The Colour of Money

Don’t tell me that you think it’s green, me I know it’s red!

Globalisation of Finance has blurred the old distinction between developed and emergent markets, between “the East” and “the West”, turning China into America’s banker – the commie creditor to the capitalist debtor.

An Overview of Modern Macroeconomics

Some Definitions to Start with

  • Inflation is defined as an upward movement of prices from one year to the next.
  • It is typically measured by the percentage change in price indices, such as the consumer price index, the producer price index, or the so called GDP deflator.
  • Inflation has often been described as The Cruelest Tax because it eats away at our savings and at our paychecks.
  • The unemployment rate is measured as the number of unemployed persons divided by the number of people in the labor force.

Economists distinguish between three kinds of unemployment, frictional, cyclical and structural:

  • Frictional unemployment occurs as a natural part of the job seeking process
  • Cyclical unemployment occurs when the economy dips into a recession
  • Structural unemployment occurs when a change in technology makes someone’s job obsolete.

The GDP is defined as the market value of all the final goods and services produced in a country in a given year:

  • One is called the flow of product or expenditures approach = consumption, plus investment, plus government expenditures, plus expenditures by foreigners or net exports
  • The other is called the flow of cost or income approach = wages earned by workers, plus rents earned by property owners, plus interest received by lenders, plus profits earned by firms.
  • Actual GDP represents what we are producing, while potential GDP represents the maximum amount the economy can produce without causing inflation.
  • When actual GDP is well below potential GDP, we are in the recessionary range of the economy.
  • In contrast, when actual GDP is above potential GDP, we run the strong risk of inflation.
  • Nominal GDP is measured in actual market prices
  • Real GDP is simply nominal GDP adjusted for inflation, and it is calculated in constant prices for a particular year, say, 1992
  • Moreover when we divide nominal GDP by a Real GDP, we obtain the GDP Deflator
  • The term business cycle refers to the recurrent ups and downs in real GDP over several years.
  • Fiscal policy uses increased government expenditure and tax cuts to stimulate the economy. Alternatively, to fight inflation by reducing government expenditures and raising taxes.
  • Monetary policy uses control over the money supply to achieve similar goals

Equilibrium in the Aggregate Supply – Aggregate Demand Model

  • The vertical axis measures the general price level for all goods and services.
  • The horizontal axis measures the level of real GDP
  • The curve labeled AS represents the economy’s aggregate supply, or how much output the economy will produce at different price levels. Note that it slopes upwards meaning that the higher the price level the more businesses will produce.
  • The downward sloping AD curve is the aggregate demand curve. It represents what everyone in the economy, consumers, businesses, foreigners and government, would buy at different aggregate price levels. Downwards slope means that as the general price level falls consumers and businesses will increase their demand for goods and services.
  • A macroeconomic equilibrium is a combination of overall price and quantity at which neither buyers nor sellers wish to change their purchases, sales, or prices.

The classical economists (Adam Smith, David Ricardo, and Jean Baptiste Say) believe that the problem of unemployment was the natural part of the business cycle. That it was self-correcting and most important, that there was no need for the government to interfere in the free market to correct it.

John Maynard Keynes flatly rejected the Classical notion of a self-correcting economy. Keynes believed that under certain circumstances, the economy would not naturally rebound, but simply stagnate, or even worse, fall into a death spiral. To Keynes, the only way to get the economy moving again, was to prime the economic pump with increased government expenditures.

Demand-Pull Inflation

The essence of Demand-Pull Inflation is too much money chasing too few goods.

  • During war time, increased defense spending moves aggregate demand from AD to AD prime.
  • And equilibrium output increases from E to E prime as real GDP expands.
  • However, when real output rises far above potential output, the price level moves up sharply as well, from P to P prime.

Cost-Push Inflation

Cost-push, or Supply-Side Inflation occurs when factors such as rapid increases in raw material prices or wage increases drive up production costs. This can happen as a result of so-called supply shocks, such as those experienced in the early 1970s. During this period, such shock included crop failures, a worldwide drought, and a quadrupling of the world price of crude oil.

  • The higher costs of doing business shift the AS curve up from AS to AS prime. And the equilibrium shifts from E to E prime.
  • Output declines from Q to Q prime while prices rise.
  • This leads to the phenomenon of stagflation, recession or stagnation combined with inflation. In this situation the economy suffers the double whammy of both lower output and higher prices.

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

Milton Friedman‘s Monetarist School argued that the problems of both inflation and recession may be traced to one thing: the rate of growth of the money supply. To the Monetarists, inflation happens when the government prints too much money, and recessions happen when it prints too little. From this Monetarist perspective, stagflation is the inevitable result of activist fiscal and monetary policies, that try to push the economy beyond its so-called natural rate of unemployment. Or, more technically, its Lowest Sustainable Unemployment Rate (LSUR). This natural rate of unemployment, or LSUR, is the lowest level of unemployment that can be attained without upward pressure on inflation.

In the 1980 presidential election, Ronald Reagan ran on a supply-side platform that promised to reduce the budget deficit. The supply side economists believed that the American people would actually work much harder and invest much more if they were allowed to keep more of the fruits of their labour. The end result would be to increase the amount of goods and services our economy could actually produce by pushing out the economy’s supply curve. Hence, supply-side economics. Most important the supply siders promised that by cutting taxes, and thereby spurring rapid growth, a loss in tax revenue from the tax cut would be more than offset by the increase in tax revenues from increased economic growth. Thus, under supply side economics, the budget deficit would actually be reduced. Unfortunately, that didn’t happen.

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

Comments (25)

  1. The Editor (Post author)

    The Ascent of Money

    In 2006 – before we have seen all the financial crises – the measured economic output of the entire world was around $47 trillion. The total market capitalisation of the world’s stock market was $51 trillion, 10% larger. The total value of domestic and international bonds was $68 trillion, 50% larger. The amount of derivatives outstanding was $473 trillion, more than ten times larger. The people who live in the in the world’s safest countries are also the most insured (or ‘hedged’). Financial activities dwarfing the ‘real’ economic outputs? These figures are taken from Niall Ferguson‘s interesting book ‘The Ascent of Money’. Apparently, more recent figures about the global economy of things we make and do speak of a worth of $60tn; the total value of derivatives circulating around financial institutions being $1.2 quadrillion. Impressed by such rhetorical numbers? Ferguson knows no doubt the difference between (cash) flows and stocks, or income and wealth. But the way he sets this up is misleading nonetheless.

    A year’s output is the value of goods and services produced over that year, while equity values reflect the discounted value of all future streams of profits. If we are comparing the two, we must at least have a sense of what a decent benchmark for comparison would be.

    So if, say, half of a GDP originates in the corporate sector and profits are one-third of value added, the present value of profits discounted at a continuous rate of 8% amounts to 115% of GDP (= 0.5 * 0.33 / 1.08). This implicates that the 10% extra which the above numbers suggest is well within the value of stock markets potentially being 15% higher than that of annual output. Planet finance is not that huge after all – at least given the numbers we are presented.

  2. The Editor

    The Aggregate Supply – Aggregate Demand Model and the Classical-Keynesian Debate

    The debate between Classical economists and Keynesians is one of the most important in macroeconomics. This debate goes back to the 1930s and the Great Depression. However, it remains important even today. This is because many of the macroeconomic policies now favored by conservatives have their roots in Classical economics while those on the other side of the ideological spectrum are generally much more supportive of the Keynesian approach.

    The Classical versus Keynesian controversy is primarily a dispute over how an economy adjusts back to full employment during a recession. On the one hand, the Classical economists believed that a “price adjustment mechanism” would cure the economy. In the event of unemployment, prices, wages, and interest rates would all fall. This would increase consumption, production, and investment and quickly return the economy back to full employment.
    In contrast, the Keynesian school argued that before the price adjustment mechanism had time to work, it would be overpowered by a more deadly “income adjustment mechanism”: When an economy sinks into a recession, people’s incomes fall. This causes them to both spend less and save less while businesses respond by investing and producing less. This drives the economy deeper into recession rather than back to full employment.
    This debate is important because the Keynesian approach calls for large scale government intervention while the Classical approach believes that the best cure for a recession is to leave the free market alone.

    • On the one hand, the Classical economists believe that a price adjustment mechanism would cure the economy.
    • Specifically, they believe that in the event of unemployment, prices, wages and interest rates would all fall.
    • This would in turn increase consumption, production and investment, and quickly return the economy back to its full employment equilibrium.

    In contrast, the Keynesian school argued that before the price adjustment mechanism had time to work, it would be overpowered by a more deadly income adjustment mechanism.

    • To the Keynesians, when an economy sinks into a recession people’s incomes fall.
    • This fall in income causes them to both spend less and save less, while businesses respond by investing and producing less.
    • This reduction in consumption, savings, investment, and output in turn drives the economy deeper into recession rather than back to full employment.

    The French economist Jean-Baptiste Say (1767–1832) introduced the idea that aggregate production necessarily creates an equal quantity of aggregate demand. Say’s Law states that the total income generated by people’s work producing goods and services, must equal the value of the goods and services. Thus if the workers spend this income it must be enough to pay for all the good and services they produce. Therefore supply creates its own demand. Or in the parlence of macroeconomics: there must be enough aggregate demand for the available aggregate supply.
    Thomas Robert Malthus said that if people did not spend all of their money, there would be a general glut of goods, and people would be out of work. [Besides this critique, Malthus is famous for the Malthusian doctrine that population will grow faster than the production of food, and that this will lead to mass starvation. In fact, it was Malthus’ dark vision that originally earned the economics profession its label as the dismal science (the original Dr. Doom).]
    Say and Ricardo’s answer to Malthus:

    • Doesn’t matter if people save some of their money because all of these savings will in turn be invested in the economy.
    • Therefore, aggregate demand – which equals consumption plus Investment – will always equal aggregate supply.
    • It didn’t say unemployment couldn’t exist but it did say if wages and prices and interest rates were allowed to adjust, unemployment would go away on its own.

    Classical economists buttress their Say’s Law analysis with the quantity theory of money:

    • The quantity theory of money determines the price level while
    • Say’s Law analysis determines real output.

    The quantity theory of money is based on the so-called equation of exchange:

    M * V = P * Q


    The Equation of Exchange

    • M * V = P * Q
    • M = money suppy
    • V = velocity of money or the amount of income generated each year by a dollar of money
    • G = general price level as measured by an index such as the consumer price index
    • Q = quantity of real output sold
    • P * Q = ‘nominal’ inflation-adjusted output as measured by GDP

    In its simplest terms, the quantity theory of money says that the price level varies in response to changes in the quantity of money. Put another way, changes in the price level are caused simply by changes in money supply. Two major assumptions of the quantity theory of money:

    • Assumption #1: Velocity is constant
    • Assumption #2: Real output is not influenced by the money supply (a.k.a. the velocity of money)
      → That is, it doesn’t matter how much money the government prints, it will not increase the amount of goods and services that the economy can actually produce.


    Implication: Increasing M will not increase Q!

      ? If the velocity V is constant on the left side of the equation,
      ? and output Q on the right side of the equation is unaffected by the money supply,
      ? the only thing that can change if money M changes, is the price level P!

    Keynes believed that before a price adjustment mechanism had time to work, it would be dwarfed by a much more powerful and deadly income adjustment mechanism:

    • When an economy sinks into recession, people’s incomes fall.
    • This fall in income causes them to both spend less and save less while businesses respond by investing and producing less.
    • This reduction in consumption, savings, Investment, and output in turn drives the economy deeper into recession rather than back to full employment.

    While eventually income will fall far enough so that savings and investment return to equilibrium, the economy will be at a level well below full employment with no way to get out stuck in a rut with a glut of goods. Just as Thomas Malthus predicted in his original critique of the Classical model.

      ? The AS-DS framework has its roots in Classical economics. It allows for price adjustment.
      ? The second model, the Keynesian model, assumes that prices are fixed!!

    Equilibrium in the aggregate supply-aggregate demand model:

    The AS-AD Framework

    • At this point, the price and output combination is compatible with the intentions of both buyers and sellers.
    • Note that equilibrium in this model does not necessarily have to occur at the full employment potential output GDP of Qc.

    Aggregate Demand

    The aggregate demand curve shows the various amounts of real output that domestic consumers, businesses, and government, along with foreign buyers, collectively desire to purchase at each possible price level – holding other things constant (ceteris paribus). Now, the downward slope of the aggregate demand curve means that – as the general price level falls – consumers and businesses will increase their demand for goods and services. This is for three reasons:

    1. First, there is a real balance or wealth effect.
      ? As the price level falls, the purchasing power of consumers increases and they demand more goods and services.
      ? This is because the real value of money is measured by how many goods and services each dollar will buy.
    2. A second reason why the aggregate demand curve slopes downward is an interest rate effect.
      ? As the price level falls, so too do interest rates.
      ? Falling interest rates, in turn, increase investment spending by businesses as well as certain kinds of consumer spending on items such as automobiles and housing.
    3. Third, there is a foreign purchase, foreign trade, or net export effect.
      ? As the domestic price level falls, the relative price of foreign goods increases.
      ? This reduces the demand for the now more expensive foreign imports.
      ? Increases the demand for exports, and thereby also increases the aggregate quantity demanded.

    Aggregate demand is defined as the graph showing the various amounts of real output that would be purchased at each possible price level, holding other things constant. But what are these other things we are talking about? These other things are grouped by the four major categories of real GDP:

    • Consumption
    • Investment
    • Government spending
    • Net exports


    1. Change in consumer spending
      • Consumer wealth
      • Consumer expectations
      • Household indebtedness or credit conditions
      • Tax policiy
    2. Change in investment spending
      • Interest rates
      • Profit expectations on investment projects
      • Business taxes
      • Technology
      • Degree of excess capacity
    3. Change in government spending
    4. Change in net export spending
      • National income abroad
      • Exchange rates

    For example as for government spending, expansionary fiscal or monetary policy can shift the AD curve out, while contractionary policy has the opposite effect.

    Aggregate Supply

    The aggregate supply curve shows the level of real GDP, or domestic output, that will be produced at each price Level – again, holding other things constant. The curve slopes upward simply because higher price levels create an incentive for businesses to produce and sell additional output, while lower price levels reduce output.

    1. Change in input prices
      • Domestic resource availability
        1. ? Land
          ? Labour
          ? Capital
          ? Entrepreneurial ability
      • Prices of imported resources
      • Market power
    2. Change in technology an productivity
    3. Change in legal-institutional environment
      • Business taxes and subsidies
      • Government regulations

    For example, productivity is defined as total output divided by total input. An increase in productivity means the economy can obtain more real output from its limited resources (inputs). If productivity increases, the average production cost of a unit of output will fall, and this will cause the aggregate supply curve to shift outward. Most broadly, this is because increases in productivity increase the potential output of an economy.

  3. The Editor (Post author)

    Shifts versus Movements along the Demand Curve

    The distinction between a shift of the demand curve and a movement along the demand curve ist important. A shift in the demand curve is caused by a factor affecting demand other than a change in price. Such a factor may be:

    • Prices of other goods – substitutes and complements
    • Incomes – the level and distribution of income
    • Tastes and fashions
    • The level and structure of the population
    • Advertising
    • Expectations of consumers

    If any of the factors affecting demand other than price change, then the amount consumers wish to purchase changes whatever the price. The shift in the demand curve is referred to as an increase or decrease in demand.
    A movement along the demand curve occurs when there is a change in price. This may occur because of a change in supply conditions. A change in price leads to a movement along the demand curve and is referred to as a change in quantity demanded.
    (Mankiw and Taylor, 2015)

  4. The Editor

    The Three Ranges of the Economy

    The horizontal, or Keynesian range, represents a range where increasing output will not lead to any inflation:

    • The economy is likely to be either in a severe recession or a full-blown depression.
    • Thus, large amounts of unused machinery, equipment, and unemployed workers are available for production.
    • In such a case, putting these idle resources back to work can be done with little or no upward pressure on the price level.
    • It follows that in this Keynesian range, prices are (for practical purposes) fixed.
    • Hence, the flat portion of the curve and fiscal policies, such as increased government expenditures, can be used to stimulate the economy without any fear of inflation.

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

    • Here, an increase in aggregate demand from AD5 to AD6 does not increase Qc, but only the price level from P5 to P6.
    • In this classical range, expansionary fiscal and monetary policies will clearly not be effective.

    Finally, there is an intermediate range where any expansion of real output is accompanied by a rising price level. Here, the problem is that the economy is comprised of enumerable product and resource markets, and as it moves to full employment, movements in all these markets may not occur simultaneously:

    • For example, as the economy expands in the intermediate range, auto and steel workers may still be unemployed, but the high-tech computer industry may begin to experience shortages in skilled workers.
    • At the same time, raw material shortages, or bottlenecks in production, may begin to appear in other industries.
    • In this case, stimulating aggregate demand through expansionary fiscal policies will move the economy to Q4. However, it will also result in demand-pull inflation as the price level rises from P3 to P4.

    The Classical Price Adjustment Mechanism

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


    • In step two, the economy suffers a demand shock, shifting the aggregate demand back to AD2.
    • The new equilibrium is a recessionary output of Q2 at a price of P1.
    • And the result is a recessionary gap equal to Q1 minus Q2.


    • Now in step three, wages, Prices, and interest rates fall as a result of the recession.
    • This causes aggregate demand to move downward along the aggregate demand curve – through wealth, interest rate and net export effects.
    • At the same time, the supply curve shifts out to AS2 as firms hire more workers and expand output.
    • Together, these price and wage adjustments drive the economy back to full employment at Q1 and close the recessionary gap.
    • But at a new and lower price of P2.
  5. The Editor (Post author)


    Budget deficits have been an unnerving fact of United States economic life for almost 50 years. Since 1960, the US has run only six budget surpluses, with four of them coming from the Clinton administration. The budget deficit first ballooned in the 1980s under the administration of Ronald Reagan and then George H.W. Bush. After inheriting a significant budget surplus from Bill Clinton, George W. Bush proceeded to break all budget deficits through his embrace of tax cuts and heavy war expenditures, plus, as he left office, the burden of recession. Today, as the US government and governments around the world continue to use fiscal stimulus dramatically, the world is faced with a ticking budget-deficit time bomb of unprecedented proportions (Navarro, 2009).

    Global Crisis: A World in Debt

    The world’s largest piles of debt stacked against national monuments of countries who borrowed the money. 

    Who Loaned Greece the Money?

    Greece owes a lot of money to a lot of people. This is the long list of banks who loaned the money. Note that the Greek public is not gaining anything from the bail-out. The foreign creditors save the debtors so their credits are on the safe side and future payments secured. 

    European Super Highway of Debt

    PIIGS countries borrowed massive amounts of money. The PIIGS debt stacked in semi-trucks full of €100 bills stretching for 26.7 km (16.6 miles). 

    Derivatives: The Global Casino

    Banks reap massive profits from unregulated casino-style betting, and the betting bubble has grown so large that it eclipses the World Economy many times over. 

