by consumers whenever they purchase goods and services. Taxes are used for all sorts of spending—from roads, to bridges, to schools (K–12 and public higher education), to police and other public safety functions. Taxes fund vital public services that support our communities. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.02%3A_Government_Spending.txt |
Learning Objectives
By the end of this section, you will be able to:
• Differentiate among a regressive tax, a proportional tax, and a progressive tax
• Identify major revenue sources for the U.S. federal budget
There are two main categories of taxes: those that the federal government collects and those that the state and local governments collect. What percentage the government collects and for what it uses that revenue varies greatly. The following sections will briefly explain the taxation system in the United States.
Taxes are paid by most, but not all, people who work. Even if you are part of the so-called “1099” or “gig” economy, you are considered an independent contractor and must pay taxes on the income you earn in those occupations. Taxes are also paid by consumers whenever they purchase goods and services. Taxes are used for all sorts of spending—from roads, to bridges, to schools (K–12 and public higher education), to police and other public safety functions. Taxes fund vital public services that support our communities.
Federal Taxes
Just as many Americans erroneously think that federal spending has grown considerably, many also believe that taxes have increased substantially. The top line of Figure 17.5 shows total federal taxes as a share of GDP since 1960. Although the line rises and falls, it typically remains within the range of 17% to 20% of GDP, except for 2009–2011, when taxes fell substantially below this level, due to the Great Recession.
Figure 17.5 Federal Taxes, 1960–2020 Federal tax revenues have been about 17–20% of GDP during most periods in recent decades. The primary sources of federal taxes are individual income taxes and the payroll taxes that finance Social Security and Medicare. Corporate income taxes and social insurance taxes provide smaller shares of revenue. (Source: Economic Report of the President, 2021. Table B-47, https://www.govinfo.gov/app/collection/erp/2021)
Figure 17.5 also shows the taxation patterns for the main categories that the federal government taxes: individual income taxes, corporate income taxes, and social insurance and retirement receipts. When most people think of federal government taxes, the first tax that comes to mind is the individual income tax that is due every year on April 15 (or the first business day after). The personal income tax is the largest single source of federal government revenue, but it still represents less than half of federal tax revenue.
The second largest source of federal revenue is the payroll tax (captured in social insurance and retirement receipts), which provides funds for Social Security and Medicare. Payroll taxes have increased steadily over time. Together, the personal income tax and the payroll tax accounted for over 85% of federal tax revenues in 2020. Although personal income tax revenues account for more total revenue than the payroll tax, nearly three-quarters of households pay more in payroll taxes than in income taxes.
The income tax is a progressive tax, which means that the tax rates increase as a household’s income increases. Taxes also vary with marital status, family size, and other factors. The marginal tax rates (the tax due on all yearly income) for a single taxpayer range from 10% to 35%, depending on income, as the following Clear It Up feature explains.
Clear It Up
How does the marginal rate work?
Suppose that a single taxpayer’s income is \$35,000 per year. Also suppose that income from \$0 to \$9,075 is taxed at 10%, income from \$9,075 to \$36,900 is taxed at 15%, and, finally, income from \$36,900 and beyond is taxed at 25%. Since this person earns \$35,000, their marginal tax rate is 15%.
The key fact here is that the federal income tax is designed so that tax rates increase as income increases, up to a certain level. The payroll taxes that support Social Security and Medicare are designed in a different way. First, the payroll taxes for Social Security are imposed at a rate of 12.4% up to a certain wage limit, set at \$137,700 in 2020. Medicare, on the other hand, pays for elderly healthcare, and is fixed at 2.9%, with no upper ceiling.
In both cases, the employer and the employee split the payroll taxes. An employee only sees 6.2% deducted from their paycheck for Social Security, and 1.45% from Medicare. However, as economists are quick to point out, the employer’s half of the taxes are probably passed along to the employees in the form of lower wages, so in reality, the worker pays all of the payroll taxes. If you are a member of the “gig economy” and receive a 1099 tax statement, then you are considered an independent contractor and so you must pay the employee and employer side of the payroll tax.
We also call the Medicare payroll tax a proportional tax; that is, a flat percentage of all wages earned. The Social Security payroll tax is proportional up to the wage limit, but above that level it becomes a regressive tax, meaning that people with higher incomes pay a smaller share of their income in tax.
The third-largest source of federal tax revenue, as Figure 17.5 shows is the corporate income tax. The common name for corporate income is “profits.” Over time, corporate income tax receipts have declined as a share of GDP, from about 4% in the 1960s to an average of 1% to 2% of GDP in the past 40 years.
The federal government has a few other, smaller sources of revenue. It imposes an excise tax—that is, a tax on a particular good—on gasoline, tobacco, and alcohol. As a share of GDP, the amount the government collects from these taxes has stayed nearly constant over time, from about 2% of GDP in the 1960s to roughly 3% by 2020, according to the nonpartisan Congressional Budget Office. The government also imposes an estate and gift tax on people who pass large amounts of assets to the next generation—either after death or during life in the form of gifts. These estate and gift taxes collected about 0.2% of GDP in 2020. By a quirk of legislation, the government repealed the estate and gift tax in 2010, but reinstated it in 2011. Other federal taxes, which are also relatively small in magnitude, include tariffs the government collects on imported goods and charges for inspections of goods entering the country.
State and Local Taxes
At the state and local level, taxes have been rising as a share of GDP over the last few decades to match the gradual rise in spending, as Figure 17.6 illustrates. The main revenue sources for state and local governments are sales taxes, property taxes, and revenue passed along from the federal government, but many state and local governments also levy personal and corporate income taxes, as well as impose a wide variety of fees and charges. The specific sources of tax revenue vary widely across state and local governments. Some states rely more on property taxes, some on sales taxes, some on income taxes, and some more on revenues from the federal government.
Figure 17.6 State and Local Tax Revenue as a Share of GDP, 1960–2020 State and local tax revenues have increased to match the rise in state and local spending. (Source: Economic Report of the President, 2020. Table B-50, https://www.govinfo.gov/app/collection/erp/2021) | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.03%3A_Taxation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the U.S. federal budget in terms of annual debt and accumulated debt
• Understand how economic growth or decline can influence a budget surplus or budget deficit
Having discussed the revenue (taxes) and expense (spending) side of the budget, we now turn to the annual budget deficit or surplus, which is the difference between the tax revenue collected and spending over a fiscal year, which starts October 1 and ends September 30 of the next year.
Figure 17.7 shows the pattern of annual federal budget deficits and surpluses, back to 1930, as a share of GDP. When the line is above the horizontal axis, the budget is in surplus. When the line is below the horizontal axis, a budget deficit occurred. Clearly, the biggest deficits as a share of GDP during this time were incurred to finance World War II. Deficits were also large during the 1930s, the 1980s, the early 1990s, 2007–2009 (the Great Recession), and 2020 (the pandemic-induced recession).
Figure 17.7 Pattern of Federal Budget Deficits and Surpluses, 1929–2020 The federal government has run budget deficits for decades. The budget was briefly in surplus in the late 1990s, before heading into deficit again in the first decade of the 2000s—and especially deep deficits in the 2007-2009 and 2020 recessions. (Source: Federal Reserve Bank of St. Louis (FRED). http://research.stlouisfed.org/fred2...es/FYFSGDA188S)
Federal Surplus or Deficit as a Percentage of Gross Domestic Product
Debt/GDP Ratio
Another useful way to view the budget deficit is through the prism of accumulated debt rather than annual deficits. The national debt refers to the total amount that the government has borrowed over time. In contrast, the budget deficit refers to how much the government has borrowed in one particular year. Figure 17.8 shows the ratio of debt/GDP since 1966. Until the 1970s, the debt/GDP ratio revealed a fairly clear pattern of federal borrowing. The government ran up large deficits and raised the debt/GDP ratio in World War II, but from the 1950s to the 1970s the government ran either surpluses or relatively small deficits, and so the debt/GDP ratio drifted down. Large deficits in the 1980s and early 1990s caused the ratio to rise sharply. When budget surpluses arrived from 1998 to 2001, the debt/GDP ratio declined substantially. The budget deficits starting in 2002 then tugged the debt/GDP ratio higher—with a big jump when the recession took hold in 2008–2009. There was another leap in the ratio in 2020.
Figure 17.8 Federal Debt as a Percentage of GDP, 1942–2014 Federal debt is the sum of annual budget deficits and surpluses. Annual deficits do not always mean that the debt/GDP ratio is rising. During the 1960s and 1970s, the government often ran small deficits, but since the debt was growing more slowly than the economy, the debt/GDP ratio was declining over this time. In the 2008–2009 recession, the debt/GDP ratio rose sharply, before leveling off through the later 2010s. In 2020, it rose sharply again. (Source: https://fred.stlouisfed.org/series/GFDEGDQ188S)
The next Clear it Up feature discusses how the government handles the national debt.
Clear It Up
What is the national debt?
One year’s federal budget deficit causes the federal government to sell Treasury bonds to make up the difference between spending programs and tax revenues. The dollar value of all the outstanding Treasury bonds on which the federal government owes money is equal to the national debt.
Gross Federal Debt as a Percentage of Gross Domestic Product
The Path from Deficits to Surpluses to Deficits
Why did the budget deficits suddenly turn to surpluses from 1998 to 2001 and why did the surpluses return to deficits in 2002? Why did the deficit become so large in 2020? Figure 17.9 suggests some answers. The graph combines the earlier information on total federal spending and taxes in a single graph, but focuses on the federal budget since 1990.
Figure 17.9 Total Government Spending and Taxes as a Share of GDP, 1990–2014 When government spending exceeds taxes, the gap is the budget deficit. When taxes exceed spending, the gap is a budget surplus. The recessionary period starting in late 2007 saw higher spending and lower taxes, combining to create a large deficit in 2009. The same thing happened in a more extreme way in 2020. (Source: Economic Report of the President, Tables B-46, https://www.govinfo.gov/app/collection/erp/2021)
Government spending as a share of GDP declined steadily through the 1990s. The biggest single reason was that defense spending declined from 5.2% of GDP in 1990 to 3.0% in 2000, but interest payments by the federal government also fell by about 1.0% of GDP. However, federal tax collections increased substantially in the later 1990s, jumping from 18.1% of GDP in 1994 to 20.8% in 2000. Powerful economic growth in the late 1990s fueled the boom in taxes. Personal income taxes rise as income goes up; payroll taxes rise as jobs and payrolls go up; corporate income taxes rise as profits go up. At the same time, government spending on transfer payments such as unemployment benefits, foods stamps, and welfare declined with more people working.
This sharp increase in tax revenues and decrease in expenditures on transfer payments was largely unexpected even by experienced budget analysts, and so budget surpluses came as a surprise. However, in the early 2000s, many of these factors started running in reverse. Tax revenues sagged, due largely to the recession that started in March 2001, which reduced revenues. Congress enacted a series of tax cuts and President George W. Bush signed them into law, starting in 2001. In addition, government spending swelled due to increases in defense, healthcare, education, Social Security, and support programs for those who were hurt by the recession and the slow growth that followed. Deficits returned. When the severe recession hit in late 2007, spending climbed and tax collections fell to historically unusual levels, resulting in enormous deficits.
Longer-term U.S. budget forecasts, a decade or more into the future, predict enormous deficits. The higher deficits during the 2007–2009 Great Recession and the 2020 pandemic-induced recession have repercussions, and the demographics will be challenging. The primary reason is the “baby boom”—the exceptionally high birthrates that began in 1946, right after World War II, and lasted for about two decades. Starting in 2010, the front edge of the baby boom generation reached age 65, and in the next two decades, the proportion of Americans over the age of 65 will increase substantially. During the 2020 recession, we saw another wave of early retirements, and we are now in the middle of this major demographic shift. The current level of the payroll taxes that support Social Security and Medicare will fall well short of the projected expenses of these programs, as the following Clear It Up feature shows; thus, the forecast is for increasingly large budget deficits. A decision to collect more revenue to support these programs or to decrease benefit levels would alter this long-term forecast.
Clear It Up
What is the long-term budget outlook for Social Security and Medicare?
In 1946, just one American in 13 was over age 65. By 2000, it was one in eight. By 2030, one American in five will be over age 65. Two enormous U.S. federal programs focus on the elderly—Social Security and Medicare. The growing numbers of elderly Americans will increase spending on these programs, as well as on Medicaid. The current payroll tax levied on workers, which supports all of Social Security and the hospitalization insurance part of Medicare, will not be enough to cover the expected costs, so what are the options?
Long-term projections from the Congressional Budget Office in 2021 are that Medicare and Social Security spending combined will rise from 8.7% of GDP in 2021 to about 10.8% by 2027–2031. If this rise in spending occurs, without any corresponding rise in tax collections, then some mix of changes must occur: (1) taxes will need to increase dramatically; (2) other spending will need to be cut dramatically; (3) the retirement age and/or age receiving Medicare benefits will need to increase, or (4) the federal government will need to run extremely large budget deficits.
Some proposals suggest removing the cap on wages subject to the payroll tax, so that those with very high incomes would have to pay the tax on the entire amount of their wages. Other proposals suggest moving Social Security and Medicare from systems in which workers pay for retirees toward programs that set up accounts where workers save funds over their lifetimes and then draw out after retirement to pay for healthcare.
The United States is not alone in this problem. Providing the promised level of retirement and health benefits to a growing proportion of elderly with a falling proportion of workers is an even more severe problem in many European nations and in Japan. How to pay promised levels of benefits to the elderly will be a difficult public policy decision.
In the next module we shift to the use of fiscal policy to counteract business cycle fluctuations. In addition, we will explore proposals requiring a balanced budget—that is, for government spending and taxes to be equal each year. The Impacts of Government Borrowing will also cover how fiscal policy and government borrowing will affect national saving—and thus affect economic growth and trade imbalances. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.04%3A_Federal_Deficits_and_the_National_Debt.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain how expansionary fiscal policy can shift aggregate demand and influence the economy
• Explain how contractionary fiscal policy can shift aggregate demand and influence the economy
Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. We know from the chapter on economic growth that over time the quantity and quality of our resources grow as the population and thus the labor force get larger, as businesses invest in new capital, and as technology improves. The result of this is regular shifts to the right of the aggregate supply curves, as Figure 17.10 illustrates.
The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The new equilibrium (E1) is an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. Now the equilibrium is E2, with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.
Figure 17.10 A Healthy, Growing Economy In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. However, if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.
Aggregate demand and aggregate supply do not always move neatly together. Think about what causes shifts in aggregate demand over time. As aggregate supply increases, incomes tend to go up. This tends to increase consumer and investment spending, shifting the aggregate demand curve to the right, but in any given period it may not shift the same amount as aggregate supply. What happens to government spending and taxes? Government spends to pay for the ordinary business of government- items such as national defense, social security, and healthcare, as Figure 17.10 shows. Tax revenues, in part, pay for these expenditures. The result may be an increase in aggregate demand more than or less than the increase in aggregate supply. Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes.
For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary increases in the price level will result. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand. As these occur, the government may choose to use fiscal policy to address the difference.
Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. If recession threatens, the central bank uses an expansionary monetary policy to increase the money supply, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If inflation threatens, the central bank uses contractionary monetary policy to reduce the money supply, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.
Expansionary Fiscal Policy
Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in tax rates. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investment spending by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased federal government spending on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investment, and decreasing government spending, either through cuts in government spending or increases in taxes. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.
Consider first the situation in Figure 17.11, which is similar to the U.S. economy during the 2007-2009 recession. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below the level of potential GDP as the LRAS curve indicates. At the equilibrium (E0), a recession occurs and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition, the price level would rise back to the level P1 associated with potential GDP.
Figure 17.11 Expansionary Fiscal Policy The original equilibrium (E0) represents a recession, occurring at a quantity of output (Y0) below potential GDP. However, a shift of aggregate demand from AD0 to AD1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of potential GDP which the LRAS curve shows. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P0 to P1 that results should be relatively small.
Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? During the 2007-2009 Great Recession, the U.S. economy suffered a 3.1% cumulative loss of GDP. That may not sound like much, but it’s more than one year’s average growth rate of GDP. Over that time frame, the unemployment rate doubled from 5% to 10%. The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that the government implement expansionary fiscal policy through spending increases. In a bipartisan effort to address the extreme situation, the Obama administration and Congress passed an \$830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending. At the same time, however, the federal stimulus was partially offset when state and local governments, whose budgets were hard hit by the recession, began cutting their spending.
Events were even more severe during the more recent pandemic-induced recession. In a single quarter (Quarter 2 of 2020), GDP fell by over 9%, or at an annualized rate of about 34%. Policymakers were quick to respond with expanded unemployment insurance, aid to state and local governments (so that they didn’t have to cut their spending like they did during the Great Recession), grants and tax breaks for small businesses, and perhaps most significantly, stimulus checks sent to over 100 million households, totaling thousands of dollars each. Since these were mostly spending measures, they were supported more by Democrats than by Republicans, although both groups recognized the severity of the problem and were largely in agreement early on. Especially during the debates over later rounds of the stimulus checks, many discussions were had over the appropriate size and target of the checks. Ultimately, compromises were made and no side got exactly what it wanted.
The conflict over which policy tool to use can be frustrating to those who want to categorize economics as “liberal” or “conservative,” or who want to use economic models to argue against their political opponents. However, advocates of smaller government, who seek to reduce taxes and government spending can use the AD AS model, as well as advocates of bigger government, who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help inform decisions about whether the government should change taxes or spending, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is a political decision rather than a purely economic one.
Contractionary Fiscal Policy
Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. As Figure 17.12 shows, a very large budget deficit pushes up aggregate demand, so that the intersection of aggregate demand (AD0) and aggregate supply (SRAS0) occurs at equilibrium E0, which is an output level above potential GDP. Economists sometimes call this an “overheating economy” where demand is so high that there is upward pressure on wages and prices, causing inflation. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP, where aggregate demand intersects the LRAS curve.
Figure 17.12 A Contractionary Fiscal Policy The economy starts at the equilibrium quantity of output Y0, which is above potential GDP. The extremely high level of aggregate demand will generate inflationary increases in the price level. A contractionary fiscal policy can shift aggregate demand down from AD0 to AD1, leading to a new equilibrium output E1, which occurs at potential GDP, where AD1 intersects the LRAS curve.
Again, the AD–AS model does not dictate how the government should carry out this contractionary fiscal policy. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. The model only argues that, in this situation, the government needs to reduce aggregate demand. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.05%3A_Using_Fiscal_Policy_to_Fight_Recession_Unemployment_and_Inflation.txt |
Learning Objectives
By the end of this section, you will be able to:
• Describe how the federal government can use discretionary fiscal policy to stabilize the economy
• Identify examples of automatic stabilizers
• Understand how a government can use standardized employment budget to identify automatic stabilizers
In 2020, more than 20 million people could collect unemployment insurance benefits to replace some of their salaries. Federal fiscal policies include discretionary fiscal policy, when the government passes a new law that explicitly changes tax or spending levels. The 2020 stimulus checks and increases in state and local government aid are an example. Changes in tax and spending levels can also occur automatically, due to automatic stabilizers, such as unemployment insurance and food stamps, which are programs that are already laws that stimulate aggregate demand in a recession and hold down aggregate demand in a potentially inflationary boom.
Counterbalancing Recession and Boom
Consider first the situation where aggregate demand has risen sharply, causing the equilibrium to occur at a level of output above potential GDP. This situation will increase inflationary pressure in the economy. The policy prescription in this setting would be a dose of contractionary fiscal policy, implemented through some combination of higher taxes and lower spending. To some extent, both changes happen automatically. On the tax side, a rise in aggregate demand means that workers and firms throughout the economy earn more. Because taxes are based on personal income and corporate profits, a rise in aggregate demand automatically increases tax payments. On the spending side, stronger aggregate demand typically means lower unemployment and fewer layoffs, and so there is less need for government spending on unemployment benefits, welfare, Medicaid, and other programs in the social safety net.
The process works in reverse, too. If aggregate demand were to fall sharply so that a recession occurs, then the prescription would be for expansionary fiscal policy—some mix of tax cuts and spending increases. The lower level of aggregate demand and higher unemployment will tend to pull down personal incomes and corporate profits, an effect that will reduce the amount of taxes owed automatically. Higher unemployment and a weaker economy should lead to increased government spending on unemployment benefits, welfare, and other similar domestic programs. In 2009, the stimulus package included an extension in the time allowed to collect unemployment insurance. In addition, the automatic stabilizers react to a weakening of aggregate demand with expansionary fiscal policy and react to a strengthening of aggregate demand with contractionary fiscal policy, just as the AD/AS analysis suggests.
