A classic method of teaching the basic economic concept of the production possibilities curve is to illustrate the relationship between a nation’s decision to invest in military goods versus civilian goods. The model typically includes two “products” that a nation can choose to invest in: guns and butter. The specific goods themselves are not so important, rather what they are meant to represent: the tradeoff any nation faces between allocating more of its scarce resources towards national defense versus goods and services that benefit the nation’s consumers.

Today the United States faces a very real version of the old “guns vs. butter” model. Rising global food prices have put public school districts in a bind: how to feed kids nutritious meals as the prices ingredients has risen at unprecedented rates:

Rising food prices are making it harder for schools to cook up ways to give kids the nutrition they need.

Right now, they’re taking shortcuts and shuffling ingredients to make up the difference, but that’s only a short-term solution with long-term consequences on the horizon.

“I’ve been in school service for 27 years and this is the worst it’s ever been,” said Sara Gasiorowski, food service director for Wayne Township Schools in Indianapolis. “I have never seen food prices jump up so far…”

Food prices nationwide have risen 4.5% between March 2007 and March 2008, according to the Bureau of Labor Statistics’ Consumer Price Index, with flour and eggs rising even more dramatically than milk. Grumbles said milk prices in her district are up 22% from last year, which means an increase of 3.5 cents for each of the federally required 16,000 half-pints she provides every day.

“For every penny on a carton of milk, it costs me $30,000 a year,” she said. “That’s $105,000 extra on my food bill.”

Flour prices have roughly doubled over the last year, according to Grumbles, to $19 per 50-pound bag. To make up for the difference, she substitutes canned peaches for fresh apples “to save a couple pennies” per meal, or she uses ground beef in place of chicken.

Unfortunately, federal funding for school lunches has increased at a much slower rate than cost to districts of providing those meals:

Federal reimbursement programs cover all or part of school districts’ lunch tabs. Congress lifts reimbursement rates every year, but Gasiorowski said it hasn’t been enough: “We need to be looking at an increase of 12% to 15%, instead of our usual annual increase of 2 or 3%.”

The current federal reimbursement program is based on household incomes; the poorest American students receive $2.47 of federal funding towards their “free lunches”, while students from the highest income bracket only receive $0.23 per meal. The problem is, the average school lunch now costs $3.10, so these days no one is actually receiving a “free lunch”, not even the poorest American students.

This article struck me in that is truly does illustrate the concept of tradeoffs as illustrated in the production possibilities curve. Society must allocate its scarce resources towards the goods and services it deems most desirable based on the needs of its citizens. Complications arise in this basic model, however, when government is involved.

The commitment to subsidizing school lunches is based on the idea that if the responsibility of feeding American school children were left to the free market, resources would surely be underallocated towards nutritious meals, representing a market failure. School lunches are a merit good, meaning they would be underprovided by the free market, since without public provision and support, millions of American children would come to school every day without nutritious meals to get them through the day.

National defense is another service that governments find it necessary to provide.  If it were left completely up to the free market, national defense would probably not be provided at all. Instead, only individuals who could afford it would hire private security forces to protect their property. To protect a whole nation, however, government provision of defense is a necessity.

Clearly, both “guns” and “butter” create benefits for society. Among the countless other goods and services the government provides or supports the provision of, the United States faces a tradeoff arising from the scarce resources at the government’s disposal. Currently, the US government spends far more on  its military ($660 billion in 2010!) than it does on lunches for American school children. Clearly, military spending is necessary, but it may be that in the tradeoff between these two important services more resources should be allocated towards “butter” at a period in the US economy when low income households are finding it harder than ever to provide their children with one of life’s most basic necessities, nutritious food.

Discussion Questions:

1. What do “guns and butter” represent on the PPC above? Why have economists found it useful to use these two goods on their analysis of the tradeoffs faced by nations?
2. Why doesn’t the United States just make all school lunches FREE for all American school children? Wouldn’t that make sense? Give an economic argument against this suggestion.
3. Why does the government feel it necessary to allocate any resources towards school lunches? Shouldn’t the government just let American families provide their own children with lunch?
4. Say the US government decided to increase its provision of both national defense and school lunches, without reducing its provision of some other good or service. How would it do this? Why wouldn’t the government do this?

Update: I received an email message from a reader about the above blog post:

I have to say that your “guns and butter” diagram is “interesting.” I am not clear on why the United States should spend vastly more on school lunches than on defending the free world While government provided school lunches may have a place, most Americans feed their own children and do not depend on Federal financing.

Where did you get the notion that feeding our children would be “under-provided by the free market”

Here was my reply to this reader. I’m posting it here because I want to make it clear the the diagram above is not meant to make any political statement about US military spending:

Hello,

Actually, the PPC was included simply to illustrate the basic tradeoff that society faces when it chooses how to allocate its scarce resources.

Having taught at least for a short while in public schools, I can say that nutritious lunches are definitely “underprovided” by the free market, that is, many students in poor communities in America depend on the “free and reduced” lunches that are provided through federal and state funding programs… I once volunteer taught in a poor Elementary School in Spokane, Washington where 40% of the students ate only two meals a day, both provided free by the school district: one at 8 in the morning, one at noon. Many of these children had parents who were poor, unemployed, often addicted to drugs, who failed to put any food on the table whatsoever.

In other words, I do think that nutritious meals are a “merit good” which by definition is one that is underprovided by the free market, therefore requires subsidies from the government. Otherwise, why would the government offer such subsidies at all, if these meals were something the free market could adequately provide on its own?

Again, I was not making any political statement with the graph, only pointing out the basic economic concept of tradeoffs and the idea that society must allocate its scarce resources towards an “optimal” combination of goods and services. The article indicates that in this time of rising food prices, not enough of America’s resources are going towards providing nutritious meals for school children, indicating that a movement along the PPC might be in order. The degree of such a move is irrelevant, only the fact that a movement must occur if nutritious meals are to continue to be provided. In fact, the x-axis could have represented any other public good the government provides for society, I chose “military spending” so that the current example was consistent with the classic example of “guns vs. butter”.

