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
• Economic growth

source: http://www.beaumontenterprise.com/

 

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.

1. Identify the four components of a nation’s aggregate demand and briefly explain two factors that affect each of the four components (this can be found in Welker’s chapter 12) [10 marks]
2. Research and identify the main macroeconomic indicators for your home country. Enter the information you find into THIS ONLINE FORM, and click submit when you’re done.

• From the CIA World Factbook you should be able to discover your country’s main macroeconomic indicators (GDP, GDP per capita, inflation rate
• Using the Eurostat website, you can find out what percentage of your country’s GDP is made up of government spending.
• If you are not from a European country, you may have to do a little more investigation to find the percentage of GDP made up of government spending.

Part 3: The Results : You can view the results of the form by clicking HERE

Discussion Questions:

1. Which of the countries appear to be doing the BEST job of meeting their macroeconomic objectives of low unemployment, low inflation and economic growth?
   
2. Which countries appear to be doing the WORST at meeting their macroeconomic objectives?
3. Which countries have the highest GDP growth rates? What do the highest growth countries have in common? What is different about them?
4. Which countries have the lowest unemployment rates? What do these countries have in common?
5. Which country experienced a recession in 2010? Discuss the possible relationship between economic growth and unemployment?

Parliament gives green light to government economic boost plan. – swissinfo

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.

Discussion Questions:

1. 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?
2. 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?
3. 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.

As yet another school year begins, we once again find ourselves returning to an atmosphere of economic uncertainty, sluggish growth, and heated debate over how to return the economies of the United States and Europe back onto a growth trajectory. In the last couple of weeks alone the US government has barely avoided a default on its national debt, ratings agencies have downgraded US government bonds, global stock markets have tumbled, confidence in the Eurozone has been pummeled over fears of larger than expected deficits in Italy and Greece, and the US dollar has reached historic lows against currencies such as the Swiss Franc and the Japanese Yen.

What are we to make of all this turmoil? I will not pretend I can offer a clear explanation to all this chaos, but I can offer here a little summary of the big debate over one of the issues above: the debate over the US national debt and what the US should be doing right now to assure future economic and financial stability.

There are basically two sides to this debate, one we will refer to as the “demand-side” and one we will call the “supply-side”. On the demand-side you have economists like Paul Krugman, and in Washington the left wing of the Democratic party, who believe that America’s biggest problem is a lack of aggregate demand.

Supply-siders, on the other hand, are worried more about the US national debt, which currently stands around 98% of US GDP, and the budget deficit, which this year is around $1.5 trillion, or 10% of GDP. Every dollar spent by the US government beyond what it collects in taxes, argue the supply-siders, must be borrowed, and the cost of borrowing is the interest the government (i.e. taxpayers) have to pay to those buying government bonds. The larger the deficit, the larger the debt burden and the more that must be paid in interest on this debt. Furthermore, increased debt leads to greater uncertainty about the future and the expectation that taxes will have to be raised sometime down the road, thus creating an environment in which firms and households will postpone spending, prolonging the period of economic slump.

The demand-siders, however, believe that debt is only a problem if it grows more rapidly than national income, and in the US right now income growth is almost zero, meaning that the growing debt will pose a greater threat over time due to the slow growth in income. Think of it this way, if I owe you $98 and I only earn $100, then that $98 is a BIG DEAL. But if my income increases to $110 and my debt grows to $100, that is not as big a deal. Yes, I owe you more money, but I am also earning more money, so the debt burden has actually decreased.

In order to get US income to grow, say the demand-siders, continued fiscal and monetary stimulus are needed. With the debt deal struck two weeks ago, however, the US government has vowed to slash future spending by $2.4 trillion, effectively doing the opposite of what the demand-siders would like to see happen, pursuing fiscal contraction rather than expansion. As government spending grows less in the future than it otherwise would have, employment will fall and incomes will grow more slowly, or worse, the US will enter a second recession, meaning even lower incomes in the future, causing a the debt burden to grow.