A combination of automatic stabilizers and discretionary fiscal policy produced the very large budget deficit in 2020. The pandemic caused high levels of unemployment, meaning less tax-generating economic activity. The high unemployment rate triggered the automatic stabilizers that reduce taxes and increase spending, due to the increased amount of unemployment insurance paid out by the federal and state governments. Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession.
A glance back at economic history provides a second illustration of the power of automatic stabilizers. Remember that the length of economic upswings between recessions has become longer in the U.S. economy in recent decades (as we discussed in Unemployment). The three longest economic booms of the twentieth century happened in the 1960s, the 1980s, and the 1991–2001 time period. One reason why the economy has tipped into recession less frequently in recent decades is that the size of government spending and taxes has increased in the second half of the twentieth century. Thus, the automatic stabilizing effects from spending and taxes are now larger than they were in the first half of the twentieth century. Around 1900, for example, federal spending was only about 2% of GDP. In 1929, just before the Great Depression hit, government spending was still just 4% of GDP. In those earlier times, the smaller size of government made automatic stabilizers far less powerful than in the last few decades, when government spending often hovers at 20% of GDP or more.
The Standardized Employment Deficit or Surplus
Each year, the nonpartisan Congressional Budget Office (CBO) calculates the standardized employment budget—that is, what the budget deficit or surplus would be if the economy were producing at potential GDP, where people who look for work were finding jobs in a reasonable period of time and businesses were making normal profits, with the result that both workers and businesses would be earning more and paying more taxes. In effect, the standardized employment deficit eliminates the impact of the automatic stabilizers. Figure 17.13 compares the actual budget deficits of recent decades with the CBO’s standardized deficit.
Link It Up
Visit this website to learn more from the Congressional Budget Office.
Figure 17.13 Comparison of Actual Budget Deficits with the Standardized Employment Deficit When the economy is in recession, the standardized employment budget deficit is less than the actual budget deficit because the economy is below potential GDP, and the automatic stabilizers are reducing taxes and increasing spending. When the economy is performing extremely well, the standardized employment deficit (or surplus) is higher than the actual budget deficit (or surplus) because the economy is producing about potential GDP, so the automatic stabilizers are increasing taxes and reducing the need for government spending. (Sources: Actual and Cyclically Adjusted Budget Surpluses/Deficits, https://www.cbo.gov/data/budget-economic-data#8)
Notice that in recession years, like the early 1990s, 2001, or 2009, the standardized employment deficit is smaller than the actual deficit. (These data are only available up until February 2020, so they do not include the effects of the pandemic.) During recessions, the automatic stabilizers tend to increase the budget deficit, so if the economy was instead at full employment, the deficit would be reduced. However, in the late 1990s the standardized employment budget surplus was lower than the actual budget surplus. The gap between the standardized budget deficit or surplus and the actual budget deficit or surplus shows the impact of the automatic stabilizers. More generally, the standardized budget figures allow you to see what the budget deficit would look like with the economy held constant—at its potential GDP level of output.
Automatic stabilizers occur quickly. Lower wages means that a lower amount of taxes is withheld from paychecks right away. Higher unemployment or poverty means that government spending in those areas rises as quickly as people apply for benefits. However, while the automatic stabilizers offset part of the shifts in aggregate demand, they do not offset all or even most of it. Historically, automatic stabilizers on the tax and spending side offset about 10% of any initial movement in the level of output. This offset may not seem enormous, but it is still useful. Automatic stabilizers, like shock absorbers in a car, can be useful if they reduce the impact of the worst bumps, even if they do not eliminate the bumps altogether.
Child Tax Credit
One new form of government spending meant to support working families is an expanded Child Tax Credit (CTC). Under changes which took effect in 2021, qualifying families will receive the credit as a monthly payment directly into their bank accounts. The credit is also an expanded amount: from \$2,000 per child to \$3,600 per child under the age of 6 (less for children older than that). Introduced by President Joe Biden’s American Rescue Plan, it is hoped that the newly expanded CTC will help reduce child poverty and support families. Because the CTC works like a grant that is automatically extended to households, the CTC is considered a new kind of fiscal policy that is related to a universal basic income policy which some have argued for in the past. By sending money out monthly instead of a lump sum as part of a person’s tax refund, the intention is to help families better manage monthly bills for things like clothes and food. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.06%3A_Automatic_Stabilizers.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand how fiscal policy and monetary policy are interconnected
• Explain the three lag times that often occur when solving economic problems
• Identify the legal and political challenges of responding to an economic problem
In the early 1960s, many leading economists believed that the problem of the business cycle, and the swings between cyclical unemployment and inflation, were a thing of the past. On the cover of its December 31, 1965, issue, Time magazine, then the premier news magazine in the United States, ran a picture of John Maynard Keynes, and the story inside identified Keynesian theories as “the prime influence on the world’s economies.” The article reported that policymakers have “used Keynesian principles not only to avoid the violent [business] cycles of prewar days but to produce phenomenal economic growth and to achieve remarkably stable prices.”
This happy consensus, however, did not last. The U.S. economy suffered one recession from December 1969 to November 1970, a deeper recession from November 1973 to March 1975, and then double-dip recessions from January to June 1980 and from July 1981 to November 1982. At various times, inflation and unemployment both soared. Clearly, the problems of macroeconomic policy had not been completely solved. As economists began to consider what had gone wrong, they identified a number of issues that make discretionary fiscal policy more difficult than it had seemed in the rosy optimism of the mid-1960s.
Fiscal Policy and Interest Rates
Because fiscal policy affects the quantity that the government borrows in financial capital markets, it not only affects aggregate demand—it can also affect interest rates. In Figure 17.14, the original equilibrium (E0) in the financial capital market occurs at a quantity of \$800 billion and an interest rate of 6%. However, an increase in government budget deficits shifts the demand for financial capital from D0 to D1. The new equilibrium (E1) occurs at a quantity of \$900 billion and an interest rate of 7%.
A consensus estimate based on a number of studies is that an increase in budget deficits (or a fall in budget surplus) by 1% of GDP will cause an increase of 0.5–1.0% in the long-term interest rate.
Figure 17.14 Fiscal Policy and Interest Rates When a government borrows money in the financial capital market, it causes a shift in the demand for financial capital from D0 to D1. As the equilibrium moves from E0 to E1, the equilibrium interest rate rises from 6% to 7% in this example. In this way, an expansionary fiscal policy intended to shift aggregate demand to the right can also lead to a higher interest rate, which has the effect of shifting aggregate demand back to the left.
A problem arises here. An expansionary fiscal policy, with tax cuts or spending increases, is intended to increase aggregate demand. If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending (as occurs with tight monetary policy), thus reducing aggregate demand. Even if the direct effect of expansionary fiscal policy on increasing demand is not totally offset by lower aggregate demand from higher interest rates, fiscal policy can end up less powerful than was originally expected. We refer to this as crowding out, where government borrowing and spending results in higher interest rates, which reduces business investment and household consumption.
The broader lesson is that the government must coordinate fiscal and monetary policy. If expansionary fiscal policy is to work well, then the central bank can also reduce or keep short-term interest rates low. Conversely, monetary policy can also help to ensure that contractionary fiscal policy does not lead to a recession.
Long and Variable Time Lags
The government can change monetary policy several times each year, but it takes much longer to enact fiscal policy. Imagine that the economy starts to slow down. It often takes some months before the economic statistics signal clearly that a downturn has started, and a few months more to confirm that it is truly a recession and not just a one- or two-month blip. Economists often call the time it takes to determine that a recession has occurred the recognition lag. After this lag, policymakers become aware of the problem and propose fiscal policy bills. The bills go into various congressional committees for hearings, negotiations, votes, and then, if passed, eventually for the president’s signature. Many fiscal policy bills about spending or taxes propose changes that would start in the next budget year or would be phased in gradually over time. Economists often refer to the time it takes to pass a bill as the legislative lag. Finally, once the government passes the bill it takes some time to disperse the funds to the appropriate agencies to implement the programs. Economists call the time it takes to start the projects the implementation lag.
Moreover, the exact level of fiscal policy that the government should implement is never completely clear. Should it increase the budget deficit by 0.5% of GDP? By 1% of GDP? By 2% of GDP? In an AD/AS diagram, it is straightforward to sketch an aggregate demand curve shifting to the potential GDP level of output. In the real world, we only know roughly, not precisely, the actual level of potential output, and exactly how a spending cut or tax increase will affect aggregate demand is always somewhat controversial. Also unknown is the state of the economy at any point in time. During the early days of the Obama administration, for example, no one knew the true extent of the economy's deficit. During the 2008-2009 financial crisis, the rapid collapse of the banking system and automotive sector made it difficult to assess how quickly the economy was collapsing.
Thus, it can take many months or even more than a year to begin an expansionary fiscal policy after a recession has started—and even then, uncertainty will remain over exactly how much to expand or contract taxes and spending. When politicians attempt to use countercyclical fiscal policy to fight recession or inflation, they run the risk of responding to the macroeconomic situation of two or three years ago, in a way that may be exactly wrong for the economy at that time. George P. Schultz, a professor of economics, former Secretary of the Treasury, and Director of the Office of Management and Budget, once wrote: “While the economist is accustomed to the concept of lags, the politician likes instant results. The tension comes because, as I have seen on many occasions, the economist’s lag is the politician’s nightmare.”
Temporary and Permanent Fiscal Policy
A temporary tax cut or spending increase will explicitly last only for a year or two, and then revert to its original level. A permanent tax cut or spending increase is expected to stay in place for the foreseeable future. The effect of temporary and permanent fiscal policies on aggregate demand can be very different. Consider how you would react if the government announced a tax cut that would last one year and then be repealed, in comparison with how you would react if the government announced a permanent tax cut. Most people and firms will react more strongly to a permanent policy change than a temporary one.
This fact creates an unavoidable difficulty for countercyclical fiscal policy. The appropriate policy may be to have an expansionary fiscal policy with large budget deficits during a recession, and then a contractionary fiscal policy with budget surpluses when the economy is growing well. However, if both policies are explicitly temporary ones, they will have a less powerful effect than a permanent policy.
Structural Economic Change Takes Time
When an economy recovers from a recession, it does not usually revert to its exact earlier shape. Instead, the economy's internal structure evolves and changes and this process can take time. For example, much of the economic growth of the mid-2000s was in the construction sector (especially of housing) and finance. However, when housing prices started falling in 2007 and the resulting financial crunch led into recession (as we discussed in Monetary Policy and Bank Regulation), both sectors contracted. The manufacturing sector of the U.S. economy has been losing jobs in recent years as well, under pressure from technological change and foreign competition. Many of the people who lost work from these sectors in the 2008-2009 Great Recession will never return to the same jobs in the same sectors of the economy. Instead, the economy will need to grow in new and different directions, as the following Clear It Up feature shows. Fiscal policy can increase overall demand, but the process of structural economic change—the expansion of a new set of industries and the movement of workers to those industries—inevitably takes time.
Clear It Up
Why do jobs vanish?
People can lose jobs for a variety of reasons: because of a recession, but also because of longer-run changes in the economy, such as new technology. Productivity improvements in auto manufacturing, for example, can reduce the number of workers needed, and eliminate these jobs in the long run. The internet has created jobs but also caused job loss, from travel agents to book store clerks. Many of these jobs may never come back. Short-run fiscal policy to reduce unemployment can create jobs, but it cannot replace jobs that will never return.
The Limitations of Fiscal Policy
Fiscal policy can help an economy that is producing below its potential GDP to expand aggregate demand so that it produces closer to potential GDP, thus lowering unemployment. However, fiscal policy cannot help an economy produce at an output level above potential GDP without causing inflation At this point, unemployment becomes so low that workers become scarce and wages rise rapidly.
Link It Up
Visit this website to read about how fiscal policies are affecting the recovery.
Political Realties and Discretionary Fiscal Policy
A final problem for discretionary fiscal policy arises out of the difficulties of explaining to politicians how countercyclical fiscal policy that runs against the tide of the business cycle should work. Some politicians have a gut-level belief that when the economy and tax revenues slow down, it is time to hunker down, pinch pennies, and trim expenses. Countercyclical policy, however, says that when the economy has slowed, it is time for the government to stimulate the economy, raising spending, and cutting taxes. This offsets the drop in the economy in the other sectors. Conversely, when economic times are good and tax revenues are rolling in, politicians often feel that it is time for tax cuts and new spending. However, countercyclical policy says that this economic boom should be an appropriate time for keeping taxes high and restraining spending.
Politicians tend to prefer expansionary fiscal policy over contractionary policy. There is rarely a shortage of proposals for tax cuts and spending increases, especially during recessions. However, politicians are less willing to hear the message that in good economic times, they should propose tax increases and spending limits. In the economic upswing of the late 1990s and early 2000s, for example, the U.S. GDP grew rapidly. Estimates from respected government economic forecasters like the nonpartisan Congressional Budget Office and the Office of Management and Budget stated that the GDP was above potential GDP, and that unemployment rates were unsustainably low. However, no mainstream politician took the lead in saying that the booming economic times might be an appropriate time for spending cuts or tax increases.
Discretionary Fiscal Policy: Summing Up
Expansionary fiscal policy can help to end recessions and contractionary fiscal policy can help to reduce inflation. Given the uncertainties over interest rate effects, time lags, temporary and permanent policies, and unpredictable political behavior, many economists and knowledgeable policymakers had concluded by the mid-1990s that discretionary fiscal policy was a blunt instrument, more like a club than a scalpel. It might still make sense to use it in extreme economic situations, like an especially deep or long recession. For less extreme situations, it was often preferable to let fiscal policy work through the automatic stabilizers and focus on monetary policy to steer short-term countercyclical efforts. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.07%3A_Practical_Problems_with_Discretionary_Fiscal_Policy.txt |
Learning Objectives
By the end of this section, you will be able to:
• Understand the arguments for and against requiring the U.S. federal budget to be balanced
• Consider the long-run and short-run effects of a federal budget deficit
For many decades, going back to the 1930s, various legislators have put forward proposals to require that the U.S. government balance its budget every year. In 1995, a proposed constitutional amendment that would require a balanced budget passed the U.S. House of Representatives by a wide margin, and failed in the U.S. Senate by only a single vote. (For the balanced budget to have become an amendment to the Constitution would have required a two-thirds vote by Congress and passage by three-quarters of the state legislatures.)
Most economists view the proposals for a perpetually balanced budget with bemusement. After all, in the short term, economists would expect the budget deficits and surpluses to fluctuate up and down with the economy and the automatic stabilizers. Economic recessions should automatically lead to larger budget deficits or smaller budget surpluses, while economic booms lead to smaller deficits or larger surpluses. A requirement that the budget be balanced each and every year would prevent these automatic stabilizers from working and would worsen the severity of economic fluctuations.
Some supporters of the balanced budget amendment like to argue that, since households must balance their own budgets, the government should too. However, this analogy between household and government behavior is severely flawed. Most households do not balance their budgets every year. Some years households borrow to buy houses or cars or to pay for medical expenses or college tuition. Other years they repay loans and save funds in retirement accounts. After retirement, they withdraw and spend those savings. Also, the government is not a household for many reasons, one of which is that the government has macroeconomic responsibilities. The argument of Keynesian macroeconomic policy is that the government needs to lean against the wind, spending when times are hard and saving when times are good, for the sake of the overall economy.
There is also no particular reason to expect a government budget to be balanced in the medium term of a few years. For example, a government may decide that by running large budget deficits, it can make crucial long-term investments in human capital and physical infrastructure that will build the country's long-term productivity. These decisions may work out well or poorly, but they are not always irrational. Such policies of ongoing government budget deficits may persist for decades. As the U.S. experience from the end of World War II up to about 1980 shows, it is perfectly possible to run budget deficits almost every year for decades, but as long as the percentage increases in debt are smaller than the percentage growth of GDP, the debt/GDP ratio will decline at the same time.
Nothing in this argument is a claim that budget deficits are always a wise policy. In the short run, a government that runs a very large budget deficit can shift aggregate demand to the right and trigger severe inflation. Additionally, governments may borrow for foolish or impractical reasons. The Impacts of Government Borrowing will discuss how large budget deficits, by reducing national saving, can in certain cases reduce economic growth and even contribute to international financial crises. A requirement that the budget be balanced in each calendar year, however, is a misguided overreaction to the fear that in some cases, budget deficits can become too large.
Bring It Home
No Yellowstone Park?
The 2013 federal budget shutdown illustrated the many sides to fiscal policy and the federal budget. In 2013, Republicans and Democrats could not agree on which spending policies to fund and how large the government debt should be. Due to the severity of the 2008-2009 recession, the fiscal stimulus, and previous policies, the federal budget deficit and debt was historically high. One way to try to cut federal spending and borrowing was to refuse to raise the legal federal debt limit, or tie on conditions to appropriation bills to stop the Affordable Health Care Act. This disagreement led to a two-week federal government shutdown and got close to the deadline where the federal government would default on its Treasury bonds. Finally, however, a compromise emerged and the government avoided default. This shows clearly how closely fiscal policies are tied to politics.
17.09: Key Terms
automatic stabilizers
tax and spending rules that have the effect of slowing down the rate of decrease in aggregate demand when the economy slows down and restraining aggregate demand when the economy speeds up, without any additional change in legislation
balanced budget
when government spending and taxes are equal
budget deficit
when the federal government spends more money than it receives in taxes in a given year
budget surplus
when the government receives more money in taxes than it spends in a year
contractionary fiscal policy
fiscal policy that decreases the level of aggregate demand, either through cuts in government spending or increases in taxes
corporate income tax
a tax imposed on corporate profits
crowding out
federal spending and borrowing causes interest rates to rise and business investment to fall
discretionary fiscal policy
the government passes a new law that explicitly changes overall tax or spending levels with the intent of influencing the level of overall economic activity
estate and gift tax
a tax on people who pass assets to the next generation—either after death or during life in the form of gifts
excise tax
a tax on a specific good—on gasoline, tobacco, and alcohol
expansionary fiscal policy
fiscal policy that increases the level of aggregate demand, either through increases in government spending or cuts in taxes
implementation lag
the time it takes for the funds relating to fiscal policy to be dispersed to the appropriate agencies to implement the programs
individual income tax
a tax based on the income, of all forms, received by individuals
legislative lag
the time it takes to get a fiscal policy bill passed
marginal tax rates
or the tax that must be paid on all yearly income
national debt
the total accumulated amount the government has borrowed, over time, and not yet paid back
payroll tax
a tax based on the pay received from employers; the taxes provide funds for Social Security and Medicare
progressive tax
a tax that collects a greater share of income from those with high incomes than from those with lower incomes
proportional tax
a tax that is a flat percentage of income earned, regardless of level of income
recognition lag
the time it takes to determine that a recession has occurred
regressive tax
a tax in which people with higher incomes pay a smaller share of their income in tax
standardized employment budget
the budget deficit or surplus in any given year adjusted for what it would have been if the economy were producing at potential GDP | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.08%3A_The_Question_of_a_Balanced_Budget.txt |
17.1 Government Spending
Fiscal policy is the set of policies that relate to federal government spending, taxation, and borrowing. In recent decades, the level of federal government spending and taxes, expressed as a share of GDP, has not changed much, typically fluctuating between about 18% to 22% of GDP. However, the level of state spending and taxes, as a share of GDP, has risen from about 12–13% to about 20% of GDP over the last four decades. The four main areas of federal spending are national defense, Social Security, healthcare, and interest payments, which together account for about 70% of all federal spending. When a government spends more than it collects in taxes, it is said to have a budget deficit. When a government collects more in taxes than it spends, it is said to have a budget surplus. If government spending and taxes are equal, it is said to have a balanced budget. The sum of all past deficits and surpluses make up the government debt.
