Note: This post was originally published in August of 2010. It is being reposted today to support a lesson on fiscal policy in my year 2 IB Economics class.
In the seemingly endless and currently ongoing debate over the role of the government in the macroeconomy, there are two main camps: Those who think the governments of the developed economies have not done enough to get their economies out of recession, and those who think they have already done too much, and therefore need to start rolling back stimulus and reducing deficits.
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.
Deflation: a decrease in the general price level of goods and services of an economy. Sounds great, right? Lower prices mean the purchasing power of our income increases, making the “average” person richer! On the surface, it could be concluded that deflation may actually be a good thing. And in some cases, it is!
If prices of goods are falling because of major technological advances (think of the price of cell phones and laptop computers over the last 20 years) or because of massive improvements in the productivity of labor and capital (think of the price of manufactured consumer goods during the Industrial Revolution), then deflation could be considered a sign of healthy economic growth. Put in terms an IB or AP Economics student should understand, a fall in prices caused by an increase in a nation’s aggregate supply is good, since it is accompanied by greater levels of employment and higher real incomes. But if the fall in prices is caused by a decline in spending in the economy (in other words, by a decrease in aggregate demand), the consequences can be catastrophic.
It just so happens that the United States, Great Britain, and my own home of Switzerland are all faced with demand-deficient deflation at this very moment. I’ll allow the Economist to elaborate:
…With unemployment nearing 9% (in the United States), economic output is further below the economy’s potential than at any time since 1982. This gap is likely to widen. House prices are not part of America’s inflation index but their decline is forcing households to reduce debt , which could subdue economic growth for years. As workers compete for scarce jobs and firms underbid each other for sales, wages and prices will come under pressure.
So far, expectations of inflation remain stable: that sentiment is itself a welcome bulwark against deflation. But pay freezes and wage cuts may soon change people’s minds. In one poll, more than a third of respondents said they or someone in their household had suffered a cut in pay or hours…
Does this matter? If prices are falling because of advancing productivity, as at the end of the 19th century, it is a sign of progress, not economic collapse. Today, though, deflation is more likely to resemble the malign 1930s sort than that earlier benign variety, because demand is weak and households and firms are burdened by debt. In deflation the nominal value of debts remains fixed even as nominal wages, prices and profits fall. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.
From 1929 to 1933 prices fell by 27%. This time central banks are on the case. In America, Britain, Japan and Switzerland they have pushed short-term interest rates to, or close to, zero…
…inflation is easier to put right than deflation. A central bank can raise interest rates as high as it wants to suppress inflation, but it cannot cut nominal rates below zero… In the worst case, rising debts and defaults depress growth, poisoning the economy by deepening deflation and pressing real interest rates higher….Given the choice, erring on the side of inflation would be less catastrophic than erring on the side of deflation.
Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?
The expectation of future deflation can have as equally devastating effect. Why is this?
What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?
Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?
Deflation or Inflation:Watch the video below, see if gives you any clues as to the causes and effects of deflation. What do you think John Maynard Keynes would say in response to the deflationary fears expressed in the Economist article?
The most important graph used in Macroeconomics today is almost certainly the Aggregate Demand / Aggregate Supply (AD/AS) model. This graph can be used to illustrate most macroeconomic indicators, including those objectives that policymakers are most interested in achieving:
Price level stability
Full employment, and
The AD/AS model, on its surface, is a very simple diagram, showing the total, or aggregate demand for a nation’s output and the total, or aggregate supply of goods and services produces in a nation. It is very similar to the microeconomics supply and demand diagram, except that instead of comparing the quantity of a particular good to the price in the market, the AD/AS model plots the national output (Y) against the average price level (PL). The model shows an inverse relationship between aggregate and price level, and a direct relationship between aggregate supply and price levels.
What makes this seemingly simple model so interesting, however, is that there are two wildly different opinions among economists on one of the its two primary components. Some economists, whom we shall refer to as Keynesians, believe that the AS curve is horizontal whenever aggregate demand decreases, and vertical whenever AD increases beyond the full employment level of output. On the other side of this debate is whom we shall refer to as the Hayekians who believe that AS is vertical, regardless of the level of demand in the nation. The two views of AS can be illustrated as follows.
