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Unit III Lesson VIII Macro Tools Economics Gone Wild! An Expanded Circular-Flow Diagram Lesson VIII Economics Gone Wild! National Income Accounting Lesson • Bureau of Economic VIII Analysis compiles National Income and Product Accounts –Assess health of economy –Track long run course –Formulate policy Economics Gone Wild! Assessing Economy’s Performance • Gross Domestic Product Lesson (GDP) VIII – A Monetary Measure • Avoid Multiple Counting – Market value final goods – Ignore intermediate goods – Count value added – Exclude Nonproduction Transactions Economics Gone Wild! Assessing Economy’s Performance • Financial Transactions Lesson Excluded VIII –Public Transfer Payments –Private Transfer Payments –Stock (and Bond) Market Transactions –Second Hand Sales • Sell used car to a friend • Yard Sales Economics Gone Wild! Two Approaches to GDP • Income approach – Count income derived from Lesson production VIII – Wages, rental income, interest income, profit • Expenditure approach – Count sum of money spent buying the final goods – Who buys the goods? – Final-Product or Value-Added – Sum of the Money Spent to Buy the Output Economics Gone Wild! Two Approaches to GDP Expenditure Income Approach Approach Consumption by Lesson Wages Households VIII + Investment by + Rents Businesses G + + = D= Interest Government Purchases P + Profits + Expenditures + Statistical By Foreigners Adjustments Economics Gone Wild! Expenditure Approach • Personal consumption Lesson expenditures (C) VIII –Durable consumer goods –Nondurable consumer goods –Consumer expenditures for services –Domestic plus foreign produced Economics Gone Wild! Expenditure Approach • Gross private domestic Lesson investment (I) VIII – Machinery, equipment, and tools – All construction – Changes in inventories – Creation of new capital asset • Noninvestment transactions – Capital consumption – Capital transfers Economics Gone Wild! Expenditure Approach Gross Investment Lesson - Depreciation VIII = Net Investment Net Investment Gross Investment Depreciation Increased Consumption Stock of & Government Stock of Capital Spending Capital January 1 Year’s GDP December 31 Economics Gone Wild! Expenditure Approach • Government purchases (G) Lesson –Expenditures for goods and VIII services –Expenditures for social capital –Excludes transfer payments Economics Gone Wild! Expenditure Approach • Net exports (Xn) Lesson VIII –Add exported goods –Subtract imported goods –NX = exports - imports Economics Gone Wild! Expenditure Approach Putting It All Together: Lesson VIII GDP = C + I + G + Xn GDP = $11,249 + 2,084 + 3,053 - 557 = $15,829 in 2012 Economics Gone Wild! GDP Approaches Compared Accounting Statement for the U.S. Economy, 2012 in Billions Receipts Expenditures Approach Lesson VIII Personal Consumption (C) $11,249 Gross Private Domestic Investment (Ig) 2,084 Government Purchases (G) 3,053 Net Exports (Xn) -557 Gross Domestic Product $ 15,829 Economics Gone Wild! Comparative GDPs GLOBAL PERSPECTIVE Select Nations GDPs - 2010 Lesson VIII GDP in Trillions of Dollars 0 1 2 3 4 5 6 7 8 9 10 12 United States $14.58 China $5.93 Japan $5.48 Germany $3.28 France $2.56 United Kingdom $2.24 Brazil $2.09 Italy $2.05 India $1.84 Canada $1.58 Russia $1.48 Spain $1.40 Mexico $1.03 South Korea $1.01 Australia $.94 Economics Gone Wild! Source: World Bank The Income Approach • Compensation of Employees Lesson • Rents VIII • Interest • Proprietor’s Income • Corporate Profits – Corporate Income Taxes – Dividends – Undistributed Corporate Profits – Taxes on Production and Economics Gone Wild! Imports The Income Approach • From National Income to GDP Lesson – Net Foreign Factor Income VIII – Statistical Discrepancy – Consumption of Fixed Capital • Other National Accounts – Net Domestic Product (NDP) – National Income (NI) – Personal Income (PI) – Disposable Income (DI) Economics Gone Wild! DI = C + S U.S. Income Relationships 2012 Gross Domestic Product (GDP) $ 15,829 Lesson Less: Consumption of Fixed Capital 2036 VIII Equals: Net Domestic Product (NDP) $ 13793 Less: Statistical Discrepancy -50 Plus: Net Foreign Factor Income 165 Equals: National Income (NI) $ 13,196 Less: Taxes on Production and Imports 1098 Less: Social Security Contributions 924 Less: Corporate Income Taxes 513 Less: Undistributed Corporate Profits 344 Plus: Transfer Payments 2361 Equals: Personal Income (PI) $ 13,936 Less: Personal Taxes 1514 Equals: Disposable Income (DI) $ 12,422 Economics Gone Wild! 7-18 GDP Approaches Compared Accounting Statement for the U.S. Economy, 2011 in Billions Receipts Allocations Expenditures Approach Income Approach Lesson Personal Consumption (C) $10,858 Compensation $ 8,242 VIII Gross Private Domestic Rents 404 Investment (Ig) 2,000 Interest 536 Government Purchases (G) 3,018 Proprietor’s Income 1108 Net Exports (Xn) -582 Corporate Profits 1870 Taxes on Production and Imports 1036 National Income $13,196 Net Foreign Factor Income 165 Statistical Discrepancy -50 Consumption of Fixed Capital 1983 Gross Domestic Product $ 15,294 Gross Domestic Product $ 15,294 Economics Gone Wild! GDP Approaches Compared Accounting Statement for the U.S. Economy, 2011 in Billions Receipts Allocations Expenditures Approach Income Approach Lesson Personal Consumption (C) $10,858 Compensation $ 8,242 VIII Gross Private Domestic Rents 404 Investment (Ig) 2,000 Interest 536 Government Purchases (G) 3,018 Proprietor’s Income 1108 Net Exports (Xn) -582 Corporate Profits 1870 Taxes on Production and Imports 1036 National Income $13,196 Net Foreign Factor Income 165 Statistical Discrepancy -50 Consumption of Fixed Capital 1983 Gross Domestic Product $ 15,294 Gross Domestic Product $ 15,294 Economics Gone Wild! Circular Flow Revisited U.S. Domestic Output and the Flows of Expenditure and Income Lesson VIII Economics Gone Wild! Nominal vs. Real GDP • GDP is a dollar measure of Lesson production VIII • Using dollar values creates problems • Nominal GDP –Use prevailing price • Real GDP –Reflect changes in price –Use base year price Economics Gone Wild! GDP Price Index Use price index to Lesson VIII determine real GDP Price Price of Market Basket Index In Specific Year In Given = Price of Same Basket x 100 Year In Base Year Real Nominal GDP GDP = Price Index (in hundredths) Economics Gone Wild! Shortcomings of GDP • Nonmarket activities Lesson • Leisure VIII • Improved product quality • The underground economy • GDP and the environment • Composition and distribution of the output • Noneconomic sources of well- being Economics Gone Wild! The Free Economy GLOBAL PERSPECTIVE Underground Economy as a Percentage Lesson of GDP - Select Nations VIII Percentage of GDP 0 5 10 15 20 25 30 Mexico South Korea India Italy Spain China Sweden Germany France United Kingdom Japan Switzerland Economics Gone Wild! US Source: Journal of Economic Literature C+I+G=Baloney • Mainstreamers add government expenditures to Gross Domestic Lesson Product (GDP) VIII • But it is really a drain depending on the weight of the fiscal extent of government activity in the economy • Government expenditure is theft not production • So we need to adjust GDP to arrive at Gross Private Product Economics Gone Wild! GPP • Corrections to GDP – Transfer payments, because they are Lesson taken from producers and given to non- VIII producers, should not be added – Any “goods or services” from government enterprises, need to be subtracted – Public employees’ salaries because it is gathered by means of taxation of the private sector need subtraction Economics Gone Wild! C+I+G=Baloney X • Now from GPP, G must be subtracted, but… Lesson VIII – If spending is larger than taxes, then the deficit is either financed by issuing new money or by borrowing private savings. • In either case, the deficit constitutes a drain of resources from the private sector. – If there is a surplus of taxes over spending, then the surplus taxes are drains on the private sector. – Subtract which ever larger Economics Gone Wild! C+I+G=Baloney This subtracted from GPP yields the private product remaining in Lesson VIII private hands: PPR (Private Output plus Costs of Government output) • GDP=C+I+G+(X-M) • GDP- GI (products or incomes from government=GPP • GPP- G (receipts or spending)=PPR Economics Gone Wild! Lesson VIII Economics Gone Wild! Magical Mystery Tour BEA Sources of Data for Analysis • Consumption Lesson – Census Bureau’s Retail Trade Survey VIII – Census Bureau’s Survey of Manufacturers – Census Bureau’s Service Survey • Investment – All Consumption Data Sources – Survey of Manufacturers – Service Survey – Industry Sources – Census Bureau’s Housing Starts Survey and Housing Sales Survey – Retail Trade Survey – Wholesale Trade Survey Economics – Survey of Manufacturing Gone Wild! Magical Mystery Tour • Government Purchases Lesson VIII – Office of Personnel Management – Construction Surveys – Census Bureau’s Survey of Government Finance • Net Exports – U.S. Customs Service – BEA Surveys and Analysis Economics Gone Wild! Seven Major Sources of Lesson VIII Economic Progress Common Sense Economics James Gwartney, Richard L. Stroup, and Dwight R. Lee 33 Economics Gone Wild! Questions to Consider • Capital investments and new Lesson technology clearly contribute to VIII economic growth and prosperity. What else is needed and what can governments add? • Why are sound institutions, governmental policies and money of stable value important? How can they advance economic progress? How can they stifle it? • Why do economic growth patterns and rates differ across countries and time? Economics Gone Wild! Source #1 Lesson Legal System VIII The foundation for economic progress is a legal system that protects the private use of land, natural resources, labor, capital, and entrepreneurial talent in an even-handed manner. Economics Gone Wild! The Foundation for Economic Progress Private property rights grant the owner of property the right to Lesson buy, sell, or derive income from VIII their land, natural resources, capital and entrepreneurial talent. Even-handed enforcement protects these rights to exclusive use, protection against abuse, and transfer rights, thus allowing property owners to focus on resource allocation, efficient production, investment, and technological advancement. Economics Gone Wild! Property Rights Encourage people to use their property productively. Lesson VIII Promote wise stewardship. Encourage people to develop their property in ways beneficial to others for possible exchange, transfer or sale. Promote the wise development and conservation of resources for the future. Economics Gone Wild! The U.S. Will Run Out of Oil! Or Will It? 1. In which year(s) did experts Lesson predict that the U.S. would run VIII out of oil in the near future? a. 1914 b. 1926 c. 1970s d. 2008 e. All of the above Economics Gone Wild! Why Have Doomsday Forecasts Been Wrong? • When the scarcity of a Lesson privately owned resource VIII increases, the invisible hand of the market takes over and prices rise. • Buyers and sellers seek substitutes, discover ways to conserve, and innovate! • Historically, competitive markets and flexible prices spur conservation, substitution, and technological advancement. Economics • And the “sky” never falls! Gone Wild! Source #2 Competitive Markets Lesson VIII Competition promotes the efficient use of resources and provides a continuous stimulus for innovative improvements. Economics Gone Wild! Consumers Rule! • Competition places pressure on producers to operate efficiently. Lesson • Competition forces businesses to cater to their customers’ preferences and provide goods and VIII services for which they are willing to pay prices sufficient to cover their costs. • Consumers vote with dollars on which businesses stay and which must go. (e.g. Target vs. Wal-Mart vs. Sears vs. K-Mart) • They make sure that sole proprietors, partnerships and large corporations charge low prices, produce quality products and provide services of value relative to costs! 