    US Debt Stacked in $100 bills

    $100 – Most counterfeited money denomination in the world. Keeps the world moving. However impressive all this, we are confronted with rhetorical numbers. Such figures would have to be contrasted not only by the GDP of the US economy, but also by its total capacity including FDI and world exports – which would reveal that it is still able to serve interest for this huge debt. For how much longer? Check out how US debt compares to Statue of Liberty, World Trade Center, Boeing 747 & Football Fields. 

    US Revenue & Defict in $100 bills

    US Revenue & Deficit = US Budget. Shows how much money US Government brings in, and how much it borrows. 

    A New Perspective on Cost of War

    Iraq and Afghanistan wars were more expensive than the Governments claim it was. See the reality.

  6. The Editor

    The Keynesian Model and Fiscal Policy

    In macroeconomics, the basic Keynesian model goes by many names. Some economists refer to it as the “Multiplier Model” while others call it the Aggregate Production – Aggregate Expenditure model. Regardless of which name it goes by, it is one of the most important analytical tools in macroeconomics.
    The basic Keynesian Model provides a very straight-forward approach to using fiscal policy to close a recessionary gap. At least in theory, this model may be used to calculate very precisely how much government expenditures must be increased. Or alternatively, how much taxes must be cut to stimulate an economy back to full employment.

    • The most important assumption underlying this model is that prices are fixed.
    • Keynes himself didn’t believe this, of course. But Keynes did believe that when an economy is in the recessionary range, prices and wages were sufficiently inflexible. So that income would adjust much faster than prices.
    • Therefore, for simplicity, price changes could be assumed away.
    • The beauty of this fixed price assumption is that it allowed Hansen and Samuelson to develop a Keynesian aggregate production-aggregate expenditures model.

    The Basic Keynesian Model and a Recessionary Gap

    • The vertical axis measures total spending or aggregate expenditures.
    • The horizontal axis measures real GDP or output.
    • And there is a 45 degree line that measures aggregate production = the total amount of goods and services produced in the economy. By definition such production creates an equal amount of income, so that the aggregate production curve can be represented by a 45 degree line.
    • In addition, there is an aggregate expenditures curve that is calculated by totaling consumption plus investment plus government spending plus net exports.


    • Note that equilibrium in this model will occur where the aggregate expenditure and aggregate production curves cross.
    • Note also, that this equilibrium doesn’t necessarily have to occur at the economy’s full potential output, Q sub P.

    “Leakage” and the Most Important Leakage in the Government Sector




    Aggregate Production in the Keynesian Model

    • The upward-sloping 45 degree line, representing the aggregate production curve, means that at any point along this curve production equals income.
    • For example, at point A where the 45 degree line crosses the full employment vertical line production and income both Q superscript P.
    • In contrast at point E, both production and income are at Q. The economy’s so-called recessionary gap is equal to the difference between Q superscript P and Q.
    • Aggregate Expenditures (AE) = C + I + G + netX
    • And the aggregate expenditures curve is simply the vertical summation of these four components.

    Aggregate Expenditure

    • Note that the aggregate expenditure curve slopes upward, but has a flatter slope than the 45 degree line that represents the aggregate production curve.
    • Note also that the aggregate expenditure curve intersects the vertical axis at a level above zero. Taken literally, this means that even if income is zero, people will still spend a certain amount of money on consumption.

    The Difference between Autonomous Consumption and Induced Consumption in the Keynesian Model

    • The largest component of aggregate expenditures is consumption. It accounts for almost 70% of total aggregate expenditures in the US economy.
    • The level of consumption that occurs regardless of changes in one’s income is called autonomous consumption.
    • Second, Keynes said that there is a level of induced consumption that will depend on the individual’s disposable income. Where disposable income is simply the amount of money you have left after paying taxes to the government.

    The Marginal Propensity to Consume (MPC) and the Marginal Propensity to Save (MPS)

    It is also referred to as, the marginal propensity to expend. This is simply the extra amount that people consume when they receive an extra dollar of disposable income.

    MPS = 1 – MPC

    The MPS measures the extra amount people save when they receive an extra dollar of disposable income.

    The aggregate expenditure curve is flatter than the 45 degree line in the Keynesian model precisely because the MPC is less than one!


    • This relates back to the problem that Thomas Malthus originally identified with Say’s Law and the Classical model:
    • Namely that people won’t necessarily spend everything they earn, and aggregate expenditure therefore need not equal aggregate production.


    The Determinants of Investment

    Investment expenditures include

    • Purchases of residential structures
    • Investment in business plant and equipment
    • Additions to a company’s inventory

    Investment in plant and equipment is by far the biggest category, averaging a full 70% of total investment annually.
    While total investment expenditures account for roughly 15% of total aggregate expenditures.
    In the Keynesian model, investment expenditures are assumed to occur independently of the level of income. Algebraically, this means that investment I is simply equal to autonomous investment I naught. The advantage of this assumption, is that it allows economists to draw the investment function as a horizontal line.
    This is illustrated in the next figure. The curve I1 shows annual business investment in 1929, just prior to the stock market crash, at $16 billion. The curve I2 shows investment after it has fallen to $1 billion by 1933.

    If investment is not determined by the level of income, what are the determinants of investment? To Keynes himself, there were at least two important factors.

    • First, he believed that investment was sensitive to changes to the interest rate.
    • He did not believe that falling interest rates and increased investment would necessarily lead to a full employment equilibrium like the classical economists did. This is because Keynes believed that investment was in large part driven by a second important determinant, namely the expectations or business confidence that businesses had regarding potential sales and profits.
      Keynes referred to these expectations as animal spirits, and basically said that if businesses believe the economy was about to go bad, it could become a self-fulfilling prophecy.
    • The third component of aggregate expenditures in the Keynesian model is government spending. This includes purchases of goods like tanks or road building equipment as well as the services of judges and public school teachers. Unlike private consumption and investment, this component of aggregate demand is determined directly by the government’s spending decisions.
      Such government expenditures account for almost 20% of total aggregate expenditures in the U.S. and as with investment, the Keynesian model assumes government expenditures to be autonomous. That is, determined outside the model. And as with the investment function, the government expenditure function can be graphically portrayed as a horizontal line.
      In general, government expenditures exhibit much less volatility than investment, although episodic events such as wars and natural disasters can lead to large fluctuations. In the Keynesian model, increased or decreased government expenditures, together with tax cuts or tax increases, serve as the primary tools of fiscal policy that are used to counterbalance changes in investment and consumption spending (e.g. to close a recessionary gap).

    The Role of Transfer Payments in Macroeconomy

    • In addition to discretionary changes in government spending and taxes, there are also important non-discretionary government expenditures that act as built-in macroeconomic stabilizers. These non-discretionary expenditures are called transfer payments, and they include such things as
      o Unemployment compensation to workers
      o Welfare payments
      o Subsidies to farmers.
      These transfer payments, help stabilize the macro economy, because they automatically rise during recessions, and fall during expansion. This is because during recessions, as more and more people become unemployed, they become eligible for these programs. And as the economy expands, there is less need for these programs, and fewer payments.
    • The fourth component of aggregate expenditures is net exports.
      o Exports create domestic production, income, and employment for an economy
      → Exports must be added to aggregate expenditures.
      o Purchasing imports from a foreign country means no such production, income, and employment is created
      → Imports must be subtracted from aggregate expenditures.
      While net exports are a very important part of a global or open economy, they were not central to the development of the Keynesian multiplier model.

    A “Closed Economy”

    To make a simplifying assumption, we’ll assume a closed economy in which there is no international trade and drop net exports from the model. This allows us to focus solely on the role of government spending in fiscal policy.

    • Because investment and government expenditure functions are both horizontal lines, the slope of the aggregate expenditures (AE) function would be the same slope as the consumption function.
    • Therefore, the slope of the AE function is the marginal propensity to consume (MPC).

    The Keynesian Expenditure Multiplier

    The Keynesian expenditure multiplier, i.e. the number by which a change in aggregate expenditures, must be multiplied in order to determine the resulting change in total output.
    This multiplier is greater than 1 and the reason is that income is re-spent, not just once but many times after the initial increase.

    The ultimate impact of this demand shock on total spending can be determined by computing the change in income and consumption at each cycle of the circular flow.

    In the Keynesian model it can be easily shown mathematically that the multiplier is simply the reciprocal of the marginal propensity to save.

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

    That is the multiplier is one divided by the MPS, or put another way, one divided by one minus the marginal propensity to consume.
    As explained above, this multiplier is the factor to be applied to aggregate expenditures in order to determine the resulting change in total output.
    Suppose the United States permanently increases defense spending by $100 billion in response to a threat to the oil fields in the Middle East. What will be the effect of this increase in government spending (G) on the gross domestic product (GDP), assuming the marginal propensity to consume is two-thirds?

    Keynesian multiplier = 1 / (1 – 0.666) = 1 / 0.333 = 3
    3 * $100 billion = $300 billion higher
    So the new GDP output is $300 billion higher, as illustrated in the next figure:

    From this example we can see now why the analogy of using government expenditures to prime the economic pump is particularly apt:

    • Such expenditures trigger increased investment and consumption, and the total expansionary effect is far larger than the initial stimulus.
    • It should also be clear from this example how important the role of the multiplier is in the conduct of fiscal policy, as in the next example:

    How much should taxes be cut to close a $100 billion recessionary gap, assuming that the marginal propensity to consume (MPC) is 0.8?

    Keynesian multiplier = 1 / (1 – 0.8) = 1 / 0.2 = 5
    $100 billion / 5 = $20 billion
    Example: the famous Kennedy Tax Cut in the 1960s.

    The Keynesian Tax Cut Multiplier

    • However, the calculation for the appropriate size for the tax cut is a little more complicated than it is for government expenditures.
    • This is because a dollar’s worth of tax cuts has slightly less of an expansionary effect than a dollar’s increase in government expenditures.
    • The reason is that consumers will not increase their expenditures by the full amount of the tax cut. Instead they will save a portion of that tax cut based on their marginal propensity to save.


    Keynesian tax cut multiplier = Keynesian expenditure multiplier * MPC

    This time, the result would be $25 billion – this is $5 billion more than in the previous calculation.
    Suppose the economy is in equilibrium at $960 billion. But this is $60 billion above the full employment output of$900 billion. What do we call this situation? How would you use fiscal policy to address it, assuming a marginal propensity to consume of .75?
    This would represent an inflationary gap. An example is the one in the late 1960’s, caused by demand-pull inflation from the Vietnam War, and great society expenditures.
    Keynesian expenditure multiplier = 1 / (1 – 0.75) = 1 / 0.25 = 4

    • $60 billion / 4 = $15 billion, i.e. reduce G by contractionary fiscal policy

    Keynesian tax cut multiplier = 4 * 0.75 = 3

    • $60 billion / 3 = $20 billion, i.e. raise tax by contractionary fiscal policy

    Is it more preferable to increase government spending or cut taxes to eliminate recessionary gaps?
    The answer depends more on one’s views of the appropriate size of the government than pure economics.

    • At one end of the ideological spectrum, liberals who think that there are many unmet social and infrastructure needs, usually recommend increased government spending during recessions. And tax increases to fight demand-pull inflation. These actions either expand or preserve the absolute size of government.
    • On the other hand, there are conservatives who seek to shrink the size of government. Conservatives will generally favor tax cuts during recessions. And cuts in government spending to fight demand pull inflation. Both shrink the size of government.

    The Great Depression in the View of the Keynesian Model

    • In 1929, the economy was booming and at full employment.
    • But the stock market crash sent the business community into a panic. In the language of Wall Street, the business communities animal spirits went from the full embodiment of a robust bull, to that of a bleak bear market.
    • Reacting to the crash, businesses cut back sharply on investment and production.
    • At the same time, frightened consumers cut back dramatically on consumption while attempting to save more. Effectively increasing their marginal propensity to save as a response to the crisis.
    • Together, the reactions of business and consumers, lead to a sharp and sudden downward shift, of the aggregate expenditures curve.
    • Business people in turn, responded by decreasing output further.
    • This depressed income and consumption, the economy continued its downward spiral And eventually, unemployment reached a staggering 25% of the workforce.

    The Paradox of Thrift

    • One of the ironies of this result was that in their attempt to save more, many individual households actually wound up saving less because their incomes were plummeting as aggregate expenditures fell.
    • This result is known in macroeconomics as the so-called paradox of thrift, and it can be an important contributor to recessionary events.
    • In this particular case, with the economy in a depressed state, consumers not only tried unsuccessfully to boost their savings. Businesses also became unwilling to invest no matter how low interest rates fell.
    • At this point the government stepped in with a massive dose of expansionary fiscal policies. The public works projects of Franklin Eleanor Roosevelt’s “new deal” followed by the dramatic spurt of defense expenditures of World War II.

    Crowding Out


    • The Keynesian multiplier model provides a very mechanistic approach to curing the economy of a recession.
    • Specifically, if you know what the actual Gross Domestic Product is and what the full employment Gross Domestic Product is, then you know the size of the recessionary or inflationary gap.
    • And if you know the marginal propensity to consume, and therefore the multiplier, you also know how much you have to increase or decrease government expenditures or taxes, to close the gap.
    • But, such is not the case even if many economists at the height of the 1960’s Keynesian Era thought it was:

    Crowding out refers to the reduction in private sector investment that can be caused by increased government spending. It can happen when the government borrows money to finance these expenditures. Such borrowing or deficit spending can drive up interest rates. Higher interest rates can in turn reduce private sector investment.

      → any fiscal policy stimulus may be partly, or fully offset, by a reduction in private sector demand.
      → This, in turn means, that the net expansionary effect of Keynesian fiscal policies might wind up being smaller, and indeed in some cases, much smaller than was intended.

    Beyond this specific problem of crowding out, there is a much broader problem with a mechanistic Keynesian approach:

    • Is that it relies on a model that is not a complete model of the economy. Particularly with respect to the monetary and financial sector.
    • It assumes away inflation. In doing so, it neglects the crucial influence of monetary factors on interest rates, and interest-sensitive components of output, such as investment.
    • Despite its limitations the Keynesian model is a powerful tool for illustrating two particular situations:
      o When the economy is in the Keynesian recessionary or depressionary range.
    • o For illustrating how a small imbalance between leakages and injections can multiply into a much larger unemployment or inflation problem.

    The Relationship between the Keynesian and the Aggregate Supply – Aggregate Demand Models

    • Both approaches lead to the same equilibrium output Q.
    • But note that in AS-AD model the economy is assumed to be operating in the intermediate range – so that if fiscal policy were to be used to close the recessionary gap, some inflation would likely result.
    • Moreover, if fiscal policy were to try to push the economy beyond Q superscript p into the classical range, the primary result would be inflation.
    • In this case, the Keynesian model is not helpful, while a deeper understanding of the monetary sector of the economy is crucial.
  7. The Editor (Post author)

    As we are exploring monetary policy next, keep in mind another definition of money:

    “Money, it is conventional to argue, is a medium of exchange, which has the advantage of eliminating inefficiencies of barter; a unit of account, which facilitates valuation and calculation; and a store of value, which allows economic transactions to be conducted over long periods as well as geographical distances. To perform all these functions optimally, money has to be available, affordable, durable, fungible, portable, and reliable. […] Money is not metal. It is trust inscribed. And it does not seem to matter much where it is inscribed: on silver, on clay, on paper, on a liquid crystal display. Anything can serve as money, from the cowrie shells of the Maldives to the huge stone discs used on the Pacific islands of Yap. And now, it seems, in this electronic age nothing can serve as money too. The central relationship that money crystallizes is between lender and borrower.
    (Ferguson 2008, pp. 23 – 30)

  8. The Editor

    The Federal Reserve and Monetary Policy

    Monetary or Fiscal Policy?

    In the 1970s the nation found itself fighting a soaring inflation and then a virulent stagflation. Monetarism emerged in the 1970s to challenge the Keynesian orthodoxy. Monetary policy involves the use of changes in the Money Supply to Contract or Expand the Economy.
    Between the Great Depression, and the height of the Vietnam War, monetary policy largely played second fiddle to fiscal policy. Perhaps rightly so. After all, fiscal policy had been a resounding success, in lifting the U.S. out of the Great Depression in the 1930s. As well as ending a more mild, but nonetheless significant recession in 1949 and 1950.
    More over, the astonishing success of the Kennedy tax cut of 1964 seemed to provide incontrovertible proof that Keynesian economics could be used to fine tune the economy.
    Nonetheless, even during these four decades of Keynesian triumphs, monetary policy played an important supporting role. Particularly in the 1950s, the Eisenhower administration relied heavily on a tight monetary policy to keep inflation in check. In fact, many critics now believe that an overly conservative monetary policy led to a stagnating economy in the late 1950s. And set up the defeat of Eisenhower’s Vice President and would-be successor, Republican Richard Nixon, in the 1960 presidential election. Nixon of course lost to democrat and Keynesian disciple John F Kennedy who ran on slogan of getting the country moving again.
    Moving again is actually what the democratic administrations of first John F. Kennedy and then Lyndon Johnson did to the economy. In fact, by the end of the 1960s the economy was moving so fast that inflation began to rear its ugly head. By 1969, inflation had crept over 5%, high for those good old days. And by the early 1970s it had jumped to almost double digits.
    And it was at this point as a new phenomenon known as stagflation began to emerge that monetarism began to challenge the Keynesian orthodoxy.

    Definition of Monetary Policy

    Monetarism involves the use of changes in the money supply to contract or expand the economy.

    The Three Kinds of Money

    Money is anything that can be widely used and accepted in exchange for other goods and services. In practice, there are three kinds of money:

    • Commodity money, like gold nuggets, silver beads, grains, etc. represents the preferred money of centuries past. Today, in virtually all countries, commodity money has been replaced by the two other kinds of money:
    • Bank money like the checkbook you use to pay your bills and bank drafts.
    • Paper (or fiat) money is simply the currencies like Dollar bills in America and the Yen in Japan.

    The Three Functions of Money

    Money is the most liquid of assets, meaning that it is the most readily spendable, and it has three major functions:

    1. First it is a medium of exchange. Without money we would have to conduct our transactions by barter.
    2. Second, money serves as a unit of account or standard of value, it tells us the rate at which goods can be exchanged.
    3. Third, money serves as a store of value. This is because people can hold onto money this year and then spend it next year However, it is this function that money performs least.

    The Difference between M1, M2, M3, and L

    Macroeconomists distinguish between four kinds of money. These different kinds of money reflect variations in the liquidity and the accessibility of assets:

    • M1 is known as transactions money because it consists of items that are actually used for transactions.
    • These items include paper currency and coins (cash), plus, checking accounts, and demand deposits (traveler’s checks).

    • M2 is known as broad money.
    • It includes M1, plus so called near moneys, such as savings accounts, small time deposits, and money market mutual fund shares.

    M3 and L, are the broadest definitions of money, and include almost all short-term assets:

    • M3 includes M2, plus time deposits larger than $100K, repurchase agreements, and overnight Eurodollars.
    • L includes M3, plus treasury bills, U.S. savings bonds, bankers’ acceptances, term Eurodollars, and commercial papers.

    The Price of Money

    Put simply, interest is the payment made for the use of money, and it is often called the price of money.
    Technically, the interest rate is the amount of interest paid per unit of time, expressed as a percentage of the amount borrowed.