Now let’s consider the supply-side argument. The supply-siders argue that America’s biggest problem is not the lack of demand, rather it is the debt itself. Every borrowed dollar spent by the goverment, say the supply-siders, is a dollar taken out of the private sector’s pocket. As government spending continues to grow faster than tax receipts, the government must borrow more and more from the private sector, and in order to attract lenders, interest on government bonds must be raised. Higher interest paid on government debt leads to a flow of funds into the public sector and away from the private sector, causing borrowing costs to rise for everyone else. In IB and AP Economics, this phenomenon is known as  the crowding-out effect: Public sector borrowing crowds out private sector investment, slowing growth and leading to less overall demand in the economy.

Additionally, argue the supply-siders, the increase in debt required for further stimulus will only lead to the expectation among households and firms of future increases in tax rates, which will be necessary to pay down the higher level of debt sometime in the future. The expectation of future tax hikes will be enough to discourage current consumption and investment, so despite the increase in government spending now, the fall in private sector confidence will mean less investment and consumption, so aggregate demand may not even grow if we do borrow and spend today!

This debate is not a new one. The demand-side / supply-side battle has raged for nearly a century, going back to the Great Depression when the prevailing economic view was that the cause of the global economic crisis was unbalanced budgets and too much foreign competition. In the early 30′s governments around the world cut spending, raised taxes and erected new barriers to trade in order to try and fix their economic woes. The result was a deepening of the depression and a lost decade of economic activity, culminating in a World War that led to a massive increase in demand and a return to full employment. Let’s hope that this time around the same won’t be necessary to end our global economic woes.

Recently, CNN’s Fareed Zakaria had two of the leading voices in this economic debate on his show to share their views on what is needed to bring the US and the world out of its economic slump. Princeton’s Paul Krugman, a proud Keynesian, spoke for the demand-side, while Harvard’s Kenneth Rogoff represented the supply-side. Watch the interview below (up to 24:40), read my notes summarizing the two side’s arguments, and answer the questions that follow.

Summary of Krugman’s argument:

• Despite the downgrade by Standard & Poor’s (a ratings agency) there appears to be strong demand for US government bonds right now, meaning really low borrowing costs (interest rates) for the US government.
• This means investors are not afraid of what S&P is telling them to be afraid of, and are more than happy to lend money to the US government at low interest rates.
• Investors are fleeing from equities (stocks in companies), and buying US bonds because US debt is the safest asset out there. The market is saying that the downgrade may lead to more contractionary policies, hurting the real economy. Investors are afraid of contractionary fiscal policy, so are sending a message to Washington that it should spend more now.
• The really scary thing is the prospect of another Great Depression.
• Can fiscal stimulus succeed in an environment of large amounts of debt held by the private sector? YES, says Krugman, the government can sustain spending to maintain employment and output, which leads to income growth and makes it easier for the private sector to pay down their debt.
• With 9% unemployment and historically high levels of long-term unemployment, we should be addressing the employment problem first. We should throw everything we can at increasing employment and incomes.
• Is there some upper limit to the national debt? Krugman says the deficit and debt are high, but we must consider costs versus benefits: The US can borrow money and repay in constant dollars (inflation adjusted) less than it borrowed. There must be projects the federal government could undertake with at least a constant rate of return that could get workers employed. If the world wants to buy US bonds, let’s borrow now and invest for the future!
• If we discovered that space aliens were about to attack and we needed a massive military buildup to protect ourselves from invasion, inflation and budget deficits would be a secondary concern to that and the recession would be over in 18 months.
• We have so many hypothetical risks (inflation, bond market panic, crowding out, etc…) that we are afraid to tackle the actual challenge that is happening (unemployment, deflation, etc..) and we are destroying a lot of lives to protect ourselves from these “phantom threats”.
• The thing that’s holding us back right now in the US is private sector debt. Yes we won’t have a self-sustaining recovery until private sector debt comes down, at least relative to incomes. Therefore we need policies that make income grow, which will reduce the burden of private debt.
• The idea that we cannot do anything to grow until private debt comes down on its own is flawed… increase income, decrease debt burden!
• Things that we have no evidence for that are supposed to be dangerous are not a good reason not to pursue income growth policies.
• When it comes down to it, there just isn’t enough spending in the economy!