41 Economics Gone Wild! Source #3 Limits on Government Lesson Regulation VIII Regulatory policies that reduce trade also retard economic progress. Economics Gone Wild! Governments Limit Trade and Retard Progress By Limiting entry into some businesses and occupations Lesson • Licensing requirements, completing bureaucratic forms, VIII etc. Substituting political authority for rule of law and freedom of contract • Imprecise, ambiguous and discriminatory laws invite people to spend resources on bribery and lobbying efforts rather than production. Imposing price controls • Price floors and ceilings interfere with trades between buyers and sellers, distort prices, and lead to inefficient levels of production and employment. Economics Gone Wild! Source #4 Lesson VIII An Efficient Capital Market To realize its potential, a nation must have a mechanism that channels capital into wealth-creating projects. Economics Gone Wild! Capital Investment and Its Role in Growth • Capital is anything used to produce Lesson something else and helps us produce more VIII goods and services in the future. – Machines, buildings, computers, tools • Capital investment requires consumption sacrifices today. It requires savings. The payoff is increased production and consumption in the future. • A mechanism is needed to channel savings into productive investments. Capital markets perform this function. Economics Gone Wild! Capital Markets • Capital markets, broadly defined, include markets for: – Loanable funds, real estate, stock markets & financial markets Lesson • Institutions like banks, credit unions and VIII investment firms bring savers and investors together. • Interest rates provide people with incentive to save. Productive investments will yield a return sufficient to cover all costs, including borrowing. • Not all investment projects are productive. In a world of uncertainty, investments can and do fail. But failures hold investors accountable and provide them the incentive to discover and undertake productive projects. Economics Gone Wild! Capital Markets and Government Intervention • Governments can and do intervene in capital markets by restricting capital Lesson movements, setting interest rates, and VIII using taxes and budgets to allocate capital. • These actions: – Distort market incentives. – Increase the importance of political rather than economic considerations. – Make unproductive investments more likely. Economics Gone Wild! Source #5 Monetary Stability Lesson VIII Inflationary monetary policies distort price signals, undermining a market economy. Economics Gone Wild! Money, Money, Money! • “Money is to an economy what Lesson language is to communication.” VIII • Money serves three functions – Medium of exchange – Unit of account – Store of value • When the value of money is stable, – Many potentially beneficial exchanges will take place. – Borrowers and lenders will face less uncertainty. – Gains from trade will be maximized. Economics Gone Wild! Money and Who Controls It • The nation’s money consists of Lesson its currency held by the public, VIII checking accounts, and traveler’s checks. • A nation’s central bank controls its money by buying and selling assets, usually government bonds. Economics Gone Wild! The Value of Money • The value of money is determined by supply and demand. Lesson • The value of money is steady when the VIII supply of money grows slowly (e.g. at approximately the same rate as goods and services). • When a central bank expands the money supply rapidly relative to the production of goods and services, inflation results and the purchasing power of money is eroded. Economics Gone Wild! Inflation’s Uncertainty • Difficult to forge long-range plans when you cannot Lesson predict the value of money VIII • Confidence in government declines when citizens lack confidence in the value of their nation’s currency • Harms different sectors of population, differently Economics Gone Wild! The Keys to Sound Money and Price Stability Lesson Central banks and their officials should be held VIII accountable for following a sound money policy and keeping the nation’s rate of inflation within a narrow range; or be dismissed. A currency board in one nation could establish a fixed rate of exchange between its domestic currency and a selected foreign counterpart with a sound money policy. This is often attractive for small countries. A country could adopt another nation’s currency to provide stability. For example, the euro or dollar are often used. Economics Gone Wild! Source #6 Lesson Low Tax Rates VIII People will produce more when they are permitted to keep more of what they earn. Economics Gone Wild! High Marginal Tax Rates Lesson VIII Discourage work effort and reduce the productivity of labor. Reduce both the level and efficiency of capital formation. Encourage individuals to consume tax- deductible goods when nondeductible goods may actually be more desirable. Economics Gone Wild! Source #7 Lesson Free Trade VIII A nation progresses by selling goods and services that it can produce at a relatively low cost and buying those that would be costly to produce. Economics Gone Wild! Increased Production and Consumption Among All Trading Partners • International trade makes it possible Lesson for each country to acquire goods and VIII services more cheaply. • It allows domestic producers and consumers to benefit from the economies of scale. • It promotes competition in domestic markets and allows consumers to purchase a wider variety of goods at lower prices. Economics Gone Wild! Free Trade Allows: • Consumers to find the lowest Lesson prices, the best value from VIII their expenditures, and the greatest variety of goods and services. • Domestic producers to sell their goods and services where they can get the highest price for the value of what they offer in the marketplace. Economics Gone Wild! Government Barriers to Trade • Include tariffs, domestic Lesson subsidies, quotas, etc. VIII • Do not create or destroy domestic jobs; they just shuffle them around. • Create inefficiencies in the protected industries, forcing domestic consumers to pay higher prices. Economics Gone Wild! International Trade: Imports and Exports • Trade restrictions that reduce imports will also reduce the ability of foreigners to buy Lesson our exports. VIII • Quotas and tariffs decrease the number of dollars earned by foreigners through the sale of imports to us. • Therefore, reductions in imports simultaneously reduce exports. Economics Gone Wild! If goods can’t cross borders, soldiers will. Lesson VIII “More than any other single action, unilateral removal of our trade restrictions would establish the environment for a more peaceful and prosperous world.” Economics Gone Wild! Concluding Thoughts How important are the following Lesson institutions/policies for a country’s VIII prosperity? a. Secure protection of privately owned property b. Even-handed enforcement of contracts c. Stable monetary environment d. Low marginal tax rates e. Minimal barriers to trade f. Market versus government allocation of capital Economics Gone Wild! The Evidence Indicates • The countries with the highest levels of economic freedom have the highest per Lesson capita GDP and growth rates. VIII • Free economies spur savings and investment resulting in economic growth and prosperity. • Differing institutions and policies explain why growth rates vary across countries and time. Economics Gone Wild! Selected Growth Rates GLOBAL PERSPECTIVE 6 Lesson VIII Percentage Change (annual rate) U.S. 4 France Germany U.K. 2 Japan Italy 0 -2 -4 1997 1999 2001 2003 2005 Economics Gone Wild! Source: Economic Report of the President, 2006 Economic Growth • Increase in Real GDP Lesson • Increase in Real GDP Per VIII Capita • Growth as a Goal • Arithmetic of Growth – Rule of 70 Approximate 70 number of years required to double = annual percentage rate real GDP of growth Economics Gone Wild! Ingredients of Growth • Supply Factors Lesson –Increases in Quantity and VIII Quality of Natural Resources –Increases in Quality and Quantity of Human Resources –Increases in the Supply (or Stock) of Capital Goods –Improvements in Economics Gone Wild! Technology Ingredients of Growth • Demand Factor Lesson –Households, Businesses, VIII And Government Must Purchase the Economy’s Expanding Output of Goods and Services • Efficiency Factor –Must Achieve Economic Efficiency and Full Employment Economics Gone Wild! Production Possibilities Production Possibilities Curve From Chapter 1 Lesson C VIII A Economic Capital Goods Growth c b a B D Economics Gone Wild! Consumer Goods Labor and Productivity Labor Productivity Lesson Real GDP = Hours of Work x Labor Productivity VIII • Size of Employed Labor Force Labor Inputs • Average (Hours of Hours Work) of Work Real • Technological GDP Advance • Quantity of Labor Capital Productivity • Education and (Average Training Output per • Allocative Hour) Efficiency • Other Economics Gone Wild! Growth in the AD-AS Model Production Possibilities and Aggregate Supply Lesson VIII ASLR1 ASLR2 C Capital Goods A Price Level B D Consumer Goods Real GDP Economics Gone Wild! Growth in the AD-AS Model Production Possibilities and Aggregate Supply Lesson VIII Depicting U.S. Growth with AD-AS Model ASLR1 ASLR2 AS2 AS1 Price Level P2 P1 AD2 AD1 Q1 Q2 Economics Gone Wild! Real GDP Accounting for Growth • Growth Accounting • U.S. Economic Growth Rates Lesson U.S. Economic Growth, Annual Averages for Five Decades VIII 5 Real GDP Average Annual Increase (Percent) Real GDP Per Capita 4 3 2 1 0 1950-1959 1960-1969 1970-1979 1980-1989 1990-1999 2000-2005 Economics Gone Wild! Year Source: Bureau of Economic Analysis Accounting for Growth • Factors Underlying Growth Lesson –Increases in Hours of Work VIII –Increases in Labor Productivity Accounting for Growth of U.S. Real GDP, 1953-2013 (Annual Percentage Changes) 1953 Q2 1973 Q4 1995 Q2 2001 Q1 2007 Q3 to to to to to Item 1973 Q4 1995 Q2 2001 Q1 2007 Q3 2013 Q4* Increases in Real GDP 3.6 2.8 3.8 2.6 2.8 Increases in Quantity of Labor 1.2 1.3 1.4 -0.1 0.3 Increases in Labor Productivity 2.5 1.5 2.4 2.7 2.5 Economics Gone Wild! *Beyond 2005 are Projections Source: Economic Report of the President, 2008 Accounting for Growth • Technological Advance Lesson • Quantity of Capital VIII – Infrastructure • Education and Training – Human Capital Changes in the Educational Attainment of the U.S. Adult Population 100 Percent of Adult Population 80 60 40 20 0 1960 1970 1980 1990 2000 2005 Economics Gone Wild! Year Source: U.S. Census Bureau Accounting for Growth Lesson • Factors affecting VIII productivity growth –Technological advance (40%) –Quantity of capital (30%) –Education and training (15%) –Economies of scale and resource allocation (15%) Economics Gone Wild! Accounting for Growth GLOBAL PERSPECTIVE Average Test