    Three Reasons why Interests Rates Differ

    There are three major reasons why interest rates differ:

    1. First, there is the term or maturity of the loan.
    2. This refers to the length of time until it must be paid off. In general, longer term loans command a higher interest rate because lenders are willing to sacrifice quick access to their funds only if they can increase their return or yield.

    3. Second, there is the degree of risk.
    4. Some loans, such as the securities of the U.S. government, are virtually riskless (the riskless rate).

    5. Third, there is the issue of liquidity.
    6. An asset is said to be liquid if it can be converted into cash quickly with little loss in value.

    Real and Nominal Rates

    If the nominal interest rate is 8 percent per year and the inflation rate is 3 percent per year, what is the real interest rate?
    These fluctuations underscore the need to understand the difference between real and nominal rates:

    • The nominal interest rate measures the yield in dollars per year per dollar investment.
    • But as with nominal GDP, inflation can make the dollar a rubbery and distorted yardstick.

    That’s why economists also compute the real interest rate by:

    R(nominal) – Inflation = R(real)
  9. The Editor (Post author)

    Real versus Nominal Values

    Distinguishing between real an nominal values is fundamental. A simple way to differentiate between real an nominal values is that real values are expressed in quantities whereas nominal values are expressed in money terms. Mankiw and Taylor (2014, p. 40) highlight that real values take into account price changes over time or the adjusting factors such as the seasons, whereas nominal values do not take account of these adjusting factors. For this reason, nominal values are referred to as current prices whereas real values are referred to as constant prices.

    So what is the consequence for GDP?

    • GDP at constant prices: GDP at constant prices indicates economic growth to measure the performance of the economy over time or in comparison with other countries/in comparison with previous periods. It is also known as real GDP.
    • GDP at current prices: The market value of goods and services produced in a country during a year. It is also known as nominal GDP.


    See also The World Bank: What is the difference between current and constant data?

  10. The Editor

    The Two Sources of Money Demand

    The two major determinants of money demand, are known as the transactions demand, and the asset demand:

    • Basic determinant of the amount of money demanded for transactions, is the level of nominal GDP. The larger the total money value of all goods and services that are exchanged in the economy, the larger amount of money needed to negotiate these transactions.
    • The asset demand or, speculative motive for holding money, arises because people use money as a store of value.

    Note that while money is an asset, money provides no rate of return or interest, like other assets, such as stocks and savings accounts do. Moreover, when you hold money, it’s value can depreciate, because of inflation. So here’s the punch line, there is an opportunity cost of holding money.

    • That includes the interest or rate of return that could have been earned by lending or investing the money.
    • As well as the loss in value from holding money during inflation.

    Therefore, if either the interest rate or the expectation of inflation increases, the opportunity cost of holding money increases. So, the Asset Demand for money must decrease.

    Three characteristics of the modern banking system were also characteristics of the early goldsmiths:

    • First the depositors figured out that they could trade their gold receipts for goods. These receipts function in effect as the first paper money.
    • Second, the gold depositors soon figured out that they didn’t have to leave their gold with the goldsmith for free. In fact, it wasn’t long before goldsmiths began competing for depositor’s gold. They did offer them interest on their gold deposits.
    • Finally, the goldsmiths figured out that they could operate under what is today called the system of fractional reserves. This system we are going to explore next.

    The Money Supply Multiplier

    Suppose the reserve requirement is 20%. What is the money multiplier?
    There is a new kind of multiplier operating on bank reserves, a money supply multiplier very different from the Keynesian expenditure multiplier:

    MM = 1 / RR
    Money supply multiplier = 1 / Bank’s required reserve ratio.

    The money multiplier and reserve requirement are inversely related!

    • So if the reserve requirement is 0.10 or 10%, then the money multiplier is ten. And, 10 times the original $1,000 increase in demand deposits, is $10,000.
    • Suppose the reserve requirement is instead 50%, the money multiplier is two. One divided by 50. So if bank one receives a new demand deposit of $1000, it can lend out $500. Bank two can lend out $250 and so on until a total of $2000 of new money is in circulation.
    • Note, the bigger the reserve requirement, the smaller the money multiplier, and the less money that is created by any dollar of demand deposits.


    • The Fed can increase the money supply by lowering the reserve requirement.
    • Or decrease the money supply by raising the reserve requirement.
    • As a practical matter, the Fed rarely uses changes in the reserve requirement to conduct monetary policy.
    • The primary function of the requirement is to ensure that banks don’t fall below a safe level of reserves and thereby undermine the stability of the system.
    • The second instrument of monetary policy is the discount rate. The discount rate is the interest rate that the fed charges banks when the borrow money from the Fed.
    • Lowering the rate makes it cheaper for banks to borrow money and expand the money supply.
    • In contrast, raising the discount rate, makes it more expensive for banks to borrow from the Fed and is contractionary.

    How a Bank Run occurs

    A bank run occurs when too many of the bank’s depositors demand their money at the same time, like in the Financial Panic of 1907. Such bank runs usually happened because, for one reason or another, people suddenly believed that they may not be able to get all their money out of their bank. The irony of course, is that when everybody tried to do that at once, the fear becomes reality – in effect a self-fulfilling prophecy.

    The Federal Reserve as the “Lender of Last Resort”

    The Fed can serve as the lender of last resort, so if a bank needs to pay off its depositors, it can always borrow it from the Fed which is, in essence, a banker’s bank.

    The Three Instruments of Monetary Policy and their Importance

    The first, and least used of these instruments, is setting the reserve ratio or the reserve requirement.

    • As we’ve learned from our discussion of the money multiplier above, the Fed can increase the money supply by lowering the reserve requirement. Or it can decrease the money supply by raising the reserve requirement.
    • As a practical matter, the Fed rarely uses changes in the reserve requirement to conduct monetary policy.
    • The primary function of the requirement is to ensure that banks don’t fall below a safe level of reserves and thereby undermine the stability of the system.

    The second instrument of monetary policy is the discount rate. The discount rate is the interest rate that the FED charges banks when they borrow money from the Fed.

    • Lowering the rate makes it cheaper for banks to borrow money and expand the money supply.
    • In contrast, raising the discount rate, makes it more expensive for banks to borrow from the Fed and is contractionary.

    The third, and by far the most important instrument of monetary policy, is open market operations.

    • Open market operations involve the buying and selling of government securities (bonds), to expand or contract the money supply.
    • In a nutshell, the Fed buys government securities when it wants to expand the money supply. And it sells government securities when it wants to contract the money supply.


    Open Market Operations

    Suppose the Federal Reserve sells bonds. Is this contractionary or expansionary monetary policy?

    • By altering its holdings of government securities, the FED can change bank reserves.
    • And, through the money supply multiplier, thereby trigger the sequence of events that ultimately determine the total supply of money.
    • In this regard, open market operations represent the FED’s most potent tool.

    To whom are the bonds sold?

    • The bonds are sold to the open market – hence open market operations.
    • This open market includes dealers in government bonds, who then resell them to commercial banks, big corporations, other financial institutions, and individuals.
    • The purchasers usually buy bonds by writing checks to the FED, drawn from an account in a commercial bank.
    • For example, if the FED sells $10,000 worth of bonds to Linda Smith, she writes a check on the Coyote Bank of Santa Fe. The FED then presents this check at the Coyote Bank.
    • And here’s the important point: when the Coyote Bank pays the check, it will reduce its balance of reserves with the FED and the reserves in the entire commercial banking system by $10,000.
    • In this way, the FED reduces the money supply!

    The Monetary Transmission Mechanism

    This is illustrated with the help of a five-step monetary policy sequence, called the monetary transmission mechanism, shown here for closing and inflationary gap:

    • The Fed reduces reserves R, through open market operations.
    • Money supply M contracts, and causes interest rates I, to rise.
    • This rise, not only reduces investment I, it also reduces consumption expenditure C, and net exports X.
      • For example, consumers may respond to higher mortgage interest rates by buying a smaller home, or renovating their old home, rather than purchasing a new one.
      • Similarly, in an economy open to international trade, higher interest rates may raise the foreign exchange rate of the dollar.
      • And this will in turn depress net exports.
    • The total effect of a fall in I, C and X is to push aggregate expenditures or aggregate demand down in doing so real GDP and inflation likewise go down. Thereby achieving the desired policy goal.

    Using Monetary Policy in the Aggregate Supply – Aggregate Demand Framework in order to Close a Recessionary Gap

    The next figure shows how an expansion of the supply of money causes a rightward shift of the aggregate demand curve from AD to AD’. Note that in the range of this shift, the aggregate supply curve is relatively flat.
    This Keynesian range reflects the presence of unemployed resources and recessionary forces. In this region, we get a very small increase in the price level from the FED’s expansionary monetary policy and a large increase in real GDP as equilibrium moves from P to P’.

    Suppose, however, that the Fed decides to expand the economy even further and tries to push the aggregate demand out even more to E’’.

    • This is well past the economies level of potential output or potential GDP, and in this case we are in the so-called classical range of the economy.
    • Here, the slope of the aggregate supply curve turns steeply upward.
    • In this fully employed economy, the higher money stock would be chasing the same amount of output so that the major impact of the FED’s expansionary policy would be to significantly raise the price level.
    • With little increase in real GDP.


    About the Precision of Monetary Policy and Fiscal Policy

    • In the Keynesian multiplier model, if we know the size of a recessionary gap and the value of the multiplier, we could calculate exactly how much we have to increase government expenditures or cut taxes to close the gap.
    • In the case of monetary policy, however, it is a bit more of a guessing game. Because the link between the money supply and shifts in the Aggregate Expenditure curve, is much more complex.
    • Relying on changes in the interest rate, and the responsive investment, consumption and net exports.
    • While the FED can raise or lower interest rates, it can’t know with precision how investment, consumption, and net exports will respond.

    The Keynesian View of Monetary Policy

    This observation leads us to the major paradox of the Keynesian-Monetarist Debate. Namely, that it is the Keynesian economist, not the Monetarist, who support an activist role for monetary policy, in fighting recessions and inflation.

    • In defining an activist role for monetary policy, Keynesians believe that monetary policy is most effective as a “fine tuning” policy instrument, when the economy is near full employment (either in a mild recession, or in a mild inflation).
    • In this narrow band of output, Keynesians believe that investment in aggregate expenditures will respond relatively swiftly to changes in the interest rate which are brought about by changes in the money supply.
    • This is particularly true when there is an inflationary gap in the economy. In such a case, Keynesians see the use of contractionary monetary policy as pulling on a string.
    • However, Keynesians also believe, that in a severe recession, or depression, monetary policy is largely ineffective, equivalent to pushing on a string.
    • That is, in a severe economic downturn, Keynesians believe, that an increase in the money supply may well lead to a reduction in interest rates. However, these lower rates will have little or no success, in encouraging additional investment, and shifting the aggregate expenditures curve upward.
    • Thus in the recessionary and depressionary ranges, Keynesians believe, that expansionary fiscal policy is much more appropriate.

    The Monetarist View of Monetary Policy

    In contrast, the Monetarist School doesn’t believe in an activist fiscal and monetary policy at all:

    • According to the father of Monetarism, Milton Friedman, the problems of both inflation and recession may be traced to one thing, the rate of growth of the money supply.
    • Inflation happens when the government prints too much money, and recession happens when it prints too little.
    • In fact, Milton Friedman totally rejects the Keynesian view of the origins of the Great Depression, as well as the Keynesian fiscal policy cure.

    Explanation of the Great Depression from a Monetarist Perspective

    • Instead, Friedman blames the nation’s economic collapse in 1929 on bad monetary policy by the Federal Reserve rather than any inherent Keynesian instability with the system.
    • As Friedman has argued, the Federal Reserve contracted the money supply, plunging a private economy that would otherwise have been pretty stable into a depression.
    • And in fact, there is much truth in Friedman’s argument. In the wake of numerous bank failures immediately preceding and then following the 1929 stock market crash, people began hoarding cash, rather than leaving it in banks.
    • The same time, the banks themselves dramatically increase their reserves in case nervous depositors triggered a bank run.
    • This fall in demand deposits coupled with an increase in the banks own self-imposed reserve requirements led to a sharp contraction of the money supply.
    • And Friedman faults the Federal Reserve for not stepping in to the monetary policy breach to stabilize the situation.
    • Moreover to Friedman, if the Fed had acted promptly and injected enough currency to stabilize the money supply, an activist fiscal policy as embodied in Franklin Roosevelt’s New Deal, would never have been necessary.
    • More broadly, monetarists like Friedman liken the Federal Reserve to a bad driver, constantly either accelerating too fast or braking to hard on the money supply.
    • This analogy describes quite well the behavior of the Federal Reserve during the 1970s, as it tried to cope alternatively with the recession and inflation and then both at the same time.
    • As the Keynesian successes in the 1960s gave way to a soaring inflation in the early 1970s, the Federal Reserve stomped on the monetary brakes, and watched as interest rates climbed dramatically. Predictably, investment slowed and the economy plunged into a recession until 1975.
    • The government stomped back on the accelerator using a Keynesian-style tax cut to stimulate the economy. To accommodate this tax cut, the Federal Reserve reluctantly increased the money supply, and then stood by as a new and ugly macroeconomic phenomenon called stagflation, simultaneous high unemployment and high inflation, began to tighten its deadly grip on the nation.

    Stagflation Illustrated using the Aggregate Supply – Aggregate Demand Framework

    • This illustration provides a simple example of stagflation brought about by cost-push inflation. Here we started full employment output Y*.
    • However a supply shot shifts the aggregate supply curve back to AS prime. This leads to a recessionary gap of Y* minus Y sub r.
    • But note also that the price level has also risen from P* to P sub R.
    • In other words, we’ve got both recession and inflation.
    • Prior to the 1970s, economists didn’t believe you could even have both high inflation and high unemployment at the same time. One went up, the other had to go down.
    • But the nineteen seventies proved economists wrong on this point, and likewise exposed Keynesian economics as being incapable of solving the new stagflation problem. Now, we see the Keynesian dilemma.

    The Keynesian Dilemma created by Stagflation

    The Keynesian dilemma was simply this:

    • Using expansionary policies to reduce unemployment, simply created more inflation.
    • While using contractionary policies to curb inflation only deepened the recession.
    • That meant that the traditional Keynesian tools could solve only half of the stagflation problem, at any one time, and only by making the other half worse!!! It was this inability of Keynesian economics to cope with stagflation that set the stage for professor Milton Friedman’s monetarist challenge to what had become the Keynesian orthodoxy.

    The Monetarist Solution to Stagflation

    To fight stagflation and to, more broadly, prevent the roller coaster ride of economic booms and busts, the Monetarist solution is to set monetary targets and stick with them:

    • For example, if we want economic growth to proceed at an annual rate of 3%, then we should simply increase the money supply by 3%.
    • This monetary targets approach was precisely the policy prescription embraced by the Fed in 1979, after almost a decade of fruitless battling against inflation.
    • In October of that year, federal reserve chairman Paul Volcker, announced that the Fed would no longer focus on holding interest rates stable. Instead, it would simply adopt monetary growth targets, and stick by them.
    • Unfortunately, the Fed’s Monetarist cure proved to be almost as bad as the stagflation disease. Interest rates soared to above 20%. Inflation remained in the double digits. And the economy entered into the beginning of a severe 3 year recession.
    • While chairman Volcker stuck to his monetarist guns and watched as both tight money and a deep recession eventually helped wring inflation out of the economy, the cost in human terms was high.
    • Finally, in the summer of 1982 the Fed relaxed its monetarist rules and by late fall, the recession had ended, just in time to try the latest evolution in economic theory – supply side economics.
  11. The Editor (Post author)

    To understand the process of money creation better, many first-year MBA students play a simplified money game:
    It begins with a hypothetic central bank paying the professor € 100.- on behalf of the government. The professor takes the bank note to a bank notionally operated by one of the students and deposits it there, receiving a deposit slip. Assuming that this bank operates on a 10% reserve ratio, it deposits € 10.- with the central bank and lends the other € 90.- to one of its clients, a fellow student. This student happens to be another bank and deposits the money there. This bank also has a 10% reserve rule, so it deposits € 9.- at the central bank and lends out the remaining € 81.- to a third bank. After several more rounds, the professor asks the increase of the money supply by the time money has been deposited at three different banks:

    • M0: the monetary base or high-powered money = € 100.-
    • Equal to the total liabilities of the central bank, that is, cash plus the reserves of private banks on deposit of the central bank.

    • M1: narrow money = € 271.-
    • Equal to cash in circulation plus demand or “sight” deposits.

    This illustrates nicely how modern fractional reserve banking allows the creation of credit and hence the creation of money.
    The professor then surprisingly asks the first student to give him his € 100.- back. The student also has to draw back on his reserves and call in his loan to the second bank, setting off a domino effect that causes M1 to contract as swiftly as it expanded – which illustrates the danger of a bank run.

  12. The Editor

    Unemployment, Inflation, and Stagflation

    Unemployment and inflation are two of the most important problems in macroeconomics, and in most cases, macroeconomists can solve at least one of them – but only by worsening the other. For example, expansionary fiscal or monetary policy can usually pull an economy out of a recession. But such actions may cause inflation. On the other hand, contractionary policies typically can be used to fight inflation. But often at the cost of more unemployment and recession.
    But what happens when an economy faces both high unemployment and soaring inflation – as many nations of the globe did during the turbulent 1970s? Are traditional, Keynesian-style monetary and fiscal policies still effective in fighting such “stagflation?”
    One of the great debates in macroeconomic theory advocates for a clear tradeoff between unemployment and inflation, as the so-called “Phillip’s Curve” suggests. The competing Keynesian and Monetarist views of stagflation have given rise another theory: the doctrine of Supply-side economics emerged in the 1980s as a viable political alternative.

    The distinction between cyclical, frictional, and structural unemployment

    • Frictional unemployment is the least of the economist’s worries. It arises because of the incessant movement of people between regions and jobs or through different stages of their life cycle.
    • For example, even when an economy is at full employment there is still some turnover as students search for jobs when they graduate from school and when women re-enter the labor force after having children.
    • Cyclical unemployment is a much more serious problem. It occurs when the economy dips into a recession, and it is this type of unemployment that macroeconomists have historically spent most of their time trying to solve.
    • In an increasingly technological age, the third type of unemployment, structural unemployment, has begun receiving more attention. Structural unemployment occurs when there is a mismatch between the available jobs and the skills workers have to perform them. It often results when technological change makes someone’s job obsolete.
    • The highly skilled glassblower thrown out of work by the invention of bottle making machines. The specialized autoworker replaced by a robot.
    • A second source of structural unemployment results from a mismatch between the location of workers and the location of job openings. For example, in the 1980s when the price of oil plunged, many oil field workers in the oil producing states found themselves structurally unemployed when widespread layoffs occurred. Even though unemployment was low in other parts of the country

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

    The Unemployment Rate

    Unemployment Rate = Unemployed / Labor Force * 100

    Okun’s Law

    Unemployment is a problem that results not only in a waste of valuable labor resources, but also the loss of potential output. By studying macroeconomic data, economist Arthur Okun found an important relationship between output and unemployment, a co-movement, as it were:

    • When GDP falls, unemployment rises!
    • For every 2% GDP falls, unemployment rises by 1%


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

    Demand-pull Inflation Illustrated

    The essence of demand-pull inflation is too much money chasing too few goods. And that’s exactly what happened when the US tried to finance both guns and butter – both the Vietnam War and the Great Society.