Summary of Rogoff’s argument:

• The downgrade was well justified, and the reason for the demand for treasuries is that they look good compared to the other options right now.
• There is a panic going on as investors adjust to lower growth expectations, due to lack of leadership in the US and Europe.
• This is not a classical recession, rather a “Great Contraction”: Recessions are periodic, but a financial crisis like this is unusual, this is the 2nd Great Contraction since the Depresssion. It’s not output and employment, but credit and housing which are contracting, due to the “debt overhang”.
• If you look at a contraction, it can take up to 4 or 5 years just to get back where you started.
• This is not a double dip recession, because we never left the first one.
• Rogoff thinks continued fiscal stimulus would worsen the debt overhang because it leads to the expectation of future tax increases, thus causing firms and households increased uncertainty and reduces future growth.
• If we used our credit to help facilitate a plan to bring down the mortgage debt (debt held by the private sector), Rogoff would consider that a better option than spending on employment and output. Fix the debt problem, and spending will resume.
• Rogoff thinks we should not assume that interest rates of US debt will last indefinitely. Infrastructure spending, if well spent, is great, but he is suspicious whether the government is able to target its spending so efficiently to make borrowing the money worthwhile.
• Rogoff thinks if government invests in productive projects, stimulus is a good idea, but “digging ditches” will not fix the economy.
• Until we get the debt levels down, we cannot get back to robust growth.
• It’s because of the government’s debt that the private sector is worried about where the country’s going. If we increase the debt to finance more stimulus, there will be more uncertainty, higher interest rates, possibly inflation, and prolonged stagnation in output and incomes.
• When it comes down to it, there is just too much debt in the economy!

Discussion Question:

1. What is the fundamental difference between the two arguments being debated above? Both agree that the national debt is a problem, but where do the two economists differ on how to deal with the debt?
2. The issues of “digging ditches and filling them in” comes up in the discussion. What is the context of this metaphor? What are the two economists views on the effectiveness of such projects?
3. Following the debate, Fareed Zakaria talks about the reaction in China to S&P’s downgrade of US debt. What does he think about the popular demands in China for the government to pull out of the market for US government bonds?
4. Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.
5. Should the US government pursue a second stimulus and directly try to stimulate employment and income? Or should it continue down the path to austerity, cutting government programs to try and balance its budget?

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?

The business cycle is an economic phenomenon which describes changes in the level of economic output compared to a long run average. A simple set of data illustrating the business cycle is shown below. The level of Real GDP in most countries increased by a positive rate each year from 2000 – 2008, before the Global Financial Crisis caused the most significant recession and then recovery in recent history.

In Macroeconomics we can model changes in the level of economic activity using the Aggregate Demand and Aggregate Supply model. This theoretical idea is shown on the following diagram, which explains the link between the business cycle and the level of aggregate demand and aggregate supply in the economy.

When the actual GDP line is above the potential GDP line the economy is said to have a positive output gap as at the peak point. Aggregate Demand exceeds the potential capacity thus shortages occur and prices rise (inflation) also called an inflationary gap. Factors of production such as labour, land and capital are fixed in the short run, and wages can not change. Therefore the inflationary gap will remain in the short run.

When the actual GDP line is below the potential GDP line the economy has a negative output gap as in a recession. At this point there is spare capacity, higher then average unemployment leading to less inflationary pressures in the aggregate economy.  Also called a recessionary gap. We can relate this concept back to the Real GDP data, which explains a dramatic fall in the level of economic activity in 2009.