Hope that clears things up… Best regards,

Jason

Related posts:

1. Guns and Butter – a dangerous combination
2. Renewable energy resources still have significant opportunity costs
3. When markets work…

Jason,

I hate to bug you, but I have a question. I am a first year AP Econ teacher and I know something is going to come up right away and I want to explain it in the simplest way. “Why can’t the govt. just print more money?” I know the inflation part of it, but when I am reading to look for quality ways of explaining it, I see plenty of information about it, but I can’t grasp it. Principle 9 in Mankiw text states “Prices rise when the govt. prints too much money.” I feel like a dumb kid and I am supposed to teach this!!!!

If you can help, great, if not, I will figure it out.

Thanks,
Teacher

Dear Teacher,

I love your question! It is definitely one of those issues that gets glossed over in most economics textbooks. Or it is assumed that the money supply diagram makes it obvious why excessive monetary growth leads to inflation. But I agree, this is one of those things that for the first couple of years I taught economics, I probably didn’t really understand all that well either! So let me try to break it down in plain English for you. This will be good for me too, cause I always understand things more clearly myself after writing them (which is why writing a textbook is about the best PD I’ve every undertaken!)

So, here it goes:

Printing money and its effect on inflation is a bit more complicated than it sounds. In fact, it is the US treasury that prints money, but it is the Federal Reserve that determines how much money is actually in circulation in the economy. Money printed by the Treasury is distributed to the twelve Federal Reserve banks around the country. The treasury and the government of which it is a part does not have any say on how much money actually gets injected into the economy, as monetary policy decisions are left up to the Federal Reserve.

Traditionally, the Fed has one tool for injecting new money into the economy, a tool known as “open market operations”. (I say traditionally, because in the last three years the Fed has devised numerous new ways to “inject liquidity” into the economy, which I will not get into now). To increase the nation’s money supply, the Fed buys US government bonds on the open market from commercial banks. Commercial banks invest some of American households’ savings into government bonds just like they invest some of our money into individuals and businesses by making loans and charging interest on those loans. Commercial banks will want to buy government bonds if the interest on them rises and will want to sell those bonds when the interest rate falls.

If the Fed want to increase the money supply to stimulate spending in the economy, it will announce an open market purchase of bonds. When the Fed buys bonds, the demand for bonds increases, raising their prices and lowering their effective interest rate. As the interest on government bonds falls as a result of the Fed’s open market operations, banks find them less desirable to hold onto as investments and therefore sell them to the Fed in exchange for, you guessed it, liquid money, fresh off the printing presses!

Remember, the money printed at the Treasury and held at the Fed was NOT part of the money supply, since it is out of reach of private borrowers. But as soon as the Fed buys bonds with that money, it is deposited into commercial banks’ excess reserves and is therefore now in the commercial banking system and therefore part of the money supply. So, “printing money” does not immediately increase the money supply since newly printed money only ends up in the Fed; only once the Fed has undertaken an expansionary monetary policy (an open market bond purchase) does the newly printed money enter the money supply.

Now, commercial banks have just sold their illiquid assets (government bonds) to the Fed in exchange for liquid money. Picture the money market diagram and you will see the money supply increasing.

So the next question is, why does this lead to inflation?

Banks now hold more excess reserves, most of which are kept on reserve at their regional Federal Reserve bank. Reserves held at the Fed do NOT earn interest for the banks, and therefore actually lose value over time as inflation erodes the purchasing power of these idle reserves. Banks, of course, want to invest these reserves to earn interest beyond the rate of inflation and thereby create earn them revenue. In order to attract new borrowers, commercial banks, whose reserves have increased following the Fed’s bond purchase, must offer borrowers a lower interest rate. The increase in the supply of money leads to a decrease in the “price” of money, i.e. the interest rates banks charge borrowers.

So here we see why an increase in the money supply leads to lower interest rates. With greater excess reserves, banks must lower the rate they charge each other (the federal funds rate) and thus the prime rate they charge their most credit-worthy borrowers and all other interest rates in the economy, in order to attract new borrowers and get their idle reserves out there earning interest for the bank.

Lower interest rates create an incentive for firms to invest in new capital since now more investment projects have an expected rate of return equal to or greater than the new lower interest rate. Additionally, the lower rates on savings discourages savings by households and thereby increases the level of household consumption. Households find it cheaper to borrow money to purchase durable goods like cars and it also becomes cheaper to buy new homes or undertake costly home improvements. So we begin to see investment and consumption rise across the economy as the increase in the money supply reduces borrowing costs and decreases the incentive to save. Aggregate demand has started to rise.

Additionally, the lower rate on US government bonds resulting from the Fed’s open market purchase reduces the incentive for foreign investors to save their money in US bonds and in US banks, which are now offering lower interest rates. Falling foreign demand for the dollar causes it to depreciate. A weaker dollar makes US exports more attractive to foreign consumers, so in addition to increased consumption and investment in the US, net exports begin to rise as well, further increasing aggregate demand.

Increasing the money supply (not so much by printing money rather because of the “easy money” policy of the Fed), leads to increased consumption, investment, and net exports, and therefore aggregate demand in the economy. The rising demand among domestic consumers, foreign consumers, and domestic producers for the nation’s output puts upward pressure on prices as the nation’s producers find it hard to keep up with the rising demand. Once consumers start to see prices rising, inflationary expectations will further increase the incentive to buy more now and save less, leading to even more household consumption. Firms see price rises in the future and increase their investment now to meet the expected rises in demand tomorrow.

It does not take much for inflation to accelerate in such an environment. If the the government and the Fed do not slow down the increase in the money supply (STOP THE PRINTING PRESSES!) then soon enough workers will begin demanding higher wages and resource costs will start to increase in all sectors of the economy, causing the nation’s aggregate supply to decline as firms find it harder to cover their rising costs. Now we have both demand-pull AND cost push inflation! The weaker currency also makes imported raw materials more costly to firms, further adding to the inflationary environment. An inflationary spiral is now underway!

Milton Friedman said that “inflation is always and everywhere a monetary phenomenon”. Controlling the rate of growth in the money supply, say the monetarists, will assure that the fluctuations in the business cycle will be mild and periods of dramatic inflation and deflation can be avoided. Stable money growth should lead to stable economic growth. But as soon as we start running the printing presses inflation will not be far behind. On the flip-side, contractionary monetary policies should in theory lead to the exact opposite of what I describe above and cause a deflation. If a central bank were to tighten the money supply too much, interest rates would rise, investment, consumption and net exports would fall, and falling prices would force firms to lay off workers, leading to high unemployment and an economic contraction.