    • Increased government expenditures on both guns and butter drive aggregate demand from AD to AD’.
    • And equilibrium output increases from E to E’ as real GDP expands.
    • However, when real output rises far above potential output the price level moves up sharply as well from P to P’.

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

    Cost-push Inflation Illustrated

    Cost-push or supply side inflation occurs when external shocks such as rapid increases in raw material prices or wage increases drive up production costs. In the early 1970s, such supply shocks included crop failures, a worldwide drought, and a quadrupling of the world price of crude oil.

    • Sharply higher oil, commodity, and labor costs increased the cost of doing business.
    • The higher costs shift the AS curve up from AS to AS’ and the equilibrium shifts from E to E’.
    • Output declines from Q to Q’, while prices rise.
    • This leads to stagflation, the double whammy of both lower output and higher prices.

    The Keynesian Dilemma Arising with Stagflation

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

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

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

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

    The Core or Inertial Rate of Inflation

    In modern industrial nations like the US, most economists believe that there is a core or inertial rate of inflation that tends to persist at the same rate until some kind of demand or supply side shock comes along to change things.
    At the heart of this idea of inertial or core inflation, is the concept of inflationary expectations, and a behavioral model known as adaptive expectations.

    Why Inflationary Expectations are Important

    Inflationary expectations are important because the expectation of inflation can significantly contribute to actual inflation. The reason is that inflationary expectations strongly influence the behavior of businesses, investors, workers, and consumers. When we assume adaptive expectations, we are assuming that people believe that next year’s rate of inflation will be the same as the current or last year’s rate.

    For example, during the 1990s prices in the US rose steadily at around 3% annually and most people came to expect that inflation rate. This expected rate of inflation was, in turn, built into a core rate of inflation for the economy through institutional arrangements such as negotiated labor contracts.

    Adaptive Expectations

    Adaptive expectations will put upward pressure on prices so that the expectation of inflation becomes a self-fulfilling prophecy and the inertial or core rate of inflation is maintained.

    How Adaptive Expectations Lead to an Inertial Inflation Rate

    This figure illustrates how adaptive expectations lead to an inertial inflation rate. In the figure, the price level is on the vertical axis, real output is on the horizontal axis, and we start off at point E where the aggregate supply and demand curves cross at potential output Q superscript P. At this point, the core rate of inflation is 3%.

    • Because of their adaptive expectations, everyone expects average costs and prices to rise at 3% this year, cause that’s what it did last year. So workers demand and receive higher nominal wages.
    • This pushes up the aggregate supply curve even as their increased spending pushes up the aggregate demand curve.
    • And over time, the aggregate supply and demand curves continue to rise by 3% a year as the macroeconomic equilibrium moves from E, E’ to E’’.
    • In this case, the core, or inertial rate of inflation, is maintained.

    What Relationship the Phillips Curve Purports to Illustrate

      ? The Phillips curve was developed by English economist A. W. Phillips after a study of more than a century’s worth of data on unemployment and money wages in the UK.
      ? What Phillips found was that wages tended to rise when unemployment was low, but fall when unemployment was high.
      ? Workers press less strongly for wage hikes when fewer jobs are available, and businesses fight harder against wage demands when profits are low.


    • Holding the aggregate supply curve steady, we start at AD naught. But an increase in aggregate demand shifts the AD curve upwards from AD one to AD two, and eventually to AD three.
    • The result is that the price level rises from P naught to P three, while output increases from Q naught to Q three.
    • Unless robots are doing all the work, the increase in real output is almost certainly accompanied by a fall in the unemployment rate as the price level is rising. This is the essence of the Phillips Curve relationship.

    How the 1970s shook Economists’ Faith in the Phillips Curve

    On the basis of earlier historical evidence, most economists came to believe that a stable, predictable tradeoff exists between unemployment and inflation. And if this is so, the important policy implication is this:

    • You can always use fiscal or monetary policy to expand the economy a bit more to reduce unemployment.
    • The only price you will pay is a bit more inflation – not a bad trade-off to keep people employed.

    But something very significant happened in the 1970s to shake economists’ faith in the Phillips curve: The emergence of the chaotic “Phillips Curl”.

    The Standard Explanation of the Phillips Curve Breakdown

    • The series of supply shocks in the 1970s shifted the short run aggregate supply curve leftward. This moved the Phillips curve rightward and upward.
    • As oil prices fell back down in the 1980s, this and other positive supply side effects shifted the Phillip’s curve back – a supply shock process in reverse.

    From a macro policy perspective, the virtue of this standard explanation is that it preserves the Phillip’s curve relationship. This means that in stable times and absent supply-side shocks, policy makers can still engage in discretionary fiscal and monetary policies to expand or contract the economy as they see fit. The only price paid is a little more inflation for a little more employment.

    What Two Things Explain Best the Disappearance of the Phillips Curve in the 1970s According to the Monetarists

    The Monetarists have a very different explanation of stagflation and the events of the 1970s. And it is an explanation that calls into question the very existence of the Phillips curve:

    • According to the Monetarists, this disappearance of the Phillips Curve in the 1970’s may best be explained through the concept of the natural rate of unemployment. And by distinguishing between a short run and long run Phillips Curve.
    • The Modified Phillips Curve theory of the monetarists, grew out of the work of Edmund Phelps and Milton Friedman. The theory asserts that there is a minimum unemployment rate, that is consistent with steady inflation.
    • This rate is what classical Economists and Monetarists, typically refer to as the natural rate of unemployment (= lowest sustainable rate of unemployment).

    The Policy Implications of the Monetarist’s Natural Rate Theory, particularly with Regard to Keynesian Activism

      ? It is simply impossible to drive unemployment below the natural or lowest sustainable rate in the long run. And this assertion clearly implies, that the long run Phillips Curve is vertical rather than downward sloping.
      ? The Monetarist’s Natural Rate Theory strike to the very heart of Keynesian activism. Indeed, while the theory allows that a nation can use expansionary fiscal or monetary policy to drive unemployment below the natural rate temporarily, such a Keynesian joyride along the short run Phillips Curve must inevitably come at the price of rising inflation.
      ? Even more to the point, if a nation repeatedly uses Keynesian policies to try and keep unemployment below the natural rate, the only result over the longer run will be a deadly upwards spiral of wages and prices – precisely like the one we witnessed in the 1970s.

    Is the Natural Rate of Unemployment Constant?

    It is not a constant rate, but rather it can change as the structure of an economy changes:

    • For example, in the prosperous decade of the 1960s, the natural rate of unemployment was somewhere in the 4 to 5% range.
    • However, in the 1970s the natural rate of unemployment actually climbed into the 5 to 6% range.
    • This increase in the natural rate came about because the supply side shocks of the 1970s, particularly the energy price shocks, raised the real costs of production in the economy. These higher costs in turn, lowered the economy’s potential output, relative to what it would have been.

    An Inflationary Spiral from the Monetarists’ Perspective

    How do the Monetarists stop an inflationary spiral?

    • In the figure, we start at point a1, where the core rate of inflation is 3% and the natural rate of unemployment is 6% as indicated by the vertical curve.
    • Note, however, that from a political perspective, this 6% rate of unemployment is seen as unacceptably high by a congress and Keynesian president.
    • With voters growing restive over an apparent recession, they are going to engage in expansionary fiscal policy to reduce the unemployment rate to 4%.
    • And this is where the idea of adaptive expectations comes back in. In particular, because people are assuming inflation will remain at 3%, they do not immediately demand higher wages, even as inflation rises above the core rate to 6%. This lag in wage demands, allows the economy to move up the short run Phillips Curve to point b1, and the unemployment rate does indeed fall to 4%.
    • Known however, that once people finally figure out that inflation has risen and successfully demand higher wages to offset this rise in inflation, the short-run is over. At this time the rise in nominal wages, brought about by successful wage demands, shifts the short run the Phillips Curve, PC1, out to PC2. And we are back to where we started, at an unemployment rate of 6%. But of course, now, we have a higher inflation rate.
    • This game goes on and the economy is caught in a vicious inflationary spiral.

    To the monetarist, the solution is simple. Stop using expansionary Keynesian policies. And allow the economy to return to the natural or lowest sustainable rate of unemployment. But, of course, you see the problem. Even if we stop the upward spiral of inflation, we still have significant inflation. This is because a higher core rate of inflation has been built into the economy. Specifically, in this case, even if we stop inflation’s upward spiral, we may still find ourselves stuck at point a3 in the figure, with a new and higher inertial rate of inflation of 9%.

    The Traditional Keynesian versus Monetarist Approaches to Wringing Inflation out of the Economy

    Neither the traditional Keynseian or monetarist approaches to wringing this inflation out of the economy has any political appeal. The traditional Keynesian solution is a so-called incomes policy. Impose wage and price controls until the inflation dissipates.

    • One problem with this approach, however, is that it may not work.
    • This is a lesson President Nixon learned when his administration imposed temporary wage and price controls in 1971. And then watched helplessly as inflation jumped right back up into double digits, once the controls were lifted in 1973.
    • The other problem with an incomes policy is that it runs contrary to the ideological beliefs of the majority of Americans who see their country as a bastion of free market capitalism.
    • But simply, businesses don’t want the heavy handed government holding down their prices. And workers don’t want that same government holding down their wages. Accordingly, there are very few advocates of wage and price controls today.

    That leaves the Monetarists’ solution, and from a political point of view, it is equally unpalatable:
    Specifically, Monetarists believe that the only way to wring inflation and inflationary expectations out of the economy is to have the actual inflation rate below the expected inflation rate.
    However to achieve this, the actual unemployment rate must be above the natural rate of unemployment.
    That means only one thing: Inducing a recession.

    • This is at least one interpretation of what the federal reserve did beginning in 1979 under the monitors banner of setting monetary growth target. In 1979 the Fed under chairman Paul Volcker adopted a sharply contractionary monetary policy and interest rates soared to over 20%.
    • The resulting recession was the worst since the great depression. And it probably cost President Jimmy Carter the 1980 election and a second term.
    • Nonetheless, the Fed’s bitter medicine worked. Between 1979 and 1984, inflation fell dramatically. But at great human and economic cost.

    How Supply-side Economics Offers a very Painless Way to Avoid Both the Keynesian Stagflation Dilemma and the Bitter Monetarist Cure for an Inflationary Spiral

    The supply siders believed that the American people would actually work much harder and invest much more if they were allowed to keep more of the fruits of their labor. The end result would be to increase the amount of goods and services our economy could actually produce by pushing out the economy’s supply curve. Hence, supply side economics.
    Supply-side economics offers a very painless way to avoid both the Keynesian stagflation dilemma and the bitter monetarist as indicated by this figure:

    • After a supply shock, inflation rises, while output and employment falls, but use supply side policies to push the aggregate supply curve back out and voilà,
    • the price level falls even as real output and employment is rising.

    The Laffer Curve Illustrated

    The Laffer Curve, named after economist Arthur Laffer, is illustrated in this figure:

    Where the marginal tax rate is measured on the vertical axis and total tax revenues are measured on the horizontal axis. Note that the Laffer Curve is backward bending, reflecting the behavioral notion that at some point, people will work less the more they are taxed. This backward bend means that above a certain tax rate, m in the figure, an increase in the tax rate will actually cause overall tax revenues to fall.
    Note also, for a supply side tax cut to actually increase tax revenues, the existing tax rate before the tax cut must be above m, say, at a rate associated with point n.

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

    The next obvious question is, did this supply side experiment work? The answer is a difficult one, and here’s what we know:

    • The Reagan years witnessed significant declines in both inflation and interest rates, while we enjoyed a record-long peacetime expansion, and the economy roared back to full employment.
    • Unfortunately, however, as the economy boomed, so too did America’s budget deficit. And as the budget deficit soared America’s trade deficit soared with it.
    • These so-called twin deficits deeply concerned Reagan’s successor, George Bush, particularly after the budget deficit jumped to over $200 billion at the midpoint of his term in 1990, and the economy began to slide into recession.
    • In the Bush White House, Ronald Reagan’s supply side advisers had been supplanted by a new breed of macroeconomic thinkers, the so called New Classicals, who had abandoned the old theory of adaptive expectations in favor of a new behavioral model known as rational expectations.
  13. The Editor (Post author)

    “We start 2009 in the midst of a crisis unlike any we have seen in our lifetime… Nearly two million jobs have now been lost… Manufacturing has hit a twenty-eight-year low. Many businesses connot borrow or make payroll. Many families cannot pay their bills or their mortgage. Many workers are watching their life savings disappear. And many, many Americans are both anxious and uncertain of what the future will hold… If nothing is done, this recession could linger for years.”
    (US President Barack Obama, 2009)

    “But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again.”
    (John Maynard Keynes, 1923)

    Keynes was exasperated with the classical view of economists (Adam Smith, David Ricardo, and Jean Baptiste Say) that the economy is an equilibrium system which will eventually return to a point of balance, so long as the government doesn’t interfere and if we are only willing to wait. He challenged that view (1935) arguing that the economy can slip into a long term underemployment equilibrium from which only government policy can rescue it. Keynes claimed that before a price adjustment mechanism had time to work, it would be overpowered by a more deadly “income adjustment mechanism”: When an economy sinks into a recession, peoples’ incomes fall. This causes them to both spend less and save less while businesses respond by investing and producing less. This drives the economy deeper into recession rather than back to full employment.

    The same type of arguing was used in Barack Obama’s rhetoric to justify passage of the largest fiscal stimulus package in US history immediately after he took office in 2009. However, as we know today, Obama’s fiscal policy had a very moderate effect:

    “Real economic activity continued to increase at a moderate pace in the first quarter of 2013, though available indicators suggest that the pace of economic growth was somewhat slower in the second quarter. Federal fiscal policy is imposing a substantial drag on economic growth this year, and subdued growth in foreign economies continues to weigh on export demand.”
    (Monetary Policy Report submitted to the Congress on July 17, 2013, pursuant to section 2B of the Federal Reserve Act)

    This kind of Keynesian fix creates all sorts of problems. At the core of these problems is the need for governments to run ever larger budget deficits to finance their fiscal stimuli. There are two politically acceptable ways (with higher taxes hardly accepted) to finance such deficits: to sell government bonds or print money. The ultimative irony of such bond financing is that as the government tries to stimulate the GDP through increased spending, any stimulative effects may be “crowded out” by a fall in business investment (Navarro, 2009).

  14. The Editor

    The Warring Schools of Macroeconomics

    So far, we have looked closely at both the historical evolution and the distinguishing features of four important schools of macroeconomics: Classical Economics, Keynesianism, Monetarism, and Supply-side Economics. Now, we are first going to take an in-depth look at a fifth school, so-called New Classical Economics and then take an in-depth look at the “warring schools” of macroeconomics.
    New Classical economics is based on the controversial theory of “rational expectations. ” If you form your expectations “rationally, ” you will take into account all available information including the future effects of activist fiscal and monetary policies. The idea behind rational expectations is that such activist policies might be able to fool people for a while. However, after a while, people will learn from their experiences, and then, you can’t fool them at all. The central policy implication of this idea is profound: rational expectations render activist fiscal and monetary policies completely ineffective so they should be abandoned.
    The five major schools of macroeconomics differ on three interrelated questions:

    1. What causes instability in the economy?
    2. Is the economy self-correcting?
    3. Should the government adhere to rules such as setting monetary targets or should it instead use discretionary fiscal and monetary policy?

    These disagreements lie at the heart of many of the macroeconomic policy debates that involve the Federal Reserve, Congress, the White House, and ultimately our own economic welfare.

    The Three Major Questions about which the Major Schools of Macroeconomics Differ

    There are three important questions we have to ask to fully evaluate the warring schools of macroeconomics:
    1) What causes instability in the economy so that it deviates from its full employment output?
    → see sections 8 – 9
    2) Is the economy self-correcting, and if so, what is the speed of the adjustment back to full employment output?
    → see sections 10 – 13
    3) Should the government adhere to a set of hard and fast rules, or rather use discretion in setting fiscal and monetary policy?
    → see sections 14 – 17

    The Leading Economic Indicators

    • Consumer confidence is a leading indicator of future growth.
    • A healthy ISM index with the value above 50, likely means an expanding economy.
    • Forecasters also pay very close attention to inflation indicators like consumer price index (CPI). If this index shows inflation rising, the Federal Reserve might raise the interest rates, and thereby slow down GDP growth.

    The Difference between Rational and Adaptive Expectations

    Adaptive expectations: people tend to assume that inflation will continue to be what it already is.
    Rational expectations: take into account all available information including the future effects of activist fiscal and monetary policies.

    • The idea behind rational expectations is that such activist policies might be able to fool people for a while. However, after a while, people will learn from their experiences, and then you can’t fool them at all.
    • The central policy implication of this idea is profound. Rational expectations render activist fiscal and monetary policies completely ineffective.

    The Central Policy Implication of Rational Expectations Theory

    Fiscal and monetary policies are completely ineffective. So, they should be abandoned:

      ? Suppose the federal reserve undertakes expansionary monetary policy to close a recessionary gap. In a world of rational expectations, businesses will immediately respond to the Fed’s expansion by raising prices. Workers will demand higher wages and the attempted stimulus will be completely offset by the contractionary effects of inflation.
      ? Alternatively, suppose the government undertakes expansionary fiscal policy to stimulate the economy. People with rational expectations will respond by increasing their savings and reducing consumption, and thereby, likewise offset any expansionary effect. They will do this because they know that a larger budget deficit now means higher taxes later.

    The Adjustment Process of the Economy Contrasted by Adaptive versus Rational Expectations

    • In the next figure, the general price level is on the vertical axis. Real output is on the horizontal axis. The vertical line represents the long run aggregate supply curve (LRAS) at the natural rate of unemployment and the economy is in both the short and long run equilibrium at full employment output Y sub 1 and price P sub 1. This is where the short-run aggregate supply and aggregate demand curves cross at point A.
    • Suppose, then, we first assume adaptive expectations, and the government undertakes expansionary policy to increase output above the full employment rate. This expansion shifts the aggregate demand curve out to AD sub 1 and the economy temporarily reaches a new equilibrium output at point B. Here, output is Y sub 2, at a new price level of P sub 2.


    Key point: Expansionary policy leads to a growth spurt under adaptive expectations!

    • Note however, that once businesses and workers realize that inflation is higher, they add these inflationary expectations into their calculations of prices and wages. This shifts the aggregate supply curve inwards to AS1 and the economy falls back to point C. The end result is a short run spurt of growth above full employment output, followed by a return to the natural rate, albeit at a higher price level of P sub 3.
    • Now, what the new classical school says is that rather than travel from point A to point B and back to point C, the economy will enjoy no short run growth spurt at point B. Instead, the economy will move instantaneously from point A to point C. And the only result of the government’s activist policy will be higher inflation.


    Key Point: Expansionary policy leads ONLY to inflation under rational expectations!

