Honors Economics
Unit 3: Macroeconomics
Beijing West Station: Subway, Train, Bus and Taxi
What are the 4 factors of production? (Land, Labor, Capital and Entrepreneurship)
Remember the Circular Flow of Income model. What does the Circular Flow Chart demonstrate about the transfer and transformation of resources?
When activity between households/consumers and firms increases, the circular flow expands. When activity decreases, the circular flow is said to contract. These same terms, expand and contract, are used when describing the same activity with regard to the business cycle. The business cycle is a series of expansions and contractions of activity between households/ consumers and firms. |
Macroeconomics discusses what occurs in the market at different points in the business cycle. The business cycle is the longer view of the circular flow model.
The four phases of the business cycle: Expansion, Peak, Recession, and Trough. It is easiest to understand the business cycle by considering only 4 of many economic indicators: unemployment , consumer income, consumer spending and business productivity. (We will add to these economic indicators later.) Note that the rate of unemployment affects consumer income, which affects consumer spending, which affects business productivity, which affects the unemployment rate. We will constantly be referring back to the business cycle to understand what trends occur in the market, what legislative and monetary actions may occur to manage the economy. For the longer view, take a look at "Growth In GDP per capita 1871-2009. |
Just a note, we are not discussing any longer a particular product market. We are referring to the overall or aggregate consumer demand, the total or aggregate supply by all firms and the price level of all products. The graph that we refer to looks just like the supply and demand graphs we have been using, but we are applying them to a broader context. Quantity on the graph refers to the Real GDP. In some texts they will label the horizontal axis as Real GDP rather than Quantity.
|
|
Note:
|
ThatWatch these videos from EconStories. You'll want to watch them again after studying Fiscal and Monetary policy. At that point you will catch many more concepts and really grasp the dueling economic theories of Keynes and Hayek. Note that these videos were filmed after the economic recession of late 2007, early 2008. Keynesian economics was being question. Yet, The American government steamed ahead increasing the rate of applying the Keynesian model to the problem of unemployment. Was Hayek right that natural correction in the economy has been impeded and will occur only worse than if the economy was allowed to naturally correct problems? Economicst debate this very question.
|
Note the chart to the right.
When inflation occurs during expansion there is too much money in circulation. The government will increase taxes and/or decrease federal spending to reduce the amount of money in circulation between firms and households. (Contractionary Fiscal Policy) They have less money in their pockets to spend. The reduced amount of money supplied to the economy increases the value of the money and the rate of inflation is slowed. When unemployment occurs during a recession not enough money is in circulation to support jobs. The government will decrease taxes and increase spending. This will increase the supply of money in the pockets of firms and households, which they will spend. (Expansionary Fiscal Policy) Increased spending will lead to a lower unemployment rate and hopefully an end to the recession. |
Watch only the first 3:12 of the video. We're not ready for the Money Multiplier Effect.
|
Arthur Laffer developed this model to demonstrate how tax cuts affect tax revenues and economic growth. At the top of the curve the tax collections are at their highest. However, as the tax rate continues to rise, tax collections start to decrease. Why?
People who have to pay those taxes find ways to avoid taxes. they turn down opportunities to earn greater income because the increase in income would place them in higher tax brackets. They find tax deferred or tax sheltered investments. Both legal and illegal means to avoid taxes. There is a point at which taxpayers believe they've paid enough. Mr. Laffer offered his model at a time when it was argued that lowering the taxes would actually increase tax revenues because the current tax rate was past the optimum level. It was offered as an argument for supply-side economics. |
The Democratic Party typically advocates raising taxes and increasing government spending. Yet, pursuing both of these policies at the same time does not make sense. Neither policy is appropriate in both economic phases of the business cycle. During an expansion, if democrats increase government spending, they actually add to the increased rate of inflation. During recession, by raising taxes, they are reducing the money firms and consumers have to put people back to work by spending.
|
The Republican Party typically advocates lowering taxes and decreasing government spending. Yet, pursuing both of these policies at the same time does not make sense. Neither policy is appropriate in both economic phases of the business cycle. During an expansion, if Republicans lower taxes, they give up a tool for reducing the rate of inflation. During recession, by reducing spending, they give up a tool for putting people back to work.
|
The Fed has three tools for managing the economy. It doesn't want inflation to increase too much during economic expansions. Nor does it want unemployment to increase during recessions. For that matter, the Fed and everyone else would prefer we don't have recessions. (Yet, recessions are a natural process of the economy. Like inhaling and exhaling, recessions are exhaling bad gases or wasteful practices among firms and households. We will discuss this more in class.)
The Fed has 3 tools for controlling the supply of money to the economy:
|
Start watching this video at 3:42.
|
The problem to be addressed during economic Expansion is inflation. To reduce inflation, the Fed wants to reduce the supply of money by increasing the RRR and Discount Rate on banks, and the OMC authorizes the the sale of bonds.
The problem to be addressed during economic Recession is unemployment. To reduce unemployment, the Fed wants to increase the supply of money by decreasing the RRR and Discount Rate on banks, and the OMC authorizes the purchase of bonds. |
Expansionary Policy: During a recession, the Fed will increase the supply of money available at the banks (MS1 to MS2). Notice that the interest rate decreases as the equilibrium slides down the demand curve for money (MD). As borrowing money becomes more affordable. firms and households borrow money for spending. The economy is stimulated and the hope is that increased spending will decrease unemployment.
|
Contractionary Policy: During an expansion, the Fed will decrease the supply of money available at the banks (MS1 to MS2). Notice that the interest rate increases as the equilibrium slides up the demand curve for money (MD). As borrowing money becomes more expensive. firms and households borrow less money for spending. The economic expansion is slowed and the hope is that decreased spending will slow the rate of inflation.
|
Phillips Curve: notice in the graph to the right, as the government works to reduce unemployment, people have more money to spend, and the inflation rate begins to increase.
Logically, if the government works on reducing the inflation rate, they must reduce the supply of money available to spend. Reduced spending leads to increased unemployment. This graph would show a reverse in inflation rate and unemployment rate. |
Consider the foreign exchange market (FOREX) that is to the right. The supply curve is the supply of dollars to the market of Mexican Pesos to the US Dollar. The demand curve represent the Pesos being brought to the market to be exchanged for US Dollars. When consumers of Mexico want to buy US products, there is an increase in Pesos demanding to be exchanged into Dollars. The increased demand leads to a higher exchange rate, more Pesos to the Dollar. This means the Peso has depreciated and the Dollar has appreciated in value.
|
Remember the economy is about organizing and using factors of production: land, labor, capital and entrepreneurship. For economic growth to occur, there must be an increase of available natural resources, laborers, human capital and capital. Many of these resources can be increased through trade between nations based upon comparative advantage. Still, for developing nations, there are social and political issues that have to be overcome or managed in order to achieve a developed economy. The following presentation provides us a simple outline to discuss the needs of developing nations and what developed nations can do to help.
|