Scores of Eighth Students Lesson In Math and Science, Top 10 Countries VIII and the United States Mathematics Science 1 Singapore 605 1 Singapore 578 2 South Korea 589 2 Taiwan 571 3 Hong Kong 586 3 South Korea 558 4 Taiwan 585 4 Hong Kong 556 5 Japan 570 5 Estonia 552 6 Belgium 537 6 Japan 552 7 Netherlands 536 7 Hungary 543 8 Estonia 531 8 Netherlands 536 9 Hungary 529 9 United States 527 10 Malaysia 508 10 Australia 527 15 United States 504 Economics Gone Wild! Accounting for Growth • Economies of Scale Lesson VIII • Improved Resource Allocation • Other Factors –Economic Freedom –Political Freedom –“Growth Friendly” –Positive Attitudes Toward Work and Risk Taking Economics Gone Wild! Tax Rates Country Rate of All Taxes on Goods Lesson UK 20% VIII France 19.6% Germany 19% EU 15 Original Average 20.77% Canada 5 to 13%* China 17% Mexico 16% India 12.5% Japan 5% US 35% *Canada has varied provincial rates Economics Gone Wild! Economic Growth • Is accelerated productivity Lesson VIII growth sustainable? • Is economic growth desirable and sustainable? Economics Gone Wild! Growth Desirability • The Antigrowth View Lesson –Adverse Spillovers VIII –Alternative Quality of Life Opinions –Environmental and resource issues Economics Gone Wild! Growth Desirability • In Defense of Economic Growth Lesson VIII – Higher Standard of Living – Poverty Reduction – Limited Only by Human Imagination – Human imagination can solve environmental and resource issues Economics Gone Wild! The Production Possibilities Frontier Lesson VIII The Consumption- Investment Tradeoff And the Essence of Economic Growth Economics Gone Wild! In any economy, some resources are devoted to CONSUMPTION producing consumables, the remaining resources being available for maintaining and Lesson expanding the economy’s VIII productive capacity. The PPF The Production Possibilities INVESTMENT Frontier (PPF) depicts these A “fully employed market economy” allows alternatives during a given time so-called “natural for aperiod, typically one rate of unemployment,” which is about five or six year. percent. That is, frictional and structural The tradeoff between CONSUMPTION (in the present) and unemployment are characteristic of even part of our INVESTMENT (for the future) should be an integral a macroeconomic thinking. healthy economy. Under favorable conditions, a fully employed market economy allocates resources to both uses, making the most of the trade-off. Economics Gone Wild! A PPF with If resources were and capital But raw materials homogeneous heterogeneous CONSUMPTION characterized by perfect equipment are inputs homogeneity, such that each heterogeneous. Riverboats unit of input is equally and river barges are not suitable for producing either readily substitutable one for Lesson kindother. the of output (consumption VIII goods or investment goods), then the PPF would be linear. INVESTMENT The heterogeneity of equipment and materials implies a convex PPF. As the tradeoff is made away from consumption and toward more investment, the scope for still more investment diminishes. Microeconomists would describe this feature of the PPF in terms of a diminishing marginal rate of substitution. Economics Gone Wild! CONSUMPTION “Investment” in this construction represents gross investment, which includes replacement capital. Lesson Typically, the investment VIII needed just to replace The out or obsolete capital wornextent to which gross INVESTMENT is substantial but investment exceeds the Replacement Capital “replacement” than gross something lessmagnitude Net Investment investment.net investment constitutes Gross and allows for the expansion Investment of the economy. Positive net investment means that the economy is growing. The PPF shifts outward from year to year, permitting increasing levels of both consumption and investment. This outward shifting of the PPF represents sustainable economic growth. Economics Gone Wild! YEAR 34 YEAR0 2 1 Watch the economy grow. CONSUMPTION Four periods of growth are shown—with consumption, as well as investment, increasing Lesson in each period. VIII The actual rate of expansion of the PPF depends upon many INVESTMENT factors. For instance, with Replacement Capital economic expansion, more Net Investment resources are needed for Gross capital replacement. And the Investment desired trade-off between consuming and investing can itself change as the economy generates more wealth. Economics Gone Wild! Watch the economy grow. CONSUMPTION Importantly, we note that forgoing some consumption Lesson with an eye toward VIII consuming more in the future triggers a movement along the initial PPF and INVESTMENT hence affects the rate at which the PPF expands Watch the movement outward. along the PPF. Economics Gone Wild! Now watch the economy CONSUMPTION grow. 0 YEAR 1 3 2 4 Lesson VIII INVESTMENT Increased thriftiness makes the difference. Let’s compare the high- growth economy with the original low-growth economy. Economics Gone Wild! CONSUMPTION CONSUMPTION Lesson VIII INVESTMENT INVESTMENT Note the difference that an initial trading off of consumption for investment makes in the subsequentat the expense of With an initial increase in investment pattern of consumption and investment. consumption and investment increase consumption, both Without an initial increase in investment, consumption and dramatically from period to period. investment increase modestly from period to period. By the fourth period, that initial increase in investment pays off as a higher level of consumption than would otherwise have been possible. Economics Gone Wild! The time dimension is CONSUMPTION represented by the sequence of shifts of the PPF. We can add to our Lesson understanding if we VIII represent time explicitly on a horizontal axis and then keep track of consumption on the INVESTMENT vertical axis. In both representations, Explicitly tracking the level of CONSUMPTION consumption is seen to fall consumption over time allows as the economy tradeoff is us to see that theis adapting to a higher growth rate, after essentially an intertemporal which consumption rises tradeoff. more rapidly than before… and eventually surpasses Consumption in the present the old projected is traded for and near futuregrowth path. consumption in the more TIME distant future. Economics Gone Wild! There is nothing pre- CONSUMPTION ordained about the economy YEAR 1 0 4 2 3 actually having a positive rate of growth. Lesson Suppose that gross investment in the economy is VIII just enough to replace worn out and obsolete capital— INVESTMENT which means that net Replacement Capital investment is zero. Gross Net Investment Net Investment = 0 The levels of consumption Investment and (gross) investment would be maintained, but the Gross Investment economy would not grow. Watch the economy not grow. Economics Gone Wild! In a no-growth economy (meaning no net investment), CONSUMPTION would it be possible for 3 2 1 4 YEAR 0 people to increase consumption? Lesson Yes, there is still some scope for movement along the PPF in VIII the direction of more consumption and less INVESTMENT investment. Replacement Capital But what would be the Gross consequences for the PPF in Investment subsequent years? Watch the economy experience negative growth, i.e., watch it contract. Notice that consumption rises initially and then falls as the economy’s productive capacity diminishes over time. Economics Gone Wild! As in the case of a clockwise CONSUMPTION movement along the PPF, we can add to our understanding of this counterclockwise movement by representing Lesson time explicitly on a horizontal VIII axis and then keeping track of consumption on the vertical axis. INVESTMENT In both representations, CONSUMPTION The increase seen to rise consumption isin consumption in the present is adapting as the economyand near future to a negative growth rate, a comes at the expense of declining consumption after whichrate of consumption declines—soon falling below in the more distant future. the initial level. TIME Economics Gone Wild! CONSUMPTION If gross investment exceeds replacement capital, the economy expands. Lesson VIII TIME CONSUMPTION If gross investment falls short of replacement capital, the economy contracts. Economics Gone Wild! TIME Consider two separate economies, one large CONSUMPTION and one small. On what basis can you make a prediction about the sizes Lesson of the two is broadly Each PPF economies, say, VIII descriptive of two particular two or three decades after countries at the end of the war? World War much faster than Japan grewII. INVESTMENT the United States—not Post-war United these? Apart from their differing What two countries are States because it had been bombed, sizes, one possibly but because the consumption- CONSUMPTION relevant difference is that investment tradeoff in post-war the small country’s Japan was made in favor of a economy had been high level of investment. wrecked by bombing to a much greater extent the In the United States, than the large country’s tradeoff was made in the economy. opposite direction by the consumption-oriented INVESTMENT Americans. Post-war Japan Economics Gone Wild! To this point, we’ve assumed that the economy is either on CONSUMPTION its PPF or is being expeditiously moved by market forces toward a point on its Lesson shifting PPF. VIII Suppose, though, that during a given year, some market malfunction (or some perverse INVESTMENT policy) takes the economy off its PPF. If the economy is pushed beyond the PPF, its unemployment rate being driven below the 5-6 percent band, we say the economy is “overheated.” Points very far beyond the PPF are simply out of reach (in real terms). Strong market forces pushing in this direction will impinge on prices rather than on quantities. The economy will experience price inflation. And in extreme cases, it can experience hyper-inflation. Economics Gone Wild! To this point, we’ve assumed that the economy is either on CONSUMPTION its PPF or is being expeditiously moved by market forces toward a point on its Points very far beyond the PPF Lesson shifting PPF. are simply out of reach (in real Suppose, though, that during a VIII terms). Strong market forces given year, some market pushing in this direction will malfunction (or some perverse impinge on prices rather than on INVESTMENT policy) takes the economy off its quantities. The economy will PPF. experience price inflation. If the economy is pushed beyond the PPF, its unemployment rate being driven below the 5-6 percent band, we say the If the economy is pushed inside its PPF, its unemployment economy is “overheated.” rate rising above the 5–6 percent band, we say that the economy is in a recession. And in extreme cases, it can experience hyper-inflation. If the economy is pushed far inside its PPF for an extended period of time, we say that the economy is in a depression. Economics Gone Wild! Notice that, together with the locus of the fully CONSUMPTION employed economy, the What do you suppose is various possible market the significance of the malfunctions (or straight line that passes Lesson consequences of perverse through these points? policy) are arrayed along VIII a linear path: A depressed economy INVESTMENT A recessed economy Economists who believe that Economists who believe that the market economy is A fully employed “markets work” argue that economy inherently flawed argue that market forces can move