I’ll leave you with one question to ponder (the answer to which would require a much longer article than this one!). If Friedman was right, and increasing the money supply will always and everywhere lead to inflation, then how is it that the monetary base in the United States increased by 142% between 2008 and 2009, yet inflation declined over the same period and fell to as low as -2% in mid-2009? That’s right, the money supply more than doubled, yet the economy went into deflation. Was Friedman missing something in his calculation that monetary growth always leads to price level increases? In other words, is an open market purchase of bonds by the Fed all that is needed to stimulate demand during a recession? Perhaps Friedman, who died in 2006 right before the US entered the Great Recession, would have to re-consider his famous quote if he could see the effect (or lack of effect) of America’s unprecedented monetary growth over the last three years!

Related posts:

1. From the Help Desk – more on loanable funds and the money market
2. Loanable Funds vs. Money Market: what’s the difference?
3. Helicopter Ben and Monetary Policy: the cartoon version!

At the heart of this debate are the two macroeconomic schools of thought, the  Keynesian demand-side theories and the classical, supply-side theories. Two intellectuals have emerged in the last several years representing the two sides of the macroeconomic debate. On the demand-side, representing the Keynesian school of thought, is 2008 Nobel Prize winning economist Paul Krugman. Representing the classical, supply-side school of thought is Harvard economic historian Niall Ferguson. These two have squared off in many forums over the last three years, Krugman arguing for more and continued fiscal stimulus to prop up and increase demand in the economy, Ferguson arguing for smaller deficits, lower taxes and less government spending to increase private sector confidence and thereby supply in the economy.

During our long summer break the two squared off once again in the aftermath of a G20 meeting in which the governments of several major economies from Europe and North America announced plans to begin rolling back the stimulus spending they embarked on throughout 2008 and 2009. The reason for increased “austerity measures” (policies that reduce the budget deficit and slow the growth of national debt), argue global leaders, is to reduce the chances of more countries experiencing debt crises like that experienced in Greece this spring.

International investors realized earlier this year that Greece’s budget deficits were a much larger percentage of its GDP than previously thought, and very quickly decided that Greek government bonds were an unsafe investment. Almost overnight the cost of borrowing in Greece shot up above 20%, bringing investment in the economy to a halt and forcing the government to cut its budget, leading to higher unemployment and reduced social benefits for the people of Greece.  If investors were to look at the growing budget deficits in other developed countries and  then suddenly lose faith in other government’s ability to pay back their debts, then a similar crisis could occur in much larger economies, including the UK, Germany and the United States. Hence these country’s apparent desire to begin reducing deficits and rolling back stimulus spending; measures that may just plunge these economies into an even deeper recession than that which they have experienced over the last two years.

The videos below show the leading intellectuals on both sides of the stimulus/austerity debate presenting their arguments. Below each video are discussion questions to help guide your understanding of their views. Watch the videos and respond to the discussion questions in the comment section below.

Video 1 - Krugman argues for continued stimulus:

Click here to view the embedded video.

Discussion Questions:

Video 2 - Ferguson argues for austerity and “fiscal regime change”:

Click here to view the embedded video.

Discussion Questions:

Related posts:

1. Will the stimulus package “crowd-out” private investment and reduce long-run growth potential in America?
2. The almighty bond market: Niall Ferguson’s concerns about the US deficit explained
3. How big is the government spending multiplier in America? Well, it depends on which economist you ask…

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2. An introduction to consumption externalities from a Singapore perceptive

• Two sections of year 1 IB Economics totaling 35 students
• One section of year 2 IB Economics with 12 returning students
• One section of AP Economics (micro and macro combined) with 17 students
• One section of AP Microeconomics with 14 student.

Including 18 students in my colleague’s class, the 53 students enrolled in year one IB Econ represent nearly half of the 11th grade class and three fourths of the students in the IB program, making Economics far and away the single most popular IB subject at our school. I suppose this is no surprise considering finance and economics are the largest industries here in Switzerland.

One of the questions I like to ask my student during the first week of class every year is “What is Economics?” The answers are always interesting to read, because unlike many other high school classes, Econ is one of those subjects students sometimes have no idea what it’s all about when they sign up for the class. Below are some of the definitions of “Economics” students shared in their first day survey this week:

• “Economics is the study of money flow between either countries or individual companies.”
• “My definition of Economics is the control of money by a person, organization or nation.”
• “Economics is a complex system that determines and justifies global prices, currency values, and ultimately the success of a nation.”
• “I’d say Economics is the study of how humans use resources including income, investments, taxes and the economy.”
• “I think economics is the study of investments and money. Especially income and outcome, and taxes in the government.”
• “The study of the distribution of wealth and how humanbeings tend to handle wealth.”
• “A bunch of old men moaning about all of the potentially free lunch oppurtunities they had missed in their youth, passed off as the behaviour of markets.”

As you can see, most students do not yet have a clear definition of the subject in their heads when they start the course, which is perfectly understandable! So I thought I’d start the year off by sharing my definition of economics. Please read the following introduction to Economics then answer the discussion question that follows.

So what IS Economics, anyway? Well, look around you. What do you see? From here in my classroom at Zurich International School, I see five new condominium buildings being built. I can count eight yellow cranes swinging their arms hauling construction materials around their respective sites. Beyond the cranes I see a beautiful forest stretching up a hillside with green sheep pastures and quaint farm houses scattered here and there. I see a church steeple and the rooftops of the businesses down in the village below school. I can just see the tops of cars racing along the A3 highway to and from Zurich and the other cities of central and eastern Switzerland.

Now ask yourself, how did things get to be this way? Why are new condos going up in the midst of Europe’s deepest recession in decades? Why are farmers still able to graze sheep on hillsides when 100 square meter condos are selling for a million francs just below their fields? Why are the ancient forests of the Sihlwald still standing even as development has encroached into most of the region’s  forests and natural ecosystems? How do normal people make enough money to live comfortably in this expensive country? Where do the things we buy come from? Who built this computer I’m typing on and what will I be doing for a living in twenty years?