Underlying the two models above are very different ideas about a nation’s economy. The Keynesian AS curve implies that anything that leads to a fall in a nation’s aggregate demand (either household consumption, investment by firms, government spending or net exports) will cause a relatively mild fall in prices in the economy but a significant decline in the real GDP (or the total output and employment in the nation). The neo-classical AS curve, on the other hand, being vertical (or perfectly inelastic), implies that no matter what happens to AD, the nation’s output and employment will always remain at the full employment level (Yfe).
Behind these two models of AS are two schools of economic thought, one rooted in Keynesian theories and one rooted in the theories of an intellectual rival and contemporary of John Maynard Keynes’, Friedrich Hayek. Keynes and Hayek were the most pre-eminent economists of their era. Both lived in the first half of the 20th century, and rose to prominence in between the two World Wars. Both economists saw the world fall into the Great Depression, but each of them formulated their own distinct theory on the best way to deal with the Depression. The episode of Planet Money below goes into some detail about the lives and the theories of these to most influential economists.
Keynes believed in what we today call demand-management. The idea that through well planned economic policies, governments and central banks could intervene in a nation’s economy during periods of economic downturn to return the economy to its full-employment level, or the level of output the nation would be producing at if everyone who was willing and able to work was actually working. Keynes believed that aggregate demand was the most vital measure of economic activity in a nation, and that through its use of fiscal and monetary policies (changes in the tax rates, the levels of government spending, and the interest rates in the economy), the government and central bank could provide stimulus to a depressed economy and create demand for the nation’s resources that would help move a depressed economy back towards full employment.
Hayek and his disciples, on the other hand (sometimes referred to today as the supply-siders) had a different interpretation of the macroeconomy. Hayek was what many today refer to as a libertarian. He believed that the government’s best strategy for handling an economic downturn was to get out of the way. Any attempt by the government to influence the allocation of resources through “stimulus projects” would only reduce the private sector’s ability to quickly and efficienty correct itself. The free market, argued Hayek, was always superior to the government when it came to allocating resources towards the production of the goods and services consumers demanded, so why allow government to intervene in the economy at all. All a government should do, argued Hayek, was provide a few basic guidelines to allow the economy to function. A legal system of property rights, for instance. The government need not provide anything else. The free market would take care of health care, education, defense, security, infrastructure, and anything else the market demanded.
During depressions, Hayek believed that government could only make things worse by trying to intervene to restore full employment. At any and all times, government’s best action would be to lower taxes, reduce its spending on goods and services, and thereby encourage private entrepreneurs to provide the nation’s households with the output they demand. Any regulation of the private sector, including minimum wages, environmental regulations, workplace safety laws, government pensions, unemployment benefits, welfare payments, or any other measures by government to redistribute wealth or promote equality or social welfare would reduce incentives for individuals in society to achieve their full productivity and strive to maximize their potential output. By minimizing the government’s role in the economy, argued Hayek, a nation would be likely to recover swiftly from a 1930’s style Depression, and output can be maintained at a level that corresponds with full employment of the nation’s resources.
The graphs below show how the two competing ideologies view the effects of a fall in aggregate demand in the economy.
On the left we see the Keynesian model, which shows output (real GDP) falling with a fall in AD. The fall in output corresponds with a fall in employment, and therefore a recession (or Depression). To return to full employment, aggregate demand must move back to the right (or increase). To facilitate this, Keynes and his contemporaries believed that government should increase its spending, decrease taxes (to encourage households and firms to spend) and lower interest rates (to make saving less appealing). All that is needed, say the Keynesians, is a dose of stimulus to get back to full employment (Yfe).