the market forces will move the An over-heated economy along the PPF in economy along the linear path economy response to changes in producing periodic bouts of intertemporal preferences. An inflated economy unemployment and inflation. They argue that movements off A hyper-inflated They argue that “stimulus the PPF are largely a economy packages” and price controls consequence of perverse are essential to the economy’s macroeconomic policy. Economics Gone Wild! macroeconomic health. Phases of the Business Cycle Lesson VIII Economics Gone Wild! Causes of Business Cycles • Shocks and price stickiness Lesson • Supply and productivity shocks VIII • Monetary shocks • Financial bursts and bubbles • Unexpected political events • Common link – Unexpected changes in spending • REAL CAUSE: Government Interference in Money and Interest Rates Economics Gone Wild! 9-100 Austrian Macroeconomics Lesson VIII Sustainable and Unsustainable Growth The Macroeconomics of Boom and Bust Economics Gone Wild! 2011 Capital-Based Macroeconomics in Perspective The Elements of Capital-Based Lesson Macroeconomics VIII The Production Possibilities Frontier The Loanable-Funds Market The Structure of Production Stage-Specific Labor Markets Sustainable Growth (supported by saving) Unsustainable Growth (triggered by credit creation) Economics Gone Wild! Capital-Based Macroeconomics is an outgrowth of the Austrian theory of the business cycle—a theory set out in 1912 by Ludwig von Mises and developed in the 1930s by Friedrich A. Hayek and others. Lesson VIII LUDWIG VON MISES FRIEDRICH A. HAYEK 1881-1973 1899-1992 Economics Gone Wild! Three Views of the Market Economy Capital-based high level of Theorizing at a macroeconomics is Milton Friedman’s monetarism was distinguished higher level Keynes aggregation, John Maynardof based on a stillby its propitious Lesson argued that Thewhich brings into aggregation.market economies disaggregation, equation of VIII perform perversely—especially an exchange MV=PQ made use of the view both the problem of inter- market mechanisms that are and temporal resource allocation all-inclusive output variable (Q), supposed eclipse saving solution. putting intoto bring market and the the potential for a the issue of investment resources between F. A. Hayek balance with one allocation ofinto showed that a another. coordination of saving and current consumption and investment Seeing unemployment and investment decisions could be for the future. resource idleness as the norm, Seeing no problems emerging achieved by market-governed Keynes marketinterest rates. He from the called for countercyclical movements in itself, Friedman also and monetary policies and fiscalrecognized that this aspect of focused on the relationship between ultimately for a “comprehensive the market economy is especially the government-controlled money vulnerable to investment.” socialization of overall price level. supply and thethe manipulation of interest rates by the central bank. Economics Gone Wild! The Macroeconomics of Boom and Bust Lesson VIII A Methodological Point: Before we can even ask how things might go wrong, we must first explain how they could ever go right. — F. A. Hayek Economics Gone Wild! The market process is entrepreneurs and investors responding to profit and loss signals. (1) More production needed Lesson Demand Prices Profits Production >VIII Increase Increase Increases Supply Existing firms increase Entrepreneurs production of that increase prices to try product, and new firms to maximize profits enter the market. The structure of production is rearranged to increase production Economics Gone Wild! The market process is entrepreneurs and investors responding to profit and loss signals. (2) Less production needed; resources are needed elsewhere Lesson Supply Productio VIII Prices Profits n > Decrease Decrease Decrease Demand s Competition impels Existing firms entrepreneurs to decrease production decrease prices to try of that product, and to maximize profits some firms go bankrupt. The structure of production is rearranged to decrease production Economics Gone Wild! In capital-based macroeconomics, consumption CONSUMPTION and investment represent alternative uses of the economy’s resources. Lesson Under favorable conditions, a fully VIII employed market economy allocates resources to both uses, making the most of the trade-off. INVESTMENT The Production Possibilities Frontier The Production Possibilities Frontier (PPF) is often used for emphasizing the concept of scarcity and illustrating the implied trade- off and for expositing theories of capital and interest, economic growth, and international trade. But the PPF rarely appears in macroeconomic constructions. Featuring the trade-off between consumption and investment provides a contrast to Keynesian constructions, in which these two macroeconomic magnitudes are treated as additive components of private-sector spending. Economics Gone Wild! “Investment” in this construction represents gross investment, CONSUMPTION which includes replacement capital. Typically, the investment needed Lesson just to replace worn out or obsolete capital is something less VIII than total, or gross, investment. The difference between the Replacement INVESTMENT “replacement” and the “gross” Capital magnitudes constitutes net Net Investment investment, which allows for the Gross expansion of the economy. Investment Positive net investment means that the economy is growing. The PPF shifts outward from year to year, permitting increasing levels of both consumption and investment. This outward shifting of the PPF represents sustainable economic growth. Economics Gone Wild! Watch the economy grow. CONSUMPTION Four periods of growth are shown—with consumption, as well as saving and Lesson investment, increasing in VIII each period. The actual rate of expansion INVESTMENT of the PPF depends upon Replacement Capital many factors. Net Investment Gross Investment For instance, with economic expansion, capital depreciation increases, too. But increasing incomes are generally accompanied by further increases in saving and investment. Economics Gone Wild! Watch the economy grow. CONSUMPTION Four periods of growth are shown—with consumption, as well as saving and investment, increasing in each period. Lesson The actual rate of expansion of VIII the PPF depends upon many factors. For instance, with economic INVESTMENT expansion, capital depreciation increases, too. But increasing Watch the movement incomes are generally along the PPF. accompanied by further saving preferences, which provokes a Importantly, a change in increases in saving and movement along the initial PPF, affects the rate at which the PPF investment. expands outward. Suppose people become more thrifty, more future oriented. They reduce their current consumption and save instead. With the increased saving (and investment), the economy grows at a faster rate. Economics Gone Wild! CONSUMPTION Now watch the economy grow. Lesson VIII INVESTMENT Increased thriftiness makes the difference. Let’s compare the high-growth economy with the original low-growth economy. Economics Gone Wild! CONSUMPTION CONSUMPTION Lesson VIII INVESTMENT INVESTMENT Note the difference that an initial increase in saving makes in the pattern of consumption and investment. Without an initial increase in saving, consumption and investment increase modestly from period to period. With an initial increase in saving, investment increases at the expense of consumption, after which both consumption and investment increase dramatically from period to period. Starting with the fourth period, the initial saving pays off as a higher level of consumption than would otherwise have been possible. Economics Gone Wild! The Production Possibilities Frontier shows us what is possible— given the state of technology, resource constraints, and (intertemporal) preferences. Lesson Remaining to be shown is how the “possible” can actually happen in a VIII market economy. How can intertemporal preferences—and especially changes in intertemporal preferences—get translated into accommodating decisions in the investment community? The key price signal is the rate of interest, which is broadly associated with the market for loanable funds. In actual application, of course, account must be taken of a spectrum of interest rates, the variations deriving from considerations of risk, uncertainty, and maturity structure. Economics Gone Wild! The Market for Loanable Funds Loanable-funds theory was a staple in pre-Keynesian macroeconomics. Saving constitutes the supply of loanable funds. Lesson Demand reflects the business community’s willingness to borrow and VIII undertake investment projects. With the interest rate serving as the price, loanable-funds theory is a straightforward application of Alfred Marshall’s supply-and- RATE OF INTEREST demand analysis. S Both Eugen von Böhm-Bawerk and John Maynard Keynes recognized that the relevant interest rate should be a broadly conceived one and that the D correspondingly broad market being equilibrated is the market for investable resources. Investable SAVING (S) Resources INVESTMENT (D) Economics Gone Wild! The Market for Loanable Funds Loanable-Funds theory was most closely identified with Dennis Robertson, a contemporary of Keynes and a critic of Keynes’s alternative theory—his liquidity-preference theory of Lesson interest. VIII Sir Dennis H. Robertson (1890 —1963) RATE OF INTEREST S D SAVING (S) INVESTMENT (D) Economics Gone Wild! The Market for Loanable Funds Loanable-Funds theory was most closely identified with Dennis Robertson, a contemporary of Keynes and a critic of Keynes’ alternative theory—his liquidity-preference theory of Lesson interest. VIII On the suggestion of Roy Harrod, who was pro-Keynesian, Keynes included in his General Theory (p. 180) a graph of the loanable-funds market. RATE OF INTEREST S This is the only diagram to appear in his book. Keynes’s purpose was to show he was discarding Harrod’s loanable- funds theory. D SAVING (S) INVESTMENT (D) Economics Gone Wild! The Market for Loanable Funds The Austrian economists based much of their theorizing about saving, investment, and the interest rate on the loanable-funds framework, though they rarely included a graphical rendering of it. Lesson VIII If people become more future- oriented, they increase their Watch the saving curve saving, causing the interest rate shift rightward. to fall and thereby encouraging the business community to RATE OF INTEREST undertake more investment S projects. With a given technology, saving and investment are prerequisite to genuine (sustainable) economic D growth. SAVING (S) INVESTMENT (D) Economics Gone Wild! The interest rate is a reflection of time-preferences • The interest rate is the price of borrowing money. • Like all prices, in a free market, the interest rate is determined by supply and demand. The supply of Lesson money to be loaned (savings) and the demand for loans. VIII • The free market interest rate is therefore a reflection of the time-preferences of the individuals in society; that is, how highly people value current consumption over saving that will allow them future consumption. High time-preferences High spending, low saving High interest rates Low time-preferences Low spending, high saving Low interest rates • Interest rates coordinate the time-structure of production. That is, the profitability