17.2 Taxation
The two main federal taxes are individual income taxes and payroll taxes that provide funds for Social Security and Medicare; these taxes together account for more than 80% of federal revenues. Other federal taxes include the corporate income tax, excise taxes on alcohol, gasoline and tobacco, and the estate and gift tax. A progressive tax is one, like the federal income tax, where those with higher incomes pay a higher share of taxes out of their income than those with lower incomes. A proportional tax is one, like the payroll tax for Medicare, where everyone pays the same share of taxes regardless of income level. A regressive tax is one, like the payroll tax (above a certain threshold) that supports Social Security, where those with high income pay a lower share of income in taxes than those with lower incomes.
17.3 Federal Deficits and the National Debt
For most of the twentieth century, the U.S. government took on debt during wartime and then paid down that debt slowly in peacetime. However, it took on quite substantial debts in peacetime in the 1980s and early 1990s, before a brief period of budget surpluses from 1998 to 2001, followed by a return to annual budget deficits since 2002, with very large deficits in the recession of 2008 and 2009. A budget deficit or budget surplus is measured annually. Total government debt or national debt is the sum of budget deficits and budget surpluses over time.
17.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP.
17.5 Automatic Stabilizers
Fiscal policy is conducted both through discretionary fiscal policy, which occurs when the government enacts taxation or spending changes in response to economic events, or through automatic stabilizers, which are taxing and spending mechanisms that, by their design, shift in response to economic events without any further legislation. The standardized employment budget is the calculation of what the budget deficit or budget surplus would have been in a given year if the economy had been producing at its potential GDP in that year. Many economists and politicians criticize the use of fiscal policy for a variety of reasons, including concerns over time lags, the impact on interest rates, and the inherently political nature of fiscal policy. We cover the critique of fiscal policy in the next module.
17.6 Practical Problems with Discretionary Fiscal Policy
Because fiscal policy affects the quantity of money that the government borrows in financial capital markets, it not only affects aggregate demand—it can also affect interest rates. If an expansionary fiscal policy also causes higher interest rates, then firms and households are discouraged from borrowing and spending, reducing aggregate demand in a situation called crowding out. Given the uncertainties over interest rate effects, time lags (implementation lag, legislative lag, and recognition lag), temporary and permanent policies, and unpredictable political behavior, many economists and knowledgeable policymakers have concluded that discretionary fiscal policy is a blunt instrument and better used only in extreme situations.
17.7 The Question of a Balanced Budget
Balanced budget amendments are a popular political idea, but the economic merits behind such proposals are questionable. Most economists accept that fiscal policy needs to be flexible enough to accommodate unforeseen expenditures, such as wars or recessions. While persistent, large budget deficits can indeed be a problem, a balanced budget amendment prevents even small, temporary deficits that might, in some cases, be necessary. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.10%3A_Key_Concepts_and_Summary.txt |
1.
When governments run budget deficits, how do they make up the differences between tax revenue and spending?
2.
When governments run budget surpluses, what is done with the extra funds?
3.
Is it possible for a nation to run budget deficits and still have its debt/GDP ratio fall? Explain your answer. Is it possible for a nation to run budget surpluses and still have its debt/GDP ratio rise? Explain your answer.
4.
Suppose that gifts were taxed at a rate of 10% for amounts up to \$100,000 and 20% for anything over that amount. Would this tax be regressive or progressive?
5.
If an individual owns a corporation for which he is the only employee, which different types of federal tax will he have to pay?
6.
What taxes would an individual pay if he were self-employed and the business is not incorporated?
7.
The social security tax is 6.2% on employees’ income earned below \$113,000. Is this tax progressive, regressive or proportional?
8.
Debt has a certain self-reinforcing quality to it. There is one category of government spending that automatically increases along with the federal debt. What is it?
9.
True or False:
1. Federal spending has grown substantially in recent decades.
2. By world standards, the U.S. government controls a relatively large share of the U.S. economy.
3. A majority of the federal government’s revenue is collected through personal income taxes.
4. Education spending is slightly larger at the federal level than at the state and local level.
5. State and local government spending has not risen much in recent decades.
6. Defense spending is higher now than ever.
7. The share of the economy going to federal taxes has increased substantially over time.
8. Foreign aid is a large portion, although less than half, of federal spending.
9. Federal deficits have been very large for the last two decades.
10. The accumulated federal debt as a share of GDP is near an all-time high.
10.
What is the main reason for employing contractionary fiscal policy in a time of strong economic growth?
11.
What is the main reason for employing expansionary fiscal policy during a recession?
12.
In a recession, does the actual budget surplus or deficit fall above or below the standardized employment budget?
13.
What is the main advantage of automatic stabilizers over discretionary fiscal policy?
14.
Explain how automatic stabilizers work, both on the taxation side and on the spending side, first in a situation where the economy is producing less than potential GDP and then in a situation where the economy is producing more than potential GDP.
15.
What would happen if expansionary fiscal policy was implemented in a recession but, due to lag, did not actually take effect until after the economy was back to potential GDP?
16.
What would happen if contractionary fiscal policy were implemented during an economic boom but, due to lag, it did not take effect until the economy slipped into recession?
17.
Do you think the typical time lag for fiscal policy is likely to be longer or shorter than the time lag for monetary policy? Explain your answer?
18.
How would a balanced budget amendment affect a decision by Congress to grant a tax cut during a recession?
19.
How would a balanced budget amendment change the effect of automatic stabilizer programs?
17.12: Review Questions
20.
Give some examples of changes in federal spending and taxes by the government that would be fiscal policy and some that would not.
21.
Have the spending and taxes of the U.S. federal government generally had an upward or a downward trend in the last few decades?
22.
What are the main categories of U.S. federal government spending?
23.
What is the difference between a budget deficit, a balanced budget, and a budget surplus?
24.
Have spending and taxes by state and local governments in the United States had a generally upward or downward trend in the last few decades?
25.
What are the main categories of U.S. federal government taxes?
26.
What is the difference between a progressive tax, a proportional tax, and a regressive tax?
27.
What has been the general pattern of U.S. budget deficits in recent decades?
28.
What is the difference between a budget deficit and the national debt?
29.
What is the difference between expansionary fiscal policy and contractionary fiscal policy?
30.
Under what general macroeconomic circumstances might a government use expansionary fiscal policy? When might it use contractionary fiscal policy?
31.
What is the difference between discretionary fiscal policy and automatic stabilizers?
32.
Why do automatic stabilizers function “automatically?”
33.
What is the standardized employment budget?
34.
What are some practical weaknesses of discretionary fiscal policy?
35.
What are some of the arguments for and against a requirement that the federal government budget be balanced every year? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.11%3A_Self-Check_Questions.txt |
36.
Why is government spending typically measured as a percentage of GDP rather than in nominal dollars?
37.
Why are expenditures such as crime prevention and education typically done at the state and local level rather than at the federal level?
38.
Why is spending by the U.S. government on scientific research at NASA fiscal policy while spending by the University of Illinois is not fiscal policy? Why is a cut in the payroll tax fiscal policy whereas a cut in a state income tax is not fiscal policy?
39.
Excise taxes on tobacco and alcohol and state sales taxes are often criticized for being regressive. Although everyone pays the same rate regardless of income, why might this be so?
40.
What is the benefit of having state and local taxes on income instead of collecting all such taxes at the federal level?
41.
In a booming economy, is the federal government more likely to run surpluses or deficits? What are the various factors at play?
42.
Economist Arthur Laffer famously pointed out that, in some cases, income tax revenue can actually go up when tax rates go down. Why might this be the case?
43.
Is it possible for a nation to run budget deficits and still have its debt/GDP ratio fall? Explain your answer. Is it possible for a nation to run budget surpluses and still have its debt/GDP ratio rise? Explain your answer.
44.
How will cuts in state budget spending affect federal expansionary policy?
45.
Is expansionary fiscal policy more attractive to politicians who believe in larger government or to politicians who believe in smaller government? Explain your answer.
46.
Is Medicaid (federal government aid to low-income families and individuals) an automatic stabilizer?
47.
What is a potential problem with a temporary tax decrease designed to increase aggregate demand if people know that it is temporary?
48.
If the government gives a \$300 tax cut to everyone in the country, explain the mechanism by which this will cause interest rates to rise.
49.
Do you agree or disagree with this statement: “It is in the best interest of our economy for Congress and the President to run a balanced budget each year.” Explain your answer.
50.
During the Great Recession of 2008–2009, what actions would have been required of Congress and the President had a balanced budget amendment to the Constitution been ratified? What impact would that have had on the unemployment rate?
17.14: Problems
51.
A government starts off with a total debt of \$3.5 billion. In year one, the government runs a deficit of \$400 million. In year two, the government runs a deficit of \$1 billion. In year three, the government runs a surplus of \$200 million. What is the total debt of the government at the end of year three?
52.
If a government runs a budget deficit of \$10 billion dollars each year for ten years, then a surplus of \$1 billion for five years, and then a balanced budget for another ten years, what is the government debt?
53.
Specify whether expansionary or contractionary fiscal policy would seem to be most appropriate in response to each of the situations below and sketch a diagram using aggregate demand and aggregate supply curves to illustrate your answer:
1. A recession.
2. A stock market collapse that hurts consumer and business confidence.
3. Extremely rapid growth of exports.
4. Rising inflation.
5. A rise in the natural rate of unemployment.
6. A rise in oil prices. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/17%3A_Government_Budgets_and_Fiscal_Policy/17.13%3A_Critical_Thinking_Questions.txt |
Figure 18.1 President Lyndon B. Johnson President Lyndon Johnson played a pivotal role in financing higher education. (Credit: modification of "Lyndon Johnson in 1970” by LBJ Museum & Library, Public Domain)
Chapter Objectives
In this chapter, you will learn about:
• How Government Borrowing Affects Investment and the Trade Balance
• Fiscal Policy, Investment, and Economic Growth
• How Government Borrowing Affects Private Saving
• Fiscal Policy and the Trade Balance
Bring It Home
Financing Higher Education
On November 8, 1965, President Lyndon B. Johnson signed The Higher Education Act of 1965 into law. With a stroke of the pen, he implemented what we know as the financial aid, work study, and student loan programs to help Americans pay for a college education. In his remarks, the President said:
Here the seeds were planted from which grew my firm conviction that for the individual, education is the path to achievement and fulfillment; for the Nation, it is a path to a society that is not only free but civilized; and for the world, it is the path to peace—for it is education that places reason over force.
This Act, he said, "is responsible for funding higher education for millions of Americans. It is the embodiment of the United States’ investment in ‘human capital’." Since Johnson signed the Act into law, the government has renewed it several times.
The purpose of The Higher Education Act of 1965 was to build the country’s human capital by creating educational opportunity for millions of Americans. The three criteria that the government uses to judge eligibility are income, full-time or part-time attendance, and the cost of the institution. According to education.org, in the 2011–2012 school year, over 80% of all full-time college students received some form of federal financial aid; 43% received grants; and another 41% of students aged 15–23 received federal government student loans. The budget to support financial aid has increased not only because of more enrollment, but also because of increased tuition and fees for higher education. In 2022, the government generally took an approach of increasing student aid through programs such as Pell Grant expansion, while also taking steps to ease student loan debt.
Governments have many competing demands for financial support. Any spending should be tempered by fiscal responsibility and by looking carefully at the spending’s impact. When a government spends more than it collects in taxes, it runs a budget deficit. It then needs to borrow. When government borrowing becomes especially large and sustained, it can substantially reduce the financial capital available to private sector firms, as well as lead to trade imbalances and even financial crises.
The Government Budgets and Fiscal Policy chapter introduced the concepts of deficits and debt, as well as how a government could use fiscal policy to address recession or inflation. This chapter begins by building on the national savings and investment identity, which we first introduced in The International Trade and Capital Flows chapter, to show how government borrowing affects firms’ physical capital investment levels and trade balances. A prolonged period of budget deficits may lead to lower economic growth, in part because the funds that the government borrows to fund its budget deficits are typically no longer available for private investment. Moreover, a sustained pattern of large budget deficits can lead to disruptive economic patterns of high inflation, substantial inflows of financial capital from abroad, plummeting exchange rates, and heavy strains on a country’s banking and financial system. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/18%3A_The_Impacts_of_Government_Borrowing/18.01%3A_Introduction_to_the_Impacts_of_Government_Borrowing.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the national saving and investment identity in terms of demand and supply
• Evaluate the role of budget surpluses and trade surpluses in national saving and investment identity
When governments are borrowers in financial markets, there are three possible sources for the funds from a macroeconomic point of view: (1) households might save more; (2) private firms might borrow less; and (3) the additional funds for government borrowing might come from outside the country, from foreign financial investors. Let’s begin with a review of why one of these three options must occur, and then explore how interest rates and exchange rates adjust to these connections.
The National Saving and Investment Identity
The national saving and investment identity, which we first introduced in The International Trade and Capital Flows chapter, provides a framework for showing the relationships between the sources of demand and supply in financial capital markets. The identity begins with a statement that must always hold true: the quantity of financial capital supplied in the market must equal the quantity of financial capital demanded.
The U.S. economy has two main sources for financial capital: private savings from inside the U.S. economy and public savings.
$Total savings = Private savings (S) + Public savings (T – G)Total savings = Private savings (S) + Public savings (T – G)$
These include the inflow of foreign financial capital from abroad. The inflow of savings from abroad is, by definition, equal to the trade deficit, as we explained in The International Trade and Capital Flows chapter. We can write this inflow of foreign investment capital as imports (M) minus exports (X). There are also two main sources of demand for financial capital: private sector investment (I) and government borrowing. Government borrowing in any given year is equal to the budget deficit, which we can write as the difference between government spending (G) and net taxes (T). Let’s call this equation 1.
$Quantity supplied of financial capital = Quantity demanded of financial capitalPrivate savings + Inflow of foreign savings = Private investment + Government budget deficitS + (M – X) = I + (G –T)Quantity supplied of financial capital = Quantity demanded of financial capitalPrivate savings + Inflow of foreign savings = Private investment + Government budget deficitS + (M – X) = I + (G –T)$
Governments often spend more than they receive in taxes and, therefore, public savings (T – G) is negative. This causes a need to borrow money in the amount of (G – T) instead of adding to the nation’s savings. If this is the case, we can view governments as demanders of financial capital instead of suppliers. In algebraic terms, we can rewrite the national savings and investment identity like this:
$Private investment = Private savings + Public savings + Trade deficitI = S + (T – G) + (M – X)Private investment = Private savings + Public savings + Trade deficitI = S + (T – G) + (M – X)$
Let’s call this equation 2. We must accompany a change in any part of the national saving and investment identity by offsetting changes in at least one other part of the equation because we assume that the equality of quantity supplied and quantity demanded always holds. If the government budget deficit changes, then either private saving or investment or the trade balance—or some combination of the three—must change as well. Figure 18.2 shows the possible effects.
Figure 18.2 Effects of Change in Budget Surplus or Deficit on Investment, Savings, and The Trade Balance Chart (a) shows the potential results when the budget deficit rises (or budget surplus falls). Chart (b) shows the potential results when the budget deficit falls (or budget surplus rises).
What about Budget Surpluses and Trade Surpluses?
The national saving and investment identity must always hold true because, by definition, the quantity supplied and quantity demanded in the financial capital market must always be equal. However, the formula will look somewhat different if the government budget is in deficit rather than surplus or if the balance of trade is in surplus rather than deficit. For example, in 1999 and 2000, the U.S. government had budget surpluses, although the economy was still experiencing trade deficits. When the government was running budget surpluses, it was acting as a saver rather than a borrower, and supplying rather than demanding financial capital. As a result, we would write the national saving and investment identity during this time as:
$Quantity supplied of financial capital =Quantity demanded of financial capital Private savings + Trade deficit + Government surplus= Private investment S + (M – X) + (T – G) = IQuantity supplied of financial capital =Quantity demanded of financial capital Private savings + Trade deficit + Government surplus= Private investment S + (M – X) + (T – G) = I$
Let's call this equation 3. Notice that this expression is mathematically the same as equation 2 except the savings and investment sides of the identity have simply flipped sides.
During the 1960s, the U.S. government was often running a budget deficit, but the economy was typically running trade surpluses. Since a trade surplus means that an economy is experiencing a net outflow of financial capital, we would write the national saving and investment identity as:
$Quantity supplied of financial capital=Quantity demanded of financial capitalPrivate savings=Private investment + Outflow of foreign savings + Government budget deficitS=I + (X – M) + (G – T)Quantity supplied of financial capital=Quantity demanded of financial capitalPrivate savings=Private investment + Outflow of foreign savings + Government budget deficitS=I + (X – M) + (G – T)$
Instead of the balance of trade representing part of the supply of financial capital, which occurs with a trade deficit, a trade surplus represents an outflow of financial capital leaving the domestic economy and invested elsewhere in the world.
$Quantity supplied of financial capital=Quantity demanded of financial capital demandPrivate savings=Private investment + Government budget deficit + Trade surplusS=I + (G – T) + (X – M) Quantity supplied of financial capital=Quantity demanded of financial capital demandPrivate savings=Private investment + Government budget deficit + Trade surplusS=I + (G – T) + (X – M)$
We assume that the point to these equations is that the national saving and investment identity always hold. When you write these relationships, it is important to engage your brain and think about what is on the supply and demand side of the financial capital market before you start your calculations.
As you can see in Figure 18.3, the Office of Management and Budget shows that the United States has consistently run budget deficits since 1977, with the exception of 1999 and 2000. What is alarming is the dramatic increase in budget deficits that has occurred since 2008, which in part reflects declining tax revenues and increased safety net expenditures due to the Great Recession. While deficits were controlled as the economy began to recover in the mid-2010s, the budget deficit increased again in 2020 during the pandemic, and forecasters expect deficits to remain high for the foreseeable future. (Recall that T is net taxes. When the government must transfer funds back to individuals for safety net expenditures like Social Security and unemployment benefits, budget deficits rise.) These deficits have implications for the future health of the U.S. economy.
Figure 18.3 United States On-Budget, Surplus, and Deficit, 1952–2020 (\$ billions) The United States has run a budget deficit for over 30 years, with the exception of 1999 and 2000. Military expenditures, entitlement programs, and the decrease in tax revenue coupled with increased safety net support during the Great Recession are major contributors to the dramatic increases in the deficit after 2008. (Source: Office of Management and Budget, https://fred.stlouisfed.org/series/FYFSGDA188S)
A rising budget deficit may result in a fall in domestic investment, a rise in private savings, or a rise in the trade deficit. The following modules discuss each of these possible effects in more detail. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/18%3A_The_Impacts_of_Government_Borrowing/18.02%3A_How_Government_Borrowing_Affects_Investment_and_the_Trade_Balance.txt |
Learning Objectives
By the end of this section, you will be able to:
• Discuss twin deficits as they related to budget and trade deficit
• Explain the relationship between budget deficits and exchange rates
• Explain the relationship between budget deficits and inflation
• Identify causes of recessions
Government budget balances can affect the trade balance. As The Keynesian Perspective chapter discusses, a net inflow of foreign financial investment always accompanies a trade deficit, while a net outflow of financial investment always accompanies a trade surplus. One way to understand the connection from budget deficits to trade deficits is that when government creates a budget deficit with some combination of tax cuts or spending increases, it will increase aggregate demand in the economy, and some of that increase in aggregate demand will result in a higher level of imports. A higher level of imports, with exports remaining fixed, will cause a larger trade deficit. That means foreigners’ holdings of dollars increase as Americans purchase more imported goods. Foreigners use those dollars to invest in the United States, which leads to an inflow of foreign investment. One possible source of funding our budget deficit is foreigners buying Treasury securities that the U.S. government sells, thus a trade deficit often accompanies a budget deficit.
Twin Deficits?
In the mid-1980s, it was common to hear economists and even newspaper articles refer to the twin deficits, as the budget deficit and trade deficit both grew substantially. Figure 18.4 shows the pattern. The federal budget deficit went from 2.6% of GDP in 1981 to 5.1% of GDP in 1985—a drop of 2.5% of GDP. Over that time, the trade deficit moved from 0.5% in 1981 to 2.9% in 1985—a drop of 2.4% of GDP. In the mid-1980s an inflow of foreign investment capital matched, the considerable increase in government borrowing, so the government budget deficit and the trade deficit moved together.