In the Hayekian model, no government intervention is needed at all when aggregate demand falls. In fact, in an economy with very limited government, a fall in AD will have little or no effect on output and employment. Without minimum wages or laws making it difficult or expensive for firms to reduce wages or fire and hire workers, firms faced with falling demand will simply lower their employees’ wages and reduce the prices of their products to maintain their output. If there is no more demand for some products, those firms will shut down and their workers will go to work for firms whose products are still in demand, at whatever wage rate the market is offering. Wages and prices are perfectly flexible in the Hayekian view, because there is no government interfering, demanding workers for big government projects, competing wages up, enforcing a minimum wage, or paying unemployment benefits to those out of work: all policies that make it difficult for wages to adjust downwards during a recession. Without government intervention, wages and prices rise and fall with the level of demand in the economy, but output remains constant at its full employment level.
The two models could not be more different. In one (Keynes’) recessions will occur anytime demand falls below the level needed to maintain full employment. In the other (Hayek’s), recessions are impossible as long as government gets out (and stays out) of the way.
Which models is the right model? For most of the last 100 years, most Western economies have demonstrated more of the characteristics of the Keynesian model. As the last several years show, recessions certainly are possible. Wages and prices have NOT fallen as much as Hayek’s model suggest they should, and economic output has declined in many Western nations and remains below the levels achieved in 2007 in many places. Most economists would argue that this prolonged recession is likely due to a weak level of aggregate demand. And the economic policies of many Western nations have reflected the Keynesian belief that government can “fix the problem” through stimulus plans involving tax cuts, spending increases, and low interest rates.
But two years of Keynesian policies are now being reversed. US President Obama’s latest attempt at a Keynesian-style stimulus (his $447 billion “American Jobs Act”) has been rejected by the US Congress. Across Europe, government spending is being slashed and taxes are being raised, both policies that threaten to further reduce aggregate demand. Deregulation is the battle cry of the Republican Party in the United States one year before the next presidential election. Presidential candidates are promising to “cut taxes, cut spending and cut government”, which sounds like a Hayekian battle cry. Less government will lead to more competition, greater efficiency, more employment and a stronger economy, goes the thinking. Government cannot solve our problems, government is our problem.
This debate is not a new one. It has been going on since the 1930s when two scholars, one an Englishman from Cambridge, the other an Austrian at the London School of Economics, went toe to toe on the role of government in a nation’s economy. The two models of aggregate supply above survive to this day, and 80 years later, in the midst of what may be the second Great Depression, economists and politicians still haven’t figured out which theory is correct. Part of our problem is that in our Western democracies in which economic policies are determined by politicians who are often only in office for two to four years, we have not had the opportunity to truly put either economic theory to the test. Less than three years ago Barack Obama, freshly elected, embarked on the greatest experiment in Keynesianism since Franklin Roosevelt’s “New Deal”, which was widely credited with getting the US out of the Depression. Now, with another election looming, we have politicians promising to bring America back to economic prosperity in a truly Hayekian fashion, by “cutting, cutting and cutting”.
Directions: Macroeconomics is an area of study with precise goals attached to it. Macroeconomists generally agree that there are three primary goals towards which policies should be used to try and achieve:
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 your textbook (Welker’s chapters 11, 12, 13, 14 and 15), answer the following questions. Most of the country data you are asked to find can be found in the CIA World Factbook.
Define and explain the various types of each of the following:
Define inflation[2 marks]
Type 1 [1 mark]:
Type 2 [1 mark]:
Research and identify the current inflation rates in [3 marks]:
Define unemployment [2 marks]
Type 1 [1 mark]:
Type 2 [1 mark]:
Type 3 [1 mark]:
Research and identify the current unemployment rates in [3 marks]:
In the last two weeks, both my countries, America and Switzerland, have put forward stimulus packages aimed at helping their economies avoid entering a second recession. The US American Jobs Act, announced by President Obama to the US people two weeks ago today, will provide relief to American businesses and households mostly in the form of tax cuts. Some new spending on infrastructure, primarily schools and transportation, is provided, as is continued relief for unemployed Americans.
The chart below shows how the American Jobs Act plans to spend the proposed $447 billion.