One of my favorite quotes that to me sums up what economics is all about comes not from an economist, but from the civil rights leader Martin Luther King. In 1967 King wrote:

Did you ever stop to think that you can’t leave for your job in the morning without being dependent on most of the world? You get up in the morning and go to the bathroom and reach over for the sponge, and that’s handed to you by a Pacific islander. You reach for a bar of soap, and that’s given to you at the hands of a Frenchman. And then you go into the kitchen to drink your coffee for the morning, and that’s poured into your cup by a South American. And maybe you want tea: that’s poured into your cup by a Chinese. Or maybe you’re desirous of having cocoa for breakfast, and that’s poured into your cup by a West African. And then you reach over for your toast, and that’s given to you at the hands of an English-speaking farmer, not to mention the baker. And before you finish eating breakfast in the morning, you’ve depended on more than half the world. This is the way our universe is structured, this is its interrelated quality.

Economics is about all the questions I posed above and it’s about all the interactions King describes. Economics is about solving one major problem faced by all human societies going back thousands of years. Economics is about the problem of scarcity. Scarcity is the natural phenomenon arising from the fact that all the world’s resources are physically limited in quantity.

Limited resources alone would not pose a problem if it were not for one characteristics of human beings that makes us truly unique in the animal kingdom. The fact that we have desires and wants beyond our basic physical needs. In the face of humans’ practically unlimited desires and wants, the limited nature of the earth’s limited natural resources gives rise to conflicts regarding the allocation of those resources. Economics is the social science that deals with the allocation of earth’s scarce resources among the competing wants and needs of society. Economists provides society with various tools and techniques for efficiently allocating our scarce resources.

Discussion question:

1. Scarcity of resources has given rise to countless conflicts among and between societies throughout history. Identify one conflict from the past or present that you think the problem of scarcity gave rise to.
2. Some say that many of the environmental problems our world faces to day can be solved by economics. If that’s the case, then they must have to do with scarcity. Identify one environmental problem and explain how it relates to scarcity.
3. Time is one of the scarcest resources. Explain how the decisions you make regarding your limited time in and out of school can be considered economic decisions.

Related posts:

1. Marco Garofolo on the imperfect science of Economics

Understanding price elasticity of supply, which measures the responsiveness of producers to changes in the price of different goods, allows firm managers and government policymakers to better evaluate the effects of their output decisions and economic policies.

Excises taxes and PES: A tax on a particular good, known as an excise tax, will be paid by both the producers and the consumers of that good. When a government taxes a good for which supply is highly elastic, it is the consumer who ends up bearing the greatest burden of the tax, as producers are forced to pass the tax onto buyers in the form of a higher sales price. If the producer of a highly elastic good bears the the tax burden itself, it may be forced to reduce output to such a degree that production of the good becomes no longer economically viable. A tax on a good for which supply is highly inelastic will be born primarily by the producer of the good. The price paid by consumers will only increase slightly while the after-tax amount received by the producer will decrease significantly, but in the case of inelastic supply this will have a relatively small impact on output. A graphical representation of the effects of taxes on different goods will be introduced in chapter 4.

Price controls and PES: A common policy in rich countries aimed at assisting farmers is the use of minimum prices for agricultural commodities. The European Union’s Common Agricultural Policy (CAP) involves a complex system of subsidies, import and export controls and price controls, the objective of which is to ensure a fair standard of living for Europe’s agricultural community. The use of minimum prices in agricultural markets can have the unintended consequence of creating substantial surpluses of unsold output. Take the example of butter in the EU. The following excerpt was taken from the January 22, 2009 issue of the New York Times:

“Two years after it was supposed to have gone away for good, Europe’s ‘butter mountain’ is back… Faced with a drastic drop in the [demand for] dairy goods, the European Union will buy 30,000 tons of unsold butter. Surpluses… have returned because of the sharp drop in the [demand for]… butter and milk resulting partly from the global slowdown.

In response, the union’s executive body, the European Commission, said it would buy 30,000 tons of butter at a price of 2,299 euros a ton… Michael Mann, spokesman for the European Commission, said that the move was temporary but that if necessary, the European Union would buy more than those quantities of butter — though not at the same price.”

The situation in the European Union butter market can be attributed to an underestimate by policy makers of the responsiveness of butter producers to the price controls established under the CAP. A minimum price scheme of any sort, if effective, will result in surplus output of the good in question, but the 30,000 tons of unsold butter in Europe appears to exceed the expected surplus considerably. The graph below illustrates why:

A price floor (Pf) is set above the equilibrium price of butter established by the free market. Butter producers in Europe are guaranteed a price of Pf, and any surplus not sold at this price will be bought by the European Commission (EC). Assuming a relatively inelastic supply, which corresponds with the short-run period (Ssr), the increase in butter production is relatively small (Qsr), resulting in a relatively small surplus (Qsr – Qd). In the short-run, the amount of surplus butter the EU governments needed to purchase was minimal. But as we learned earlier in this chapter, as producers of goods have time to adjust to the higher price, which in the case of the CAP is a price guaranteed by the EC, they become more responsive to the higher price and are able to increase their output by much more than in the short-run. Slr represents the supply of butter in Europe after years of the minimum price scheme. As demand has fallen due to the global economic slowdown, butter producers have continued to produce at a level corresponding with the price floor (Pf), leading to ever growing butter stocks and the need for the EC to spend, in this case, 69 million euros on surplus butter.

Understanding the behavior of producers in response to changes in prices, whether due to excise taxes or price controls, better allows both firm managers and government policy makers to respond appropriately to the conditions experienced by producers and consumer in the market place and avoid inefficiencies resulting from various economic policies.

Discussion questions:

1. Explain why the price elasticities of both demand and supply of primary commodities tend to be relatively low in the short run and higher in the long-run.
2. Explain the factors which influence price elasticity of supply. Illustrate your answer with reference to the market for a commodity or raw material.
3. Discuss the importance of price elasticity of supply and price elasticity of demand for producers of primary commodities in less developed countries.