Figure 18.4 U.S. Budget Deficits and Trade Deficits In the 1980s, the budget deficit and the trade deficit declined at the same time. However, since then, the deficits have stopped being twins. The trade deficit grew smaller in the early 1990s as the budget deficit increased, and then the trade deficit grew larger in the late 1990s as the budget deficit turned into a surplus. In the first half of the 2000s, both budget and trade deficits increased. However, in 2009, the trade deficit declined as the budget deficit increased. Through the 2010s, the trade deficit remained relatively stable as the budget deficit declined. While the budget deficit increased in 2020, there has been hardly any change in the trade deficit.
Of course, no one should expect the budget deficit and trade deficit to move in lockstep, because the other parts of the national saving and investment identity—investment and private savings—will often change as well. In the late 1990s, for example, the government budget balance turned from deficit to surplus, but the trade deficit remained large and growing. During this time, the inflow of foreign financial investment was supporting a surge of physical capital investment by U.S. firms. In the first half of the 2000s, the budget and trade deficits again increased together, but in 2009, the budget deficit increased while the trade deficit declined. Through the 2010s, as there were bigger changes in the budget deficit, the trade deficit remained stable. The budget deficit and the trade deficits are related to each other, but they are more like cousins than twins.
Budget Deficits and Exchange Rates
Exchange rates can also help to explain why budget deficits are linked to trade deficits. Figure 18.5 shows a situation using the exchange rate for the U.S. dollar, measured in euros. At the original equilibrium (E0), where the demand for U.S. dollars (D0) intersects with the supply of U.S. dollars (S0) on the foreign exchange market, the exchange rate is 0.9 euros per U.S. dollar and the equilibrium quantity traded in the market is \$100 billion per day. Then the U.S. budget deficit rises and foreign financial investment provides the source of funds for that budget deficit.
International financial investors, as a group, will demand more U.S. dollars on foreign exchange markets to purchase the U.S. government bonds, and they will supply fewer of the U.S. dollars that they already hold in these markets. Demand for U.S. dollars on the foreign exchange market shifts from D0 to D1 and the supply of U.S. dollars falls from S0 to S1. At the new equilibrium (E1), the exchange rate has appreciated to 1.05 euros per dollar while, in this example, the quantity of dollars traded remains the same.
Figure 18.5 Budget Deficits and Exchange Rates Imagine that the U.S. government increases its borrowing and the funds come from European financial investors. To purchase U.S. government bonds, those European investors will need to demand more U.S. dollars on foreign exchange markets, causing the demand for U.S. dollars to shift to the right from D0 to D1. European financial investors as a group will also be less likely to supply U.S. dollars to the foreign exchange markets, causing the supply of U.S. dollars to shift from S0 to S1. The equilibrium exchange rate strengthens from 0.9 euro/ dollar at E0 to 1.05 euros/dollar at E1.
A stronger exchange rate, of course, makes it more difficult for exporters to sell their goods abroad while making imports cheaper, so a trade deficit (or a reduced trade surplus) results. Thus, a budget deficit can easily result in an inflow of foreign financial capital, a stronger exchange rate, and a trade deficit.
You can also imagine interest rates are driving the exchange rate appreciation. As we explained earlier in Figure 18.8, a budget deficit increases demand in markets for domestic financial capital, raising the domestic interest rate. A higher interest rate will attract an inflow of foreign financial capital, and appreciate the exchange rate in response to the increase in demand for U.S. dollars by foreign investors and a decrease in supply of U. S. dollars. Because of higher interest rates in the United States, Americans find U.S. bonds more attractive than foreign bonds. When Americans are buying fewer foreign bonds, they are supplying fewer U.S. dollars. U.S. dollar appreciation leads to a larger trade deficit (or reduced surplus). The connections between inflows of foreign investment capital, interest rates, and exchange rates are all just different ways of drawing the same economic connections: a larger budget deficit can result in a larger trade deficit, although do not expect the connection to be one-to-one.
From Budget Deficits to International Economic Crisis
We lay out step-by-step the economic story of how an outflow of international financial capital can cause a deep recession in the Exchange Rates and International Capital Flows chapter. When international financial investors decide to withdraw their funds from a country like Turkey, they increase the supply of the Turkish lira and reduce the demand for lira, depreciating the lira exchange rate. When firms and the government in a country like Turkey borrow money in international financial markets, they typically do so in stages. First, banks in Turkey borrow in a widely used currency like U.S. dollars or euros, then convert those U.S. dollars to lira, and then lend the money to borrowers in Turkey. If the lira's exchange rate value depreciates, then Turkey’s banks will find it impossible to repay the international loans that are in U.S. dollars or euros.
The combination of less foreign investment capital and banks that are bankrupt can sharply reduce aggregate demand, which causes a deep recession. Many countries around the world have experienced this kind of recession: along with Turkey in 2002, Mexico followed this general pattern in 1995, Thailand and countries across East Asia in 1997–1998, Russia in 1998, and Argentina in 2002. In many of these countries, large government budget deficits played a role in setting the stage for the financial crisis. A moderate increase in a budget deficit that leads to a moderate increase in a trade deficit and a moderate appreciation of the exchange rate is not necessarily a cause for concern. However, beyond some point that is hard to define in advance, a series of large budget deficits can become a cause for concern among international investors.
One reason for concern is that extremely large budget deficits mean that aggregate demand may shift so far to the right as to cause high inflation. The example of Turkey is a situation where very large budget deficits brought inflation rates well into double digits. In addition, very large budget deficits at some point begin to raise a fear that the government would not repay the borrowing. In the last 100 years, the government of Turkey has been unable to pay its debts and defaulted on its loans four times. Over the past 175 years, Brazil’s government has been unable to pay its debts and defaulted on its loans seven times; Venezuela, nine times; and Argentina, five times. The risk of high inflation or a default on repaying international loans will worry international investors, since both factors imply that the rate of return on their investments in that country may end up lower than expected. If international investors start withdrawing the funds from a country rapidly, the scenario of less investment, a depreciated exchange rate, widespread bank failure, and deep recession can occur. The following Clear It Up feature explains other impacts of large deficits.
Clear It Up
What are the risks of chronic large deficits in the United States?
If a government runs large budget deficits for a sustained period of time, what can go wrong? According to a recent Brookings Institution report, a key risk of a large budget deficit is that government debt may grow too high compared to the country’s GDP growth. As debt grows, the national savings rate will decline, leaving less available in financial capital for private investment. The impact of chronically large budget deficits is as follows:
• As the population ages, there will be an increasing demand for government services that may cause higher government deficits. Government borrowing and its interest payments will pull resources away from domestic investment in human capital and physical capital that is essential to economic growth.
• Interest rates may start to rise so that the cost of financing government debt will rise as well, creating pressure on the government to reduce its budget deficits through spending cuts and tax increases. These steps will be politically painful, and they will also have a contractionary effect on aggregate demand in the economy.
• Rising percentage of debt to GDP will create uncertainty in the financial and global markets that might cause a country to resort to inflationary tactics to reduce the real value of the debt outstanding. This will decrease real wealth and damage confidence in the country’s ability to manage its spending. After all, if the government has borrowed at a fixed interest rate of, say, 5%, and it lets inflation rise above that 5%, then it will effectively be able to repay its debt at a negative real interest rate.
The conventional reasoning suggests that the relationship between sustained deficits that lead to high levels of government debt and long-term growth is negative. How significant this relationship is, how big an issue it is compared to other macroeconomic issues, and the direction of causality, is less clear.
What remains important to acknowledge is that the relationship between debt and growth is negative and that for some countries, the relationship may be stronger than in others. It is also important to acknowledge the direction of causality: does high debt cause slow growth, slow growth cause high debt, or are both high debt and slow growth the result of third factors? In our analysis, we have argued simply that high debt causes slow growth. There may be more to this debate than we have space to discuss here.
Using Fiscal Policy to Address Trade Imbalances
If a nation is experiencing the inflow of foreign investment capital associated with a trade deficit because foreign investors are making long-term direct investments in firms, there may be no substantial reason for concern. After all, many low-income nations around the world would welcome direct investment by multinational firms that ties them more closely into the global networks of production and distribution of goods and services. In this case, the inflows of foreign investment capital and the trade deficit are attracted by the opportunities for a good rate of return on private sector investment in an economy.
However, governments should beware of a sustained pattern of high budget deficits and high trade deficits. The danger arises in particular when the inflow of foreign investment capital is not funding long-term physical capital investment by firms, but instead is short-term portfolio investment in government bonds. When inflows of foreign financial investment reach high levels, foreign financial investors will be on the alert for any reason to fear that the country’s exchange rate may decline or the government may be unable to repay what it has borrowed on time. Just as a few falling rocks can trigger an avalanche; a relatively small piece of bad news about an economy can trigger an enormous outflow of short-term financial capital.
Reducing a nation’s budget deficit will not always be a successful method of reducing its trade deficit, because other elements of the national saving and investment identity, like private saving or investment, may change instead. In those cases when the budget deficit is the main cause of the trade deficit, governments should take steps to reduce their budget deficits, lest they make their economy vulnerable to a rapid outflow of international financial capital that could bring a deep recession. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/18%3A_The_Impacts_of_Government_Borrowing/18.03%3A_Fiscal_Policy_and_the_Trade_Balance.txt |
Learning Objectives
By the end of this section, you will be able to:
• Apply Ricardian equivalence to evaluate how government borrowing affects private saving
• Interpret a graphic representation of Ricardian equivalence
A change in government budgets may impact private saving. Imagine that people watch government budgets and adjust their savings accordingly. For example, whenever the government runs a budget deficit, people might reason: “Well, a higher budget deficit means that I’m just going to owe more taxes in the future to pay off all that government borrowing, so I’ll start saving now.” If the government runs budget surpluses, people might reason: “With these budget surpluses (or lower budget deficits), interest rates are falling, so that saving is less attractive. Moreover, with a budget surplus the country will be able to afford a tax cut sometime in the future. I won’t bother saving as much now.”
The theory that rational private households might shift their saving to offset government saving or borrowing is known as Ricardian equivalence because the idea has intellectual roots in the writings of the early nineteenth-century economist David Ricardo (1772–1823). If Ricardian equivalence holds completely true, then in the national saving and investment identity, any change in budget deficits or budget surpluses would be completely offset by a corresponding change in private saving. As a result, changes in government borrowing would have no effect at all on either physical capital investment or trade balances.
In practice, the private sector only sometimes and partially adjusts its savings behavior to offset government budget deficits and surpluses. Figure 18.6 shows the patterns of U.S. government budget deficits and surpluses and the rate of private saving—which includes saving by both households and firms—since 1980. The connection between the two is not at all obvious. In the mid-1980s, for example, government budget deficits were quite large, but there is no corresponding surge of private saving. However, when budget deficits turn to surpluses in the late 1990s, there is a simultaneous decline in private saving. When budget deficits got very large in 2008 and 2009, there was another a rise in saving. When the deficit increased again in 2020, saving jumped up as well. A variety of statistical studies based on the U.S. experience suggests that when government borrowing increases by \$1, private saving rises by about 30 cents. A World Bank study from the late 1990s, looking at government budgets and private saving behavior in countries around the world, found a similar result.
Figure 18.6 U.S. Budget Deficits and Private Savings The theory of Ricardian equivalence suggests that additional private saving will offset any increase in government borrowing, while reduced private saving will offset any decrease in government borrowing. Sometimes this theory holds true, and sometimes it does not. (Source: Bureau of Economic Analysis and Federal Reserve Economic Data)
Private saving does increase to some extent when governments run large budget deficits, and private saving falls when governments reduce deficits or run large budget surpluses. However, the offsetting effects of private saving compared to government borrowing are much less than one-to-one. In addition, this effect can vary a great deal from country to country, from time to time, and over the short and the long run.
If the funding for a larger budget deficit comes from international financial investors, then a trade deficit may accompany a budget deficit. In some countries, this pattern of twin deficits has set the stage for international financial investors first to send their funds to a country and cause an appreciation of its exchange rate and then to pull their funds out and cause a depreciation of the exchange rate and a financial crisis as well. It depends on whether funding comes from international financial investors. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/18%3A_The_Impacts_of_Government_Borrowing/18.04%3A_How_Government_Borrowing_Affects_Private_Saving.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain crowding out and its effect on physical capital investment
• Explain the relationship between budget deficits and interest rates
• Identify why economic growth is tied to investments in physical capital, human capital, and technology
The underpinnings of economic growth are investments in physical capital, human capital, and technology, all set in an economic environment where firms and individuals can react to the incentives provided by well-functioning markets and flexible prices. Government borrowing can reduce the financial capital available for private firms to invest in physical capital. However, government spending can also encourage certain elements of long-term growth, such as spending on roads or water systems, on education, or on research and development that creates new technology.
Crowding Out Physical Capital Investment
A larger budget deficit will increase demand for financial capital. If private saving and the trade balance remain the same, then less financial capital will be available for private investment in physical capital. When government borrowing soaks up available financial capital and leaves less for private investment in physical capital, economists call the result crowding out.
To understand the potential impact of crowding out, consider the U.S. economy's situation before the exceptional circumstances of the recession that started in late 2007. In 2005, for example, the budget deficit was roughly 3% of GDP. Private investment by firms in the U.S. economy has hovered in the range of 14% to 18% of GDP in recent decades. However, in any given year, roughly half of U.S. investment in physical capital just replaces machinery and equipment that has worn out or become technologically obsolete. Only about half represents an increase in the total quantity of physical capital in the economy. Investment in new physical capital in any year is about 7% to 9% of GDP. In this situation, even U.S. budget deficits in the range of 3% of GDP can potentially crowd out a substantial share of new investment spending. Conversely, a smaller budget deficit (or an increased budget surplus) increases the pool of financial capital available for private investment.
Link It Up
Visit this website to view the “U.S. Debt Clock.”
Figure 18.7 shows the patterns of U.S. budget deficits and private investment since 1980. If greater government deficits lead to less private investment in physical capital, and reduced government deficits or budget surpluses lead to more investment in physical capital, these two lines should move up and down simultaneously. This pattern occurred in the late 1990s and early 2000s. The U.S. federal budget went from a deficit of 2.2% of GDP in 1995 to a budget surplus of 2.4% of GDP in 2000—a swing of 4.6% of GDP. From 1995 to 2000, private investment in physical capital rose from 15% to 18% of GDP—a rise of 3% of GDP. Then, when the U.S. government again started running budget deficits in the early 2000s, less financial capital became available for private investment, and the rate of private investment fell back to about 15% of GDP by 2003. However, in more recent years, in the 2010s after the economy recovered from the Great Recession, private investment as a share of GDP increased even as deficits slightly worsened, especially around 2016. And while the deficit increased substantially in 2020, private investment as a share of GDP did not.
Figure 18.7 U.S. Budget Deficits/Surpluses and Private Investment The connection between private savings and flows of international capital plays a role in budget deficits and surpluses. Consequently, government borrowing and private investment sometimes rise and fall together. For example, the 1990s show a pattern in which reduced government borrowing helped to reduce crowding out so that more funds were available for private investment.
This argument does not claim that a government's budget deficits will exactly shadow its national rate of private investment; after all, we must account for private saving and inflows of foreign financial investment. In the mid-1980s, for example, government budget deficits increased substantially without a corresponding drop off in private investment. In 2009, nonresidential private fixed investment dropped by \$300 billion from its previous level of \$1,941 billion in 2008, primarily because, during a recession, firms lack both the funds and the incentive to invest. Investment growth between 2009 and 2014 averaged approximately 5.9% to \$2,210.5 billion—only slightly above its 2008 level, according to the Bureau of Economic Analysis. During that same period, interest rates dropped from 3.94% to less than a quarter percent as the Federal Reserve took dramatic action to prevent a depression by increasing the money supply through lowering short-term interest rates. The "crowding out" of private investment due to government borrowing to finance expenditures appears to have been suspended after the Great Recession.
The Interest Rate Connection
Assume that government borrowing of substantial amounts will have an effect on the quantity of private investment. How will this affect interest rates in financial markets? In Figure 18.8, the original equilibrium (E0) where the demand curve (D0) for financial capital intersects with the supply curve (S0) occurs at an interest rate of 5% and an equilibrium quantity equal to 20% of GDP. However, as the government budget deficit increases, the demand curve for financial capital shifts from D0 to D1. The new equilibrium (E1) occurs at an interest rate of 6% and an equilibrium quantity of 21% of GDP.
Figure 18.8 Budget Deficits and Interest Rates In the financial market, an increase in government borrowing can shift the demand curve for financial capital to the right from D0 to D1. As the equilibrium interest rate shifts from E0 to E1, the interest rate rises from 5% to 6% in this example. The higher interest rate is one economic mechanism by which government borrowing can crowd out private investment.
A survey of economic studies on the connection between government borrowing and interest rates in the U.S. economy suggests that an increase of 1% in the budget deficit will lead to a rise in interest rates of between 0.5 and 1.0%, other factors held equal. In turn, a higher interest rate tends to discourage firms from making physical capital investments. One reason government budget deficits crowd out private investment, therefore, is the increase in interest rates. There are, however, economic studies that show a limited connection between the two (at least in the United States), but as the budget deficit grows, the dangers of rising interest rates become more real.
At this point, you may wonder about the Federal Reserve. After all, can the Federal Reserve not use expansionary monetary policy to reduce interest rates, or in this case, to prevent interest rates from rising? This useful question emphasizes the importance of considering how fiscal and monetary policies work in relation to each other. Imagine a central bank faced with a government that is running large budget deficits, causing a rise in interest rates and crowding out private investment. If the budget deficits are increasing aggregate demand when the economy is already producing near potential GDP, threatening an inflationary increase in price levels, the central bank may react with a contractionary monetary policy. In this situation, the higher interest rates from the government borrowing would be made even higher by contractionary monetary policy, and the government borrowing might crowd out a great deal of private investment.
Alternatively, if the budget deficits are increasing aggregate demand when the economy is producing substantially less than potential GDP, an inflationary increase in the price level is not much of a danger and the central bank might react with expansionary monetary policy. In this situation, higher interest rates from government borrowing would be largely offset by lower interest rates from expansionary monetary policy, and there would be little crowding out of private investment.
However, even a central bank cannot erase the overall message of the national savings and investment identity. If government borrowing rises, then private investment must fall, or private saving must rise, or the trade deficit must rise. By reacting with contractionary or expansionary monetary policy, the central bank can only help to determine which of these outcomes is likely.
Public Investment in Physical Capital
Government can invest in physical capital directly: roads and bridges; water supply and sewers; seaports and airports; schools and hospitals; plants that generate electricity, like hydroelectric dams or windmills; telecommunications facilities; and military weapons. In 2021, the United States spent about \$146 billion on transportation, including highways, mass transit, and airports. Table 18.1 shows the federal government's total outlay for 2021 for major public physical capital investment in the United States. We have omitted physical capital related to the military or to residences where people live from this table, because the focus here is on public investments that have a direct effect on raising output in the private sector.
Type of Public Physical Capital Federal Outlays 2014 Federal Outlays 2021
Transportation \$91,915 \$146,156
Community and regional development \$20,670 \$83,619
Natural resources and the environment \$36,171 \$40,691
Education, training, employment, and social services \$90,615 \$236,723
Other \$37,282 \$41,227
Total \$276,653 \$548,416
Table 18.1 Grants for Major Physical Capital Investment, 2014 and 2021, in \$ Millions (Source: Bureau of Economic Analysis, Table 3.15.5, https://apps.bea.gov/itable/index.cfm).
Public physical capital investment of this sort can increase the economy's output and productivity. An economy with reliable roads and electricity will be able to produce more. However, it is hard to quantify how much government investment in physical capital will benefit the economy, because government responds to political as well as economic incentives. When a firm makes an investment in physical capital, it is subject to the discipline of the market: If it does not receive a positive return on investment, the firm may lose money or even go out of business.
In some cases, lawmakers make investments in physical capital as a way of spending money in key politicians' districts. The result may be unnecessary roads or office buildings. Even if a project is useful and necessary, it might be done in a way that is excessively costly, because local contractors who make campaign contributions to politicians appreciate the extra business. Alternatively, governments sometimes do not make the investments they should because a decision to spend on infrastructure does not need to just make economic sense. It must be politically popular as well. Managing public investment cost-effectively can be difficult.