of short-term versus long-term production projects. Economics Gone Wild! The loanable-funds market and CONSUMPTION the production possibilities frontier tell mutually reinforcing stories. Lesson The loanable-funds market shows how the interest rate VIII brings saving and investment in line with one another. INVESTMENT The production possibilities frontier shows how the tradeoff is struck between consumption RATE OF INTEREST and investment. S Market adjustments in output prices, wage rates, and other input prices keep the economy functioning on its PPF. D SAVING (S) INVESTMENT (D) Economics Gone Wild! These two elements of capital- based macroeconomics show the CONSUMPTION pattern of movements in consumption, saving, investment, and the interest rate that are consistent with a change in Lesson intertemporal preferences. VIII As before, we let people become more future-oriented. They save more, which transmits a signal (a INVESTMENT lower interest rate) to the business community. RATE OF INTEREST Watch the saving-induced S The lowerin the interest rate and decrease interest rate establishes a new equilibrium in the corresponding movement the loanable-funds market, as along the PPF. the economy moves along the PPF in the direction of more D investment and less (current) consumption. SAVING (S) INVESTMENT (D) Economics Gone Wild! Even the possibility that a market This is only to recognize, of economy could work in this way is CONSUMPTION course, that movements along the at odds with Keynesian theory. PPF necessarily entail opposing Note that moreconsumption and movements of investment is undertaken as consumption falls. investment. Lesson According to Keynes, however, VIII any reduction in consumer spending would result in excess inventories, which in turn would INVESTMENT cause production cutbacks, worker layoffs, and a spiraling downward of income and RATE OF INTEREST expenditures. The economy would go into recession, and the S business community would commit itself to less, not more, investment. This is Keynes’s “Paradox of D Thrift.” SAVING (S) INVESTMENT (D) Economics Gone Wild! If retail inventories were a “representative” investment, then CONSUMPTION Keynes would be right. Here, the derived-demand effect dominates. Reduced consumer spending means reduced inventory Lesson replacement. In general, late-stage investments move with consumer VIII spending. However, the interest-rate effect INVESTMENT dominates in long-term, or early- stage, investments. A lower interest rate can stimulate RATE OF INTEREST industrial construction, for instance, or product development. S To keep track of changes in the general pattern of investment activity, we need to consider the structure of production and stage- D specific labor markets. SAVING (S) INVESTMENT (D) Economics Gone Wild! The Structure of Production CONSUMPTION Lesson VIII STAGES OF PRODUCTION Capital-based macroeconomics disaggregates capital intertemporally. Consumable output is produced by a sequence of stages of production, the output of one stage feeding in as input to the next. is exemplified by Early-stage investment activity Late-stage investment activity is from left to by The temporally defined stages are arrayed graphicallyexemplified right, product development. the output of the final stage constituting consumable output. inventory management. PRODUCT INVENTORY Economics Gone Wild! DEVELOPMENT MANAGEMENT The Structure of Production CONSUMPTION Lesson VIII STAGES OF PRODUCTION For pedagogical convenience, the initial capital structure is shown as having five stages. With growth, the number of stages will increase. Although all five of these stages are in operation during each time period, resources can be tracked through the structure of production over time. Watch the resources, or “goods in process,” move through the stages. Economics Gone Wild! The Structure of Production CONSUMPTION Lesson VIII STAGES OF PRODUCTION For pedagogical convenience, the initial capital structure is shown as having five stages. With growth, the number of stages will increase. Although all five of these stages are in operation during each time period, resources can be tracked through the structure of production over time. Watch the resources, or “goods in process,” move through the stages. NOTE: Hayek introduced his triangle in 1931, when Henry Ford was still producing the Model A. If only Hayek had had PowerPoint, he could have shown how the abstract triangle aligns with real-world output. Economics Gone Wild! CONSUMPTION Lesson VIII STAGES OF PRODUCTION Together, the sequence of stages form a Hayekian triangle, a summary depiction of the economy’s intertemporal structure of production. In a growing economy, the triangle increases in size along with the outward expansion of the production possibilities frontier. Economics Gone Wild! CONSUMPTION CONSUMPTION Lesson VIII STAGES OF PRODUCTION INVESTMENT Together, the sequence of stages form a Hayekian triangle, a summary depiction of the economy’s intertemporal structure of production. In a growing economy, the triangle increases in size along with the outward expansion of the production possibilities frontier. Watch the PPF and the Structure of Production expand together. Economics Gone Wild! CONSUMPTION Lesson VIII STAGES OF PRODUCTION When people choose to save more, they send two seemingly conflicting signals to the market: 1. Decreased consumption dampens the demand for the investment goods that are in close temporal proximity with consumable output. This is the derived demand effect. 2. A reduced interest rate, which means lower borrowing costs, stimulates the demand for investment goods that are temporally remote from consumable output. This is the time-discount, or interest-rate, effect. Economics Gone Wild! CONSUMPTION Lesson VIII STAGES OF PRODUCTION Derived demand and time discount are in conflict only if “investment” is conceived as a simple aggregate—as it is in Keynes’ C + I + G. In capital-based macroeconomics, capital—and hence investment—is conceived as a structure. Changes in the demand for investment, then, can add differentially to (and/or subtract differentially from) the several stages of production that make up the structure. Keynes’s theorizing in terms of an aggregate rather than in terms of a structure underlies Hayek’s claim that “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.” Economics Gone Wild! CONSUMPTION Watch the structure of production Lesson respond to an increase in saving. VIII Note the emergence of a sixth stage of production. STAGES OF PRODUCTION Increased saving results in a reallocation of resources among the stages of production. The two effects (derived demand and time discount) have their separate and complementary effects on the capital structure: 1. Derived demand effect: A decreased demand for consumption goods dampens investment activities in the late states of production, reducing the height of the Hayekian triangle. 2. Time-discount effect: A reduced rate of interest stimulates investment activities in the early stages of production, increasing the base of the Hayekian triangle. Economics Gone Wild! CONSUMPTION Lesson VIII STAGES OF PRODUCTION Economics Gone Wild! Watch the economy respond to CONSUMPTION an increase in saving. CONSUMPTION Lesson VIII STAGES OF PRODUCTION INVESTMENT Increased saving, then, has an effect on both the magnitude of the investment aggregate and the temporal pattern of capital creation. The PPF shows that more saving permits more investment. The Hayekian triangle shows that capital creation in the late stages (such as retail inventories) is decreased while capital creation in the early stages (such as product development) is increased. The structure of production is given more of a future-orientation, which is consistent with the saving that made the restructuring possible. That is, people are saving now in order to increase their future spending power. Economics Gone Wild! CONSUMPTION CONSUMPTION Lesson VIII STAGES OF PRODUCTION INVESTMENT Watch the economy grow more rapidly. As tracked by both the PPF and the Hayekian triangle, consumption is seen to fall as Saving implies the giving up of CONSUMPTION the economy is adapting to a some consumption in the higher growth rate, after which near future … consumption risesin order to more rapidly enjoybefore… than more consumption in the intermediate (and possibly far) eventually surpasses the and future. old projected growth path. Economics Gone Wild! TIME Stage-Specific Labor Markets While most macroeconomic theories CONSUMPTION deal with THE labor market and THE Lesson wage rate, capital-based VIII macroeconomics allows for stage- specific labor markets. With a STAGES OF PRODUCTION change in the interest rate, stage- specific wage rates change in a pattern rather than change uniformly. W W Although a labor market for each stage could be depicted, the pattern of changes (the wage-rate gradient, N N as Hayek called it) is revealed by distinguishing between early-stage EARLY-STAGE LABOR MARKET LATE-STAGE LABOR MARKET and late-stage labor markets. Economics Gone Wild! Stage-Specific Labor Markets An increase in saving has differential CONSUMPTION Lesson effects on the demand for labor in the early and late stages. VIII STAGES OF PRODUCTION In the late stages, the derived- demand effect (labor demand moves with consumption) dominates the interest-rate effect. W W In the early stages, the interest-rate effect (favorable credit conditions) dominates the derived-demand effect. N N EARLY-STAGE LABOR MARKET LATE-STAGE LABOR MARKET The differential shifting of labor Watch the economy respond to demands gives rise to an increase in saving. a “wage-rate gradient.” Economics Gone Wild! CONSUMPTION CONSUMPTION Lesson PRODUCTION VIII STUCTURE OF POSSIBILITIES PRODUCTION FRONITER STAGES OF PRODUCTION INVESTMENT RATE OF INTEREST S W W STAGE-SPECIFIC LOANABLE-FUNDS LABOR MARKETS MARKET N N D EARLY-STAGE LABOR MARKET LATE-STAGE LABOR MARKET SAVING (S) INVESTMENT (D) Economics Gone Wild! CONSUMPTION Watch the economy respond to an increase in saving. CONSUMPTION Lesson VIII STAGES OF PRODUCTION INVESTMENT RATE OF INTEREST S W W N N D EARLY-STAGE LABOR MARKET LATE-STAGE LABOR MARKET SAVING (S) INVESTMENT (D) Economics Gone Wild! CONSUMPTION Watch the economy respond to an increase in saving. CONSUMPTION Lesson VIII STAGES OF PRODUCTION INVESTMENT RATE OF INTEREST S W W N N D EARLY-STAGE LABOR MARKET LATE-STAGE LABOR MARKET SAVING (S) INVESTMENT (D) Economics Gone Wild! Sustainable and Unsustainable Growth The Macroeconomics of Boom and Bust Lesson With interest rates artificially low, VIII consumers reduce savings in favor of consumption, and entrepreneurs increase their rate of investment spending. And then you have an imbalance between savings and investment. You have an economy on an unsustainable growth path. This, in a nutshell, is the lesson of the Austrian critique of central banking developed in the 1920s and 1930s. ---from Steve H. Hanke’s “Panic Time at the Fed ,” Forbes, May 2008. Economics Gone Wild! Sustainable and Unsustainable Growth The Macroeconomics of Boom and Bust Lesson “Booms have always appeared with a great increase in investment, a large VIII part of which proved to be erroneous, mistaken. That, of course, suggests that a supply of capital was made apparent which wasn’t actually existing. The whole combination of a stimulus to invest on a