Each of these two simple scenarios is caused by changes in Aggregate Demand. As we studies last week, changes in Aggregate Demand can be caused by a variety of factors which influence each component

Components of Aggregate Demand (AD)

C – Consumer Spending

I – Investment

G – Government Spending

(X-M) – Net Export Receipts

The two following videos highlight changes to the level of Aggregate Demand and the resulting inflationary and recessionary gaps. The first video explains how the Chinese government is boosting aggregate demand by increasing government spending and investment. It is a likely response to boost economic activity, and to reduce unemployment.

The second video is a quick look at the UK government budget. A government budget explains the countries spending and taxation decisions for the coming year. The UK was forced to reduce government spending due to the countries very high levels of public debt. The UK has been forced to borrow money to pay for current spending, which increases the nations debt to the rest of the world.

Discussion Questions and Activities:

1. Explain any changes to Aggregate Demand that would result in an inflationary gap occurring?
2. When a country is experiencing an inflationary gap, what happens to price levels and the level of unemployment?
3. Video 1: What are the impacts on level of economic activity due to the government investment? Evaluate if you think this is an effective form of investment.
4. Video 2: The UK government is planning to increase VAT tax rates and decrease spending on national defence. Explain the likely effect of the level of economic activity (Real GDP), unemployment and the price level using the AD/AS model.
5. In your notes draw an AS/AD model to explain the impacts of the events shown in each video. Be careful to fully label each diagram with any changes.

This is a follow up to a recent post to this blog, Hey, what are you Laffing at? The relationship between tax rate and tax revenue

The unbearable lightness of being Martin Feldstein | Free exchange | Economist.com

Supply-side economics, advocated by most Republican politicians, including presidential candidate John McCain, places great emphasis on the idea that investment is the main engine of economic growth, price level stability, and low unemployment. To encourage firms to invest, government should play a minimal role in the economy; taxes should be sufficiently low to incentivize firms to invest, while at the same time government spending should be reduced to avoid crowding-out of private investment.

Without a healthy level of investment, a country’s capital stock wears out and is not replaced, raising costs of production and shifting short-run (and maybe even long-run) aggregate supply leftward. If investment remains sufficiently low, over time an economy’s output could even begin to shrink.

In the article below, The Economist’s Free Exchange explores the relationship between tax rates and long-run economic growth. The Economist takes the position of “supply-siders” who study the impact of tax rates on the level of output. The idea of supply-side economics is that lower taxes encourage more investment and thus higher growth rates.

Here’s the gist of the supply-side argument:

Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.

On the other hand…

…we find that a tax cut of one percent of GDP increases real output by approximately three percent over the next three years.

In the case of the Laffer Curve, which shows the relationship between tax rates and tax revenue, the article concludes that:

Tax cuts don’t exactly “pay for themselves”, but they also don’t diminish revenue after about two years. That is, after about two years, the government receives revenues equal to what it would have received at the higher rate, but taxpayers enjoy a lower burden. It is an important advance to discover that because cuts do lead to an immediate dip in revenue, they often inspire offsetting tax increases that retard the growth effect of the origina cut. Nevertheless, the effect of cuts on output is generally strong enough to bring revenue back to where it would have been otherwise.

Supply-side economics, folks. Understanding the effects of fiscal and monetary policies on not only aggregate demand, but on aggregate supply (both short-run and long-run) is a crucial skill in  answering AP free response questions.

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I received the following email today, which gave me a great excuse to write a blog post about monetary policy! My reply to the teacher is below.

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!

Over a year has gone by since the 2009 American Recovery and Reinvestment Act (ARRA) was passed and put into action by the Obama Administration. Supporters of the program say that it has been successful, arguing that the economy would be in much worse shape if no stimulus had been introduced at all. In fact, some are arguing that government spending has not been sufficient for a full economic recovery and that more direct government spending is necessary. Economists on the other side argue that the stimulus package has done little for the economy except to delay the inevitable, self correcting forces of the economy needed to pave the road back to recovery. Some actually say that we are in a worse situation now due to the massive increase in government debt which will eventually have to be paid back.