If a government decides to finance an investment in public physical capital with higher taxes or lower government spending in other areas, it need not worry that it is directly crowding out private investment. Indirectly however, higher household taxes could cut down on the level of private savings available and have a similar effect. If a government decides to finance an investment in public physical capital by borrowing, it may end up increasing the quantity of public physical capital at the cost of crowding out investment in private physical capital, which could be more beneficial to the economy.
Public Investment in Human Capital
In most countries, the government plays a large role in society's investment in human capital through the education system. A highly educated and skilled workforce contributes to a higher rate of economic growth. For the low-income nations of the world, additional investment in human capital seems likely to increase productivity and growth. For the United States, critics have raised tough questions about how much increases in government spending on education will improve the actual level of education.
Among economists, discussions of education reform often begin with some uncomfortable facts. As Figure 18.9 shows, spending per student for kindergarten through grade 12 (K–12) increased substantially in real dollars through 2010, declined slightly in 2011 and 2012, and began rising again after that through 2020. However, as measured by standardized tests like the SAT, the level of student academic achievement has barely budged in recent decades. On international tests, U.S. students lag behind students from many other countries. (Of course, test scores are an imperfect measure of education for a variety of reasons. It would be difficult, however, to argue that there are not real problems in the U.S. education system and that the tests are just inaccurate.)
Figure 18.9 Total Spending for Elementary, Secondary, and Vocational Education (1998–2020) in the United States The graph shows that government spending on education was continually increasing up until 2006 where it leveled off until 2008 when it increased dramatically. Since 2010, spending has steadily decreased. (Source: Office of Management and Budget)
The fact that increased financial resources have not brought greater measurable gains in student performance has led some education experts to question whether the problems may be due to structure, not just to the resources spent.
Other government programs seek to increase human capital either before or after the K–12 education system. Programs for early childhood education, like the federal Head Start program, are directed at families where the parents may have limited educational and financial resources. Government also offers substantial support for universities and colleges. For example, in the United States about 60% of students take at least a few college or university classes beyond the high school level. In Germany and Japan, about half of all students take classes beyond the comparable high school level. In the countries of Latin America, only about one student in four takes classes beyond the high school level, and in the nations of sub-Saharan Africa, only about one student in 20.
Not all spending on educational human capital needs to happen through the government: many college students in the United States pay a substantial share of the cost of their education. If low-income countries of the world are going to experience a widespread increase in their education levels for grade-school children, government spending seems likely to play a substantial role. For the U.S. economy, and for other high-income countries, the primary focus at this time is more on how to get a bigger return from existing spending on education and how to improve the performance of the average high school graduate, rather than dramatic increases in education spending.
How Fiscal Policy Can Improve Technology
Research and development (R&D) efforts are the lifeblood of new technology. According to the National Science Foundation, federal outlays for research, development, and physical plant improvements to various governmental agencies have remained at an average of 8.8% of GDP. About one-fifth of U.S. R&D spending goes to defense and space-oriented research. Although defense-oriented R&D spending may sometimes produce consumer-oriented spinoffs, R&D that is aimed at producing new weapons is less likely to benefit the civilian economy than direct civilian R&D spending.
Fiscal policy can encourage R&D using either direct spending or tax policy. Government could spend more on the R&D that it carries out in government laboratories, as well as expanding federal R&D grants to universities and colleges, nonprofit organizations, and the private sector. By 2014, the federal share of R&D outlays totaled \$135.5 billion, or about 4% of the federal government's total budget outlays, according to data from the National Science Foundation. Fiscal policy can also support R&D through tax incentives, which allow firms to reduce their tax bill as they increase spending on research and development.
Summary of Fiscal Policy, Investment, and Economic Growth
Investment in physical capital, human capital, and new technology is essential for long-term economic growth, as Table 18.2 summarizes. In a market-oriented economy, private firms will undertake most of the investment in physical capital, and fiscal policy should seek to avoid a long series of outsized budget deficits that might crowd out such investment. We will see the effects of many growth-oriented policies very gradually over time, as students are better educated, we make physical capital investments, and man invents and implements new technologies.
Physical Capital Human Capital New Technology
Private Sector New investment in property and equipment On-the-job training Research and development
Public Sector Public infrastructure Public education Job training Research and development encouraged through private sector incentives and direct spending.
Table 18.2 Investment Role of Public and Private Sector in a Market Economy
Bring It Home
Financing Higher Education
According to the Bureau of Labor Statistics, between 1980 and 2020, the average tuition and fees at a 4-year public university increased from \$738 to \$9,349. This represents a more than 12-fold increase in this 40 year period. To put this increase into perspective, median yearly household income in the U.S. has increased from about \$20,000 to \$67,000 during the same time—about a 3.5-fold increase. Clearly, college is becoming increasingly expensive, even as it continues to provide the same benefits that were mentioned at the beginning of this chapter by President Lyndon B. Johnson.
Crucial to the mission of higher education is the Pell Grant program, which was initiated by President Johnson as part of the Higher Education Act of 1965. But Pell Grant amounts have not adequately kept up with the rising costs of college tuition and fees. As part of President Joe Biden's Build Back Better proposal, the maximum Pell Grant award would increase to \$7,045 between 2022–2025, representing an 8.5% increase, which is one of the largest 1-year increases in the last 20 years (the largest increase occurred between 2009 and 2010, during President Barack Obama's term in office). The original proposal also aimed to allow for Deferred Action for Childhood Arrivals program participants to benefit from the awards, through 2030. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/18%3A_The_Impacts_of_Government_Borrowing/18.05%3A_Fiscal_Policy_Investment_and_Economic_Growth.txt |
Head Start program
a program for early childhood education directed at families with limited educational and financial resources.
Ricardian equivalence
the theory that rational private households might shift their saving to offset government saving or borrowing
twin deficits
deficits that occur when a country is running both a trade and a budget deficit
18.07: Key Concepts and Summary
18.1 How Government Borrowing Affects Investment and the Trade Balance
A change in any part of the national saving and investment identity suggests that if the government budget deficit changes, then either private savings, private investment in physical capital, or the trade balance—or some combination of the three—must change as well.
18.2 Fiscal Policy and the Trade Balance
The government need not balance its budget every year. However, a sustained pattern of large budget deficits over time risks causing several negative macroeconomic outcomes: a shift to the right in aggregate demand that causes an inflationary increase in the price level; crowding out private investment in physical capital in a way that slows down economic growth; and creating a dependence on inflows of international portfolio investment which can sometimes turn into outflows of foreign financial investment that can be injurious to a macroeconomy.
18.3 How Government Borrowing Affects Private Saving
The theory of Ricardian equivalence holds that changes in private saving will offset changes in government borrowing or saving. Thus, greater private saving will offset higher budget deficits, while greater private borrowing will offset larger budget surpluses. If the theory holds true, then changes in government borrowing or saving would have no effect on private investment in physical capital or on the trade balance. However, empirical evidence suggests that the theory holds true only partially.
18.4 Fiscal Policy, Investment, and Economic Growth
Economic growth comes from a combination of investment in physical capital, human capital, and technology. Government borrowing can crowd out private sector investment in physical capital, but fiscal policy can also increase investment in publicly owned physical capital, human capital (education), and research and development. Possible methods for improving education and society’s investment in human capital include spending more money on teachers and other educational resources, and reorganizing the education system to provide greater incentives for success. Methods for increasing research and development spending to generate new technology include direct government spending on R&D and tax incentives for businesses to conduct additional R&D.
18.08: Self-Check Questions
1.
In a country, private savings equals 600, the government budget surplus equals 200, and the trade surplus equals 100. What is the level of private investment in this economy?
2.
Assume an economy has a budget surplus of 1,000, private savings of 4,000, and investment of 5,000.
1. Write out a national saving and investment identity for this economy.
2. What will be the balance of trade in this economy?
3. If the budget surplus changes to a budget deficit of 1000, with private saving and investment unchanged, what is the new balance of trade in this economy?
3.
In the late 1990s, the U.S. government moved from a budget deficit to a budget surplus and the trade deficit in the U.S. economy grew substantially. Using the national saving and investment identity, what can you say about the direction in which saving and/or investment must have changed in this economy?
4.
Imagine an economy in which Ricardian equivalence holds. This economy has a budget deficit of 50, a trade deficit of 20, private savings of 130, and investment of 100. If the budget deficit rises to 70, how are the other terms in the national saving and investment identity affected?
5.
Why have many education experts recently placed an emphasis on altering the incentives that U.S. schools face rather than on increasing their budgets? Without endorsing any of these proposals as especially good or bad, list some of the ways in which incentives for schools might be altered.
6.
What are some steps the government can take to encourage research and development? | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/18%3A_The_Impacts_of_Government_Borrowing/18.06%3A_Key_Terms.txt |
7.
Based on the national saving and investment identity, what are the three ways the macroeconomy might react to greater government budget deficits?
8.
How would you expect larger budget deficits to affect private sector investment in physical capital? Why?
9.
Under what conditions will a larger budget deficit cause a trade deficit?
10.
What is the theory of Ricardian equivalence?
11.
What does the concept of rationality have to do with Ricardian equivalence?
12.
What are some of the ways fiscal policy might encourage economic growth?
13.
What are some fiscal policies for improving a society’s human capital?
14.
What are some fiscal policies for improving the technologies that the economy will have to draw upon in the future?
15.
Explain how cuts in funding for programs such as Head Start might affect the development of human capital in the United States.
18.10: Critical Thinking Questions
16.
Assume there is no discretionary increase in government spending. Explain how an improving economy will affect the budget balance and, in turn, investment and the trade balance.
17.
Explain how decreased domestic investments that occur due to a budget deficit will affect future economic growth.
18.
The U.S. government has shut down a number of times in recent history. Explain how a government shutdown will affect the variables in the national investment and savings identity. Could the shutdown affect the government budget deficit?
19.
Explain how a shift from a government budget deficit to a budget surplus might affect the exchange rate.
20.
Describe how a plan for reducing the government deficit might affect a college student, a young professional, and a middle-income family.
21.
Explain whether or not you agree with the premise of the Ricardian equivalence theory that rational people might reason: “Well, a higher budget deficit (surplus) means that I’m just going to owe more (less) taxes in the future to pay off all that government borrowing, so I’ll start saving (spending) now.” Why or why not?
22.
Explain why the government might prefer to provide incentives to private firms to do investment or research and development, rather than simply doing the spending itself?
23.
Under what condition would crowding out not inhibit long-run economic growth? Under what condition would crowding out impede long-run economic growth?
24.
What must take place for the government to run deficits without any crowding out?
18.11: Problems
25.
Sketch a diagram of how a budget deficit causes a trade deficit. (Hint: Begin with what will happen to the exchange rate when foreigners demand more U.S. government debt.)
26.
Sketch a diagram of how sustained budget deficits cause low economic growth.
27.
Assume that the newly independent government of Tanzania employed you in 1964. Now free from British rule, the Tanzanian parliament has decided that it will spend 10 million shillings on schools, roads, and healthcare for the year. You estimate that the net taxes for the year are eight million shillings. The government will finance the difference by selling 10-year government bonds at 12% interest per year. Parliament must add the interest on outstanding bonds to government expenditure each year. Assume that Parliament places additional taxes to finance this increase in government expenditure so the gap between government spending is always two million. If the school, road, and healthcare budget are unchanged, compute the value of the accumulated debt in 10 years.
28.
Illustrate the concept of Ricardian equivalence using the demand and supply of financial capital graph.
29.
During the most recent recession, some economists argued that the change in the interest rates that comes about due to deficit spending implied in the demand and supply of financial capital graph would not occur. A simple reason was that the government was stepping in to invest when private firms were not. Using a graph, explain how the use by government in investment offsets the deficit demand. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/18%3A_The_Impacts_of_Government_Borrowing/18.09%3A_Review_Questions.txt |
Figure 19.1 Looking for Work Job fairs and job centers are often available to help match people to jobs. This fair took place at a college in the U.S., a high-income country with policies to keep unemployment levels in check. Unemployment is an issue that has different causes in different countries, and is especially severe in the low- and middle-income economies around the world. (Credit: modification of “College of DuPage Hosts Career Fair 2015 36” by COD Newsroom/Flickr, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• The Diversity of Countries and Economies across the World
• Improving Countries’ Standards of Living
• Causes of Unemployment around the World
• Causes of Inflation in Various Countries and Regions
• Balance of Trade Concerns
Bring It Home
Youth Unemployment
Chad Harding, a young man from Cape Town, South Africa, completed school having done well on his exams. He had high hopes for the future. Like many young South Africans, however, he had difficulty finding a job. “I was just stuck at home waiting, waiting for something to come up,” he said in a BBC interview. In South Africa over 60% of young adults are unemployed. In fact, the problem is not limited to South Africa. Seventy-three million of the world’s youth aged 15 to 24 are currently unemployed, according to the International Labour Organization.
This chapter will look at macroeconomic policies around the world, specifically those related to reducing unemployment, promoting economic growth, and stable inflation and exchange rates.
There are extraordinary differences in the composition and performance of economies across the world. What explains these differences? Are countries motivated by similar goals when it comes to macroeconomic policy? Can we apply the same macroeconomic framework that we developed in this text to understand the performance of these countries? Let’s take each of these questions in turn.
Explaining differences: Recall from Unemployment that we explained the difference in composition and performance of economies by appealing to an aggregate production function. We argued that differences in productivity explain the diversity of average incomes across the world, which in turn were affected by inputs such as capital deepening, human capital, and “technology.” Every economy has its own distinctive economic characteristics, institutions, history, and political realities, which imply that access to these “ingredients” will vary by country and so will economic performance.
For example, South Korea invested heavily in education and technology to increase agricultural productivity in the early 1950s. Some of this investment came from its historical relationship with the United States. As a result of these and many other institutions, its economy has managed to converge to the levels of income in leading economies like Japan and the United States.
Similar goals and frameworks: Many economies that have performed well in terms of per capita income have—for better or worse—been motivated by a similar goal: to maintain the quality of life of their citizens. Quality of life is a broad term, but as you can imagine it includes but is not limited to such things as low level of unemployment, price stability (low levels of inflation), and the ability to trade. These seem to be universal macroeconomic goals as we discussed in The Macroeconomic Perspective. No country would argue against them. To study macroeconomic policy around the world, we begin by comparing standards of living. In keeping with these goals, we also look at indicators such as unemployment, inflation, and the balance of trade policies across countries. Remember that every country has had a diverse set of experiences; therefore although our goals may be similar, each country may well require macroeconomic policies tailored to its circumstances.
Link It Up
For more reading on the topic of youth unemployment, visit this website to read “Generation Jobless” in the Economist. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/19%3A_Macroeconomic_Policy_Around_the_World/19.01%3A_Introduction_to_Macroeconomic_Policy_around_the_World.txt |
Learning Objectives
By the end of this section, you will be able to:
• Analyze GDP and GNI per capita as a measure of the diversity of international standards of living
• Identify what classifies a country as low income, lower-middle income, upper-middle income, or high income
• Explain how geography, demographics, industry structure, and economic institutions influence standards of living
The national economies that comprise the global economy are remarkably diverse. Let us use one key indicator of the standard of living, GDP per capita, to quantify this diversity. You will quickly see that quantifying this diversity is fraught with challenges and limitations. As we explained in The Macroeconomic Perspective, we must consider using purchasing power parity or “international dollars” to convert average incomes into comparable units. Purchasing power parity, as we formally defined in Exchange Rates and International Capital Flows, takes into account that prices of the same good are different across countries.
The Macroeconomic Perspective explained how to measure GDP, the challenges of using GDP to compare standards of living, and the difficulty of confusing economic size with distribution. In China’s case, for example, China ranks as the second largest global economy, second to only the United States, with Japan ranking third. However, when we take China’s GDP of \$9.2 trillion and divide it by its population of 1.4 billion, then the per capita GDP is only \$6,900, which is significantly lower than that of Japan, at \$38,500, and that of the United States, at \$52,800. Measurement issues aside, it’s worth repeating that the goal, then, is to not only increase GDP, but to strive toward increased GDP per capita to increase overall living standards for individuals. As we have learned from Economic Growth, countries can achieve this at the national level by designing policies that increase worker productivity, deepen capital, and advance technology.
The related measure gross national income (GNI) per capita also allows us to rank countries into high-, upper-middle-, lower-middle-, or low-income groups. The World Bank updates the classifications each year. Low-income countries are those with \$1,085 per capita GNI per year; lower-middle-income countries have a per capita GNI between \$1,086 and \$4,255; upper-middle-income countries have a per capita GDP between \$4,265 and \$13,205; while high-income countries have over \$13,206 per year per capita income. According to the 2022 classifications, there are 27 low-income nations and 80 high-income nations. The other 110 measured nations occupy the two tiers of middle-income nations, and are comprised of the vast majority—75%, of the world’s population. Despite the population and quantitative majority, these nations only produce one third of global GNI and have nearly two-thirds of the world’s people living in poverty.
Income Group GDP (in billions) % of Global GDP Population (millions) % of Global Population
Low income (\$1,085 or less) \$457.6 0.5% 665.1 8.6%
Lower- and upper-middle income (\$1,086–\$13,205) \$30,535 36.5% 5,853 75.7%
High income (more than \$13,205) \$53,396 63% 1,215 15.7%
World Total income \$84,388 7,773.1
Table 19.1 World Income versus Global Population Note that while the income categories are determined by GNI, many other economic measures use GDP. (Source: World Bank, https://data.worldbank.org/indicator/NY.GDP.PCAP.CD)
Figure 19.2 Percent of Global GDP and Percent of Population The two pie charts show that low-income countries represent less than 1% of global income and make up 8.6% of global population. The combined middle-income countries represent 36.5% of income and make up 75.7% of global population. And the high-income countries have 63% of the world’s income and make up 15.7% of the population. (Source: https://data.worldbank.org/indicator/NY.GDP.MKTP.CD)
An overview of the regional averages of GDP per person for developing countries, measured in comparable international dollars as well as population in 2018 (Figure 19.3), shows that the differences across these regions are stark. As Table 19.2 shows, nominal GDP per capita in 2020 for the 652 million people living in Latin America and the Caribbean region (excluding high income countries in that region) was \$6,799, which far exceeds that of South Asia and sub-Saharan Africa. In turn, people in the world’s high-income nations, such as those who live in the European Union nations or North America, have a per capita GDP three to four times that of the people of Latin America. To put things in perspective, North America and the European Union (plus the United Kingdom) have slightly more than 10% of the world’s population, but they produce and consume about 44% of the world’s GDP.
Figure 19.3 GDP Per Capita in U.S. Dollars There is a clear imbalance in the GDP across the world. North America, Australia, and Western Europe have the highest GDPs while large areas of the world have dramatically lower GDPs. Russia and other former Soviet nations, as well as Argentina, Botswana, Brazil, Chile, Gabon, and Mexico, have a mid-tier per capita GDP of about \$6,000–10,000. China, though a major economic engine for the world, is about \$10,500. Egypt, India, Indonesia, Mongolia, and Sudan are lower at about \$920–3,500. (Credit: modification of work by Bsrboy/Wikimedia Commons)
Population (in millions) GDP Per Capita
East Asia and Pacific 2,361 \$8,254
South Asia 1,857 \$1,823.7
Sub-Saharan Africa 1,136.7 \$1,499.4
Latin America and Caribbean 652 \$6,799.2
Middle East and North Africa 465 \$3,018.4
Europe and Central Asia 923 \$7,688.5
Table 19.2 Regional Comparisons of Nominal GDP per Capita and Population in 2020 GDP per capita excludes high income countries in each region. (Source: https://data.worldbank.org/indicator/NY.GDP.PCAP.CD)
Such comparisons between regions are admittedly rough. After all, per capita GDP cannot fully capture the quality of life. Many other factors have a large impact on the standard of living, like health, education, human rights, crime and personal safety, and environmental quality. These measures also reveal very wide differences in the standard of living across the regions of the world. Much of this is correlated with per capita income, but there are exceptions. For example, life expectancy at birth in many low-income regions approximates those who are more affluent. The data also illustrate that nobody can claim to have perfect standards of living. For instance, despite very high income levels, there is still undernourishment in Europe and North America.
Link It Up
Economists know that there are many factors that contribute to your standard of living. People in high-income countries may have very little time due to heavy workloads and may feel disconnected from their community. Lower-income countries may be more community centered, but have little in the way of material wealth. It is hard to measure these characteristics of standard of living. The Organization for Economic Co-Operation and Development has developed the “OECD Better Life Index.” Visit this website to see how countries measure up to your expected standard of living.