Related posts:

1. So, how are those Zimbabweans doing under Mugabe’s price controls?
2. Will limiting exectutive pay send American business leaders packing for Europe? Probably not…
3. Letting markets work: the Malaysia fuel subsidy goes bye bye

Notice in the table above that the total tax paid by Americans at the top of each income bracket is NOT the simply the tax rate times income. Rather, the tax rate for each income bracket only applies to income earned above and beyond the upper boundary of the previous bracket. An American worker earning $8,000, for instance, will pay $800 in income tax. But if his income increases to $10,000 he will NOT pay 15% of the full $10,000, or $1,500. Rather, he will pay 15% on the income earned above $8,375. Such a worker would therefore pay 10% of his first $8,375 ($837.50) plus 15% on the additional $1,625 he earned, which is another $243.75. The marginal rate of taxation (MRT) is the change in tax (t) divided by the change in gross income (y_g). His total tax would therefore equal $1,081.25.

The marginal rate of taxation between the first and second income brackets above is found using the equation:

The average rate of taxation (ART) is equal to the tax paid (t) divided by the gross income (y_g):

The average rate for workers who fall in the second income bracket above can be found using the equation:

Marginal and average tax rates in the US

In other Western economies, progressive income taxes typically account for the largest proportion of total tax receipts by the government. America’s neighbor to the north, Canada, has an even higher top marginal tax rate than the US, and rather than applying to people earning above $370,000, as it does in the US, Canada’s top tax rate kicks in for workers earning just $100,000 per year. In Canada, personal income taxes account account for around 50% of total federal tax revenues, while the corporate tax and the national goods and services tax make up the next largest portions.

As mentioned, the highest marginal tax rates tend to exist in the social democratic nations of Northern and Western Europe. Denmark, a country with a Gini index of 29, has the highest tax rate on top income earners. More significant than the high rate, however, is the fact that it kicks in at such a low income level, around $50,000 per year. This means that a large number of Danish workers are paying a high marginal and average tax rate. The burden of the income tax in Denmark is born not by only the rich, but by the middle class as well. In contrast, Germany’s top marginal tax rate of 47% is only reached when a worker’s gross income exceeds $300,000 per year, meaning the income tax burden in Germany will be born more by the rich than those earning lower incomes, as is the case in the United States.

Marginal tax rates in OECD countrieshttp://www.oecd.org/document/60/0,3343,en_2649_34533_1942460_1_1_1_1,00.html#pir

Related posts:

1. Understanding the difference between progressive and regressive taxes
2. Tax progressivity in the US: Do the rich pay more than their fair share? The evidence indicates NO!
3. Regressive or progressive taxes: Which road to follow towards fiscal discipline?

It should be noted that the original Phillips Curve theory did not distinguish between the short-run and the long-run. In fact, the original Phillips Curve itself was a long-run model demonstrating a trade-off between unemployment and changes in the wage rate over a span of 52 years in the United Kingdom.

Up until the early 1970s, the Phillips Curve was treated as a generally accurate demonstration of the relationship between two important macroeconomic indicators. Throughout the 60′s data for the United States showed in most cases that increases in unemployment corresponded with lower inflation rates, and vis versa.

Related posts:

1. Politics, priorities, and the Phillips Curve
2. You can’t always get what you want… the tradeoff between unemployment and inflation
3. The Federal Reserve and the tradeoff between unemployment and inflation

1. Why does Hayek's "classical" aggregate supply curve always lead to an equilibrium level of national output equal to the full-employment level of
   

    real GDP?

2. The vertical AS curve above is sometimes referred to as the "flexible-wage and flexible-price" model of the macroeconomy. Why must wages and prices be perfectly flexible for this model to be an accurate representation of a nation's economy.
3. Hayek was an advocate for free markets, he felt that government intervention in a nation's economy would only interfere and disrupt the efficient allocation of resources. How does the model above reflect his belief that governments cannot improve a nation's level of output beyond what the free market is able to achieve?
4. Do you believe that the classical model of aggregate supply is representative of the real world? Why or why not? What evidence is there from recent history that the model is or is not accurate?

Figure 2: The Keynesian AD/AS model

1. Based on the model above, which level of aggregate demand corresponds with the macroeconomic goals of "full-employment and stable 
   

   prices"? 

2. Changes in which factors could cause aggregate demand to shift from AD2 to AD3? If AD falls to AD3, what happens to the price level in the economy? What happens to the level of output of goods and services? What happens to employment and unemployment?
3. Sometimes the Keynesian AS model is known as the "sticky-wage and sticky-price model". How does the model reflect the idea that wages are downwardly inflexible, in other words, will not fall even if demand for goods and services fall? For what reasons might wages in an economy be downwardly inflexible (in other words, not fall even as total demand in the economy falls)?
4. How realistic is the Keynsian model of aggregate supply in the real world? 
1. Can you point to any evidence from the last few years that it might be correct (in other words, that a fall in AD will lead to decrease in national output?) Find data on the GDP's of two Western European countries from 2008 and 2009 to support your findings. 
2. Can you point to any evidence from the last few years that the model might be flawed (in other words, that a fall in AD actually does lead to a fall in the price level)? Find data on inflation in the same two Western European countries to examine whether or not wages and prices are completely inflexible downwards as the model suggests.

1. How does the above model represent a compromise between Keynes' and Hayek's view of aggregate supply?
2. Why are there two aggregate supply curves? What is the difference between the two?
3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the "fixed-wage period" and the long-run the "flexible-wage period". The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run? 

Related posts:

1. Recession’s effects on small vs. large companies: some evidence in support of the Classical view of self-correction
2. Supply – side economists: “lower taxes, more growth, more tax revenue!”
3. IB Review – Neo-classical vs. Keynesian views of inflation

A common impressions among students is that a trade surplus is good and a trade deficit is bad. One challenge I face in teaching this topic is separating economic terms such as “suplus” and “deficit” from non-economic, normative concepts such as “good” and “bad”. In fact, a trade surplus is not always a good thing. To illustrate, I will look at the current account balances between China and the United States. In 2007, the US ran a trade deficit with China of $258 billion. While the US imported $321 billion of Chinese goods and services, it only earned $63 billion from the sale of exports to China. To most students, it would appear that China is “winning” in the game of trade, since it has such an enormous trade surplus with the United States. This, however, is not necessarily the case.