    An Economic and Political Critique of New Classical Economics


      ? Most people are not as sophisticated in their economic thinking as the theory requires.
      ? And therefore, adjustments will not take place with anywhere near the speed they’re supposed to.

    However, this criticism should not detract from the central point of rational expectations, namely that people’s behavior may partially, or perhaps, completely counteract goals of activist fiscal monetary policy.

    • Politically however, as George Bush painfully learned, relying on new classical economic thinking can be hazardous to one’s health.
    • Bill Clinton actually did very little to stimulate the economy. The mere fact, however, that Clinton promised a more activist approach helped restore business and consumer confidence. At the same time, congressional passage of Clinton’s deficit reduction legislation in 1993, sent Wall Street a clear signal that his administration was serious about budget balance.
    • Together, these factors helped accelerate a recovery that had already begun by the end of Bush’s term and set the stage for Clinton’s remarkably easy reelection in 1996.

    The Loss of Jobs due to Slow Growth during the Stagnant 2000s

    • The rule of thumb is that one percentage point of GDP growth lost = one million new jobs not created (in the US).
    • So a difference of 3.5% growth versus 1.6% growth in the 2000s is about two GDP points a year, or two million jobs lost per year.

    So over a decade, that’s about 20 million jobs not created because of slow growth below potential output.
    Not coincidentally, that was about the same amount America needed to bring its unemployment rate back down to its natural rate.

    • It wasn’t just slow GDP growth plaguing the economy. Wage growth would fall dramatically as well. In fact, average median household income – the best measure of income growth – plunged to roughly zero during the 2000s, after growing close to 2% a year in the previous two decades.
    • Of course, the worst part of the 2000s was the great recession of 2007. This was the steepest economic downturn since the Great Depression. It was an era characterized by massive bailouts, not just to private corporations like General Motors and AIG, but also public corporations like housing agencies Fannie Mae and Freddie Mac.
    • In the slow growth years following the great recession, the outgoing Bush administration and the new Obama administration would team up to execute the largest fiscal stimulus in world history. At the same time, central bankers from Washington and Ban to Tokyo and Seoul would print vast sums of money in their Keynesian struggle to restart their respective economies.
    • The US Federal Reserve alone added trillions in liabilities to its balance sheet while printing money. Moreover, in an effort to stimulate the US economy in an era of nearly zero short-term interest rates, Fed Chairman Ben Bernanke would inaugurate a new Keynesian monetary policy tool known as quantitative easing (QE). QE involves the massive purchase of long-term government bonds by the Fed to drive up bond prices and thereby drive down yields and interest rates.


    As bond prices rise, the bond yields fall!
    • Of course the Fed’s goal in lowering long-term interest rates was to stimulate both domestic investment and US exports. Domestic investment benefits from low, fixed long-term rates because most investment requires longer term financing. At the same time, lower long-term interest rates, and a flood of easy money, would help depress the value of the U.S. dollar, giving U.S. exports a boost. Despite all these Keynesian fiscal and monetary policy stimuli, unemployment in both the US and Europe would soar to double digits.


    Key Point: Many economists failed to understand the underlying structural nature of the slow GDP and wage growth problems in the 2000s.



      ? During this time the economies of Europe, India, Brazil, and many others run large growth-sapping trade deficits with China.
      ? A structural emergence of a growth-sapping global trade imbalance


      ? By the year 2012, these deficits would help slow growth dramatically in both Europe and the US. And China’s two biggest customers would thereby, be too weak to sustain China’s export dependent growth.
      ? In a ripple effect, slow growth in China, in turn, would lead to slower growth in so called commodity countries → Australia, Brazil and Canada, whose economies depend heavily on the sale of natural resources like coal, iron ore and soybeans to China.
      ? Most broadly, these structural trade relationships would lead to a new type of butterfly effect the world had not yet seen:


      ? Weak demand for Chinese exports from Europe and the U.S., in turn leads to weak import demand from China for commodities and other natural resources.
      ? In this way, chronic trade imbalances between China and other countries around the world would, make it very difficult for a robust, global economic recovery. From this butterfly effect, a short-run Keynesian approach did nothing to address the underlying, chronic, long-term structural trade imbalances, acting as a drag on both the U.S. and European economies – and by extension, much of the rest of the world.


    The Keynesian View of what Causes Macroeconomic Instability

    It holds that instability in the economy arises from two sources:

    1. The most common problem is significant changes in investment spending. And to a lesser extent consumption spending – both of which change aggregate demand.
    2. The more occasional problem is adverse supply side shocks which change aggregate supply.

    The Classical-Monetarist View of what Causes Macroeconomic Instability

    • Monetarists hold that it is inappropriate government policies that are the major cause of macroeconomic instability. In fact, modern monetarism is a classically based perspective.
    • This is because, like classical economics, monetarism argues that the price and wage flexibility provided by competitive markets cause fluctuations in aggregate demand to alter product and resource prices, rather than output and employment.
    • The problem, as Monetarists see it, is that wages can’t adjust freely downward because of government policies, ranging from minimum wage and pro-union legislation, to guaranteeing prices for farm products, pro-business monopoly protections, and so on.
    • Even more importantly, the Monetarists also blame instability to the government’s clumsy and often misguided attempts to achieve greater stability to activists monetary policies. This problem of a misguided government is rooted in the Monetarists view of the economy through the lens of the Equation of Exchange and quantity theory of money:


    MV = PQ
      ? If the velocity of money V is stable, and real output Q is independent of price level P, changes in the money supply M can only lead to changes in inflation.
      ? Of course it is a matter of some debate as to whether the velocity of money is stable. And in fact Keynesians take the view that velocity is actually unstable.


    The New Classical View of a Self-correcting Economy

    • From the perspective of supply side economics, supply siders agree with the Keynesians that macroeconomic instability can result from supply side shocks.
    • However, supply siders at least partly share the classical and monetarist view that it is often the government that is to blame for causing the shocks.
    • Of particular concern to the supply siders are high tax rates and regulations that reduce supply incentives.

    The Keynesian-based Mainstream View of a Self-correcting Economy

    In this debate, it not just a question of whether an economy corrects itself when instability does occur, economists also disagree as to the length of time it will (or should) take for any such self correction to happen.

    The Monetarist versus New Classical Views on the Speed of Adjustment of the Economy

    Both take the view that when the economy occasionally diverges from its full employment output, internal mechanisms within the economy automatically move it back to that output. This perspective is associated with the theories of adaptive and rational expectations.

    • An unanticipated increase in aggregate demand from AD1 to AD2 moves the economy from point A to point B. This causes the price level to rise from P1 to P2, as real output increases from Q1 to Q2.

    In a new classical world, the following would happen in order to bring the economy back to Q1:

    • In the long run, nominal wages will rise to restore the real wages that have been eroded by inflation.
    • This causes per unit production cost to rise, and eventually the short run aggregate supply curve shifts leftward and inward, from AS1 to AS2.
    • As the economy moves from point b to point c, the price level rises from P2 to P3, and the economy returns to the full employment level of Q1.


    Key Point: Activism is warranted only if the economy is not self-correcting or may be very slow to correct.

    The Speed of Adjustment Issue

    There is much controversy within the various schools of macroeconomics:

    • For example, classically orientated monetarists usually hold the adaptive expectations view that people form their expectations on present realities, and only gradually change their expectations as experience unfolds. This implies that the shifts in the short run aggregate supply curves that we have just illustrated, may not occur for two or three years or even longer.
    • On the other hand, the new classical economists accept the rational expectations assumption that workers anticipate some future outcomes before they even occur. This suggests that when price level changes are fully anticipated, the adjustments in our figures occur very quickly, indeed even instantaneously.


    Key Point: With rational expectations, shifts of AS and AD curves and corrections are very fast or instantaneous.

    So what do the Keynesians think about all this?

    • Well, almost all economists today acknowledge that new classical economics has taught us some important lessons about the theory of aggregate supply.
    • None the less, most mainstream economists strongly disagree with new classical rational expectations theory on the question of downward price and wage flexibility.
    • In this regard, while the stock market, foreign exchange market and certain commodity markets experience day-to-day changes, including price declines, this is not true in many product markets and in most labor markets. Indeed, there appears to be ample evidence, say mainstream economists, that many prices and wages are inflexible downward for long periods. Implication: In the Keynesian view, it may take years for an economy to move from recession back to full employment output, unless it gets help from fiscal and monetary policy.


    The Monetarists’ Rationale for a Monetary Rule

    How the Monetarists frame the debate: should the government adhere to policy rule that prohibit it from causing instability in an economy that would otherwise be stable?
    The purpose of such rules is to prevent government from trying to “manage” aggregate demand. In this view, such management is misguided and thus likely to cause more instability than it cures.
    For the monetarist, the enactment of a monetary rule makes the most sense. This is because monetarists believe inappropriate monetary policy is the major source of macroeconomic instability.
    Such a rule would direct the federal reserve to expand the money supply each year at the same annual rate as the typical growth of the economy’s production capacity. The Fed’s sole monetary rule would then be to use tools – such as open market operations, changes in the reserve requirement, and discount rate changes to ensure that the nation’s money supply grows steadily by say 3 to 5% a year.
    Or into the father of monetarism, Milton Friedman, “such a rule […] would eliminate […] the major cause of instability in the economy – the capricious and unpredictable impact of countercyclical monetary policy.”

    Why New Classical Rational Expectations Economists also Support a Monetary Rule

    The next figure helps illustrate the rationale for a monetary rule: here we assume that the economy is operating at a full employment real output of Q 1.
    We also assume that the nation’s long run aggregate supply curve shifts rightward each year, as from AS LR1, to AS LR2. This shift depicts the average annual potential increase in real output.

      ? Now the monetarist monetary rule would tie increases in the money supply to the typical rightward shift of long run aggregate supply.
      ? In view of the direct link between changes in the money supply and aggregate demand, this would ensure that the AD curve shifts rightward as from AD1 to AD2 each year.
      ? As a result, real GDP would rise from Q1 to Q2 and the price level would remain constant at P1.

    In this view, a monetary rule would promote steady growth of real output along with price stability. Generally New Classical rational expectations economists also support a monetary rule. They conclude that an easy or tight money policy will alter the rate of inflation but not real output.
    For example, suppose the Federal Reserve implements an easy money policy to reduce interest rates, expand investment spending and boost real GDP:

    • On the basis of past experience and economic knowledge, the public will anticipate that this policy is inflationary and take self-protective action. Workers will press for higher wages, firms will increase product prices, and lenders will raise their nominal interest rates.
    • While these responses are designed to prevent inflation from having adverse effects on real income of workers, businesses, and lenders, the collective impact is to immediate raise wage and price levels.
    • This offsets the increase in aggregate demand brought about by easy money so real output and employment do not expand, but wages and prices do.

    A second rule that is often debated is that of a balanced budget rule. In this regard, Monetarists and New Classical economists question the effectiveness of fiscal policy.

    • At at the extreme, a few of these economists favor a constitutional amendment to require the Federal government to annually balance its budget.
    • Still others simply suggest that the government be passive in its fiscal policy, meaning that it should not intentionally create budget deficits or surpluses.
    • This is because in this view, deficits and surpluses caused by recession or inflationary expansion will eventually correct themselves as the economy self-corrects to its full-employment output.

    The Keynesian Defense of Discretionary Monetary Policy

    From the Keynesian view, should the government use discretionary fiscal and monetary policy when needed to stabilize a sometimes unstable economy?
    In supporting discretionary monetary policy, Keynesian based economists argue that the rationale for a monetary rule is flawed. While there is indeed a close relationship between the money supply and nominal GDP over long periods, in shorter periods this relationship breaks down.
    This argument goes back to our earlier argument about the stability of the velocity of money alleged by the monetarists. Arguing that velocity is variable, both cyclically and over time, the Keynesian based economists contend that a constant annual rate of increase in the money supply need not eliminate fluctuations in aggregate demand.

    Key Point: In terms of the equation of exchange,
    MV = PQ
    a steady rise in M does not guarantee a steady expansion of aggregate demand, because the velocity V can change.

    The Keynesian Defense of Discretionary Fiscal Policy

    As for the use of discretionary fiscal policy, the major area of debate revolves around one of the most important concepts in macroeconomics, the so-called “crowding out” of private sector investment by expansionary fiscal policy.

    “Crowding Out” Explained

    Key Concept: Crowding out is the offsetting effect on private expenditures caused by the government’s sale of bonds to finance expansionary fiscal policy:

    • When the Federal government borrows money to finance a budget deficit, the U.S. treasury sells bonds or treasury bills directly to the private capital markets and uses the proceeds of the sales to finance the deficit.
    • Note that in this case, the Federal Reserve is out of the loop. Note also that the U.S. Treasury is competing directly in the capital markets with private corporations, which may also be seeking to sell bonds and stocks in order to raise capital to invest in new plant and equipment.
    • In order to compete for these scarce investment dollars, the treasury typically must raise the interest rate it is offering in order to attract enough funds.
    • Running a deficit is largely a zero sum game. The money used to finance the deficit is money that would otherwise have been borrowed and spent by corporations and businesses on private investment. In this case, deficit spending by the government is said to “crowd out” private investment.


    → Deficits lead to higher interest rates!

    The Keynesian versus Monetarist Views on the Size of the Crowding Out Effect and their Policy Implications

    Monetarists believe that substantial crowding out is associated with discretionary expansionary fiscal policy. And therefore conclude it shouldn’t be used because it is ineffective.

    Key Point: Monetarists conclude fiscal policy shouldn’t be used because increases in G are largely offset by declines in I.

    On the other hand, while Keynesian based economist recognized the possibility of crowding out, they do not think it is a major problem when business borrowing is depressed, as is usually the case in a recession. Therefore, activist expansionary fiscal policy is appropriate.

    Why Keynesian-based Economists Oppose a Balanced Budget Rule

    Keynesian based mainstream economists argue the tax revenues fall sharply during recessions, and rise briskly during periods of demand-pull inflation. Therefore, a law or constitutional amendment mandating an annually balanced budget would require the government to increase tax rates and reduce government spending during recession, and reduce tax rates and increase government spending during economic booms. Clearly, the first set of actions would worsen recession, while the second set would fuel inflation.

    The Supply-side View of Rules versus Discretion

    From the supply side view, should the government pursue discretionary policies to increase aggregate supply as a way of increasing output and reducing inflationary pressures?
    Supply siders argue that marginal tax rates and government regulations, must be reduced in order to get more output, without added inflation. Thus, supply siders favor discretionary policy actions much like Keynesians do.
    However, very often, the focus of such actions is classically oriented, in that the actions advocated seek to reduce or undo the negative effects of earlier government regulations or tax policies.

    Where the Warring Schools of Macroeconomics Converge

    • Most Keynesian based economists now agree with the monetarists that, money matters. And that excessive growth of the money supply is the major cause of long-lasting rapid inflation.
    • Keynesian based economists also agree with the rational expectations proponents, that expectations are, indeed, important. In this regard, if government can create expectations of price stability, full employment, and economic growth, households and firms will tend to act in ways to make that happen.
    • Finally, Keynesians concur with the supply siders that government needs to focus on policies to increase economic growth.

    Bottom line is that thanks to ongoing challenges to the conventional macroeconomics wisdom, macroeconomics continues to be an evolving policy science.

  15. The Editor (Post author)

    Du Contrat Social

    Of The Social Contract, Or Principles of Political Right (Du contrat social ou principes du droit politique) is the book in which Rousseau (1762) theorised about the way in which to set up a political community in the face of the problems of commercial society, which he had already identified in his Discourse on Inequality (1754). In his Reflections on the Revolution in France, Edmund Burke (1790) wrote that the real social contract is not the one between the sovereign and the people, as identified by Rousseau, but the partnership between the generations:

    “One of the first and most leading principles on which the commonwealth and the laws are consecrated is, lest the temporary possessors and life-renters in it, unmindful of what they have received from their ancestors or of what is due to their posterity, should act as if they were the entire masters, that they should not think it among their rights to cut off the entail or commit waste on the inheritance by destroying at their pleasure the whole original fabric of their society, hazarding to leave to those who come after them a ruin instead of an habitation – and teaching there successors as little to respect their contrivances as they had themselves respected the institutions of their forefathers […]. Society is indeed a contract […] the state is […] a partnership not only between those who are living, but between those who are living, those who are dead, and those who are to be born.”

    Niall Ferguson (2012) argues that today’s excessive public debts are a symptom of the breakdown of the social contract between the generations. He sees the enormous inter-generational transfers implied by current fiscal policies as a unparalleled breach of precisely that partnership (pp. 39 – 45). I would like to highlight that this contract has not been broken by the younger generation, but the older. It is the current voters supporting policies of inter-generational inequity, especially when the older voters are so much likely to vote than the younger voters.

    Ferguson (pp. 46 – 48) draws three potential consequences or scenarios from the current state:

    1. Best option: to improve the public sector balance sheets so the assets can be compared with liabilities and the adaption of accounting principles.
    2. Bad case: Zero growth over decades. Central bank bond purchases and low interest rates.
    3. Worst case: Western democracies carry on their feckless practices until they follow Greece and other Mediterranean economies: A combination of default and inflation.

    I can think of two more scenarios. It is always useful to test a theory by going to extremes:

    1. Revolution: The younger generation responds to the broken social contract.
    2. War: Once everything has been razed to the ground, the trend can only point upwards.
  16. The Editor

    Economic Growth and Productivity

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


    Key Definition: Living standards, as measured by output per capita or consumption per household, are primarily determined by the level of productivity and growth of a country.

    Economic Growth

    1. Economic growth represents the expansion of a country’s potential GDP or national output.
    2. The growth rate of output per person determines the rate at which the country’s standard of living is rising.

    The Four Supply Factors of Growth

    The engine of economic progress must ride on the same four wheels (supply side factors), no matter how rich or poor the country:

    • Human resources (including labor supply, education, discipline and motivation)

      Labor inputs include, of course the quantity of workers. However, many economists believe that the quality of labor inputs, the skills, knowledge, and discipline of the labor force, is the single most important element in economic growth. capital goods can be effectively used and maintained only by skilled and trained workers.

      Key Point: Improvements in literacy, health, and discipline, and most recently, the ability to use computers, add greatly to the productivity of labor.

    • Natural resources (including land, minerals, fuels and environmental quality)

      The important resources here are, arable land, oil and gas, forests, water, and mineral resources.
      But the possession of natural resources is hardly necessary for economic success in the modern world. New York City prospers primarily on its high density service industries. While many countries that have virtually no natural resources, such as Japan, have thrived by concentrating on sectors that depend more on labor and capital than on indigenous resources.

    • Capital formation (including machines, factories and roads)

      Tangible capital includes structures like roads, and power plants, and equipment, like trucks and computers. In this regard, some of the most dramatic stories in economic history, often involve the rapid accumulation of capital.
      Note, however, that accumulating capital requires a sacrifice of current consumption over many years. Countries that grow rapidly, tend to invest heavily in new capital goods. In the most rapidly growing countries, 10 to 20% of output may go into capital formation. In this regard when we think of capital we must not concentrate only on private sector investment. In fact, many investments are undertaken only be governments, and provide the necessary social overhead capital and infrastructure for businesses to prosper. Roads, irrigation and water projects, and public health measures are important.