The differences in economic statistics and other measures of well-being, substantial though they are, do not fully capture the reasons for the enormous differences between countries. Aside from the neoclassical determinants of growth, four additional determinants are significant in a wide range of statistical studies and are worth mentioning: geography, demography, industrial structure, and institutions.
Geographic and Demographic Differences
Countries have geographic differences: some have extensive coastlines, some are landlocked. Some have large rivers that have been a path of commerce for centuries, or mountains that have been a barrier to trade. Some have deserts, some have rain forests. These differences create different positive and negative opportunities for commerce, health, and the environment.
Countries also have considerable differences in the age distribution of the population. Many high-income nations are approaching a situation by 2020 or so in which the elderly will form a much larger share of the population. Most low-income countries still have a higher proportion of youth and young adults, but by about 2050, the elderly populations in these low-income countries are expected to boom as well. These demographic changes will have considerable impact on the standard of living of the young and the old.
Differences in Industry Structure and Economic Institutions
Countries have differences in industry structure. In the world’s high-income economies, only about 2% of GDP comes from agriculture; the average for the rest of the world is 12%. Countries have strong differences in degree of urbanization.
Countries also have strong differences in economic institutions: some nations have economies that are extremely market-oriented, while other nations have command economies. Some nations are open to international trade, while others use tariffs and import quotas to limit the impact of trade. Some nations are torn by long-standing armed conflicts; other nations are largely at peace. There are also differences in political, religious, and social institutions.
No nation intentionally aims for a low standard of living, high rates of unemployment and inflation, or an unsustainable trade imbalance. However, nations will differ in their priorities and in the situations in which they find themselves, and so their policy choices can reasonably vary, too. The next modules will discuss how nations around the world, from high income to low income, approach the four macroeconomic goals of economic growth, low unemployment, low inflation, and a sustainable balance of trade. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/19%3A_Macroeconomic_Policy_Around_the_World/19.02%3A_The_Diversity_of_Countries_and_Economies_across_the_World.txt |
Learning Objectives
By the end of this section, you will be able to:
• Analyze the growth policies of low-income countries seeking to improve standards of living
• Analyze the growth policies of middle-income countries, particularly the East Asian Tigers with their focus on technology and market-oriented incentives
• Analyze the struggles facing economically-challenged countries wishing to enact growth policies
• Evaluate the success of sending aid to low-income countries
Jobs are created in economies that grow. What is the origin of economic growth? According to most economists who believe in the growth consensus, economic growth (as we discussed in Economic Growth) is built on a foundation of productivity improvements. In turn, productivity increases are the result of greater human and physical capital and technology, all interacting in a market-driven economy. In the pursuit of economic growth, however, some countries and regions start from different levels, as the differences in per capita GDP presented earlier in Table 19.2 illustrate.
Growth Policies for the High-Income Countries
For the high-income countries, the challenge of economic growth is to push continually for a more educated workforce that can create, invest in, and apply new technologies. In effect, the goal of their growth-oriented public policy is to shift their aggregate supply curves to the right (refer to The Aggregate Demand/Aggregate Supply Model). The main public policies targeted at achieving this goal are fiscal policies focused on investment, including investment in human capital, in technology, and in physical plant and equipment. These countries also recognize that economic growth works best in a stable and market-oriented economic climate. For this reason, they use monetary policy to keep inflation low and stable, and to minimize the risk of exchange rate fluctuations, while also encouraging domestic and international competition.
However, early in the second decade of the 2000s, many high-income countries found themselves more focused on the short term than on the long term. The United States, Western Europe, and Japan all experienced a combination of financial crisis and deep recession, and the after-effects of the recession—like high unemployment rates—seemed likely to linger for several years. Most of these governments took aggressive, and in some cases controversial, steps to jump-start their economies by running very large budget deficits as part of expansionary fiscal policy. These countries must adopt a course that combines lower government spending and higher taxes.
Similarly, many central banks ran highly expansionary monetary policies, with both near-zero interest rates and unconventional loans and investments. For example, in 2012, Shinzo Abe (see Figure 19.4), then newly-elected Prime Minister of Japan, unveiled a plan to pull his country out of its two-decade-long slump in economic growth. It included both fiscal stimulus and an increase in the money supply. The plan was successful in some ways and unsuccessful in others. While real GDP growth in Japan has averaged around 1% since 2012 (and was only 0.2% in 2014 and 0.7% in 2016) and while the inflation rate has struggled to stay positive in recent years, the unemployment rate continued to decline through the 2010s. By early 2020, prior to the pandemic, the unemployment rate stood at just 2.5%. Public debt has also reached a plateau in the last 5–7 years of about 230–240% of GDP, although this number did increase slightly in 2020 due to the pandemic. Shinzo Abe stepped down as Prime Minister of Japan in 2020, and was assassinated in 2022.
Figure 19.4 Japan’s Former Prime Minister, Shinzo Abe Japan used fiscal and monetary policies to stimulate its economy, which has helped bring down unemployment, but inflation remains stubbornly low. (Credit: modification of “Shinzo Abe, Prime Minister of Japan” by Chatham House/Flickr Creative Commons, CC BY 2.0)
As we discussed in other chapters, macroeconomics needs to have both a short-run and a long-run focus. The challenge for many of the developed countries in the next few years will be to grapple with the consequences of the pandemic. With high unemployment and no end of the virus containment in sight, it will be challenging for these governments to refocus their efforts on new technology, education, and physical capital investment.
Growth Policies for the Middle-Income Economies
The world’s great economic success stories in the last few decades began in the 1970s with that group of nations sometimes known as the East Asian Tigers: South Korea, Thailand, Malaysia, Indonesia, and Singapore. The list sometimes includes Hong Kong and Taiwan, although often under international law they are treated as part of China, rather than as separate countries. The economic growth of the Tigers has been phenomenal, typically averaging 5.5% real per capita growth for several decades. In the 1980s, other countries began to show signs of convergence. China began growing rapidly, often at annual rates of 8% to 10% per year. India began growing rapidly, first at rates of about 5% per year in the 1990s, but then higher still in the first decade of the 2000s.
We know the underlying causes of these rapid growth rates:
• China and the East Asian Tigers, in particular, have been among the highest savers in the world, often saving one-third or more of GDP as compared to the roughly one-fifth of GDP, which would be a more typical saving rate in Latin America and Africa. These countries harnessed higher savings for domestic investment to build physical capital.
• These countries had policies that supported heavy investments in human capital, first building up primary-level education and then expanding secondary-level education. Many focused on encouraging math and science education, which is useful in engineering and business.
• Governments made a concerted effort to seek out applicable technology, by sending students and government commissions abroad to look at the most efficient industrial operations elsewhere. They also created policies to support innovative companies that wished to build production facilities to take advantage of the abundant and inexpensive human capital.
• China and India in particular also allowed far greater freedom for market forces, both within their own domestic economies and also in encouraging their firms to participate in world markets.
This combination of technology, human capital, and physical capital, combined with the incentives of a market-oriented economic context, proved an extremely powerful stimulant to growth. Challenges that these middle-income countries faced are a legacy of government economic controls that for political reasons can be dismantled only slowly over time. In many of them, the government heavily regulates the banking and financial sector. Governments have also sometimes selected certain industries to receive low-interest loans or government subsidies. These economies have found that an increased dose of market-oriented incentives for firms and workers has been a critical ingredient in the recipe for faster growth. To learn more about measuring economic growth, read the following Clear It Up feature.
Clear It Up
What is the rule of 72?
It is worth pausing a moment to marvel at the East Asian Tigers' growth rates. If per capita GDP grows at, say, 6% per year, then you can apply the formula for compound growth rates—that is (1 + 0.06)30—meaning a nation’s level of per capita GDP will rise by a multiple of almost six over 30 years. Another strategy is to apply the rule of 72. The rule of 72 is an approximation to figure out doubling time. We divide the rule number, 72, by the annual growth rate to obtain the approximate number of years it will take for income to double. If we have a 6% growth rate, it will take 72/6, or 12 years, for incomes to double. Using this rule here suggests that a Tiger that grows at 6% will double its GDP every 12 years. In contrast, a technological leader, chugging along with per capita growth rates of about 2% per year, would double its income in 36 years.
Growth Policies for Economically-Challenged Countries
Many economically-challenged or low-income countries are geographically located in Sub-Saharan Africa. Other pockets of low income are in the former Soviet Bloc, and in parts of Central America and the Caribbean.
There are macroeconomic policies and prescriptions that might alleviate the extreme poverty and low standard of living. However, many of these countries lack the economic and legal stability, along with market-oriented institutions, needed to provide a fertile climate for domestic economic growth and to attract foreign investment. Thus, macroeconomic policies for low income economies are vastly different from those of the high income economies. The World Bank has made it a priority to combat poverty and raise overall income levels through 2030. One of the key obstacles to achieving this is the political instability that seems to be a common feature of low-income countries.
Figure 19.5 shows the ten lowest income countries as ranked by The World Bank in 2020. These countries share some common traits, the most significant of which is the recent failures of their governments to provide a legal framework for economic growth. Civil and ethnic wars have impacted Burundi. Command economies, corruption, as well as political factionalism and infighting are commonly adopted elements in these low-income countries. The Democratic Republic of the Congo (often referred to as “Congo”) is a resource-wealthy country that has not been able to increase its subsistence standard of living due to the political environment.
Figure 19.5 The Ten Lowest Income Countries This bar chart that shows the ten lowest-income countries by per capita income. They are, from lowest income to highest: Burundi, Somalia, Mozambique, Madagascar, Central African Republic, Sierra Leone, Afghanistan, Democratic Republic of Congo, Niger, and Sudan. (Source: http://databank.worldbank.org/data/v...orts/map.aspx#)
Low-income countries are at a disadvantage because any incomes that people receive are spent immediately on necessities such as food. People in these countries live on less than \$1,035 per year, which is less than \$100 per month. Lack of saving means a lack of capital accumulation and a lack of loanable funds for investment in physical and human capital. Recent research by two MIT economists, Abhijit Bannerjee and Esther Duflo, has confirmed that the households in these economies are trapped in low incomes because they cannot muster enough investment to push themselves out of poverty.
For example, the average citizen of Burundi, a low-income country, subsists on \$239 per year (adjusted to 2020 dollars). According to Central Intelligence Agency data in its CIA Factbook, as of 2021, 85% of Burundi’s population is agrarian, with bananas as the main income producing crop. Only one in two children attends school and, as Figure 19.6 shows, many are not in schools comparable to what occurs in developed countries. Political instability has made it difficult for Burundi to make significant headway toward growth, as verified by the electrification of only 11% of households and 40% of its national income coming from foreign aid.
Figure 19.6 Lack of Funds for Investing in Human Capital In low-income countries, people often spend all income on necessities for living and cannot accumulate or invest in physical or human capital. The students in this photograph learn in an outside “classroom” void of not only technology, but even chairs and desks. (Credit: “Living in Kuito” by Rafaela Printes/Flickr Creative Commons, CC BY 2.0)
Link It Up
The World Factbook website is loaded with maps, flags, and other information about countries across the globe.
Other low-income countries share similar stories. These countries have found it difficult to generate investments for themselves or to find foreign investors willing to put up the money for more than the basic needs. Foreign aid and external investment comprise significant portions of the income in these economies, but are not sufficient to allow for the capital accumulation necessary to invest in physical and human capital. However, is foreign aid always a contributor to economic growth?
Development economics is a branch of economics that often focuses on answering that question and others like it. Development economists analyze the forces and outcomes of economics in developing nations. The field is typically focused on—and sometimes defined as—understanding and implementing policies and practices to improve economic and social wellbeing in low- and middle-income nations or regions. But it is an extremely wide and varied area of study, often blending politics, fiscal policy, education, innovation, health and medicine, international trade, natural resources, and military/geopolitical considerations.
Many development economists have focused on understanding the best mix of approaches to foster equitable and sustainable growth. Like other economists, they may analyze practices or outcomes from the past and apply that knowledge to the present and future. And many prominent development economists challenge traditional ways of thinking. Dambisa Moyo, for example, provides evidence indicating that foreign aid is rarely a positive solution and often does more harm than good. In her book Dead Aid: Why Aid Is Not Working and How There Is Another Way for Africa (2009), she lays out the failure of past aid, indicating that it typically ends up in the pockets of corrupt officials and has the adverse effect of minimizing other types of investment. At the time, Moyo proposed a complete stoppage of foreign aid into Africa. Moyo sees far greater promise in increases in trade and direct private investment, as well as other financing options such as bonds.
Clear It Up
Does foreign aid to low-income countries work?
According to the Organization of Economic Cooperation and Development (OECD), about \$134 billion per year in foreign aid flows from the high-income countries of the world to the low-income ones. Relative to the size of their populations or economies, this is not a large amount for either donors or recipients. For low-income countries, aid averages about 1.3 percent of their GDP. However, even this relatively small amount has been highly controversial.
Supporters of additional foreign aid point to the extraordinary human suffering in the world's low-and middle-income countries. They see opportunities all across Africa, Asia, and Latin America to set up health clinics and schools. They want to help with the task of building economic infrastructure: clean water, plumbing, electricity, and roads. Supporters of this aid include formal state-sponsored institutions like the United Kingdom’s Department for International Development (DFID) or independent non-governmental organizations (NGOs) like CARE International that also receive donor government funds. For example, because of an outbreak of meningitis in Ethiopia in 2010, DFID channeled significant funds to the Ethiopian Ministry of Health to train rural health care workers and also for vaccines. These monies helped the Ministry offset shortfalls in their budget.
Opponents of increased aid do not quarrel with the goal of reducing human suffering, but they suggest that foreign aid has often proved a poor tool for advancing that goal. For example, according to an article in the Attaché Journal of International Affairs, the Canadian foreign aid organization (CIDA) provided \$100 million to Tanzania to grow wheat. The project did produce wheat, but nomadic pastoralists and other villagers who had lived on the land were driven off 100,000 acres of land to make way for the project. The damage in terms of human rights and lost livelihoods was significant. Villagers were beaten and killed because some refused to leave the land. At times, the unintended collateral damage from foreign aid can be significant.
William Easterly, professor of economics at New York University, argues that countries often receive aid for political reasons and the aid does more harm than good. If a country's government creates a reasonably stable and market-oriented macroeconomic climate, then foreign investors will be likely to provide funds for many profitable activities. For example, Facebook partnered with multiple organizations in a project called Internet.org to provide access in remote and low-income areas of the world, and Google began its own initiative called Project Loon in 2011, although it was phased out in 2021. Facebook’s first forays into providing internet access via mobile phones began in stable, market-oriented countries like India, Brazil, Indonesia, Turkey, and the Philippines and continues its work in Africa by working with telecommunications corporations in China to develop an undersea cable network.
Policymakers are now wiser about foreign aid limitations than they were a few decades ago. In targeted and specific cases, especially if foreign aid is channeled to long-term investment projects, foreign aid can have a modest role to play in reducing the extreme levels of deprivation that hundreds of millions of people around the world experience.
Link It Up
Watch this video on the complexities of providing economic aid in Africa. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/19%3A_Macroeconomic_Policy_Around_the_World/19.03%3A_Improving_Countries_Standards_of_Living.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the nature and causes of unemployment
• Analyze the natural rate of unemployment and the factors that affect it
• Identify how undeveloped labor markets can result in the same hardships as unemployment
We can categorize the causes of unemployment in the world's high-income countries in two ways: either cyclical unemployment caused by the economy when in a recession, or the natural rate of unemployment caused by factors in labor markets, such as government regulations regarding hiring and starting businesses.
Unemployment from a Recession
For unemployment caused by a recession, the Keynesian economic model points out that both monetary and fiscal policy tools are available. The monetary policy prescription for dealing with recession is straightforward: run an expansionary monetary policy to increase the quantity of money and loans, drive down interest rates, and increase aggregate demand. In a recession, there is usually relatively little danger of inflation taking off, and so even a central bank, with fighting inflation as its top priority, can usually justify some reduction in interest rates.
With regard to fiscal policy, the automatic stabilizers that we discussed in Government Budgets and Fiscal Policy should be allowed to work, even if this means larger budget deficits in times of recession. There is less agreement over whether, in addition to automatic stabilizers, governments in a recession should try to adopt discretionary fiscal policy of additional tax cuts or spending increases. In the case of the Great Recession, the case for this kind of extra-aggressive expansionary fiscal policy is stronger, but for a smaller recession, given the time lags of implementing fiscal policy, countries should use discretionary fiscal policy with caution.
However, the aftermath of the Recession emphasizes that expansionary fiscal and monetary policies do not turn off a recession like flipping a switch turns off a lamp. Even after a recession is officially over, and positive growth has returned, it can take some months—or even a couple of years—before private-sector firms believe the economic climate is healthy enough that they can expand their workforce.
The Natural Rate of Unemployment
Unemployment rates in European nations have typically been higher than in the United States. In 2020, before the start of the COVID-19 pandemic, the U.S. unemployment rate was 3.5%, compared with 8.5% in France, 10% in Italy, and 7.1% in Sweden. We can attribute the pattern of generally higher unemployment rates in Europe, which dates back to the 1970s, to the fact that European economies have a higher natural rate of unemployment because they have a greater number of rules and restrictions that discourage firms from hiring and unemployed workers from taking jobs.
Addressing the natural rate of unemployment is straightforward in theory but difficult in practice. Government can play a useful role in providing unemployment and welfare payments, for example, by passing rules about where and when businesses can operate, and assuring that the workplace is safe. However, these well-intentioned laws can, in some cases, become so intrusive that businesses decide to place limits on their hiring.
For example, a law that imposes large costs on a business that tries to fire or lay off workers will mean that businesses try to avoid hiring in the first place, as is the case in France. According to Business Week, “France has 2.4 times as many companies with 49 employees as with 50 ... according to the French labor code, once a company has at least 50 employees inside France, management must create three worker councils, introduce profit sharing, and submit restructuring plans to the councils if the company decides to fire workers for economic reasons.” This labor law essentially limits employment (or raises the natural rate of unemployment).
Undeveloped and Transitioning Labor Markets
Low-income and middle-income countries face employment issues that go beyond unemployment as it is understood in the high-income economies. A substantial number of workers in these economies provide many of their own needs by farming, fishing, or hunting. They barter and trade with others and may take a succession of short-term or one-day jobs, sometimes receiving pay with food or shelter, sometimes with money. They are not “unemployed” in the sense that we use the term in the United States and Europe, but neither are they employed in a regular wage-paying job.
The starting point of economic activity, as we discussed in Welcome to Economics!, is the division of labor, in which workers specialize in certain tasks and trade the fruits of their labor with others. Workers who are not connected to a labor market are often unable to specialize very much. Because these workers are not “officially” employed, they are often not eligible for social benefits like unemployment insurance or old-age payments—if such payments are even available in their country. Helping these workers to become more connected to the labor market and the economy is an important policy goal. Recent research by development economists suggests that one of the key factors in raising people in low-income countries out of the worst kind of poverty is whether they can make a connection to a somewhat regular wage-paying job.
Economist Sir W. Arthur Lewis examined such transitions of labor and the impact on economic development. His core theoretical framework—the dual sector economy—proposes that, essentially, the marginal product of low-skilled workers is greater in the manufacturing sector than it is in the agricultural sector. That’s because most agricultural societies are both mature and have fixed inputs (land, water, and related resources); the marginal product of additional farmers on that land is nearly zero, creating what Lewis termed “surplus workers.” Early-stage manufacturing sectors, however, have great need for low-skilled workers, and can make better use (greater marginal product) of them. Their wages will remain low, but as stated above, the wages are more likely to be consistent and therefore move toward a large-scale transition of the labor force.
We have seen this practically in many nations experiencing a shift in labor, particularly in China. In many regions, it is marked by a level of migration—people leaving rural areas for cities or manufacturing zones. At some point, nations achieve what economists call the Lewis turning point, in which the surplus agricultural labor is fully absorbed into the manufacturing sector. Typically, when this occurs, wages in both agricultural and manufacturing sectors begin to rise in a sustainable manner. Despite massive transformation in the Chinese economy over the past decades, economists dispute whether China has actually reached the Lewis turning point.