large scale followed by a period of acute scarcity of capital is consistent with the idea that there has been a misdirection due to monetary influences. And that general schema, I still believe, is correct.” --from an interview conducted by Jack High as part of the UCLA Oral History Program (1978). Economics Gone Wild! Credit Expansion Increases in the money supply enter the economy through credit markets. The central bank literally lends money into existence. Lesson The new money masquerades as saving. That is, the supply of loanable funds shifts rightward—but without there being any VIII increase in saving. Watch the opposing movements of saving and investment as the central bank adds money (ΔM) to the supply side of the market for RATE OF INTEREST loanable funds. S +ΔM Responding to a lower interest rate, people actually save less and consume more. The result is not a new D sustainable equilibrium but rather a disequilibrium that, for a time, is masked by the infusion of SAVING (S) INVESTMENT (D) loanable Economics Gone Wild! funds. Pumping new money through credit markets drives a wedge between saving and investment. Investors move down along their demand curves, taking advantage of the lower borrowing costs. Lesson Savers move down along their unshifted saving curves in response to VIII the weakened incentive to save. The discrepancy between saving and investment is papered over with newly created money, which itself represents no investable RATE OF INTEREST resources. S Much of Hayek’s writings on S+ΔM money is aimed at shifting the focus away from the bedrock relationship between money and the general level of prices and D toward the intertemporal discoordination that is caused by credit expansion. SAVING (S) INVESTMENT (D) Economics Gone Wild! Favorable credit conditions spur CONSUMPTION on investment activity→ clockwise movement along the PPF to more investment. But income-earners are actually Lesson saving less (and hence VIII consuming more)→ counterclockwise movement to consumption. INVESTMENT The wedge between saving and investment translates into a tug-of- RATE OF INTEREST war between consumers and S investors. S+ΔM Noting the investment dimension of the clockwise movement and the consumption dimension of the counterclockwise movement, we D see that credit expansion pushes the economy toward a point that lies beyond the PPF. SAVING (S) INVESTMENT (D) Economics Gone Wild! CONSUMPTION CONSUMPTION Lesson VIII STAGES OF PRODUCTION INVESTMENT The low interest rate, consistent with a future orientation, RATE OF INTEREST stimulates investment activities to In fact, increased consumer S earlier stages some resources demand draws S+ΔM toward the late stages, further But not enough resources being reducing elsewhere, many freed up the prospects for completing a new capital projects will never be completed. structure. D SAVING (S) INVESTMENT (D) Economics Gone Wild! Overconsumption CONSUMPTION Overconsumption CONSUMPTION Lesson Overinvestment VIII Malinvestment STAGES OF PRODUCTION INVESTMENT The dynamics of boom and bust entail both overinvestment (as shown RATE OF INTEREST in the PPF diagram) and S malinvestment (an unsustainable S+ΔM lengthening of the Hayekian triangle). These distortions are compounded by overconsumption (as shown in both the PPF and the Hayekian triangle). D Mises repeatedly used the phrases “malinvestment” and “overconsumption.” SAVING (S) INVESTMENT (D) Economics Gone Wild! Overconsumption CONSUMPTION Overconsumption CONSUMPTION Lesson Overinvestment VIII Malinvestment STAGES OF PRODUCTION INVESTMENT The tug-of-war that pits consumers against investors RATE OF INTEREST pushes the economy beyond the S The temporally conflicted PPF. The low interest rate favors S+ΔM structure of production (dueling investment, and increasingly triangles) eventually turns boom binding resource constraints keep into bust, and the economy goes the economy from reaching the into recession—and possibly into extra-PPF point. deep depression. D SAVING (S) INVESTMENT (D) Economics Gone Wild! CONSUMPTION TUG–OF–WAR BETWEEN CONSUMPTION Lesson CONSUMERS & INVESTORS VIII DUELING TRIANGLES STAGES OF PRODUCTION INVESTMENT RATE OF INTEREST S S+ΔM WEDGE BETWEEN SAVING & INVESTMENT D SAVING (S) INVESTMENT (D) Economics Gone Wild! Watch the economy respond to a credit expansion. CONSUMPTION CONSUMPTION Lesson VIII STAGES OF PRODUCTION INVESTMENT Padding supply of loanable funds with new money → wedge between RATE OF INTEREST saving and investment. S Papering over the saving and +ΔM investment gives play to the tug-of- war between consumers and investors. Pitting early-stages against late- D stages distorts the triangle in both directions, eventually turning boom SAVING (S) into bust. INVESTMENT (D) Economics Gone Wild! CONSUMPTION CONSUMPTION Lesson VIII STAGES OF PRODUCTION INVESTMENT Increased Saving vs. Credit RATE OF INTEREST S Expansion: A summary Comparison Saving supports genuine growth. Watch. D SAVING (S) INVESTMENT (D) Economics Gone Wild! CONSUMPTION CONSUMPTION Lesson VIII STAGES OF PRODUCTION INVESTMENT Increased Saving vs. Credit RATE OF INTEREST Expansion: S A summary Comparison +ΔM Credit expansion triggers boom and bust. Watch. D SAVING (S) INVESTMENT (D) Economics Gone Wild! Unemployment • Twin Results of the Business Lesson Cycle VIII – Unemployment – Inflation • Measurement of Unemployment • Labor Force • Unemployment Rate – Part-Time Employment – Discouraged Workers Unemployed Unemployment Rate = x 100 Labor Force Economics Gone Wild! Unemployment Labor Force, Employment, and Unemployment, 2012 Under 16 And/or Lesson Institutionalized VIII (70.7 Million) Not in Labor Force (89.0 Million) Total Population (315.3 Million) Employed Labor (143.3 Million) Force (155.6 Million) Unemployed Economics Gone Wild! (12.3 Million) Unemployment • Types of Unemployment Lesson – Frictional Unemployment VIII – Structural Unemployment – Cyclical Unemployment – Seasonal?? • Full Employment Defined S=D – No Cyclical Unemployment • Full-Employment Rate of Unemployment Economics Gone Wild! Unemployment • Natural rate of unemployment Lesson – 1980s 4-6% VIII – Today 5.25% • Aging labor force • Temp agencies and the internet • New welfare laws and work requirements • Prison population has doubled Economics Gone Wild! Cost of Unemployment • Foregone output Lesson • Potential output VIII • GDP gap – (Actual output – potential output) • Okun’s Law – Each 1% above NRU creates negative 2% output gap Economics Gone Wild! United States population: 315 million. To quantify the extent of the problem Lesson VIII of unemployment, we start with the civilian, non-institutionalized, off-the- farm population (16 and older) of 244.6 million. Then, surveying by phone, we ask a series of questions to arrive at the unemployment rate. Economics Gone Wild! 1. Are you currently employed? Lesson A. Yes. VIII B. Yes, but only part time. A + B = Employed = 143.3 million. Economics Gone Wild! 1. Are you currently employed? Lesson A. Yes. VIII B. Yes, but only part time. C. No. No = 244.6 – 143.3 = 101.3 million. Are all these people actually unemployed? Economics Gone Wild! 2. If “No,” are you actively Lesson looking? VIII A. Yes. Yes = Unemployed = 12.3 million. Economics Gone Wild! 2. If “No,” are you actively Lesson looking? VIII A. Yes. B. No. No = not working; not looking No = 101.3 – 6.6 = 94.7 million. These people are not in the labor force. Economics Gone Wild! The Unemployment Rate = Lesson Unemployed Unemployed VIII Employed + Unemployed Labor Force Unemployed Looking Labor Force Working + Looking Economics Gone Wild! The Unemployment Rate = Lesson Unemployed Unemployed VIII Labor Force Employed + Unemployed Unemployment Rate = 12.3/ (143.3 + 12.3) Unemployment Rate = 12.3 / 155.7 Unemployment Rate = 0.0789 = 7.9 % Economics Gone Wild! To those not employed and not looking: 3. Why aren’t you looking for a job? Lesson VIII A. I don’t want a job. B. I’m discouraged—I can’t find one. “Discouraged Workers” = 1.3 million. Economics Gone Wild! Unemployment Rate Lesson (Discouraged Worker included) VIII Unemployed plus Discouraged Worker Labor Force plus Discouraged Worker = (12.3 + 6.6) / (155.7 + 6.6) The U+ DW Rate = 0.116 = 11.6% Economics Gone Wild! Lesson VIII What is the current Unemployment Rate? Economics Gone Wild! Lesson VIII 7.9% This is the unemployment rate for January of 2013, as reported by the BLS on Friday, February 1, 2013. For updates, check the BLS website. Economics Gone Wild! Labor Force Participation Rate Lesson VIII Labor Force 65.8% Population (16 and older) LFPR = 155.7million / 244.6 million LFPR = 0.641 = 64.1 percent Economics Gone Wild! To get a real unemployment rate Use the average LFPR since 1980: 65.8% Lesson Apply this participation rate to the civilian VIII noninstitutional population This is the “implied" labor force number Now calculate the implied unemployed Calculating the jobless rate using this new implied data, as of December, the real implied unemployment rate was 11.4% - basically where it has been ever since 2009. ZEROHEDGE Economics Gone Wild! Lesson VIII Economics Gone Wild! Lesson VIII Economics Gone Wild! CATEGORIES OF UNEMPLOYMENT: frictional (still looking) Lesson VIII Not in the Labor Force Economics Gone Wild! CATEGORIES OF UNEMPLOYMENT: Lesson frictional (still looking) VIII plus structural (a mismatch) If this typewriter repairman loses his job, he’ll be structurally unemployed! Economics Gone Wild! W W W Supply Supply Supply Demand Demand Demand N N N Lesson Market for Labor Skilled Labor Unskilled Labor VIII In a that the natural rate this Notehealthy economy, to of 5%–6% Macroeconomists referfrictionally W W unemployment, like the of unemployment. unemployed workers and structurally band as the natural ratenormal levels of Supply Supply unemployed workers make consistent inventory is other markets, isin a market That is, it in perfectly naturalup five-to-six with labor-market equilibrium. economy for the workforce to experience percent of the workforce. Demand Demand unemployment in this range. N N Industrial Labor Agricultural Labor W W Supply Supply Demand Demand Structural Unemployment N N Western-States Labor Plains-States Labor Economics Gone Wild! Employment and Unemployment In a Healthy Market Economy unemployment rate is the ratio of the workforce to NOTE: The economy’s labor force(or the ratio population (16 years old and the laborof the unemployed workers toolder adult force) includes employed workers labor force. In the U.S., the ratio not institutionalized) and and unemployed workersis calledisthe Lesson W labor-force about economy in constitutes participation rate.US the U.S., 5%–6% when the half of the isIn good VIII population. abouthealth. macroeconomic 65%. this ratio is W Supply Demand N N Adult population (16 years old and older) Market for Labor minus military personnel minus the institutionalized citizenry Employed workers Frictionally and structurally unemployed workers Not in the labor force Economics Gone Wild! Cyclical Unemployment In a Depressed Market Economy unemployment occurs CyclicalThe amount ofstructural when unemployment rate NOTE: Frictional and cyclical reported unemployment makefrictional, the3.9%) there is an overall reduction in structural, (currently 3.4% showing by the BLS includes no explicitor demand for labor (a reduction not in makes an exaggerated appearance in the analytical reckoning. and