      Key Point: Government projects involve external benefits that private firms cannot capture so government is necessary to provide them.

    • Technology (from science and engineering to management and entrepreneurship)

      Historically, growth has definitely not been a process of simple replication, adding rows of steel mills, or power plants next to each other. Rather, a never-ending stream of inventions and technological advances led to a vast improvement in the production possibilities of Europe, North America, and Japan. Technological change denotes changes in production processes or the introduction of new products or services.

      Key Point: Technological change is a continuous process of small and large improvements.

    Two other Factors Important in Economic Growth

    While the four supply factors of growth relate to the physical ability of the economy to expand, there are two other factors that are equally important:

    • First, there is the demand factor. To realize its growing production otential, a nation must fully employ its expanding supply of resources. This requires a growing level of aggregate demand.
    • Second, there is the efficiency factor. To reach its production potential, a nation must not only achieve full employment, but also two kinds of economic efficiency. Specifically, a country must achieve productive efficiency. That is, it must use its existing and new resources in the least costly way to produce what it does. And it must also achieve allocative efficiency, meaning that the specific mix of goods and services it produces must maximize society’s well-being.

    We can illustrate how the six factors of economic growth interact using the following production possibilities curve.
    Here we see that a country starts at point A. Then growth is made possible by the four supply factors which shift the production possibilities curve outward as from A-B to C-D.

    But economic growth is realized only when the demand and efficiency factors move the economy from point a to point b.
    One of the most famous studies ever conducted in economics was the study done by Edward Denisen. He found that the most important factor accounting for a full 28% of increased productivity, has been technological advance – just as our growth theory suggested.
    And by the way, you should note that the eighth category is a negative number. It estimates the negative impact that legal and regulatory constraints have had on productivity and growth.

    The Factors of Economic Growth and their Relative Importance

    • While some economists and policy makers stress the need to increase capital investment,
    • others advocate measures to stimulate research and development and technological change.
    • Still a third group emphasizes the role of a better educated work force.

    PPF Analysis Contrasting Adam Smith’s Golden Age of Growth versus Thomas Malthus’ Doomsday

    Early economists like Adam Smith and Thomas Malthus stressed the critical role of land in economic growth. Because land is freely available, people simply spread out onto more acres as the population increases, just as the settlers did in the American west. Because there is no capital, national output exactly doubles as population doubles. Wages earn the entire national income, because there is no subtraction for land rent or interest on capital.
    Eventually, as population growth continues, all the land will be occupied. New laborers begin to crowd onto already worked soils. Land becomes scarce and rents rise to ration it among different uses. opulation still grows and so does the national product, but output must grow more slowly than does population because of an immutable law known in economics as the law of diminishing returns.

    Malthus believed that the working classes would be destined to a life that, in the words of the philosopher Thomas Hobbes, would be nasty, brutish, and short. In fact it was this gloomy Malthusian picture that lead to the critical depiction of economics as the dismal science.
    Malthus did not recognize that technological innovation and capital investment could overcome the law of diminishing returns. As a result, land did not become the limiting factor in production. Instead the industrial revolution brought forth power driven machinery that increased production.
    Moreover, as market economies entered the 20th century, important new industries grew up while capital accumulation and new technologies became the dominant force effecting economic development.

    The Basic Underlying Principle of the Neoclassical Growth Model

    This approach was pioneered by professor Robert Solow of MIT:

    • Major model components in this neoclassical growth model: Capital and technological change.
    • Primary tool: Aggregate Production Function (APF), which relates technology and inputs, like capital and labor, to total potential GDP.
    • Key concept: Capital deepening – the process of increasing the amount of capital per worker, e.g. more farm machinery and irrigation systems in farming, more railroads and highways in transportation, and more computers and communication systems in banking. In each of these industries societies have invested heavily in capital goods. And as a result, the output per worker has grown enormously.

    Capital Deepening and Increase in Output

    The first major insight of the model is that in the absence of technological change, capital deepening does not lead to a proportional increase in output:

    ? The law of diminishing returns: the basic idea is that as you add more and more capital to a fixed supply of labor, eventually the marginal product of capital must fall as the law of diminishing returns kicks in.

    The second major insight of the neoclassical growth model is that while capital deepening can dramatically increase the productive output of an economy, it will eventually lead to economic stagnation in the absence of technological change.

    Worker Wages and the Return on Capital as a Result of Capital Deepening

      ? For workers the news is good. The wage rate paid to workers will tend to rise as capital deepening takes place because each worker has more capital to work with and his or her marginal product therefore rises. As a result the competitive wage rate rises along with the marginal product of labor…
      ? However, for the owners of capital, the news is less satisfying. As capital deepens, diminishing returns to capital set in. So, the rate of return on capital and the real interest rate fall. What this means is that in the long run, the economy will enter a so-called steady state in which capital deepening ceases as the capital labor ratio stops rising. This is because even as capital deepening is driving real wages up, the returns to capital are falling, so that at some point, further investments in capital deepening become unprofitable.

    Capital Deepening in the Absence of Technological Change

      ? At this point, the economy enters a steady state in which, without technological change, both capital incomes and wages end up stagnating.
      ? In the long run, equilibrium of the neoclassical growth model makes it clear that if economic growth consists only of accumulating capital through replicating factories with existing methods of production, then people’s standard of living will eventually stop rising. And that’s why we must come to understand the importance of technological change in averting this fate, as modern economies in this century have so obviously done.

    Technological Change

    This leads to the third major insight of the neoclassical growth model. It is ultimately only through technological change that we can avoid the trap of economic stagnation.
      ? Technological change represents both advances in production processes, and the introduction of new and improved goods and services. It also includes new managerial techniques, as well as new forms of business organization.

    The Differing Roles that Capital Deepening and Technological Change play in Economic Growth


    Key Point: With technological change, both wages and returns to capital rise along with the standard of living!

    Factors of Growth most Instrumental in Increasing Labor Productivity

    Gas and diesel engines, conveyor belts, and assembly lines were significant developments of the more distant past. While more recently we have bigger, faster and more fuel efficient aircraft, integrated microcircuits, computers, xerography, containerized shipping, and the Internet, not to mention biotechnology, lasers, and superconductivity.

    The Relationship between Productivity and Wages – the Capital/Labor Ratio

    • First, we know that productivity increases as the ratio of capital to labor increases.
    • And to boost the capital labor ratio we must accelerate the rate of investment in new plant and equipment, for example through tax code incentives.
    • The second way to increase productivity is to improve the quality of our human capital, that is, our labor force and its managers. In this category, policy options range from tuition tax credits and expanded student loans to job retraining programs and a focus on lifetime learning.
    • A third way to increase productivity is to accelerate the rate of technological change, because such change allows us to produce more goods and services from a given amount of resources.
    • In this regard, an increase in the rate of investment in new plant and equipment works hand in hand with increased R&D. Together, they speed the diffusion of new technology and accelerates the rate of productivity gains.
    • The fourth way to increase the rate of productivity growth is to raise the level of investment in public infrastructure. Just as new plant and equipment help workers produce more, so too does modern infrastructure help businesses produce more. This means that in the quest to balance its budget, the US must be careful not to ignore appropriate investments in basic infrastructure.
    • Many of the factors that determine productivity growth will be enhanced by in increase in the domestic savings rate. This is because increased saving ultimately helps provide the funds necessary to invest in new plant and equipment, human capital, R&D, and public infrastructure.

    Is more Growth always Good?

    Increased economic growth increases our wages and our standard of living. But, there are some major disadvantages of rapid growth that have been noted by many economists:

    • Indeed critics of growth say it results in dirtier air, a dying ocean, global warming, ozone depletion and other environmental problems.
    • Such critics also point out that while growth may permit us to make a better living it does not guarantee us the good life in this sense: “It seems that man is more concerned with having than with being”.
    • Growth often means worker burnout and alienation – and accompanying health problems not just for assembly line workers, but in the high stress managerial ranks as well.

    But one important distinction to make in talking about the merits of growth is between economic growth and population growth:

    Economic growth /= Popular growth

    In this regard, congested neighborhoods, crowded cities, and gridlocked freeways are often the consequence of too many people, not too many goods and services. However, the two are interrelated.

    How the Government uses Public Policy to Stimulate Growth

    From the demand-side of the equation, low growth is often the consequence of inadequate aggregate demand and the result in recessionary gap. And both fiscal and monetary policies can be used to address this problem:

    • Monetary policy, which provides low real interest rates, helps promote high levels of investment spending.
    • While a fiscal policy, which eliminates budget deficits, can reinforce this “easy money” policy.

    Economists more often think about the supply-side of the equation, because policies which can successfully shift the economy’s supply curve out, do so with the twin advantages of both lower unemployment and lower inflation:

  17. The Editor (Post author)

    Quis Custodiet Ipsos Custodies?

    As mentioned in another comment, national systems of accounting differ profoundly from each other in many respects. The British system of accounting regulation has been driven by capital market requirements, and the need for transparent financial reporting. In continental Europe capital markets have traditionally been of lesser importance, and a principal driver for accounting regulation has been the tax system. International standards are based upon what is referred to as the “Anglo-Saxon model” of accounting and there is no cultural barrier to their adoption in the US, UK, Ireland, Australia, New Zealand. A well funded body like the IASB, staffed by very able technical experts, will naturally continue to produce standards, and they are likely to become technically more complex like the “rules-based” nature of US accounting standards.

    Baxter (1981) identifies a similarity between accounting standards and the rules of the medieval gilds. He notes that there were 311 laws on the wool trade alone, many of these minute in detail. The rules ultimately failed to achieve the desired outcome:

    “The long-run results of these controls were disappointing. Authority did not ‘succeed in destroying the evil which it lamented’. The multitude of rules tended to confuse business and thus defeat their own purpose. Enforcement proved hard: and, where it was effective, it hindered progress and mobility […] Thus, history does not offer us much comfort.”

    Even Sir David Tweedie (2002), Chairman of the IASB, is taking the view that a US style rule-book mentality is harmful:

    “In my view, the US approach is a product of the environment in which US standards are set. Simply put, US accounting standards are detailed and specific because the FASB’s constituents have asked for detailed and specific standards […] The IASB has concluded that a body of detailed guidance […] encourages a rule-book mentality of ‘where does it say I can’t do this?’ We take the view that this is counter-productive and helps those who are intent on finding ways around standards more than it helps those seeking to apply standards in a way that gives useful information”

    The argument was heard at the time of the Enron collapse that it resulted in part from the highly complex “rules-based” nature of US accounting standards. Niall Ferguson (2012) argues that regulation should be designed to heighten anti-fragility. But the regulation we are considering today does the opposite because of its very complexity – and often contradictory objectives – it is pro-fragile. In other words: Among the most deadly enemies of the rule of law is bad law.

    One of the most famous studies ever conducted in economics was the study done by Edward Denisen (1985). He found that the most important factor accounting for a full 28% of increased productivity has been technological advance, but that legal and regulatory constraints have had a negative impact of -9% on productivity and growth.

  18. The Editor

    Budget Deficits and the Public Debt

    Historically, Classical economists have argued that such budget deficits are bad and should be avoided except in wartime. In contrast, Keynesians believe that, at least during recessions, budget deficits are a necessary byproduct of an expansionary fiscal policy. Nonetheless, both Classical and Keynesian economists agree that chronic budget deficits are undesirable. This dark side of using discretionary fiscal policy can occur when the government uses the fiscal policy level to boost aggregate demand. The important policy question is this: How big a danger are these chronic deficits and a collateral soaring national debt?

    The Formula for a Budget Deficit

    The Difference between Government Debt and a Budget Deficit or Surplus

    • When the government incurs a budget deficit, it must borrow from the public to pay its bills.
    • In this case, it issues bonds, and the government debt, or the national or public debt, as it is also called, is simply the total dollar value of the bonds owned by the public.
    • Debt calculated: This debt is simply the accumulated budget deficits minus the accumulated surpluses.
    • This debt is held not only by banks, households, and businesses in the US, but also by foreign investors.


    Key Point: Whatever the merits of Keynesian economics, the practice of using discretionary fiscal policy has produced precious few budget surpluses since the 1930s. This has been especially true since the 1970s.

    Why Economists like to Compare the Debt to the Size of the Nations’ GDP

    Comparing the debt to the GDP gives a measure of a nation’s ability to produce and therefore its ability to pay off its debt.

    The Difference between the Real and Nominal Budget Deficit

    This distinction is important because it allows us to measure how inflation in any given year reduces the effective burden of the debt:

    • The real deficit in any given year is the actual or nominal deficit adjusted for inflation’s effect on the debt.
    • In particular, the real deficit equals the nominal deficit minus the inflation rate times the total debt:


    Real Deficit = Nominal Deficit – (Inflation * Total Debt) → compared to GDP

    Calculating the Real Deficit

    Suppose the nominal deficit is $100 billion, inflation is 10 percent, and total debt is $5 trillion. What is the real deficit?
    From the formula above: Real Deficit = $100 billion – (10% * $5 trillion) = -$400 billion

    ? Even though there is a nominal deficit, inflation has eroded the actual burden of the total debt!!

    • This suggests that one way the government can lower the burden of the national debt is by increasing the inflation rate.
    • Perhaps needless to say, this is a controversial strategy to reduce the debt. Such a strategy can only work if the inflation is unanticipated. Otherwise bond holders will demand a higher interest rate to compensate for the anticipated inflation and thereby drive up the nominal deficit through higher interest payments.

    The Difference between the Structural and the Cyclical or Passive Deficit

    The structural deficit is that part of the actual budget deficit that would exist even if the economy were at full employment.

    • It is due to the existing structure of tax and spending programs.
    • Accordingly, the structural part of the budget is thought of as active. It is determined by discretionary fiscal policies, such as those covering tax rates, public works projects, and education and defense spending.

    In contrast, the cyclical or passive deficit is that part of the actual budget deficit attributable to a recessionary economy.

    • It results, at least partly, from the government’s “automatic stabilizers” – increased income transfers that kick in during a recession for unemployment compensation, food stamps, and other welfare benefits.
    • The cyclical deficit results primarily from the shortfall of tax revenues that arises when the economy’s resources are underutilized (downward portions of the business cycle).

    Definition of Automatic Stabilizers

    Income transfers are payments to the individuals by the government for which no current goods or services are exchanged.

    • They include payments for entitlement programs like Social Security, welfare, and unemployment benefits.

    At least some of these income transfers, particularly, welfare and unemployment, are part of the government’s automatic stabilizer system.

    • Automatic stabilizers are defined as federal revenues or expenditures that automatically respond to changes in the GDP in a counter-cyclical way.



    Structural vs.Cyclical Deficit Calculated

    Suppose the gross domestic product is $10 trillion, the budget deficit is $100 billion, and the unemployment rate is 7%, or 1% above the assumed full employment rate. Suppose further that the marginal tax rate is 30%. Which portion of the $100 billion deficit is structural and which portion is cyclical?

    Marginal tax rate = 30% meaning that for every additional dollar the GDP grows, the government will collect 30 additional cents in taxes.
    We need Okun’s law to calculate this:

    • When GDP falls, unemployment rises!
    • For every 2% GDP falls, unemployment rises by 1% (or vice versa:)
    • A 1% fall in the unemployment rate leads to a 2% increase in GDP

    Full employment rate of 6% = structural
    Rate above that of 1% = cyclical

      ? Real GDP must increase by 2%, i.e 2% * $10 trillion = $200 billion
      ? Additional tax would therefore generate $60 billion in new tax revenues
      ? $100 billion deficit – $60 billion = $40 billion = structural part, because that’s the part that would remain at full employment.

    Why is the difference between the structural versus the cyclical deficit so important?

    Identifies long-term structural changes in the budget caused by discretionary policies versus short run cyclical changes caused by the business cycle.

    Policy guidelines:

    • Keynesian stimulus can be used to decrease a cyclical budget deficit by returning the economy to full employment.
    • Keynesian stimulus in the presence of a structural budget deficit will only increase that deficit.

    Estimating the Natural Rate of Unemployment Correctly

    Key Point: Calculation of the structural deficit is clearly determined by what economists assume the full employment, natural rate of unemployment to be. In particular, the structural deficit will be lower if we assume the economy can sustain a 4% rate of unemployment without increasing inflation – as opposed to, say, a 6% rate.

    The Three Main Ways of Financing a Budget Deficit

    1. Raise taxes
    2. Raising taxes is politically unpopular, and favorable politics of raising taxes typically means that the government has to resort to one of two other means to finance the deficit.

    3. Borrow money
    4. With the borrow money option, the U.S. Treasury sells IOUs in the form of bonds or treasury bills directly to the private capital markets and uses the proceeds of the sales to finance the deficit.
      Note that in this case the Federal Reserve is out of the loop. Note also that the US Treasury is competing directly in the capital markets with private corporations. In order to compete for these scarce investment dollars, the Treasury typically must raise the interest rate it is offering in order to attract enough funds → crowding out.

    5. Print money
    6. With this option, the Federal Reserve is said to accommodate the Treasury’s expansionary fiscal policy. In particular, the Fed simply buys the Treasury’s securities itself rather than letting the securities be sold in the open capital markets.
      In order to pay for these deficit financing treasury securities, the Federal Reserve simply prints new money. The problem with this option, of course, is that the increase in the money supply can cause inflation. An undesirable result in itself. Moreover, if such inflation drives interest rates up and private investment down, as it likely does, the end result of the print money option may be a crowding out effect as well.

    Why the Balanced Budget Multiplier has a Value of One

    The Balanced Budget Multiplier: When you simultaneously increase government expenditures and increase taxes by the same amount, you get an economic expansion exactly equal to the increase in government expenditures.

    • While the balance budget multiplier approach to financing a deficit may sound like a great way to conduct expansionary fiscal policy without increasing the budget deficit, this macroeconomic technique is rarely used.
    • The reason is that raising taxes is politically unpopular, and favorable politics of raising taxes typically means that the government has to resort to one of two other means to finance the deficit: borrowing money or printing money. Both of which create their own problems.

    Crowding Out Illustrated by the Keynesian Model

    • This is on the basis of this kind of analysis that critics of discretionary Keynesian fiscal policy have argued that it is a very weak policy tool.
    • In fact, monetarists tend to take the view that crowding out is almost complete so that fiscal policy is completely ineffective.
    • Keynesians, on the other hand, typically argue that crowding out is minimal. At least in theory, it’s possible to avoid crowding out all together with the print money option.

    The Primary Problem with the “Print Money” Option of Financing the Deficit

    But if the economy starts at C in a recession and moves to B, crowding out need not occur. The broader point here is that crowding out applies only to structural deficits. If the cyclical deficit rises because of a recession, the logic of crowding out simple does not apply.

    • A recession causes the decline in the demand for money and leads to lower interest rates.
    • This point is important because it underscores the observation that there is no automatic link between deficits and investment.

    Major Arguments – Pro and Con – in the Budget Deficit Debate

    Deficit hawks review deficits and a rising government debt as a serious threat and the deficit doves would take the position that such deficits and debt are relatively harmless.