Economic transition is not without its downsides. Many manufacturing-focused countries still rely heavily on their agricultural sectors for their own sustenance and as a core part of international trade. As the agricultural sector faces competition from manufacturing, and as people physically leave rural areas, farming economies can suffer downturns and unpredictability. Finally, countries or individual farmers seeking to make up for their missing labor may encourage migration and/or immigration that may cause political or financial conflict. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/19%3A_Macroeconomic_Policy_Around_the_World/19.04%3A_Causes_of_Unemployment_around_the_World.txt |
Learning Objectives
By the end of this section, you will be able to:
• Identify the causes and effects of inflation in various economic markets
• Explain the significance of a converging economy
Policymakers of the high-income economies appear to have learned some lessons about fighting inflation. First, whatever happens with aggregate supply and aggregate demand in the short run, countries can use monetary policy to prevent inflation from becoming entrenched in the economy in the medium and long term. Second, there is no long-run gain to letting inflation become established. In fact, allowing inflation to become lasting and persistent poses undesirable risks and tradeoffs. When inflation is high, businesses and individuals need to spend time and effort worrying about protecting themselves against inflation, rather than seeking better ways to serve customers. In short, the high-income economies appear to have both a political consensus to hold inflation low and the economic tools to do so. Despite this, periods of growing inflation can stagnate economic growth and lead to significant political consequences for leaders. In 2022, the U.S. inflation rate reached 9.1%, an unexpected peak that the country hadn't seen since 1981. As is often the case, President Joe Biden was held politically responsible, and negotiated with Congress to pass a massive economic and climate bill titled the Inflation Reduction Act.
In a number of middle- and low-income economies around the world, inflation is far from a solved problem. In the early 2000s, Turkey experienced inflation of more than 50% per year for several years and continues to experience high inflation today. Belarus had inflation of about 100% per year from 2000 to 2001. From 2008 to 2010, Venezuela and Myanmar had inflation rates of 20% to 30% per year. Indonesia, Iran, Nigeria, the Russian Federation, and Ukraine all had double-digit inflation for most of the years from 2000 to 2010. Zimbabwe had hyperinflation, with inflation rates that went from more than 100% per year in the mid-2000s to a rate of several million percent in 2008.
In these countries, the problem of very high inflation generally arises from huge budget deficits, which the government finances by printing its domestic currency. This is a case of “too much money chasing too few goods.” In the case of Venezuela, beginning in 2016 the government covered its widening deficits by printing ever higher currency notes, with inflation reaching 1,000,000% by 2018. The crisis continues today, with high rates of inflation and high unemployment (over 40%). There is some discussion of dollarization, or a conversion from Venezuelan bolivars to U.S. dollars as the main currency, as a solution to the hyperinflation. Even in 2019, over 50% of transactions in Venezuela were reportedly using U.S. dollars, and banks issued debit cards denominated in U.S. dollars in 2021.
A number of countries have managed to sustain solid levels of economic growth for sustained periods of time with inflation levels that would sound high by recent U.S. standards, like 10% to 30% per year. In such economies, the governments index most contracts, wage levels, and interest rates to inflation. Indexing wage contracts and interest rates means that they will increase when inflation increases to retain purchasing power. When wages do not rise as price levels rise, this leads to a decline in the real wage rate and a decrease in the standard of living. Likewise, interest rates that are not indexed mean that money lenders will receive payment in devalued currency and will also lose purchasing power on monies that they lent. It is clearly possible—and perhaps sometimes necessary—for a converging economy (the economy of a country that demonstrates the ability to catch up to the technology leaders) to live with a degree of uncertainty over inflation that would be politically unacceptable in the high-income economies. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/19%3A_Macroeconomic_Policy_Around_the_World/19.05%3A_Causes_of_Inflation_in_Various_Countries_and_Regions.txt |
Learning Objectives
By the end of this section, you will be able to:
• Explain the meaning of trade balance and its implications for the foreign exchange market
• Analyze concerns over international trade in goods and services and international flows of capital
• Identify and evaluate market-oriented economic reforms
In the 1950s and 1960s, and even into the 1970s, low- and middle-income countries often viewed openness to global flows of goods, services, and financial capital in a negative light. These countries feared that foreign trade would mean both economic losses as high-income trading partners "exploited" their economy and they lost domestic political control to powerful business interests and multinational corporations.
These negative feelings about international trade have evolved. After all, the great economic success stories of recent years like Japan, the East Asian Tiger economies, China, and India, all took advantage of opportunities to sell in global markets. European economies thrive with high levels of trade. In the North American Free Trade Agreement (NAFTA), 1 the United States, Canada, and Mexico pledged themselves to reduce trade barriers. Many countries have clearly learned that reducing barriers to trade is at least potentially beneficial to the economy. Many smaller world economies have learned an even tougher lesson: if they do not participate actively in world trade, they are unlikely to join the success stories among the converging economies. There are no examples in world history of small economies that remained apart from the global economy but still attained a high standard of living.
Although almost every country now claims that its goal is to participate in global trade, the possible negative consequences have remained highly controversial. It is useful to divide these possible negative consequences into issues involving trade of goods and services and issues involving international capital flows. These issues are related, but not the same. An economy may have a high level of trade in goods and services relative to GDP, but if exports and imports are balanced, the net flow of foreign investment in and out of the economy will be zero. Conversely, an economy may have only a moderate level of trade relative to GDP, but find that it has a substantial current account trade imbalance. Thus, it is useful to consider the concerns over international trade of goods and services and international flows of financial capital separately.
Concerns over International Trade in Goods and Services
There is a long list of worries about foreign trade in goods and services: fear of job loss, environmental dangers, unfair labor practices, and many other concerns. We discuss these arguments at some length in the chapter on The International Trade and Capital Flows.
Of all of the arguments for limitations on trade, perhaps the most controversial one among economists is the infant industry argument; that is, subsidizing or protecting new industries for a time until they become established. (Globalization and Protectionism explains this concept in more detail.) Countries have used such policies with some success at certain points in time, but in the world as a whole, support for key industries is far more often directed at long-established industries with substantial political power that are suffering losses and laying off workers, rather than potentially vibrant new industries that are not yet established. If government intends to favor certain industries, it needs to do so in a way that is temporary and that orients them toward a future of market competition, rather than a future of unending government subsidies and trade protection.
Concerns over International Flows of Capital
Recall from The Macroeconomic Perspective that a trade deficit exists when a nation’s imports exceed its exports. In order for a trade deficit to take place, foreign countries must provide loans or investments, which they are willing to do because they expect eventual repayment (that the deficit will become a surplus). A trade surplus, you may remember, exists when a nation’s exports exceed its imports. Thus, in order for a trade deficit to switch to a trade surplus, a nation’s exports must rise and its imports must fall. Sometimes this happens when the currency decreases in value. For example, if the U.S. had a trade deficit and the dollar depreciated, imports would become more expensive. This would, in turn, benefit the foreign countries that provided the loans or investments.
The expected pattern of trade imbalances in the world economy has been that high-income economies will run trade surpluses, which means they will experience a net outflow of capital to foreign destinations or export more than they import, while low- and middle-income economies will run trade deficits, which means that they will experience a net inflow of foreign capital.
This international investing pattern can benefit all sides. Investors in the high-income countries benefit because they can receive high returns on their investments, and also because they can diversify their investments so that they are at less risk of a downturn in their own domestic economy. The low-income economies that receive an inflow of capital presumably have potential for rapid catch-up economic growth, and they can use the international financial capital inflow to help spur their physical capital investment. In addition, financial capital inflows often come with management abilities, technological expertise, and training.
However, for the last couple of decades, this cheerful scenario has faced two “dark clouds.” The first cloud is the very large trade or current account deficits in the U.S. economy. (See The International Trade and Capital Flows.) Instead of offering net financial investment abroad, the U.S. economy is soaking up savings from all over the world. These substantial U.S. trade deficits may not be sustainable according to Sebastian Edwards writing for the National Bureau of Economic Research. While trade deficits on their own are not bad, the question is whether governments will reduce them gradually or hastily. In the gradual scenario, U.S. exports could grow more rapidly than imports over a period of years, aided by U.S. dollar depreciation. An unintended consequence of the slow growth since the Great Recession has been a decline in the U.S. current account deficit's from 6% pre-recession to 3% most recently.
The other option is that the government could reduce the U.S. trade deficit in a rush. Here is one scenario: if foreign investors became less willing to hold U.S. dollar assets, the dollar exchange rate could weaken. As speculators see this process happening, they might rush to unload their dollar assets, which would drive the dollar down still further.
A lower U.S. dollar would stimulate aggregate demand by making exports cheaper and imports more expensive. It would mean higher prices for imported inputs throughout the economy, shifting the short-term aggregate supply curve to the left. The result could be a burst of inflation and, if the Federal Reserve were to run a tight monetary policy to reduce the inflation, it could also lead to recession. People sometimes talk as if the U.S. economy, with its great size, is invulnerable to this sort of pressure from international markets. While it is difficult to rock, it is not impossible for the \$17 trillion U.S. economy to face these international pressures.
The second “dark cloud” is how the smaller world economies should deal with the possibility of sudden foreign financial capital inflows and outflows. Perhaps the most vivid recent example of the potentially destructive forces of international capital movements occurred in the East Asian Tiger economies in 1997–1998. Thanks to their excellent growth performance over the previous few decades, these economies had attracted considerable interest from foreign investors. In the mid-1990s, however, foreign investment into these countries surged even further. Much of this money funneled through banks that borrowed in U.S. dollars and loaned in their national currencies. Bank lending surged at rates of 20% per year or more. This inflow of foreign capital meant that investment in these economies exceeded the level of domestic savings, so that current account deficits in these countries jumped into the 5–10% GDP range.
The surge in bank lending meant that many banks in these East Asian countries did not do an especially good job of screening out safe and unsafe borrowers. Many of the loans—as high as 10% to 15% of all loans in some of these countries—started to turn bad. Fearing losses, foreign investors started pulling out their money. As the foreign money left, the exchange rates of these countries crashed, often falling by 50% or more in a few months. The banks were stuck with a mismatch: even if the rest of their domestic loans were repaid, they could never pay back the U.S. dollars that they owed. The banking sector as a whole went bankrupt. The lack of credit and lending in the economy collapsed aggregate demand, bringing on a deep recession.
If the flow and ebb of international capital markets can flip even the economies of the East Asian Tigers, with their stellar growth records, into a recession, then it is no wonder that other middle- and low-income countries around the world are concerned. Moreover, similar episodes of an inflow and then an outflow of foreign financial capital have rocked a number of economies around the world: for example, in the last few years, economies like Ireland, Iceland, and Greece have all experienced severe shocks when foreign lenders decided to stop extending funds. Especially in Greece, this caused the government to enact austerity measures which led to protests throughout the country (Figure 19.7).
Figure 19.7 Protests in Greece The economic conditions in Greece have deteriorated from the Great Recession such that the government had to enact austerity measures, (strict rules) cutting wages and increasing taxes on its population. Massive protests are but one byproduct. (Credit: modification of work by Apostolos/Flickr Creative Commons)
Many nations are taking steps to reduce the risk that their economy will be injured if foreign financial capital takes flight, including having their central banks hold large reserves of foreign exchange and stepping up their regulation of domestic banks to avoid a wave of imprudent lending. The most controversial steps in this area involve whether countries should try to take steps to control or reduce the flows of foreign capital. If a country could discourage some speculative short-term capital inflow, and instead only encourage investment capital that it committed for the medium and the long term, then it could be at least somewhat less susceptible to swings in the sentiments of global investors.
If economies participate in the global trade of goods and services, they will also need to participate in international flows of financial payments and investments. These linkages can offer great benefits to an economy. However, any nation that is experiencing a substantial and sustained pattern of trade deficits, along with the corresponding net inflow of international financial capital, has some reason for concern. During the Asian Financial Crisis in the late 1990s, countries that grew dramatically in the years leading up to the crisis as international capital flowed in, saw their economies collapse when the capital very quickly flowed out.
Market-Oriented Economic Reforms
The standard of living has increased dramatically for billions of people around the world in the last half century. Such increases have occurred not only in the technological leaders like the United States, Canada, the nations of Europe, and Japan, but also in the East Asian Tigers and in many nations of Latin America and Eastern Europe. The challenge for most of these countries is to maintain these growth rates. The economically-challenged regions of the world have stagnated and become stuck in poverty traps. These countries need to focus on the basics: health and education, or human capital development. As Figure 19.8 illustrates, modern technology allows for the investment in education and human capital development in ways that would have not been possible just a few short years ago.
Figure 19.8 Solar-powered Technology Modern technologies, such as solar-power and Wi-Fi, enable students to obtain education even in remote parts of a country without electricity. These students in Ghana are sharing a laptop provided by a van with solar-power. (Credit: “Hands on computer class - children in Ho, Volta Region, Ghana” by EIFL/Flickr Creative Commons, CC BY 2.0)
Other than the issue of economic growth, the other three main goals of macroeconomic policy—that is, low unemployment, low inflation, and a sustainable balance of trade—all involve situations in which, for some reason, the economy fails to coordinate the forces of supply and demand. In the case of cyclical unemployment, for example, the intersection of aggregate supply and aggregate demand occurs at a level of output below potential GDP. In the case of the natural rate of unemployment, government regulations create a situation where otherwise-willing employers become unwilling to hire otherwise-willing workers. Inflation is a situation in which aggregate demand outstrips aggregate supply, at least for a time, so that too much buying power is chasing too few goods. A trade imbalance is a situation where, because of a net inflow or outflow of foreign capital, domestic savings are not aligned with domestic investment. Each of these situations can create a range of easier or harder policy choices.
Bring It Home
Youth Unemployment
Spain and South Africa had the same high youth unemployment in 2020, but the reasons for this unemployment are different. Spain’s current account balance is negative, which means it is borrowing heavily. To cure cyclical unemployment during a recession, the Keynesian model suggests increases in government spending—fiscal expansion or monetary expansion. Neither option is open to Spain. It currently can borrow at only high interest rates, which will be a real problem in terms of debt service. In addition, the rest of the European Union (EU) has dragged its feet when it comes to debt forgiveness. Monetary expansion is not possible because Spain uses the euro and cannot devalue its currency unless it convinces all of the EU to do so. What can be done? The Economist, summarizing some ideas of economists and policymakers, suggests that Spain’s only realistic (although painful) option is to reduce government-mandated wages, which would allow it to reduce government spending. As a result, the government would be able to lower tax rates on the working population. With a lower wage or lower tax environment, firms will hire more workers. This will lower unemployment and stimulate the economy. Spain can also encourage greater foreign investment and try to promote policies that encourage domestic savings.
South Africa has more of a natural rate of unemployment problem. It is an interesting case because its youth unemployment is mostly because its young are not ready to work. Economists commonly refer to this as an employability problem. According to interviews of South African firms as reported in the Economist, the young are academically smart but lack practical skills for the workplace. Despite a big push to increase investment in human capital, the results have not yet borne fruit. Recently the government unveiled a plan to pay unemployed youth while they were “trained-up” or apprenticed in South African firms. The government has room to increase fiscal expenditure, encourage domestic savings, and continue to fund investment in education, vocational training, and apprentice programs. South Africa can also improve the climate for foreign investment from technology leaders, which would encourage economic growth.
India has a smaller youth employment problem in terms of percentages. However, bear in mind that since this is a populous country, it turns out to be a significant problem in raw numbers. According to Kaushik Basu, writing for the BBC, “there are 45 national laws governing the hiring and firing decisions of firms and close to four times that amount at the state level”. These laws make it difficult for companies to fire workers. To stay nimble and responsive to markets, Indian companies respond to these laws by hiring fewer workers. The Indian government can do much to solve this problem by adjusting its labor laws. Essentially, the government has to remove itself from firms’ hiring and firing decisions, so that growing Indian firms can freely employ more workers. Indian workers, like those in South Africa, do not have workforce skills. Again, the government can increase its spending on education, vocational training, and workforce readiness programs.
Finally, India has a significant current account deficit. This deficit is mainly a result of short- and long-term capital flows. To solve this deficit, India has experimented by lifting the limitation on domestic savers from investing abroad. This is a step in the right direction that may dampen the growth in the current account deficit. A final policy possibility is to improve domestic capital markets so many self-employed Indians can obtain access to capital to realize their business ideas. If more Indians can obtain access to capital to start businesses, employment might increase.
Footnotes
• 1As of July 1, 2020, NAFTA was officially replaced with the United States-Mexico-Canada (USMCA) free trade agreement. It is broadly similar to the original NAFTA. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/19%3A_Macroeconomic_Policy_Around_the_World/19.06%3A_Balance_of_Trade_Concerns.txt |
converging economy
economy of a country that has demonstrated the ability to catch up to the technology leaders by investing in both physical and human capital
East Asian Tigers
the economies of Taiwan, Singapore, Hong Kong, and South Korea, which maintained high growth rates and rapid export-led industrialization between the early 1960s and 1990 allowing them to converge with the technological leaders in high-income countries
growth consensus
a series of studies that show, statistically, that 70% of the differences in income per person across the world is explained by differences in physical capital (savings/investment)
high-income country
nation with a per capita income of \$12,475 or more; typically has high levels of human and physical capital
low-income country
a nation that has a per capita income of less than \$1,025; a third of the world’s population
middle-income country
a nation with per capita income between \$1,025 and \$12, 475 and that has shown some ability, even if not always sustained, to catch up to the technology leaders in high-income countries
19.08: Key Concepts and Summary
19.1 The Diversity of Countries and Economies across the World
Macroeconomic policy goals for most countries strive toward low levels of unemployment and inflation, as well as stable trade balances. Economists analyze countries based on their GDP per person and ranked as low-, middle-, and high-income countries. Low-income are those earning less than \$1,025 (less than 1%) of global income. They currently have 18.5% of the world population. Middle-income countries are those with per capital income of \$1,025–\$12,475 (31.1% of global income). They have 69.5% of world population. High-income countries are those with per capita income greater than \$12,475 (68.3% of global income). They have 12% of the world’s population. Regional comparisons tend to be inaccurate because even countries within those regions tend to differ from each other.
19.2 Improving Countries’ Standards of Living
The fundamentals of growth are the same in every country: improvements in human capital, physical capital, and technology interacting in a market-oriented economy. Countries that are high-income tend to focus on developing and using new technology. Countries that are middle-income focus on increasing human capital and becoming more connected to technology and global markets. They have charted unconventional paths by relying more on state-led support rather than relying solely on markets. Low-income, economically-challenged countries have many health and human development needs, but they are also challenged by the lack of investment and foreign aid to develop infrastructure like roads. There are some bright spots when it comes to financial development and mobile communications, which suggest that low-income countries can become technology leaders in their own right, but it is too early to claim victory. These countries must do more to connect to the rest of the global economy and find the technologies that work best for them.
19.3 Causes of Unemployment around the World
We can address cyclical unemployment by expansionary fiscal and monetary policy. The natural rate of unemployment can be harder to solve, because it involves thinking carefully about the tradeoffs involved in laws that affect employment and hiring. Unemployment is understood differently in high-income countries compared to low- and middle-income countries. People in these countries are not “unemployed” in the sense that we use the term in the United States and Europe, but neither are they employed in a regular wage-paying job. While some may have regular wage-paying jobs, others are part of a barter economy.
19.4 Causes of Inflation in Various Countries and Regions
Most high-income economies have learned that their central banks can control inflation in the medium and the long term. In addition, they have learned that inflation has no long-term benefits but potentially substantial long-term costs if it distracts businesses from focusing on real productivity gains. However, smaller economies around the world may face more volatile inflation because their smaller economies can be unsettled by international movements of capital and goods.
19.5 Balance of Trade Concerns
There are many legitimate concerns over possible negative consequences of free trade. Perhaps the single strongest response to these concerns is that there are good ways to address them without restricting trade and thus losing its benefits. There are two major issues involving trade imbalances. One is what will happen with the large U.S. trade deficits, and whether they will come down gradually or with a rush. The other is whether smaller countries around the world should take some steps to limit flows of international capital, in the hope that they will not be quite so susceptible to economic whiplash from international financial capital flowing in and out of their economies. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/19%3A_Macroeconomic_Policy_Around_the_World/19.07%3A_Key_Terms.txt |
1.