One way of looking at trade balances is that a nation with a substantial current account surplus is actually consuming less of its own output due to the high demand from abroad. As mentioned above, in 2007 Americans spent $321 billion on Chinese goods and services. China only produced $3.2 trillion of goods and services that year, meaning Americans actually consumed over 10% of the stuff produced in China! This represents Chinese output that is NOT being consumed by the Chinese. Additionally, since China imported far less from abroad than it sold, Chinese output being consumed abroad is far from made up for by Chinese consumption of foreign output. While this may sound like a good deal from the perspective of producers, who have a larger market due to trade, from the perspective of Chinese households it means they are consuming less than they are producing as a nation!

One of the goals of macroeconomics is to increase the standards of living of the nation’s people through an increase in the consumption of goods and services. In this regard trade deficit countries are actually better off than trade surplus countries, since they are actually consuming MORE than they are producing as a nation! A trade deficit country gets more than it gives, in a way, which sounds pretty good when if you consider total consumption to be an end in itself. A trade surplus country, on hte other hand, gives the rest of the world more than it gets in return (in terms of goods and services, that is).

Another consequence of running a large trade surplus is the build up of foreign exchange reserves. China, for instance, held over $1.3 trillion USD in its central bank in 2007, representing an enormous level of savings for the Chinese people, since these are dollars earned by the people of China (from their export sales to America), but not spent. These reserves represent a form of forced savings on the people of the nation.

The average Chinese consumer is also made worse off because the governments’ US dollar reserves are held intentionally to keep the value of the dollar high, thereby keeping the price of American and other nation’s imports prohibitively high for Chinese consumers. In this regard, China’s 50% national savings rate is a form of financial tyranny by the government perpetrated against the Chinese people, who, as consumers, would be much better off if the RMB were allowed to appreciate and imported goods and services could be more easily and affordably attained by Chinese households. Employment in the export sector might suffer but falls in exports would likely be made up for with gains in domestic consumption, meaning the overall effect on employment is likely to be mild upon a reductions in China’s trade surplus.

Furthermore, in order to maintain China’s trade surplus the Chinese government must keep the RMB weak. As already mentioned, one way it does this is by holding its US dollar reserves to keep the supply of dollars on foreign exchange markets low and its value high. Another way the Chinese central bank manipulates its currency is by constantly changing the level of interest rates to limit or encourage foreign capital flows into or out of the country, since such flows affect the Chinese currency’s value. If the Chinese central bank and government were to adopt a flexible exchange rate policy, which would help reduce the country’s trade surplus with the United States, this would allow the central bank to use monetary policy in the way it is meant to be used: to stimulate or contract the level of domestic consumption and investment. This week US Fed chairman Ben Bernanke spoke to the US Senate about China’s exchange rate controls, and made a similar point:

“Most economists agree the Chinese currency is undervalued and has been used to promote a more export-oriented economy. I think it would be good for the Chinese to allow more flexibility in their exchange rate.”

Letting its currency, the renminbi, appreciate would give China’s central bank more flexibility in monetary policy and help stimulate domestic demand and consumption, Mr. Bernanke said

China’s trade surplus does not necessarily benefit the country as a whole. Surpluses do keep export sector employment high, but result in a lower overall level of consumption among Chinese households and impose a higher than necessary level of savings on the nation. More balanced trade would increase the level of imported goods and services in China, increase real incomes as the value of the nation’s currency rises, and also allow for more inflows of foreign capital from abroad, further stimulating growth in China’s domestic economy.

Related posts:

1. Exchange rates and trade: a delicate balancing act, currently out of balance!
2. Silver lining of US recession- more balanced trade
3. The Marshall-Lerner Condition, the J-curve, and the US trade deficit

• Full employment of the nation’s resources, including labor, land and capital.
• Price level stability, meaning a low (generally between 2% and 4%) inflation rates
• Economic growth, meaning a year on year increase in the nation’s output of goods and services and the average income of the nation’s people.

Understanding the indicators used in macroeconomics to measure the success in these three areas is important. In the activity that follows, you will research, define, and explain the various types of inflation, unemployment and economic growth. You will also research and record examples of these indicators from several countries. Finally, you will investigate your OWN country, and determine what precisely makes up the total amount of economic activity in your country.

Part 1: Using your notes and Welker’s Unit 3.1 study guide, answer the following questions. Most of the country data you are asked to find can be found in the CIA World Factbook.

1. Identify the four components of a nation’s aggregate demand and briefly explain two factors [10 mark]
2. Research and identify the percentage of your own country’s GDP each of the four types of spending account for (as a percentage of total GDP). Enter your findings into THIS ONLINE FORM [5 marks]:
3. When you’ve completed the form for your own country, VISIT THE RESULTS PAGE and analyze the data with your classmates.

Related posts:

1. Lesson plan: Elasticity, exchange rates and the balance of payments – understanding the Marshall Lerner Condition
2. China: formerly the world’s factory, now a nation of consumers…
3. Lesson Plan: Sources of Economic Growth and Development

As a culminating activity for the two year IB Economics course here at Zurich International School, senior econ students research, prepared and presented proposals to the World Bank. The purpose was to choose a developing country, identify its current development status, pinpoint the major obstacles to development, brainstorm the country’s major assets and areas of potential, then request funds for a specific development project aimed at improving human welfare in the country.

Proposals ranged from transportation infrastructure to language schools to fair trade schemes to improvements in police protection. In the table below all 22 of my students’ projects can be viewed by clicking on the country’s name and following the link to the student’s presentation. Also below I have embedded some of the presentations for you to browse and evaluate here.

World Bank Development Project Proposals: Click on the name of the countries below to view the student’s presentation to the World Bank.

Samples of students’ presentations:

The assignment:

Goal: To win a concessionary loan from the World Bank to put towards a specific development project in the developing country you represent. Funds are extremely limited, and whether or not you will receive aid and how much aid you receive will be determined by a panel of judges consisting of your classmates.

Background: You will assume the role of Finance Minister for a country that you chose to research earlier in this unit. In that role, you will write a detailed report of your country’s development status, obstacles to economic development, existing resources and potential within the country, concluding with a proposal for a specific development project that will improve human welfare in your country. You will then make an appeal to lenders at the World Bank, requesting funding for your project. A committee made up of your classmates will decide whether to approve requests and bring them to the chief economist of the bank, your teacher. The best proposals (accurate, appropriate, achievable) will get the limited money available…and those students will earn the best marks.