So the question is, are we better off as an economy a year after the stimulus package was introduced? With growth still sluggish and unemployment at 9.5%, many people have begun to question the success of the ARRA. Again, some say the $784 billion was insufficient while others say less regulation and more tax cuts should have been utilized.

In a recent Washington Post article, Neil Irwin argues that the obstacles towards economic growth may not be solved by more stimulus, lower interest rates or tax cuts for corporations. The problem, he claims, is not a lack of funds for investment, but in the uncertainty businesses have in future conditions. He writes:

Corporate profits are soaring. Companies are sitting on billions of dollars of cash. And still, they’ve yet to amp up hiring or make major investments — the missing ingredients for a strong economic recovery. Many Democrats say the economy needs more stimulus. Business lobbyists and their Republican allies say it needs less regulation and lower taxes. But here in the heartland of America, senior executives say neither side’s assessment fits.

They blame their profound caution on their view that U.S. consumers are destined to disappoint for many years. As a result, they say, the economy is unlikely to see the kind of almost unbroken prosperity of the quarter-century that preceded the financial crisis.

With consumers choosing to save or pay off their debts now rather than spend, many businesses find it in their interest to hold off on investments into new capital until consumers begin spending again. With no planned investment and no incentive to hire workers, unemployment stays high and economic growth remains stagnant. With inflation rates low and economists predicting deflation, it makes more sense to hold onto money as it is not losing its value.

So is there a solution? In this situation, expansionary monetary policy through lower interest rates will not have the desired effect as demand for loanable funds is low. As stated in the article:

For large companies such as Illinois Tool Works, the price of borrowed money isn’t the problem. The company had $1.3 billion in cash on its balance sheet at the end of June, up from $743 million at the end of 2008. Lower interest rates wouldn’t make much of a difference, either.

“I could borrow $2 billion tomorrow for 3 1/2 percent,” said Speer. “But what am I going to do with it?””

Other executives claim that an increase in government spending would only provide a temporary fix but have no effect on long term consumer spending.

David Speer is chief executive of the company, which has 60,000 employees worldwide in more than 800 business units and $14 billion in sales. He said an additional burst of fiscal stimulus from Washington might help boost economic growth for a period of months. But that is unlikely to affect his decisions about hiring and expansion, which Speer said are based on expectations for sales over years to come, not just the immediate future. As long as U.S. consumers remain deeply strained, he is unlikely to undertake aggressive expansion.

More fiscal stimulus “might help make things a little better for a couple of quarters, but I’m not sure it would get at the underlying economic issue,” Speer said. “The core question is: How do you get consumers back on their feet. We need growth in a sustainable way, not another Band-Aid.”

Another solution would be for the government to implement supply side measures such as less market regulation and lower corporate taxes. Again, without the much needed consumer spending and confidence, its difficult to say whether or not this will materialize into increased investment and employment.

The rest of the Washington Post article can be read here. Once you’ve read the article, answer discuss the questions below and share your thoughts in a comment on this post.

Discussion Questions:

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.

Video 1 - Krugman argues for continued stimulus:

Discussion Questions:

1. What are the two “profoundly different views of economics” that are being tested as governments begin rolling back the fiscal stimulus packages of the last two years?
2. What are three characteristics of an economy in a “depression” according to Krugman?
3. What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?
4. Why is deflation dangerous according to Krugman?
5. What is the additional annual cost to the US government of borrowing and spending an additional trillion dollars now? What is the potential additional benefit of more stimulus?

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

Discussion Questions:

1. Why might the US have to pass spending cuts and tax increases to maintain its “credibility in international bond markets”?
2. Why would fiscal tightening “choke off the recovery”?
3. How is the financial crisis in Europe a warning to the US?
4. How could the “costs” exceed the “benefits” of deficit financed expansionary fiscal policy.
5. Ferguson proposes a new type of policy that “boosts confidence”. Why will expansionary fiscal and monetary policies fail if private sector confidence remains depressed?