Using the data in Table 19.3, rank the seven regions of the world according to GDP and then according to GDP per capita.
Population (in millions) GDP Per Capita GDP = Population × Per Capita GDP (in millions)
East Asia and Pacific 2,006 \$5,536 \$10,450,032
South Asia 1,671 \$1,482 \$2,288,812
Sub-Saharan Africa 936.1 \$1,657 \$1,287,650
Latin America and Caribbean 588 \$9,536 \$5,339,390
Middle East and North Africa 345.4 \$3,456 \$1,541,900
Europe and Central Asia 272.2 \$7,118 \$1,862,384
Table 19.3 GDP and Population of Seven Regions of the World
2.
What are the drawbacks to analyzing the global economy on a regional basis?
3.
Create a table that identifies the macroeconomic policies for a high-income country, a middle-income country, and a low-income country.
4.
Use the data in the text to contrast the policy prescriptions of the high-income, middle-income, and low-income countries.
5.
What are the different policy tools for dealing with cyclical unemployment?
6.
Explain how the natural rate of unemployment may be higher in low-income countries.
7.
How does indexing wage contracts to inflation help workers?
8.
Use the AD/AS model to show how increases in government spending can lead to more inflation.
9.
Show, using the AD/AS model, how governments can use monetary policy to decrease the price level.
10.
What do international flows of capital have to do with trade imbalances?
11.
Use the demand-and-supply of foreign currency graph to determine what would happen to a small, open economy that experienced capital outflows.
19.10: Review Questions
12.
What is the primary way in which economists measure standards of living?
13.
What are some of the other ways of comparing the standard of living in countries around the world?
14.
What are the four other factors that determine the economic standard of living around the world?
15.
What other factors, aside from labor productivity, capital investment, and technology, impact the economic growth of a country? How?
16.
What strategies did the East Asian Tigers employ to stimulate economic growth?
17.
What are the two types of unemployment problems?
18.
In low-income countries, does it make sense to argue that most of the people without long-term jobs are unemployed?
19.
Is inflation likely to be a severe problem for at least some high-income economies in the near future?
20.
Is inflation likely to be a problem for at least some low- and middle-income economies in the near future?
21.
What are the major issues with regard to trade imbalances for the U.S. economy?
22.
What are the major issues with regard to trade imbalances for low- and middle-income countries?
19.11: Critical Thinking Questions
23.
Demography can have important economic effects. The United States has an aging population. Explain one economic benefit and one economic cost of an aging population as well as of a population that is very young.
24.
Explain why is it difficult to set aside funds for investment when you are in poverty.
25.
Why do you think it is difficult for high-income countries to achieve high growth rates?
26.
Is it possible to protect workers from losing their jobs without distorting the labor market?
27.
Explain what will happen in a nation that tries to solve a structural unemployment problem using expansionary monetary and fiscal policy. Draw one AD/AS diagram, based on the Keynesian model, for what the nation hopes will happen. Then draw a second AD/AS diagram, based on the neoclassical model, for what is more likely to happen.
28.
Why are inflationary dangers lower in the high-income economies than in low-income and middle-income economies?
29.
Explain why converging economies may present a strong argument for limiting flows of capital but not for limiting trade.
19.12: Problems
30.
Retrieve the following data from The World Bank database (http://databank.worldbank.org/data/home.aspx) for India, Spain, and South Africa for the most recent year available:
• GDP in constant international dollars or PPP
• Population
• GDP per person in constant international dollars
• Mortality rate, infant (per 1,000 live births)
• Health expenditure per capita (current U.S. dollars)
• Life expectancy at birth, total (years)
31.
Prepare a chart that compares India, Spain, and South Africa based on the data you find. Describe the key differences between the countries. Rank these as high-, medium-, and low-income countries, explain what is surprising or expected about this data.
32.
Use the Rule of 72 to estimate how long it will take for India, Spain, and South Africa to double their standards of living.
33.
Using the research skills you have acquired, retrieve the following data from The World Bank database (http://databank.worldbank.org/data/home.aspx) for India, Spain, and South Africa for 2010–2015, if available:
• Telephone lines
• Mobile cellular subscriptions
• Secure Internet servers (per one million people)
• Electricity production (kWh)
Prepare a chart that compares these three countries. Describe the key differences between the countries.
34.
Retrieve the unemployment data from The World Bank database (http://databank.worldbank.org/data/home.aspx) for India, Spain, and South Africa for 2011-2015. Prepare a chart that compares India, Spain, and South Africa based on the data. Describe the key differences between the countries. Rank these countries as high-, medium-, and low-income countries. Explain what is surprising or expected about this data. How did the Great Recession impact these countries?
35.
Retrieve inflation data from The World Bank data base (http://databank.worldbank.org/data/home.aspx) for India, Spain, and South Africa for 2011–2015. Prepare a chart that compares India, Spain, and South Africa based on the data. Describe the key differences between the countries. Rank these countries as high-, medium-, and low-income. Explain what is surprising or expected about the data. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/19%3A_Macroeconomic_Policy_Around_the_World/19.09%3A_Self-Check_Questions.txt |
Figure 20.1 Apple or Samsung iPhone? While the iPhone is readily recognized as an Apple product, many versions (including recently released offerings) have key components made by rival phone-maker, Samsung. In international trade, there are often “conflicts” like this as each country or company focuses on what it does best. (Credit: modification of “iPhone 4's Retina Display v.s. iPhone 3G” by Yutaka Tsutano/Flickr Creative Commons, CC BY 2.0)
Chapter Objectives
In this chapter, you will learn about:
• Absolute and Comparative Advantage
• What Happens When a Country Has an Absolute Advantage in All Goods
• Intra-industry Trade between Similar Economies
• The Benefits of Reducing Barriers to International Trade
Bring It Home
Just Whose iPhone Is It?
The iPhone is a global product. Apple does not manufacture the iPhone components, nor does it assemble them. The assembly is done by Foxconn Corporation, a Taiwanese company, at its factories in China and India. But, Samsung, the electronics firm and competitor to Apple, actually supplies many of the parts that make up an iPhone. In earlier models, Samsung parts made up as much as 26% of the total costs of production. And in more recent versions, Samsung manufactures the displays and cameras. In some ways, then, Samsung is both the biggest supplier and biggest competitor for Apple. Why do these two firms work together to produce the iPhone? To understand the economic logic behind international trade, you have to accept, as these firms do, that trade is about mutually beneficial exchange. Samsung is one of the world’s largest electronics parts suppliers. Apple lets Samsung focus on making the best parts, which allows Apple to concentrate on its strength—designing elegant products that are easy to use. If each company (and by extension each country) focuses on what it does best, there will be gains for all through trade.
We live in a global marketplace. The food on your table might include fresh fruit from Chile, cheese from France, and bottled water from Scotland. Your wireless phone might have been made in Taiwan or Korea. The clothes you wear might be designed in Italy and manufactured in China. The toys you give to a child might have come from India. The car you drive might come from Japan, Germany, or Korea. The gasoline in the tank might be refined from crude oil from Saudi Arabia, Mexico, or Nigeria. As a worker, if your job is involved with farming, machinery, airplanes, cars, scientific instruments, or many other technology-related industries, the odds are good that a hearty proportion of the sales of your employer—and hence the money that pays your salary—comes from export sales. We are all linked by international trade, and the volume of that trade has grown dramatically in the last few decades.
The first wave of globalization started in the nineteenth century and lasted up to the beginning of World War I. Over that time, global exports as a share of global GDP rose from less than 1% of GDP in 1820 to 9% of GDP in 1913. As the Nobel Prize-winning economist Paul Krugman of Princeton University wrote in 1995:
It is a late-twentieth-century conceit that we invented the global economy just yesterday. In fact, world markets achieved an impressive degree of integration during the second half of the nineteenth century. Indeed, if one wants a specific date for the beginning of a truly global economy, one might well choose 1869, the year in which both the Suez Canal and the Union Pacific railroad were completed. By the eve of the First World War steamships and railroads had created markets for standardized commodities, like wheat and wool, that were fully global in their reach. Even the global flow of information was better than modern observers, focused on electronic technology, tend to realize: the first submarine telegraph cable was laid under the Atlantic in 1858, and by 1900 all of the world’s major economic regions could effectively communicate instantaneously.
This first wave of globalization crashed to a halt early in the twentieth century. World War I severed many economic connections. During the Great Depression of the 1930s, many nations misguidedly tried to fix their own economies by reducing foreign trade with others. World War II further hindered international trade. Global flows of goods and financial capital were rebuilt only slowly after World War II. It was not until the early 1980s that global economic forces again became as important, relative to the size of the world economy, as they were before World War I. | textbooks/socialsci/Economics/Principles_of_Macroeconomics_3e_(OpenStax)/20%3A_International_Trade/20.01%3A_Introduction_to_International_Trade.txt |
Learning Objectives
By the end of this section, you will be able to:
• Define absolute advantage, comparative advantage, and opportunity costs
• Explain the gains of trade created when a country specializes
The American statesman Benjamin Franklin (1706–1790) once wrote: “No nation was ever ruined by trade.” Many economists would express their attitudes toward international trade in an even more positive manner. The evidence that international trade confers overall benefits on economies is pretty strong. Trade has accompanied economic growth in the United States and around the world. Many of the national economies that have shown the most rapid growth in the last several decades—for example, Japan, South Korea, China, and India—have done so by dramatically orienting their economies toward international trade. There is no modern example of a country that has shut itself off from world trade and yet prospered. To understand the benefits of trade, or why we trade in the first place, we need to understand the concepts of comparative and absolute advantage.
In 1817, David Ricardo, a businessman, economist, and member of the British Parliament, wrote a treatise called On the Principles of Political Economy and Taxation. In this treatise, Ricardo argued that specialization and free trade benefit all trading partners, even those that may be relatively inefficient. To see what he meant, we must be able to distinguish between absolute and comparative advantage.
A country has an absolute advantage over another country in producing a good if it uses fewer resources to produce that good. Absolute advantage can be the result of a country’s natural endowment. For example, extracting oil in Saudi Arabia is pretty much just a matter of “drilling a hole.” Producing oil in other countries can require considerable exploration and costly technologies for drilling and extraction—if they have any oil at all. The United States has some of the richest farmland in the world, making it easier to grow corn and wheat than in many other countries. Guatemala and Colombia have climates especially suited for growing coffee. Chile and Zambia have some of the world’s richest copper mines. As some have argued, “geography is destiny.” Chile will provide copper and Guatemala will produce coffee, and they will trade. When each country has a product others need and it can produce it with fewer resources in one country than in another, then it is easy to imagine all parties benefitting from trade. However, thinking about trade just in terms of geography and absolute advantage is incomplete. Trade really occurs because of comparative advantage.
Recall from the chapter Choice in a World of Scarcity that a country has a comparative advantage when it can produce a good at a lower cost in terms of other goods. The question each country or company should be asking when it trades is this: “What do we give up to produce this good?” It should be no surprise that the concept of comparative advantage is based on this idea of opportunity cost from Choice in a World of Scarcity. For example, if Zambia focuses its resources on producing copper, it cannot use its labor, land and financial resources to produce other goods such as corn. As a result, Zambia gives up the opportunity to produce corn. How do we quantify the cost in terms of other goods? Simplify the problem and assume that Zambia just needs labor to produce copper and corn. The companies that produce either copper or corn tell you that it takes two hours to mine a ton of copper and one hour to harvest a bushel of corn. This means the opportunity cost of producing a ton of copper is two bushels of corn. The next section develops absolute and comparative advantage in greater detail and relates them to trade.
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A Numerical Example of Absolute and Comparative Advantage
Consider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. Further assume that consumers in both countries desire both these goods. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country. There is only one resource available in both countries, labor hours. Saudi Arabia can produce oil with fewer resources, while the United States can produce corn with fewer resources. Table 20.1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good.
Country Oil (hours per barrel) Corn (hours per bushel)
Saudi Arabia 1 4
United States 2 1
Table 20.1 How Many Hours It Takes to Produce Oil and Corn
In Table 20.1, Saudi Arabia has an absolute advantage in producing oil because it only takes an hour to produce a barrel of oil compared to two hours in the United States. The United States has an absolute advantage in producing corn.
To simplify, let’s say that Saudi Arabia and the United States each have 100 worker hours (see Table 20.2). Figure 20.2 illustrates what each country is capable of producing on its own using a production possibility frontier (PPF) graph. Recall from Choice in a World of Scarcity that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers, and its level of technology.
Country Oil Production using 100 worker hours (barrels) Corn Production using 100 worker hours (bushels)
Saudi Arabia 100 or 25
United States 50 or 100
Table 20.2 Production Possibilities before Trade
Figure 20.2 Production Possibilities Frontiers (a) Saudi Arabia can produce 100 barrels of oil at maximum and zero corn (point A), or 25 bushels of corn and zero oil (point B). It can also produce other combinations of oil and corn if it wants to consume both goods, such as at point C. Here it chooses to produce/consume 60 barrels of oil, leaving 40 work hours that to allocate to produce 10 bushels of corn, using the data in Table 20.1. (b) If the United States produces only oil, it can produce, at maximum, 50 barrels and zero corn (point A'), or at the other extreme, it can produce a maximum of 100 bushels of corn and no oil (point B'). Other combinations of both oil and corn are possible, such as point C'. All points above the frontiers are impossible to produce given the current level of resources and technology.
Arguably Saudi and U.S. consumers desire both oil and corn to live. Let’s say that before trade occurs, both countries produce and consume at point C or C'. Thus, before trade, the Saudi Arabian economy will devote 60 worker hours to produce oil, as Table 20.3 shows. Given the information in Table 20.1, this choice implies that it produces/consumes 60 barrels of oil. With the remaining 40 worker hours, since it needs four hours to produce a bushel of corn, it can produce only 10 bushels. To be at point C', the U.S. economy devotes 40 worker hours to produce 20 barrels of oil and it can allocate the remaining worker hours to produce 60 bushels of corn.
Country Oil Production (barrels) Corn Production (bushels)
Saudi Arabia (C) 60 10
United States (C') 20 60
Total World Production 80 70
Table 20.3 Production before Trade
The slope of the production possibility frontier illustrates the opportunity cost of producing oil in terms of corn. Using all its resources, the United States can produce 50 barrels of oil or 100 bushels of corn; therefore, the opportunity cost of one barrel of oil is two bushels of corn—or the slope is 1/2. Thus, in the U.S. production possibility frontier graph, every increase in oil production of one barrel implies a decrease of two bushels of corn. Saudi Arabia can produce 100 barrels of oil or 25 bushels of corn. The opportunity cost of producing one barrel of oil is the loss of 1/4 of a bushel of corn that Saudi workers could otherwise have produced. In terms of corn, notice that Saudi Arabia gives up the least to produce a barrel of oil. Table 20.4 summarizes these calculations.
Country Opportunity cost of one unit — Oil (in terms of corn) Opportunity cost of one unit — Corn (in terms of oil)
Saudi Arabia ¼ 4
United States 2 ½
Table 20.4 Opportunity Cost and Comparative Advantage
Again recall that we defined comparative advantage as the opportunity cost of producing goods. Since Saudi Arabia gives up the least to produce a barrel of oil, ($1414$ < $22$ in Table 20.4) it has a comparative advantage in oil production. The United States gives up the least to produce a bushel of corn, so it has a comparative advantage in corn production.
In this example, there is symmetry between absolute and comparative advantage. Saudi Arabia needs fewer worker hours to produce oil (absolute advantage, see Table 20.1), and also gives up the least in terms of other goods to produce oil (comparative advantage, see Table 20.4). Such symmetry is not always the case, as we will show after we have discussed gains from trade fully, but first, read the following Clear It Up feature to make sure you understand why the PPF line in the graphs is straight.
Clear It Up
Can a production possibility frontier be straight?
When you first met the production possibility frontier (PPF) in the chapter on Choice in a World of Scarcity we drew it with an outward-bending shape. This shape illustrated that as we transferred inputs from producing one good to another—like from education to health services—there were increasing opportunity costs. In the examples in this chapter, we draw the PPFs as straight lines, which means that opportunity costs are constant. When we transfer a marginal unit of labor away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same. In reality this is possible only if the contribution of additional workers to output did not change as the scale of production changed. The linear production possibilities frontier is a less realistic model, but a straight line simplifies calculations. It also illustrates economic themes like absolute and comparative advantage just as clearly.
Gains from Trade
Consider the trading positions of the United States and Saudi Arabia after they have specialized and traded. Before trade, Saudi Arabia produces/consumes 60 barrels of oil and 10 bushels of corn. The United States produces/consumes 20 barrels of oil and 60 bushels of corn. Given their current production levels, if the United States can trade an amount of corn fewer than 60 bushels and receive in exchange an amount of oil greater than 20 barrels, it will gain from trade. With trade, the United States can consume more of both goods than it did without specialization and trade. (Recall that the chapter Welcome to Economics! defined specialization as it applies to workers and firms. Economists also use specialization to describe the occurrence when a country shifts resources to focus on producing a good that offers comparative advantage.) Similarly, if Saudi Arabia can trade an amount of oil less than 60 barrels and receive in exchange an amount of corn greater than 10 bushels, it will have more of both goods than it did before specialization and trade. Table 20.5 illustrates the range of trades that would benefit both sides.
The U.S. economy, after specialization, will benefit if it: The Saudi Arabian economy, after specialization, will benefit if it:
Exports no more than 60 bushels of corn Imports at least 10 bushels of corn
Imports at least 20 barrels of oil Exports less than 60 barrels of oil
Table 20.5 The Range of Trades That Benefit Both the United States and Saudi Arabia
The underlying reason why trade benefits both sides is rooted in the concept of opportunity cost, as the following Clear It Up feature explains. If Saudi Arabia wishes to expand domestic production of corn in a world without international trade, then based on its opportunity costs it must give up four barrels of oil for every one additional bushel of corn. If Saudi Arabia could find a way to give up less than four barrels of oil for an additional bushel of corn (or equivalently, to receive more than one bushel of corn for four barrels of oil), it would be better off.
Clear It Up
What are the opportunity costs and gains from trade?
The range of trades that will benefit each country is based on the country’s opportunity cost of producing each good. The United States can produce 100 bushels of corn or 50 barrels of oil. For the United States, the opportunity cost of producing one barrel of oil is two bushels of corn. If we divide the numbers above by 50, we get the same ratio: one barrel of oil is equivalent to two bushels of corn, or (100/50 = 2 and 50/50 = 1). In a trade with Saudi Arabia, if the United States is going to give up 100 bushels of corn in exports, it must import at least 50 barrels of oil to be just as well off. Clearly, to gain from trade it needs to be able to gain more than a half barrel of oil for its bushel of corn—or why trade at all?
Recall that David Ricardo argued that if each country specializes in its comparative advantage, it will benefit from trade, and total global output will increase. How can we show gains from trade as a result of comparative advantage and specialization? Table 20.6 shows the output assuming that each country specializes in its comparative advantage and produces no other good. This is 100% specialization. Specialization leads to an increase in total world production. (Compare the total world production in Table 20.3 to that in Table 20.6.)
Country Quantity produced after 100% specialization — Oil (barrels) Quantity produced after 100% specialization — Corn (bushels)
Saudi Arabia 100 0
United States 0 100
Total World Production 100 100
Table 20.6 How Specialization Expands Output
What if we did not have complete specialization, as in Table 20.6? Would there still be gains from trade? Consider another example, such as when the United States and Saudi Arabia start at C and C', respectively, as Figure 20.2 shows. Consider what occurs when trade is allowed and the United States exports 20 bushels of corn to Saudi Arabia in exchange for 20 barrels of oil.
Figure 20.3 Production Possibilities Frontier in Saudi Arabia Trade allows a country to go beyond its domestic production-possibility frontier
Starting at point C, which shows Saudi oil production of 60, reduce Saudi oil domestic oil consumption by 20, since 20 is exported to the United States and exchanged for 20 units of corn. This enables Saudi to reach point D, where oil consumption is now 40 barrels and corn consumption has increased to 30 (see Figure 20.3). Notice that even without 100% specialization, if the “trading price,” in this case 20 barrels of oil for 20 bushels of corn, is greater than the country’s opportunity cost, the Saudis will gain from trade. Since the post-trade consumption point D is beyond its production possibility frontier, Saudi Arabia has gained from trade.
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