cyclical unemployment. Lesson W warranted by some change in the analytical reckoning. VIII preferences or in overall resource availabilities). Supply Demand N Adult population (16 years old and older) minus military personnel Cyclically unemployed workers minus the institutionalized Employed workers Employed workers Frictionally and structurally unemployed workers Not in the labor force Economics Gone Wild! CATEGORIES OF UNEMPLOYMENT: Lesson frictional (still looking) VIII plus structural (a mismatch) = THE NATURAL RATE = 5%-6% Economics Gone Wild! THE RESIDUAL CATEGORY: Lesson VIII Measured Rate of Unemployment minus the Natural Rate = CYCLICAL UNEMPLOYMENT Economics Gone Wild! The level of unemployment consistent with sustainable Lesson prosperity--i.e., the natural rate of VIII unemployment--has long been believed to be in the range of A. 2 to 3 percent. B. 3 to 4 percent. C. 4 to 5 percent. D. 5 to 6 percent. Economics Gone Wild! Ferris Beuller graduated from college during the Bush recession. He spent 1990 looking in vain for reasonable employment. Totally discouraged, Lesson VIII he spent 1991 playing Minesweeper on his girlfriend’s computer. The Bureau of Labor Statistics would classify Mr. Beuller (in 1991) as A. self-employed. B. institutionally unemployed. C. a discouraged worker. D. structurally unemployed. Economics Gone Wild! Unemployment Unemployment Rate 1985-2013 Lesson 10 10 (percent of civilian VIII The Unemployment Rate Unemployment 8 Labor force) 8 6 4 6 2 0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 4 1985 1987 1990 1993 1996 1999 2002 2005 2008 2011 Economics Gone Wild! Source: Congressional Budget Office & Bureau of Economic Analysis Unemployment Actual and Potential GDP Lesson VIII Economics Gone Wild! Unemployment • Unequal Burdens Lesson VIII –Occupation –Age –Race and Ethnicity –Gender –Education –Duration • Noneconomic Costs Economics Gone Wild! Unemployment GLOBAL PERSPECTIVE Unemployment Rates, 1995-2007 Lesson VIII Economics Gone Wild! Source: Bureau of Labor Statistics Inflation • Rise in general level of prices Lesson VIII • Consumer price index (CPI) – Market basket – 300 goods and services – Typical urban consumer – 2 year updates Price of the Most Recent Market Basket in the Particular Year CPI = Price estimate of the Market x 100 Economics Gone Wild! Basket in 1982-1984 Inflation GLOBAL PERSPECTIVE Inflation Rates in Five Industrial Nations, 1995-2007 Lesson VIII Italy Economics Gone Wild! Source: Bureau of Labor Statistics Really? Lesson VIII Economics Gone Wild! Actual Inflations Lesson VIII Economics Gone Wild! Inflation • Types of Inflation Lesson –Demand Pull Inflation VIII –Cost-Push Inflation • Per Unit Production Costs • Redistributive Effects –Nominal and Real Income –Anticipations • Anticipated Inflation Economics Gone Wild! • Unanticipated Inflation Inflation • Who is Hurt by Inflation? Lesson –Fixed-Income Receivers VIII –Savers –Creditors • Who is Unaffected or Hurt by Inflation? –Flexible-Income Receivers • Cost-of-Living Adjustments (COLAs) –Debtors Economics Gone Wild! Inflation • Anticipated Inflation Lesson –Nominal Interest Rate VIII –Real Interest Rate –Inflation Premium 6% 11% = + Inflation Premium 5% Nominal Real Interest Interest Economics Gone Wild! Rate Rate Other Inflation Issues • Deflation Lesson • Mixed Effects VIII • Arbitrariness • Cost-Push Inflation and Real Output • Demand-Pull Inflation and Real Output • Hyperinflation Economics Gone Wild! Inflation Too Damn Much Money Lesson VIII Economics Gone Wild! Lesson VIII How Much is a Trillion? Inquiring minds want to know Economics Gone Wild! What does one TRILLION dollars look like? All this talk about “stimulus packages” and “bailouts”... A billion dollars... A hundred billion dollars... Lesson Eight hundred billion dollars... VIII One TRILLION dollars... What does that look like? I mean, these various numbers are tossed around like so many doggie treats, so I thought I’d take Google Sketchup out for a test drive and try to get a sense of what exactly a trillion dollars looks like. Economics Gone Wild! Here’s a hundred bucks We’ll start with a $100 dollar bill. Currently the largest U.S. denomination in general Lesson circulation. Most everyone has seen them, VIII slightly fewer have owned them. Guaranteed to make friends wherever they go. “A Benny saved is a Benny earned! Economics Gone Wild! Serious coin A packet of one hundred $100 bills is less than 1/2" thick and contains $10,000. Fits in Lesson your pocket easily and is more than enough VIII for a week or two of shamefully decadent fun. “Party! Party! Economics Gone Wild! One Million Dollars!!! Believe it or not, this next little pile is $1 million dollars (100 packets of $10,000). You Lesson could stuff that into a grocery bag and walk VIII around with it. “Sa-weet! Economics Gone Wild! That’s what I’m talkin’ about! While a measly $1 million looked a little unimpressive, $100 million is a little more Lesson respectable. It fits neatly on a standard VIII pallet... “Lemme get my truck! Economics Gone Wild! Holy cow! And $1 BILLION dollars... now we’re really getting somewhere... Lesson VIII “Whoa, dude! Economics Gone Wild! Please have a seat Next we’ll look at ONE TRILLION dollars. This is that number we’ve been hearing so Lesson much about. VIII What is a trillion dollars? Well, it’s a million million. It’s a thousand billion. It’s a one followed by 12 zeros. You ready for this? Economics Gone Wild! Ladies and gentlemen... I give you $1 Trillion dollars... Lesson VIII “No flippin’ way!” And notice those pallets are double stacked $100 dollar bills! So the next time you hear your Congressman toss around the phrase “trillion dollars”... that’s what they’re talking about. Read on… Economics Gone Wild! A Little More Perspective Lesson VIII Economics Gone Wild! Current National Debt Lesson VIII Economics Gone Wild! Unfunded Mandates The 114.5 Trillion dollar super-skyscraper is the Lesson amount of money the U.S. Government knows it does not have to fully fund the Medicare, VIII Medicare Prescription Drug Program, Social Security, Military and civil servant pensions. It is the money USA knows it will not have to pay all its bills. If you live in USA this is also your personal credit card bill; you are responsible along with everyone else to pay this back. The citizens of USA created the U.S. Government to serve them, this is what the U.S. Government has done while serving The People. Economics Gone Wild! For a Greener America At the rate Congress is spending our money, we’ll be out of trees before 2015! Lesson VIII For this reason, a new bill will be issued to reduce paper waste and commemorate the new monetary philosophy in America… Economics Gone Wild! Presenting, the all new Trillion Dollar Bill… Lesson VIII Economics Gone Wild! Spread the Wealth! Now that you’ve seen a Trillion, tell your friends and family. The more people who know, the Lesson more we can do to stop this runaway spending VIII train. “A wise and frugal government, which shall leave men free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned - this is the sum of good government.” – Thomas Jefferson Economics Gone Wild! Incomes around the World Lesson VIII Economics Gone Wild! Macroeconomic Goals Lesson •Full Employment VIII •Price Stability •Economic Growth Economics Gone Wild! Basic Relationships • Income-Consumption Lesson VIII • Income-Saving • 45° Line • C = DI on the Line • S = DI - C Economics Gone Wild! Income and Consumption Consumption and Disposable Income, 1983-2005 10000 Consumption (billions of dollars) Lesson 9000 05 VIII 8000 45° Reference Line 04 C=DI 03 02 7000 01 00 6000 99 C Saving 97 98 5000 In 1992 95 96 94 93 92 4000 91 90 89 88 3000 87 86 85 84 2000 83 Consumption In 1992 1000 45° 0 0 2000 4000 6000 8000 10000 Economics Gone Wild! Disposable Income (billions of dollars) Consumption and Saving • The Consumption Schedule Lesson VIII • The Saving Schedule • Break-Even Income • Average Propensity to Consume (APC) • Average Propensity to Save (APS) Consumption Saving APC = APS = Income Income Economics Gone Wild! Consumption and Saving • Marginal Propensity to Lesson VIII Consume (MPC) • Marginal Propensity to Save (MPS) Change in Consumption MPC = Change in Income Change in Saving MPS = Change in Income Economics Gone Wild! Consumption and Saving (1) (4) (5) (6) (7) Level of Average Average Marginal Marginal Output (2) Propensity Propensity Propensity Propensity Lesson And Income Consump- tion (3) Saving (S) to Consume to Save (APC) (APS) to Consume to Save (MPC) (MPS) VIII (GDP=DI) (C) (1-2) (2)/(1) (3)/(1) Δ(2)/Δ(1) Δ(3)/Δ(1) (1) $370 $375 $-5 1.01 -.01 .75 .25 (2) 390 390 0 1.00 .00 .75 .25 (3) 410 405 5 .99 .01 .75 .25 (4) 430 420 10 .98 .02 .75 .25 (5) 450 435 15 .97 .03 .75 .25 (6) 470 450 20 .96 .04 .75 .25 (7) 490 465 25 .95 .05 .75 .25 (8) 510 480 30 .94 .06 .75 .25 (9) 530 495 35 .93 .07 .75 .25 (10) 550 510 40 .93 .07 Economics Gone Wild! Consumption and Saving Consumption and Saving Schedules 500 Consumption (billions of dollars) Lesson 475 C VIII 450 425 Saving $5 Billion Consumption Schedule 400 375 Dissaving $5 Billion 45° (billions of dollars) 370 390 410 430 450 470 490 510 530 550 Disposable Income (billions of dollars) Saving 50 Dissaving Saving Schedule S 25 $5 Billion 0 Saving $5 Billion Economics Gone Wild! 370 390 410 430 450 470 490 510 530 550 Consumption and Saving GLOBAL PERSPECTIVE Average Propensities to Consume Lesson Select Nations GDPs VIII Average Propensities to Consume .80 .85 .90 .95 1.00 United States .963 Canada .958 United Kingdom .953 Japan .942 Germany .896 Netherlands .893 Italy .840 France .833 Economics Gone Wild! Source: Statistical Abstract of the United States, 2006 Consumption and Saving • MPC + MPS = 1 Lesson • MPC and MPS as Slopes VIII • Nonincome Determinants of Consumption and Saving – Wealth Effect – Expectations – Real Interest Rates – Household Debt Economics Gone Wild! Consumption and Saving • Other Important Considerations Lesson • Changes Along Schedules VIII • Switch to Real GDP • Schedule Shifts • Stability • Taxation • Debt repayment? G 8.1 – Savings after the fact! Economics Gone Wild! Consumption and Saving Consumption and Saving Schedules C1 Consumption (billions of dollars) Lesson C0 VIII C2 45° (billions of dollars) Disposable Income (billions of dollars) S2 Saving S0 S1 Economics Gone Wild! Interest Rate and Investment • Expected Rate of Return (r) Lesson VIII • The Real Interest Rate (i) • Meaning of r = i • Investment Demand Curve Economics Gone Wild! Interest Rate and Investment The Investment Demand Curve Lesson Cumulative VIII Amount of Investment 16 Having This Expected Rate of 14 Rate of Return or Higher 12 r and i (percent) Return (r) (i) 10 16% $ 0 14% 5 8 12% 10 6 10% 15 8% 20 4 6% 25 2 ID 4% 30 0 2% 35 5 10 15 20 25 30 35 40 0% 40 Investment (billions of dollars) Economics Gone Wild! Interest Rate and Investment • Shifts of the Investment Lesson Demand Curve VIII – Planned inventory changes – Acquisition, Maintenance, and Operating Costs – Business Taxes – Technological Change – Stock of Capital Goods on Hand – Expectations Economics Gone Wild! The Market for Loanable Funds The loanable funds market is a Lesson hypothetical market that examines the VIII market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders. The interest rate is the price, calculated as a percentage of the amount borrowed, charged by the lender