    • Unfortunately a trade deficit means a nation is not exporting enough to pay for its imports.
    • The difference can be paid for either by borrowing from abroad or by selling US assets: hotels, factories, shopping centers, golf courses, farms…
    • Over the longer run, deficit hawks warn that this “mortgaging” of America will reduce both, the rate of economic growth and the level of real income of Americans.

    We have to draw the distinction between external and internal debt:

    • Deficit doves argue that national debt is not really a serious matter because most of the debt is internal – so, we owe it to ourselves.
    • Nonetheless, on the economic front, paying interest on external debt acts like a tax on US citizens by foreigners. Such a “debtor’s tax” reduces domestic consumption, savings and investment. And thereby reduces the economy’s long and short term growth rates.
    • On a political front, the holding of large amounts of America’s debt by foreigners exposes American public policy to undue political pressures.

    The hawks point out that a large international debt is unacceptable for four reasons:

    1. Internal debt leads to higher taxes: First, an internal debt requires payments of interest to bondholders. This in turn means higher taxes and such taxes inevitably distort allocation of national resources and lead to an efficiency loss.
    2. Second, paying interest on internal debt unfairly redistributes income from the poor and middle class to the rich. This happens because government bondholders as a group tend to be wealthier than taxpayers as a group.
    3. Servicing the debt cuts government spending: Third, paying interest on the debt uses hundreds of billions of dollars each year, and this money could otherwise be spent on providing taxpayers with more education, health care, and other government services.
    4. In this regard, the deficit hawks point out that the size of the interest payments to service the debt, relative to total tax revenues, has been steadily rising. In an argument popularized in the early 1990s by presidential candidate Ross Perot, the deficit hawks warn that if this trend continues, we will eventually wind up using all available tax revenues simply to service the debt.

    5. Finally the deficit hawks argue that the accumulation of such a large debt places an unreasonable burden on future generations which must pay this debt off.

    The Impacts of Budget Deficits and Debt on Investment and Productivity

    • The deficit hawks point out there is a wealth of empirical evidence suggesting that public sector investment is less productive than private sector investment.
    • Thus when deficit spending crowds out private sector investment, it reduces the rate of long term economic growth because it substitutes less productive government expenditures for more productive private investment.

    Why Deficits Constrain Fiscal Policy when it is Most Needed

    A line of argument against chronic budget deficits is that a large and growing public debt makes it politically difficult to use the necessary discretionary fiscal policies during a recession.

    • Historical example: In 1991 and 1992, the Federal Reserve substantially reduced interest rates to stimulate the sluggish economy.
    • However, this expansionary monetary policy was slow to expand output and reduce unemployment.
    • At that time, had the public debt not been at historic highs, it would have been much more politically feasible to engage in expansionary fiscal policy as well, by reducing taxes or increasing spending. But, the growing debt problem rules out this stimulus on political grounds.

    The Views of the Deficit Hawks and Doves Summarised

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

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

    Perhaps the most widely debated policy response has been a balanced budget amendment.

  19. The Editor (Post author)

    The Country was at a Party

    “We’ve been able to do okay in this country and pretty well, even with the fact that we’re badly managed. Because, over the last 20 years, we’ve had a pretty free ride. We’ve gotten from all over the world, the whole global economy has been booming, and we’ve been able to get cheap goods. And these cheap goods kept us from having inflation. So very simply put, if you don’t have inflation, it’s easy for the Federal Reserve to keep pumping money into an economy. So money kept flowing, you sort of had a punch bowl. The country was at a party.”

    “And we kept drinking from this punch bowl, enjoying ourselves, and the rest of the world would take our dollars. They would take our dollars, because everybody thought, oh, America you know, it’s great. It’s a little bit like you came from some town, and there’s one family in the town that doesn’t do much work. Sort of profligates, where they lay around the pool, have fun, partying a lot, have the big cars, and have the good times. And the rest of town works hard on the farms or wherever they are, and they keep bringing stuff to this rich families estate, and give them whatever they want: They give them food, they give them clothing. But anything in the rich family just gives them IOUs. And they keep taking the IOUs. So the rich family doesn’t do anything, just lie around the pool, and have fun and travel, or whatever. Well one day, a few of these people are going to say, I don’t want your IOUs any more. You know, what the hell am I going to take your IOUs, it’s worthless because you had lost all your money.”

    “Well, our country is a bit in that situation. We’ve been giving our IOUs, which are dollar bills to the rest of the world, and taking their cheap goods. However, we’re reaching a point now where the dollar’s devaluating as we speak. And we got a, I believe, a real problem on our hands in the economy.”

    [Carl Icahn, 2011]

  20. The Editor

    International Trade and Protectionism

    NAFTA, GATT and the Euro. Tariffs, quotas, and trade deficits. Dumping, non? tariff barriers, and protectionism. This is the language of international economics, and people all across the globe are speaking it in newspapers, corporate offices, retail stores, and union halls.
    Adam Smith’s theory of absolute advantage and its much more compelling cousin, David Ricardo’s theory of comparative advantage are the theoretical perspectives on why nations trade. There are gains from trade and there are the thorny issue of trade barriers and protectionism; protectionist tools such as tariffs, quotas, and non-tariff barriers.

    The Theory of Absolute Advantage

    The idea of absolute advantage as a basis for trade was set forth by Adam Smith. A country that can produce a good at a lower cost than another country is said to have an absolute advantage in the production of that good.

    • Saudi Arabia: Cheap oil, expensive food
    • America: Cheap food, expensive oil

    → The theory of absolute advantage says America should sell food to Saudi Arabia and buy oil from it.

    At first glance, the principle of absolute advantage appears to make imminent sense. Nonetheless it has a significant implication in one that is badly flawed. This more subtle understanding is embodied in the theory of comparative advantage.

    The Theory of Comparative Advantage

    The theory of comparative advantage was first set forth in 1817 by David Ricardo.


    Ricardo’s example

    In a famous example, Ricardo considers a world economy consisting of two countries, Portugal and England, which produce two goods of identical quality. In Portugal, the ”a priori” more efficient country, it is possible to produce wine and cloth with less labor than it would take to produce the same quantities in England. However, the relative costs of producing those two goods differ between the countries.

    Hours of work necessary to produce one unit
    Country Cloth Wine
    England 100 120
    Portugal 90 80

    In this illustration, England could commit 100 hours of labor to produce one unit of cloth, or produce 5/6 units of wine. Meanwhile, in comparison, Portugal could commit 90 hours of labor to produce one unit of cloth, or produce 9/8 units of wine. So, Portugal possesses an ‘absolute advantage’ in producing cloth due to fewer labor hours, and England has a ‘comparative advantage’ due to lower opportunity cost.

    In the absence of trade, England requires 220 hours of work to both produce and consume one unit each of cloth and wine while Portugal requires 170 hours of work to produce and consume the same quantities. England is more efficient at producing cloth than wine, and Portugal is more efficient at producing wine than cloth. So, if each country specializes in the good for which it has a comparative advantage, then the global production of both goods increases, for England can spend 220 labor hours to produce 2.2 units of cloth while Portugal can spend 170 hours to produce 2.125 units of wine. Moreover, if both countries specialize in the above manner and England trades a unit of its cloth for 5/6 to 9/8 units of Portugal’s wine, then both countries can consume at least a unit each of cloth and wine, with 0 to 0.2 units of cloth and 0 to 0.125 units of wine remaining in each respective country to be consumed or exported. Consequently, both England and Portugal can consume more wine and cloth under free trade than in autarky.

    This principle still provides today’s basis for international trade.

    Bang goes the theory. However, this principle is most controversial:

    1. Think about a country with a trade deficit or a country in heavy trouble like Greece. The imported goods can become so expensive for the people that they represent an additional burden to the households. Without any domestic alternatives, people are forced to buy the imported products.
    2. The principle of comparative advantage is also used as an instrument of hegemony, in the EU as much as in the U.S. For example, a relatively strong country like Germany can put pressure on weaker countries (sometimes through the WTO) in order to secure markets for its home industry.
    3. We also hear friends in the U.S. moan about the desertification of their economy: once a rich industry and manufacture – today outsourced to Asia. “Designed by Apple in California”, but produced by cheap labour in China.

    The Difference between a Tariff and a Quota

    1. A tariff is a tax levied on imports
    2. A quota is an explicit quantity limit on imports

    This figure illustrates the domestic market for food in Europe (suppy/demand). You can see that equilibrium occurs at point A at a price of eight, and quantity of two hundred:

    • Relatively small handful of people in one domestic industry, farming, has gained a considerable profit at the expense of
    • a much larger, but politically less powerful group, namely food consumers.
    • But also note that this protectionist tariff, has also considerably harmed food producers in America. And this group is unlikely to remain silent on the tariff question (tariffs on European clothing).

    The Deadweight Loss of a Tariff versus a Quota

    It means the loss is the same regardless of whether a tariff or quota is used:

    • Loss of too many European resources being diverted into the inefficient production of food, at the expense of production in other sectors.
    • Loss in consumer surplus: The loss in consumer satisfaction, from consuming fewer units of food.


    Why, from a Political Perspective, Quotas are Often Preferred to Tariffs

    One of our big losers from the tariff would become a big winner with a quota:
    Under a tariff, the area H, I, K, J goes to the European governments in the form of tariff revenues. However, under a quota foreign exporters, in this case American food producers, will be able to capture these revenues. And in many cases, these additional revenues will largely offset their losses from selling fewer exports.

    The Six Major Arguments in Support of Protectionism

    1. National defense or military self sufficiency argument. This is not an economic argument, but rather a political and strategic one. Unfortunately, there is no objective criterion for weighing the worth of an increase in national security, relative to a decrease in economic efficiency.
    2. Save jobs: This is an argument that often becomes politically fashionable, when a country enters a recession. It is also an argument that is often made in the context of discussions of cheap foreign labor.
    3. Closely related to the jobs argument is the dumping argument: Dumping occurs when foreign producers sell their exports at a price less than the cost of production → to drive competitors out of a market, seize that market, and then use their new found monopoly power to later raise prices.
    4. The fact that one country may use protectionism or dumping to create jobs at the expense of its neighbors, raises a fourth argument for protectionism. Namely, to retaliate against another nation that engages in such protectionist measures. Unfortunately, it is through such retaliatory measures, that trade wars are born (such as in the Great Depression).
    5. Infant industry argument: The idea here is that temporarily shielding young domestic firms from the severe competition of more mature and more efficient foreign firms, will give infant industries a chance to develop and become efficient producers.

    Examples of Non-Tariff Barriers (NTBs) to Trade

    • NTBs include quotas
    • Formal restrictions or regulations that make it difficult for countries to sell their goods in foreign markets.

    The General Agreement on Tariffs and Trade

    The General Agreement on Tariffs and Trade (GATT) was a multilateral agreement regulating international trade. According to its preamble, its purpose was the “substantial reduction of tariffs and other trade barriers and the elimination of preferences, on a reciprocal and mutually advantageous basis”. It was negotiated during the United Nations Conference on Trade and Employment and was the outcome of the failure of negotiating governments to create the International Trade Organization (ITO). GATT was signed in 1947, took effect in 1948, and lasted until 1994; it was replaced by the World Trade Organization in 1995.

    The North American Free Trade Agreement

    The North American Free Trade Agreement (NAFTA) is an agreement signed by Canada, Mexico, and the United States, creating a trilateral rules-based trade bloc in North America. The agreement came into force on January 1, 1994. It superseded the Canada–United States Free Trade Agreement between the U.S. and Canada.

  21. The Editor (Post author)

    Globalisation: Not new, but recently accelerated

    Globalisation has been occurring for a long time, and certainly by the 18th Century it was underway, particularly in the Atlantic region. Economic historians consider 1865 – 1914 to be the Golden Age of globalisation – a relatively peaceful period when tariffs declined, transportation costs plunged (due to steamships, railroads, the lelegraph line, the Suez Canal, etc.), millions of workers migrated from Europe to the Americas and international capital flows increased.
    By measuring the convergence of prices throughout the world and the levels of trade, foreign investment and migration, economists have shown that this Golden Age ended in 1914. It came to an abrupt halt due to wars, protectionism and the Great Depression. It did not resume until after World War II. Initially, a reduction in trade barriers and heavy U.S. post-war investment in Europe drove a modest rebirth in globalisation. However, it was not until the last couple of decades that globalisation effectively returned due to the entry of low-cost Asian labour into the global economy and the emergence of several important newly industrialised countries in Asia. Then came the collapse of communism and huge economic growth in China plus significant growth in India. The admission of China into the WTO in 2001 marked the era.

  22. The Editor

    Exchange Rates, The Balance of Payments, and Trade Deficits

    This section explains how exchange rates and our international monetary system work and illustrates how fiscal and monetary policies may-or may not-be used in a global economy. The discussion takes place largely within the context of America’s chronic trade deficits.
    Beginning in the early 1980s, America began running huge trade deficits. Over the years, these trade deficits have led to an accumulated net foreign debt of trillions of dollars, making the U.S. the largest debtor nation in the world. We are getting back to the initial question raised about the color of money.
    To many observers, America’s chronic trade deficits are every bit as dangerous as its chronic budget deficits. Others, however, see the trade deficits simply as an opportunity to buy inexpensive foreign goods and enjoy a higher standard of living that Americans could otherwise not achieve.

    The Basic Trade Identity Equation

    The Three Major Components of the Current Account

    1. Merchandise Trade Balance
    2. Fees for Services
    3. Net Investment Income
    4. Unilateral Transfers


    Exchange Rate defined

    An exchange rate may be defined as the rate at which one nation’s currency can be traded for another nation’s currency.

    • Exchange rates are quoted in pairs, with one country’s currency exchanging for another country’s at a particular rate.
    • They can rise and fall over time. If a country’s currency gains in value relative to another, it is said to appreciate. In contrast, if a country’s currency loses value relative to another, it is said to depreciate.

    The Three Major Reasons why Exchange Rates change

    1. Differing rates of GDP growth between countries
    2. Faster GDP growth in one country like Great Britain relative to another country like the United States, will typically lead to faster income growth in that nation.
      This faster income growth in turn means, British consumers will increase their purchases of U.S. imports. As a result the U.S. will buy fewer British imports and therefore need fewer British pounds to do so.
      The result? The dollar appreciates relative to the British pound.

    3. Differing rates of inflation
    4. Because exchange rates in the currency markets must reflect real inflation adjusted price differences in the goods markets. This played a key role in the downfall of the so called gold standard.
      Suppose inflation raises the actual or nominal price of, say, an auto made in Canada relative to the nominal price of an identical auto made in Europe. In this case, there must be a corresponding adjustment in the exchange rate so that the real, inflation adjusted prices of the two autos stays the same.
      Economists refer to this key concept as The Law of One Price.

    5. A change in real relative interest rates
    6. Suppose the US Federal Reserve raises interest rates, while the Bank of England takes no such action. In this case, U.S. interest rates have risen relative to those in England.

    7. A change in taste
    8. Suppose that Japanese autos decline in popularity in the United States, perhaps because of some increased concerns over safety. Clearly, the Japanese yen will depreciate relative to the U.S. dollar, as U.S. consumers reduce their purchases of Japanese autos and therefore, their demand for yen.

    9. Simple speculation
    10. Suppose currency traders believe that the Brazilian Central Bank is going to raise interest rates to fight inflation. This rise in relative interest rates will likely attract more foreign investment into Brazil.
      This, in turn, should boost the demand for the Brazilian real. Therefore, a currency speculator is likely to buy the Brazilian real before the move. In effect, betting the real will appreciate.

    The Gold Standard, and Why it Collapsed

    Between 1867 and 1933, except for the period around World War I, most of the nations in the world were on the gold standard. Under this fixed exchange rate system, the currency issued by each country had to either be gold or redeemable in gold.

    • Once a country agreed to be on the gold standard, its currency was convertible into a fixed amount of gold.
    • With these fixed exchange rates, if the nation ran a trade deficit, it would be required to use its gold reserves to buy currency to prevent the value of the currency from falling.
    • In contrast, if a nation ran a trade surplus, it would accumulate gold.

    The Gold Specie Flow Mechanism

    This monetary adjustment mechanism was first described by Scottish philosopher and economist David Hume in 1752.

    This all happens because by the quantity theory of money, if the velocity of money V and real output Q stay the same, this reduction in money m must then reduce the price level P.
    The gold standard worked reasonably well at stabilizing the currency markets right up until World War I. However, with the advent of the war, many nations had to temporarily abandon the gold standard to finance their war efforts. This led to inflation and, in particular, to differing rates of inflation.

    The Major Difference between the Gold Standard and the Bretton Woods System

    This system replaced the gold standard with a U.S. dollar standard – the U.S. dollar was designated as the world’s key currency. Thereafter, most international trade and finance was to be transacted in dollars. Fixed exchange rate parities for all currencies were set in both gold and dollar terms.
    While the Bretton Woods agreement remained wedded to the concept of fixed exchange rates, there was one very important difference. Bretton Woods also provided for a cooperative mechanism in which these new partially fixed rates could be periodically adjusted to reflect changes in currency values in a process known as “adjusting the peg”. Through this adaptability, relative price changes across nations could be addressed through periodic and cooperative adjustments in exchange rates rather than through the painful deflations and recessions that have plagued the gold standard.

    When and Why Bretton Woods Collapsed

    For the first decade of its existence, the Bretton Woods system was a great success. Under the Marshall Plan created in 1947, the US lent large sums of dollars to Europe for its rebuilding. And these dollars flowed right back into the US for the purchase of machinery, equipment, and consumer goods.
    However, by the mid 1950s the European economies had become increasingly self-sufficient. As US exports to Europe slowed, America’s strong economy continued to attract foreign imports. At the same time U.S. deficits were further fueled by an overvalued currency, budget deficits to finance the Vietnam war and growing oversea investments by American firms. By the 1960s, with the U.S. trade deficits mounting a huge surplus of dollars began to pile up in foreign banks. As speculative concerns increased that the US would devalue the dollar, many foreign governments began to redeem their surplus dollars for US gold.
    As US gold reserves fell dramatically, the US government tried unsuccessfully to pressure these foreign governments into retaining their surplus dollars – a surplus that had grown from virtually nothing in 1945 to $50 billion by the early 1970s.
    Finally, in August of 1971 a reluctant Nixon Administration abandoned the dollar standard and Bretton Woods. No longer would dollars be redeemable for gold at $35 an ounce. And in the wake of that abandonment the dollar’s value fell precipitously.

    The Current International Monetary System

    Unlike the earlier uniform systems of first the gold standard and then Bretton Woods, today’s exchange rate system fits into no tidy mold. Without anyone having planned it, the world has moved to a hybrid system known as the managed float. It has these major features:

    1. First, a few countries like the United States have a primarily flexible or floating exchange rate. In this approach, markets determine the currency’s value and there is very little intervention.
    2. Second, other major countries, such as Canada, Japan, and more recently, Britain, have managed but flexible exchange rates. Under this system, a country will buy or sell its currency to reduce the day-to-day volatility of currency fluctuations. A country may also engage in systematic intervention to move its currency toward what it believes to be a more appropriate level.
    3. Third, many countries, particularly small ones, peg their currencies to a major currency or to a basket of currencies. Sometimes the peg is allowed to glide smoothly upward or downward in a system known as a gliding or crawling peg. Some countries join together in a currency bloc in order to stabilize exchange rates amongst themselves. These countries then allow their single currency to float flexibly relative to those of the rest of the world. The most important of these blocks is the European Union.
    4. Finally, almost all countries tend to intervene either when markets become disorderly or when exchange rates seem far out of line with the existing price levels and trade flows. Government exchange rate intervention occurs when the government buys or sells its own or foreign currencies to affect exchange rates.
      • For example, the Japanese government on a given day might buy $1 billion worth of Japanese yen with US dollars. This would cause a rise in value or an appreciation of the yen.