Clearly, the largest single category of spending proposed by the AJA is in the form of tax cuts for American households and firms (a combined 54.8% of the total). The purpose of tax cuts, of course, is to provide households with more disposable income with the hope that household consumption will increase, thereby increasing demand for goods, services, and ultimately labor, which would bring down unemployment. Businesses will also enjoy a cut in the taxes they pay when employing workers, so the costs to firms that hire new workers will be lower if the bill is passed. Extending benefits to workers who are already unemployed makes up a relatively small component of the American stimulus plan, while infrastructure and education spending, both which contribute to the long-run growth potential of the US economy, make up less than a third of the $447 billion package.
Let’s now look at the Swiss stimulus package, approved by the Swiss parliament today following a debate that lasted just seven hours. (For comparison, the American Jobs Act will require months of deliberation and when it is ultimately passed will likely have been completely modified by the American congress). The chart below shows where the $950 million of spending announced by Switzerland will be spent.
The biggest difference, as can be seen, is that a full 57.5% of the Swiss stimulus comes as relief for unemployed Swiss workers, compared to just 14% of America’s package. The 24.4% spent on research and development will go towards “a research and innovation programme, helping to translate ideas into successful business plans.” The subsidies for Switzerland’s tourist industry will come in the form of low-interest loans to businesses in the hotel and travel industry, which has been adversely affected by the recent appreciation of the Swiss franc, which has reduced tourism in Switzerland as Europeans and others have found it more expensive to travel to the country in recent months. Tourism is one of the largest sectors in the Swiss job market, so the spending on unemployment benefits will bring direct relief to individuals affected by that industry.
To compare the two country’s stimulus packages (America’s is only in the proposal stage, while Switzerland’s has been approved and will begin being implemented soon), is a study in two different economic philosophies. One major difference is the obvious lack of tax cuts in the Swiss plan. Such cuts were proposed by the conservative party in Switzerland, but the country’s finance minister, supported by the center-left party, argued that “tax policy should not be shaped by the current monetary situation.” She is referring to the fact that Switzerland’s stimulus in needed in response to the strong Swiss franc, not due to any underlying problems in the Swiss economy. The Swiss plan targets relief directly at those industries affected by the strong currency, tourism and high skilled manufacturing, which stands to benefit from increased spending on R&D.
The US plan, on the other hand, includes over $240 billion (almost 55% of the total) in tax cuts, which while they do increase households’ disposable incomes, do very little to guarantee an increase in total spending in the economy. The last two rounds of stimulus in the United States, the 2009 American Recovery and Reinvestment Act, and the 2008 tax rebate program under George W. Bush, both included significant tax cuts to Americans (all of the Bush stimulus was a tax refund). Neither of these packages produced much growth for the United States, although the ARRA likely prevented unemployment from rising higher than it would have without a stimulus.
Switzerland’s plan includes no tax cuts, instead it offers direct support to particular industries in the form of government spending, and helps unemployed workers continue to spend and contribute to aggregate demand by maintaining their incomes during their period of unemployment. Switzerland’s stimulus, it could be argued, is more of a demand-side fiscal stimulus than America’s, which, due to its large tax cuts, places more of the responsibility for increased aggregate demand on the private sector. However, the 31% of the American plan that goes towards school and transportation infrastructure, and the 14% that goes towards continued unemployment benefits, should have positive demand-side effects, and should help increse employment and output in America if the bill is passed.
What is meant by the claim that Switzerland’s stimulus package is more of a demand-side policy than the United States’? How will the various types of spending in the Swiss plan contribute to the country’s aggregate demand?
Another difference between the two plans is how they will be paid for. In Switzerland, “the money is to be taken from an expected 2011 budget surplus,” while the US budget for 2012 is expected to have a deficit of around 10% of the country’s GDP. How does the budget situation in the two country’s impact the ability to use fiscal expansionary fiscal policy to promote the macroeconomic objective of full employment?
Which is more likely to have a direct expansionary effect on aggregate demand, tax cuts of a certain size or government spending of the same size? Explain your answer.