Assignment:You will create a report for the country you selected in our earlier lesson, “Sources of Economic Growth and Development”. You will have class time over the next three weeks to research and prepare your report. The report may take any form you wish: It can be a written report to be delivered orally, it may be in the form of a Google Presentation, or it could be a video, such as a PhotoStory. You may also create a website containing the details of your report, or even an audio recording that could be podcasted in your appeal for financial support. Any other reasonable media may be used to prepare and present the report.

Resources online:

1. The World Bank Countries and Regions
2. CIA – the World Factbook
3. African Development Outlook
4. African Development Bank

Related posts:

1. Kiva.org – how YOU can be a banker for the world’s poor
2. The “bottom billion”, aid, and strategies for achieving economic development
3. Calling all Y1 and Y2 IB Economics students

Recently I received the following email from an AP Macroeconomics teacher in the United States:

I have a question about graphs that illustrate how trade preferences (specifically Supply and Demand shifts), affect P, Q and Pe on Supply-Demand GRAPHS of Currency Exchange.

In teaching my AP Macro students about this concept, I have reached a gap in our full understanding how to graph the Supply and Demand of Yen, or Euro (Price in USD).

For example, if the Price levels rise in the U.S., relative to Japan’s, and consequently, the U.S. demands more Japanese cars and stereos, the only label that we ever see for the x-axis is “Q” or Quantity, or Qe, a vertical line that represents the starting “market clearing price”, of .01USD=1Y. When DEMAND or SUPPLY shifts, the only change that I ever see labeled on the graphs is the Y-Price in USD of Yen, but descriptions simply talk about the Y=1.

When Demand or Supply shifts (in response to increased demand for Yen), and there is a new higher or lower USD Price for Yen, respectively, does the vertical line for Q simply shift outward (continuing to represent Y=1) at whatever the new Price Equilibrium becomes (simply meaning just more “1s” of them in circulation (at each new Pe market-clearing point)?

Thanks

Here is my response:

Hello, I will try to address your questions below.

Exchange rates can be determined by several factors, including relative price levels, relative interest rates, tastes and preferences of domestic and international consumers, relative income levels at home and abroad and speculation by currency traders. As you say, an increase in the price level of goods produced in United States (say, Fords), ceteris paribus, should lead to an increase in demand among American consumers for goods produced in Japan (say, Hondas), which now appear relatively cheaper. Demand for Yen increases among American households who wish to buy Japanese goods. The USD price of Yen then rises in the Yen market. Since Japanese holders of Yen now receive more USD for each Yen, they will provide more Yen (this is another way of saying with an increase in demand for Yen, the quantity supplied of Yen increases).

Theory would say that there is no increase in the supply of Yen following an increase in Demand by American consumers, only an increase in quantity supplied. The Yen clearly appreciates, as the USD/Yen exchange rate rises. Now, there is another side to this story. The Yen market refers to the market for Yen in the United States. Yen will appreciate in the United States. Simultaneously, USD will depreciate in Japan, as Americans buy more Japanese goods, they are supplying more USD in the USD market in Japan. Here the “price” or the exchange rate is Yen/USD. The Yen price of a USD will fall as the supply of USD increase as Americans exchange their dollars for Yen to buy the relatively cheap Japanese goods.

The “market-clearing price” in foreign exchange markets is the exchange rate that prevails in a floating exchanged rate system where exchange rates are determined solely by supply and demand by international consumers, investors, government, banks, and firms. Assume the Yen is trading for $0.01. If , following inflation in the United States and the corresponding increase in demand for Yen, the value of the Yen remained at $0.01, then the quantity demanded for Yen would exceed the quantity supplied. There would be shortages of Japanese goods in the United States, as Japanese goods are in greater demand yet their prices have not risen. In order to “clear the market” so to speak, the exchange rate must rise, to say $0.012. Now, a Yen’s worth of goods “costs” Americans 20% more than previous, making them less attractive over time. Likewise, a dollar’s worth of goods “costs” Japanese consumers 20% less, since the dollar is weaker in Japan.

As you can foresee, the floating value of the Yen should lead to relatively balanced trade between Japan and the US. The US current account will initially move towards deficit as inflation makes American goods more expensive, however, as demand for Japanese goods increases, the value of the Yen rises making Japanese goods more expensive, which will eventually reduce their appeal to American consumers who will once again begin consuming more American goods and importing less. Japanese will notice the weaker dollar makes US imports cheaper and begin importing more American products. The US current account should remain  balanced in the long-run in a floating exchange rate system.

I don’t know if you’ve had a look at my study guides on exchange rates and balance of payments, but those may help clarify graphically what I describe above:

• Unit 4: Exchange Rates
• Unit 4: Balance of Payments

I hope this clarifies your understanding of how relative price levels help determine exchange rates!

Best,
Jason

Related posts:

1. How do changing interest rates affect exchange rates? The example of the RMB
2. Exchange rates and trade: a delicate balancing act, currently out of balance!
3. Exchange rates, currency manipulations, and the balance of trade

As an IB Economics teacher, it is my duty to assist students who choose to write an economics extended essay. This year I will supervise four Zurich International School students, who will be researching topics ranging from the competitive nature of the local fast food market, to Malaysia’s economic policy and the country’s development, to the health insurance industry in Switzerland and Brazil’s coffee market. Helping students fine tune their research topics and refine their essay is an exciting and rewarding process.

This afternoon I received an email from an IB Economics student in Berlin. Here’s what she had to say:

Dear Mr.Welker :

I’m currently an IB Grade 11 student studying at Berlin International School, and i would like to write my extended essay in Economics. Your blog has provided me with so many ideas now that the problems is now i don’t know what to choose or how to narrow it down . My ideas are mainly focusing on China’s economy, because I’m from Taiwan, I thought it would be an advantage for me, since i can understand information if it was written in Chinese.