    In general, a government intervenes when it believes its foreign exchange rate is out of line with its currency’s fundamental value.

    • An excellent historical example of such intervention on a broad scale is offered by the actions of the so-called Group of Seven Nations. In 1987, this group, the US, Germany, Japan, Britain, France, Italy, and Canada agree to stabilize the value of the dollar relative to the other countries currencies.

    The problem was that during the previous two years, the dollar had declined rapidly because of large US trade deficits, and the G-7 nations other than the US were worried that any further weakening of the dollar Would stifle their exports and more broadly, disrupt economic growth.

    Should’t there be a natural adjustment of the US balance of payments due to the forces of supply and demand?

    After all, US trade deficits should lead to a surplus of dollars and foreign exchange markets and thereby drive down the dollar’s value. This, in turn, should lower the price of the country’s exports, increase the price of its imports, and restore balance to US trade flows.
    But such an adjustment process has not worked particularly well in curbing the chronic trade deficits of the United States. The question is why, and the answer lies in first understanding the nature of the US trade deficit.

    The Three Major Causes of the Chronic Trade Deficits of the United States

    There are several reasons for persistent US trade deficits:

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

    These two major causes of the U.S trade deficit are each driven, in some degree, by U.S domestic fiscal and monetary policies. Because this is so, we must now come to understand how the conduct of domestic, fiscal and monetary policies in a global economy, can affect not only the domestic countries trade balance. This conduct can also significantly affect the rates of growth and unemployment within the domestic country’s trading partners.

    • ? Any imbalances in either capital or trade flows in one country, will affect all trading partners.
    • ? This means, for example, that the U.S. trade deficits and capital surpluses are not just domestic headaches. They are global problems as well. Perhaps the best way to understand this important point is to illustrate the mechanisms through which domestic fiscal and monetary policies actually affect the global economy.

    The Multiplier Link Illustrated

    Fiscal policy:

    • Suppose then that America’s GDP falls. This might happen as a result of contractionary fiscal policy to slow inflation, or it may simply be that demand in the private sector is weak.
    • Regardless of the reason, the result is the same.


    ? Lower income in America (YA) leads to lower exports from Europe (ImA).
    ? And the flip side of this coin is that as European exports (ExE) to the U.S falls.
    ? So too, does European income (YE).
    In other words, America’s domestic fiscal policy can not only lead to a contraction in the American economy, it can also function as a contractionary fiscal policy for Europe, as well.
    In some textbooks, this chain of causality is referred to as the multiplier link. And from this multiplier link, you can perhaps see why it has grown increasingly important for countries to coordinate their fiscal policies.

    Suppose that America wants to reduce its trade deficit with Japan. What might the United States encourage Japan to do?

    One way to do this might be for the U.S. to adopt a more contractionary fiscal policy. However, such a policy might not be politically acceptable on the home front if the U.S. economy is in recession.
    Alternatively, the U.S. might encourage Japan to adopt a more expansionary fiscal policy as a way of stimulating Japanese demand for U.S. imports – and strengthening the yen relative to the dollar. In fact, this is precisely the kind of request that an American president might make to the Japanese prime minister at a bi-lateral trade summit. And such a coordinated macro-economic approach can work – but only if each country benefits.
    For example, if Japan is in a recession with low inflation, it may well agree to the fiscal expansion. However, if Japan is at or near full employment, it may simply refuse any fiscal stimulus for fear of igniting inflation.

    The Monetary Link Illustrated

    Monetary policy:
    Let’s consider what happens in Europe when America raises its interest rates through contractionary monetary policy.

    1. As America’s interest rate (rA) rises, investors sell European financial assets and buy American financial assets.
    2. This leads to an appreciation of the dollar (es) and a depreciation of European currencies.
    3. This in turn, increases Europe’s net exports (ExE) and thereby raises European output and income (YE).

    Note however, there is an important offsetting effect.

    1. Particularly, higher interest rates in America tend to raise European interest rates (rE) as well.
    2. These higher rates tend to depress domestic investment in Europe (IE), and thereby lower Europe’s output (YE) and employment.

    In other words, in its attempt to fight domestic inflation, the federal reserve of the United States has increased the chance that Europe will experience a recession. In some textbooks, this chain of events is referred to as the monetary link.
    Unlike with fiscal policy, in the multiplier link, the overall impact of monetary policy and the monetary link on domestic GDP is ambiguous and will depend on the particular situation:

    • Note that in a closed economy, a cut in the money supply reduces consumption andinvestment and helps relieve inflation pressures.
    • However, if the money supply reduction increases domestic interest rates, this may trigger additional capital inflows and these increased capital inflows may frustrate monetary policy by increasing the money supply and holding down interest rates.
    • These lower rates in turn may increase aggregate demand.
    • The increased capital inflows may also tend to increase the value of the U.S dollar and widen the trade deficit.
    • Of the Difficulties of Coordinating Macroeconomic Policies between Countries

      Our bottom line here is that the net impact of the contractionary monetary policy on domestic GDP is theoretically ambiguous, and will depend on the individual case.
      What should be clear, however, is the critical importance of globally coordinating fiscal and monetary policy.

      The Benefits of Global Coordination

    • In the late 1970’s, in the aftermath of the demise of Bretton Woods and the dollar standard, the nations of Europe established a fixed exchange rate system, pegged to the German mark.
    • These nations did so in the hopes of avoiding a repeat of the competitive devaluations and economic disruptions that had plagued Europe in the 1930’s after the collapse of the gold standard.
    • In fact this European Monetary System worked reasonably well for over a decade. However, in 1990 the reunification of Germany resulted in large budget deficits as West Germany subsidized East German industry.
    • To cope the result in inflationary pressures, the Bundesbank significantly raised interest rates. Here, German monetary policy was clearly uncoordinated with that of its neighbors. That is, it was being used for domestic macroeconomic management without regard to its impact on Germany’s trading partners.
    • The results, however, were severe. Faced with rising German interest rates, other European countries had to raise their interest rates to prevent their currencies from depreciating against the German mark, and moving outside the prescribed range of parities.
    • These interest rate increases, along with a worldwide recession, pushed Europe outside of Germany into an ever-deepening recession.
    • Eventually, the European monetary system was brought down by speculators who believed that the beleaguered countries would not continue to tolerate unrealistic exchange and high interest rates. One by one, currencies came under attack: the Finish mark, the Swedish crown, the Italian lira, the British pound, Spanish pesetas and the system collapsed.

    Macroeconomic lesson of this crisis, is that a country cannot simultaneously have fixed exchange rates, open capital markets, and an independent monetary policy. In the wake of this crisis, the major European countries resolved this dilemma by moving to a common currency – the Euro. The alternative to non-cooperative policy would be to find a cooperative approach that had positive rather than negative spill overs.

  23. The Editor (Post author)

    Solving the Globalisation “Trilemma”

    There is always a political context in which globalisation occurs, is managed and evolves. And it is this context that we have to consider the costs and benefits of globalisation as well as the winners and losers. From here it is but a short step to recognise that the global economy has always faced and will always face an inherent contradiction between the three goals of deeper economic integration, the self-determination that comes with the nation state and democratic politics. Deeper integration involves degrees of sacrifice as regards of self-determination and independent public policy-making by elected representatives. and those sacrifices are real, involving losses of economic and political influence or national and cultural identity. As such, they are fodder for hostility towards globalisation.
    Harvard professor Dani Rodrik has argued that we face a political trilemma, since we can only really have two of these three. As globalisation, especially in the digital age, breaks down borders and the influence of regulation and control, the role of the nation state comes into question. As globalisation proceeds and economies become more open, social dislocation and resistance may become more significant as countries are forced to adapt their production and their employment and welfare structures, and to accommodate large changes in the rewards to capital and labour.
    In the emerging markets of the global economy – and in particular in the less and least developed economies that have barely savoured the fruits of globalisation – the climate is actually even more ambivalent. The middle- and upper-income countries that have profited form globalisation want more influence and say in determining trade and other economic outcomes and policy discussions, but they essentially support a system which is gradually tilting towards their interests (not to say hegemony). The poorest countries want more from globalisation, inevitably, but in an institutional context more protective of their fragility and low state of development. It is well known that in many developing countries, governance failures and dysfunctional, corrupt institutions have been obstacles to economic integration and growth. it is also true that such weaknesses reflect a fundamental unwillingness or inability to adapt or adjust in the face of economic integration. And this point can now be seen to be central not just to poorer but also to wealthy nations and to be a continuing global theme.

  24. The Editor

    The Economics of Developing Countries

    The poorer, developing countries of the world are home to 3/4ths of the world’s population; and of the 5 billion people on this planet, perhaps 1 billion live in absolute poverty barely able to survive from day to day. The central questions in this regard are: What causes the great differences in the wealth of nations? Can the world peacefully survive with poverty in the midst of plenty? What steps can poorer nations take to improve their living standards?
    These questions are among the greatest challenges facing modern economics; and the tools of macroeconomics, particularly economic growth theory, can make a very big difference in people’s daily lives.

    Some of the Most Important Characteristics of Developing Countries

    Some textbooks prefer the term less developed country (LDC), while others simply say developing country (DVC). Regardless, the most important characteristic of developing countries is that the people have:

    • low per capita incomes. As a consequence, people have
    • poor health and a short life expectancy,
    • suffer from malnutrition,
    • and have low levels of literacy.

    We see that the richest 20% of the world’s population captures almost 83% of its income, while the poorest 20% earn less than 2%.

    The Malthusian Trap Associated with Population Growth

    Productivity and growth in modern industrialized economies depend on four major supply side factors.

    • Human resources
    • I.e. the quantity of labour, and it’s quality. On the quantity issue, because of rapid population growth, many poor countries are forever running hard just to stay in place. The problem is that even as a poor nation’s GDP rises, so too does its population, so that many developing countries are never able to escape the Malthusian trap of high birth rates and stagnant incomes.
      One argument goes that rising income first must be achieved before slower population growth can be achieved. It is an interesting argument that based in large part on micro economic reasoning. The idea is that there are both marginal costs and marginal benefits associated with having another child. In the developing countries, the marginal benefits are relatively large, because the extra child becomes an extra worker to support the family and a safety net for parents in their senior years.
      The crucial role of skilled labor has been shown again and again when sophisticated mining, defense, or manufacturing machinery has fallen into disrepair and disuse because the labor force of developing countries did not have the necessary skills for operation and maitenance. Accordingly, development programs to improve education, reduce illiteracy, and train workers, as well as to improve public safety and health, can make a developing country’s population much more productive.
      This is because workers can learn to use capital more effectively, adopt new technologies, lose fewer days to sickness or injury, and better learn from their mistakes.

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

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

    • Technology
    • Developing countries have one potential advantage here: They can benefit by relying on the technological progress of more advanced nations. In this regard, poor countries do not need to repeat the slow, meandering inventions of the Industrial Revolution. They can buy tractors, computers and power looms.
      Japan and the United States clearly illustrate this pattern in their historical developments:

    • Japan joined the industrial race late, and only at the end of the 19th century did it send students abroad to study Western technology. Same time, the Japanese government has taken an active role in stimulating the pace of development and in building infrastructure such as railroads and utilities.
    • The case of the United States likewise provides a hopeful example to the rest of the world. The key inventions involved in the automobile originated almost exclusively abroad. Nevertheless, Ford and General Motors applied foreign inventions and rapidly became the world leaders in the automotive industry.

    From the histories of Japan and the United States, it might appear that adaptation of foreign technology is an easy recipe for development. But without adequate human resources, skilled scientists, engineers and entrepreneurs, these countries can’t even begin to think about building a working petrochemical plant.

    The so-called “Brain Drain”

    For advanced learning in science, engineering, medicine, and management, countries can benefit by sending their best minds abroad to bring back the newest advances. But, there is a big warning sign that must be posted here: Countries must be aware of the brain drain, in which the most able people get drawn off to high-wage countries.

    The Catch-22 of Capital Formation for many Developing Countries

    • Max Weber, for example, emphasized the Protestant ethic as a driving force behind capitalism.
    • More recently, Mancur Olson has argued that nations begin to decline when their decision structure becomes brittle and interest groups or oligarchies prevent social and economic change.

    No doubt, each of these theories has some validity for a particular time and place but they do not hold up as universal explanations of economic development.

    • Faber’s theory leaves unexplained why the cradle of civilization appeared in the near East and Greece while the later dominant Europeans lived in caves, worshiped trolls and wore bear skins.

    The Vicious Circle of Poverty

    • The center of this circle is rapid population growth.
    • This leads to low per capital income that leads to both
    • a low level of savings and a low level of aggregate demand.
    • This in turn leads to low levels of investment in both physical and human capital.
    • The result is low productivity and low per capital income and the circle continues.


    Other elements of poverty are likewise reinforcing because poverty is accompanied by low levels of education, literacy and skill. These in turn prevent the adoption of new and improved technologies. Overcoming the barriers of poverty often requires a concerted effort on many fronts, and some development economist recommend a big push forward to break the vicious circle.

    Strategies of Economic Development: Three Major Strategic Choices faced by Developing Countries

    1. One of the most important choices the leaders of a developing country can make is whether to pursue a strategy of rapid industrialization to achieve growth as opposed to simply expanding and improving their agricultural base.
      In the past, such a choice was typically resolved in favor of industrialization as developing countries sought to mimic the successes of the industrialized nations. Today however, the lesson of decades of attempt to accelerate industrialization at the expense of agriculture has led many analysts to rethink the role of farming. Here’s the problem: Industrialization is captial intensive! It attracts workers into crowded cities and it often produces high levels of unemployment.
      On the other hand, raising productivity on farms typically requires far less capital while providing productive employment for surplus labor. Indeed, if Bangladesh could increase the productivity of its farming by just 20%, that advance would do more to release resources for the production of comforts then trying to construct a domestic steel industry to displace imports.

    3. The second major issue in development strategy is whether a country is better off relying upon a state-run versus market-oriented economy. The important elements of a market-oriented policy include an outward orientation and trade policy, low tariffs and few quantitative trade restrictions, the promotion of small business and the fostering of competition.
      Moreover, markets work best in a stable macroeconomic environment – one in which taxes are predictable and inflation is low.

      However, the problem here is that the cultures of many developing countries are hostile to the operation of markets. Often competition among firms or profit seeking behavior is contrary to traditional practices, religious beliefs or vested interest. Yet decades of experience suggest that extensive reliance on markets provides the most effective way of managing economy and promoting rapid economic growth.

    4. Still a third issue, development strategy has to do with the openness of an economy to international trade.
      • For example, should a developing country pursue a strategy of import substitution by replacing most imports with domestic production?
      • Or should a country pursue a strategy of openness or outward orientation? That is, should it strives to pay for its imports by improving efficiency and competitiveness, developing foreign markets and keeping trade barriers low?

      Historically policies of import substitution were often popular in Latin America until the 1980s. And indeed the policy most frequently used toward this end was to build high tariff walls around manufacturing industries, so that local firms could produce and sell goods that would otherwise be imported.
      In contrast, in age show countries like Taiwan, South Korea and Singapore have preferred an openness strategy.

      • ? Such a policy keeps trade barriers as low as practical by relying primarily on tariffs rather than quotas and other non-tariff barriers.
      • ? It minimizes the interference with capital flow and allows supply and demand to operate in financial markets.
      • ? It avoids a state monopoly on exports and imports.
      • ? It keeps government regulation to bare necessities for an orderly market economy.
      • ? Above all, it relies primarily on a private market system of profits and losses to guide production, rather than depending on public ownership and control or the commands of a government planning system.

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

    The Nine Ways for Developing Countries to Enhance Economic Growth

    The Role of Industrialized Nations:
    At the same time it is clear that the industrialized nations of the world can play a very constructive role in helping the developing countries grow.

    1. One way is to provide more foreign capital, both public and private. And to better target such aid to the poorest developing countries. In this regard, the United States and many other industrialized nations already assist the developing countries with substantial foreign aid in the form of both loans and grants.
    2. A second way for the industrialized nations to spur economic development in the developing countries would be to further reduce their own trade barriers. This would allow developing countries to expand their national incomes through increased trade. But such a step can be politically controversial because it raises the specter of industrialized workers having to compete against people willing to work for a dollar or less a day.
    3. Still a third way the industrialized nations can help is to provide debt relief. The problem here is that the current debt load of many developing countries is so large that monies which would otherwise go to investment in the countries has to be used for servicing these debts.
    4. The fourth way the industrialized nations might help is by addressing the so called brain drain. The problem here is that many of the best and brightest workers in the developing countries come to the industrialized nations temporarily to get education, but wind up staying permanently to work rather than returning to help build the economies of their homelands. This brain drain contributes to the deterioration in the overall skill level and productivity of labor forces often least able to suffer such losses.
    5. A final way to help developing countries grow is to discourage arms sales to them. While such sales create jobs and profits in the industrialized nations, they also divert precious public expenditures from infrastructure and education.
  25. The Editor (Post author)

    The Democratisation and Humanisation of Finance

    “As information technology advances and as our knowledge of finance advances, the principles that we should look to to see the evolution of financial markets in coming years, and these are the democratization and humanization of finance.”

    • The democratization of finance is the application of the financial technology for everyone in the world.
    • The humanization of finance is taking account of human nature in our financial plans and in the design of our financial institutions.

    “If we keep focus on both democratizing finance and humanizing finance, I think it will make for a much smoother transition to a better world. There’s so much concern these days with inequality, rising inequality. It’s also a concern for people in finance. And I’ve liked to say that inequality is a problem that finance helps deal with, because finance is about risk management. It will reduce the inequality that’s purely random and that has nothing to do with effort or skill. That’s the kind of inequality that is the worst.”

    “Another thing that comes to people’s minds when they think of finance as it’s evolving into the future is that it encourages a selfish or aggrandizing behavior. I think that it could do that, but if we have the right organizations and institutions, probably that tendency can be limited. I’ve emphasized that not everyone is kind and generous, there’s all different kinds of people in our society. A good society is one that manages to temper some of the more aggressive impulses and put them to good uses. But a lot of these people will show up in the financial world. I hear people tell me that there’s a lot of really selfish people in finance. I don’t really think that’s true. And even if it is true it’s not a problem with finance. It’s a problem of society. And I think that we have to really look at some of the aggressive elements of human kind, and we have to reflect on the role of finance in in making good outcomes out of the basic human material which is imperfect, or sometimes concerning. I’m talking about the real world that we live in. Finance is an invention that is constantly adapting to new information, new ideas about how we can make the system work even better.”

    [Robert Shiller, 2011]

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