to a borrower for the use of their savings for one year. Economics Gone Wild! The Demand for Loanable Funds The demand curve for loanable funds slopes downward: the lower the interest rate, the greater the Lesson quantity of loanable funds VIII demanded. In this example, reducing the interest rate from 12% to 4% increases the quantity of loanable funds demanded from $150 billion to $450 billion. Economics Gone Wild! The Market for Loanable Funds Lesson VIII The rate of return of a project is the profit earned on the project expressed as a percentage of its cost. Economics Gone Wild! The Supply for Loanable Funds Lesson The supply curve for VIII loanable funds slopes upward: the higher the interest rate, the greater the quantity of loanable funds supplied. In this example, increasing the interest rate from 4% to 12% increases the quantity of loanable funds supplied from $150 billion to $450 billion. Economics Gone Wild! Equilibrium in the Loanable Funds Market Lesson VIII Economics Gone Wild! At the equilibrium interest rate, the quantity of loanable funds supplied equals the quantity of loanable funds Lesson demanded. Here the equilibrium VIII interest rate is 8%, with $300 billion of funds lent and borrowed. Investment spending projects with a rate of return of 8% or higher receive financing; those with a lower rate of return do not. Lenders who demand an interest rate of 8% or lower have their offers of loans accepted; those who demand a higher interest rate do not. Economics Gone Wild! Savings, Investment Spending, and Government Policy Lesson VIII Qty of Economics Gone Wild! private loanable funds demanded falls A government must borrow if it runs a deficit, and this borrowing adds to the total demand for loanable funds. As a result, the Lesson demand curve for loanable funds shifts VIII rightward by the amount of the government borrowing and the equilibrium moves from E1 to E2. This leads to an increase in the equilibrium interest rate from r1 to r2 and crowding out: the increase in the interest rate reduces the private quantity of loanable funds demanded from Q1 to Q2, as shown by the movement up the demand curve D1. Economics Gone Wild! Increasing Private Savings Lesson VIII Economics Gone Wild! Some economists have urged reforms in the tax system and adoption of other policies that would, they say, increase Lesson private savings but keep tax revenue VIII unchanged. If they are correct, the effect would be to shift the supply curve of loanable funds to the right, leading to a reduction in the equilibrium interest rate and a larger quantity of funds lent and borrowed. Private investment spending in the economy would rise and so, ultimately, would long-run economic growth. Economics Gone Wild! Interest Rate and Investment Shifts in the Investment Demand Curve Lesson VIII Increase in r and i (percent) Investment Demand Decrease in Investment Demand ID2 ID0 ID1 0 Investment (billions of dollars) Economics Gone Wild! Interest Rate and Investment • Instability of Investment Lesson VIII –Durability –Irregularity of Innovation –Variability of Profits –Variability of Expectations Economics Gone Wild! Interest Rate and Investment GLOBAL PERSPECTIVE Gross Investment Expenditures as a Lesson Percent of GDP, Select Nations VIII Percent of GDP, 2006 0 10 20 30 South Korea Japan Mexico Canada France United States Germany United Kingdom Sweden Economics Gone Wild! Source: World Bank Interest Rate and Investment The Volatility of Investment Lesson VIII Economics Gone Wild! The Multiplier Effect Change in Real GDP Multiplier = Lesson Initial Change in Spending VIII The Multiplier and the Marginal Propensities 1 Multiplier = 1 - MPC -or- 1 Multiplier = MPS Economics Gone Wild! Graphically… The Multiplier Effect Lesson • More spending results in VIII higher GDP • Initial change in spending changes GDP by a multiple amount Economics Gone Wild! The Multiplier Effect • Causes of the initial change Lesson in spending VIII – Changes in investment – Other changes • Rationale – Dollars spent are received as income – Income received is spent (MPC) – Initial changes in spending cause a spending chain Economics Gone Wild! The Multiplier Effect Tabular and Graphical Views (2) (3) (1) Change in Change in Change in Consumption Saving Lesson Income (MPC = .75) (MPC = .25) VIII Increase in Investment of $5 $ 5.00 $ 3.75 $ 1.25 Second Round 3.75 2.81 .94 Third Round 2.81 2.11 .70 Fourth Round 2.11 1.58 .53 Fifth Round 1.58 1.19 .39 All other rounds 4.75 3.56 1.19 Total $ 20.00 $ 15.00 $ 5.00 $20.00 $4.75 15.25 13.67 $1.58 11.56 $2.11 $2.81 8.75 ΔI= $5 billion $3.75 5.00 $5.00 1 2 3 4 5 All Economics Gone Wild! Rounds of Spending The Multiplier Effect The MPC and the Multiplier Lesson MPC Multiplier VIII .9 10 .8 5 .75 4 .67 3 .5 2 Economics Gone Wild! Macroeconomic Relationships Lesson Graphing Consumption VIII Functions Economics Gone Wild! Lesson VIII The are given the coordinates of two points on this Y (income). C We MPC is the Marginal Propensity to Consume, ofconsumption (consumption spending) is a linear function which is simply the slope of theso we can the function (C = a + bY) the Y being equation, and consumption equation. Note the specific form ofdetermine both the RISE andwith RUN. The RISE is 33-21, horizontal axis 40-20, being measured measured along theor 12; the RUN is and C or 20. The SLOPE of the line, then, axis. The other symbols or 0.6. along the verticalis RISE/RUN, which is 12/20,take their meaning from the role they play in the equation. The stand-alone term "a" is the vertical intercept: the coefficient "b" is the slope. Economics Gone Wild! Lesson VIII C We are given the coordinates of two points on this consumption (consumption spending) is a linear function of Y (income). equation, and so we can the function (C = a + bY) the Y being Note the specific form ofdetermine both the RISE andwith RUN. The RISE is 33-21, horizontal axis 40-20, being measured measured along theor 12; the RUN is and C or 20. The SLOPE of the line, then, axis. The other symbols or 0.6. along the verticalis RISE/RUN, which is 12/20,take their meaning from the role they play in the equation. The stand-alone term "a" is the vertical intercept: the coefficient "b" is the slope. Economics Gone Wild! Lesson VIII C = a + bY 21 = a + 0.6(20) 21 = a + 12 This is the level of consumer spending a = 21 - 12 we a = 9 would expect to see even if income has (temporarily) fallen to zero. Economics Gone Wild! Lesson VIII So, now we visualize a right triangle with one acute vertex touching To get the slope, we need to find two points on the equation the C-intercept and the other touching the intersection with the 45- degree coordinates are known. triangle, the RISE, is such whose line. The vertical leg of theThe intercept is one15-6, or 9; The horizontal leg of The other the RUN, is 15. The SLOPE is the point: Y = 0; C = 6. the triangle,point is the intersection of the RISE over the line with the 45-degree line: Y = 15; C = 15 consumption RUN: 9/15 = 0.6. (Remember that the 45-degree line has a slope of 1.0, which means that, starting from the origin, the Y-distance and the C- distance to any point on that line are the same). Economics Gone Wild! Lesson VIII Now we know both the vertical intercept (a = 6) and the slope (b = 0.6) and can write the equation describing consumption behavior: C = a + bY C = 6 + 0.6Y Economics Gone Wild! Lesson VIII This question calls your bluff: Show me you can actually make use of Alternatively, you could write the saving equation by observing You equation relating C to 35 for Y the level offor C: There simply ways to calculate and solve saving. The this canare two substitute Y. the 6 + 0.6Y form: S = -a + (1 - b) Y, and then evaluating for = general Ceasiest is simply to recognize that saving is what's left of your an income0.6(35)you're Cincomeof Y = 35: through spending. That is, S = Y - C; S = = 6 + after S = -a 21 = - 27 (1 C35 6 + + = 8 - b)Y S = -6 C = 27 + 0.4Y S = -6 + 0.4(35) S = -6 + 14 S= 8 Economics Gone Wild! Alternatively, we can recognize that for a wholly private economy, it is always true that Y = C + S. That is, your income has to be equal to the part of it that you spend plus the part of it that you don't spend. By the now if we were dealing with a mixed economy, we I. We can way, write the equilibrium condition as C + S = C + would Lesson write as our accounting spending = C both T. That is, us the Subtracting consumptionidentity: Y from+ S + sides givesyour income has to be equal to the for of it that you spend plus the alternative equilibrium conditionpart a wholly private economy: S = I. VIII This means that if S = 8, then that amount needs to be borrowed and part of it that you don't spend plus the part that you don't even see- -because the government took it as taxes economy to be in spent by the investment community for the before you were given your (after-tax) equilibrium. macroeconomic income. In this case, the alternative equilibrium would be S + T = I + G. An income-expenditure equilibrium requires that income be equal to expenditures. For this wholly private economy, we can write the equilibrium condition as Y = C + I. We know that for an income of 35, consumption spending is 27. So we can write: 35 = 27 + I. Therefore I = 35 - 27 = 8. Economics Gone Wild! Lesson VIII We're shown C + I of income is the income that satisfies the Y = a level The equilibrium wholly private economy (no government spending; equilibrium condition Y = C + I. So, we simply make use of all we in which consumption spending is given by the equation no taxes) Y = 30 + 0.6Y + 34 C = 30 + 0.6Y and about Y 0.6Y investment solve for is know about -C and = 64 I and spendingY: 34. 0.4Y = 64 Y = 160 Economics Gone Wild! Lesson VIII Alternatively, we can write the saving equation and evaluate There's an easy way and a hard way to get this answer--and for an income pretty easy. evenitthe hard way isof Y = 160: First, if we know that the S = -a in equilibrium and we know that investment is economy is+ (1 - b)Y S = saving must 34, then -30 + 0.4Y be 34, too. So, S = 34. S = -30 + 0.4(160) S = -30 + 64 S = 34 Economics Gone Wild! Lesson VIII Again, there's an easy way and an almost-as-easy and Alternatively, we can write the consumption equationway. First, if people for an income 160 160: evaluate itare earning Y =of Y =and saving S = 34, then they must + spending the difference: C = 126. That is, we simply C = 30be 0.6Y make + 0.6(160) C = 30 use of the identity: Y = C + S. C = 30 + 96 C = 126 Economics Gone Wild! Can you say whether or not the labor force is fully employed? We can't say. We take the so-called "going wage" as the wage rate Lesson that if the current demand for labor some earlier period the given Onlycleared the labor market during happens to intersectwhen the economy was at the macroeconomic health. That very wage supply of laborin goodgoing wage (a possible but notgoinglikely is VIII circumstance, according to Maynard Keynes) would thethe economy still going--even if the demand for labor has fallen (and corresponding income (Y = WN) be full-employment income. = 160 is is in recession). In recessionary conditions, the income of Y equal to going wage rate times the quantity of worker-hours currently demanded at that wage rate. Economics Gone Wild! Next Unit Preview… Lesson VIII Macro Theories Economics Gone Wild!
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