I’m thinking of writing about the following topics:

• Limiting factors of China’s economic expansion (inequality, inflation, protectionism from other countries like US, spending and saving habits of the Chinese, export and import) and maybe the possible future of China’s economy, because while some people say it’s going to help lift the global economy out of recession, some say they see an economic crash.( but I’m not sure if as a high school student is able to do that, at the same time I think one of the criterias is to discover something new ? )
• Another thing i also find interesting is about Chinese currency and how it might solve inflation (I came across this from one of your blog posts about China at May 2008) or what policies do governments use to maintain RMB without buying US exports and the possible effects on other countries as a result of weak Chinese currency

I really can’t decide which one to do, therefore i would really appreciate it if you could advice me and give me some feedbacks.

Looking forward to your responses !

I was happy to receive an email from such an enthusiastic young economist. Below is my response and advice to the student:

Hello,

Your ideas are very interesting… it’s impressive as an IB Econ teacher to see a student as thoughtful and reflective on the EE topic as you are. Here are my thoughts on your proposed topics:

I think your first topic would be particularly difficult to research and write a good essay on. In all honesty, not many of the factors that you identify (inequality, inflation, protectionism from other countries like US, spending and saving habits of the Chinese, export and import) have really limited China’s economic growth. China’s growth has been unprecedented in the world in modern history. Inequality could be viewed as a result of the rapid growth the country has experienced; such inequality has been experienced in many countries during their early stages of economic development. Inflation is also a symptom of rapid growth, but in most cases China has keep inflation under control. It has been the lack of protectionism from countries like the US which have led to the massive growth of China’s export industry. If anything, China’s own protectionist policy of managing the value of the RMB at such a low rate has also contributed to its rapid growth.

Even Chinese spending and savings habits have contributed to the growth of the country’s economy. A high savings rate enables the Chinese government to tap the country’s savings to buy US government bonds, which keeps interest rates low in America, the dollar strong, and helps finance the US government’s budget deficits, meaning lower taxes and more disposable income among American consumers who turn around and import hundreds of billions of dollars worth of Chinese goods every year, further fueling growth in China. With a lower savings rate, China would experience fewer net exports. On the other hand, they’d experience more domestic consumption, which is probably what we should expect to see in the future if Beijing begins to loosens its control of the RMB and allows it to strengthen. Chinese will then begin consuming more of their own output and buying more imports from abroad, while net exports decrease in response to the rising prices of Chinese goods in the west. Domestic consumption will begin to replace exports as domestic savings decreases.

I like your second proposal much better. Since you are in Germany, I would consider researching the effects of China’s exchange rate controls on a particular industry in which both German and Chinese firms compete. I had a student in Shanghai who had a similar background to yours; he was of Chinese descent, but born in Germany. He spoke both German and Mandarin. He researched the impact of China’s low cost automobile parts manufacturers on the German auto parts and automobile industries. He did not focus exclusively on the exchange rate, but it was part of his research.

The IB really likes when you research local markets. If you examine the impact of the weak RMB on, say, US net exports, it’s not nearly as impressive as if you focus your investigation on German firms. You may have friends at your school whose parents work for firms who do business with or compete against Chinese firms. Interview them! You could measure historical exchange rate data between the RMB and the Euro, explain the mechanism by which China manages its currency against the US dollar but then explain how that also affects exchange rates with the Euro, then examine the impact on exports and imports from Germany to China and vis versa in response to the fluctuations of the RMB/Euro exchange rate. America is not the only country that wants China to let the RMB float. Europe’s exports are also affected by the weak RMB.

So that’s my suggestion. Take your two homes (well, not really as you’re Taiwanese, but close enough!) and focus on them. Choose one or two industries that exist in Germany AND China, and research the effects of free trade, China’s entry to the WTO, China’s exchange rate policies, and so on, to draw conclusions about how China’s entry to the global economy has affected firms in Germany.

Good luck, I hope this helps! Click on the “China” category on my blog to find all the dozens of articles I’ve written about China over the last three years!

Best,
Mr Welker

Related posts:

1. Trade surpluses are not all they’re cracked up to be!
2. How do changing interest rates affect exchange rates? The example of the RMB
3. China: formerly the world’s factory, now a nation of consumers…

When my adventure in Web 2.0 teaching began over three years ago, there was no blog. At first Welker’s Wikinomics was, not surprisingly, a wiki for my AP and IB Economics students in Shanghai to use as a study tool. But then came the blog, and for lack of a better name, it took on the same name as the wiki. Today the Welker’s Wikinomics name is actually shared by not only the wiki and this blog, but also by the Economics Universe, where econ students and teachers can find RSS feeds from hundreds of resources for learning economics, as well as the free lecture notes I publish here and which have been downloaded thousands of times by Econ students around the world.

Last year I began thinking about changing the name of this blog, as I was never quite satisfied having my blog called “Wikinomics”, since so many visitors to my site have always been confused about the difference between the wiki and the blog. So today I am happy to announce a new name for this blog, Economics in Plain English.

I thought of the new name while writing a blog post recently for which I spent a frustrating hour reading an article from the Economist. While struggling through the difficult article I guessed that most people without at least two years of college economics would have had a hard time understanding what the author was trying to say with all his economics jargon. Why, I thought, aren’t more journalists and academics writing about economics in a way that anyone interested in the subject, whether he be a high school student or a retired grandfather, can understand. Why don’t more people write about economics in plain english!?

Well, that’s precisely what I’ve been trying to do here for three years. So I decided it was the right name for this blog.

From now on this blog can be accessed by going to the URL: http://www.economicsinplainenglish.com. The original domain will remain intact, however, since over 500 articles on this blog are still used by myself and other Econ teachers and their hyperlinks must remain active. Welker’s Wikinomics is not disappearing, as my homepage will still be located at http://www.welkerswikinomics.com. Only the blog is getting a new name. The wiki, the universe, and the lecture notes will continue to be part of the Welker’s Wikinomics suite of resources available for econ teachers and students.

As always, if you’re an economics teacher who enjoys what you read here and think you may have something to add, please drop me an email at welkerswikinomics@yahoo.com to receive an author account on this blog. Become a regular contributor and I’ll add your face and bio to the “About the Authors” sidebar! How can you pass that up?

A big thanks to everyone who has visited this blog, read our posts and left a comment over the last few years!

Related posts:

1. Economics for Citizenship / The 180 Degree Science!
2. Welker’s links for 2008-05-02