Economics in Plain English » Macroeconomics

Planet Money answers the question: “What is GDP?”

Jason Welker — Fri, 13 Jan 2012 07:52:43 +0000

The folks at my favorite podcast, NPR’s Planet Money, recently produced a five minute video answering the questions, “What is GDP?”. This could be a good resource when introducing the topic to high school students:

Podcast: Time is Money

Jason Welker — Tue, 13 Dec 2011 19:13:27 +0000

Over the weekend I watched the new Justin Timberlake movie, In Time. In this edition of Welker’s Wikinomics Podcast I analyze the movie’s basic premise from a macroeconomic viewpoint.

Listen to the podcast, and then answer the discussion questions at the bottom of this post.

Discussion Questions:

Why does increasing the supply of money cause the demand for goods and services to rise?
Why does increasing the supply of money ultimately cause the supply of goods and services to fall?
When would an increase in the money supply be most inflationary, when an economy is producing close to its full employment level or when an economy is experiencing a recession? Explain.
With the help of a money market diagram and an aggregate demand / aggregate supply diagram, illustrate the effects of Will and Silvia’s re-distribution of time on the Ghetto’s economy.
According to Friedman, expansionary monetary policy cannot contribute to a nation’s long-run economic growth. What types of government policies can be implemented to promote economic growth in a nation?

Podcast Credits:

Intro song: The Rolling Stones – Time is On My Side
Ending song: Pink Floyd – Money
Milton Friedman quotes – Donahue, 1980

A closer look at the crowding-out effect

Jason Welker — Fri, 18 Nov 2011 16:03:30 +0000

To spend or not to spend. That is the question. In order to determine whether or not a government should increase its budget deficit in order to stimulate economic activity in its economy, it is important to determine whether said deficit spending will lead to a net increase in the nation’s GDP or a net decrease in GDP. Obviously, if increasing the debt to pay for a government spending package leads to lower aggregate demand in the economy, then it should not be undertaken. However, if a deficit-financed spending package leads to an overall increase in output and national income, it may be justified.

To understand the circumstances under which a government stimulus package will increase or decrease overall output in the economy, we must compare two competing possible impacts of a government stimulus. The multiplier effect of government spending refers to a theory which says that any increase in government spending will lead to further increases in private spending, as households enjoy more income and thus consume more and firms, which earn more revenues due to the government’s increased spending, make new capital investments, contributing to the stimulus provided by government and leading to an overall increase in GDP that exceeds the increase in government spending.

The crowding-out effect, on the other hand, refers to the theory that any increase in government spending, when financed by a larger deficit, will lead to a net decrease in private expenditures, as firms and households face higher interest rates due to the governments’ intervention in private financial markets. Government spending will crowd out private spending, thus any increase in spending will be off-set by a decrease in private spending, possibly even reducing overall income in the nation.

This post will focus on the second of these effects, and attempt to explain the circumstances under which crowding-out is likely to occur, and those under which it is unlikely to occur.

Deficit-financed government spending refers to any policy that increases government expenditures without increasing taxes, or one that reduces taxes without reducing government expenditures. In either case, a government must increase the amount of borrowing it does to pay for the policy, which means governments must borrow from the private sector by issuing new debt in the form of government bonds.

When a government must borrow to spend, it has to attract lenders somehow, which may require the government to offer higher rates of return on its bonds. The impact this has on the supply of private savings, which refers to the funds available in commercial banks for lending and borrowing in the private sector, will be negative. In other words, the supply of loanable funds in the private sector will decrease.

The graph below shows the market for loanable funds in a nation. The supply curve represents all households and other savers who put their money in private banks, in which they earn a certain interest rate on their savings. The demand for loanable funds represents private borrowers in the nation, who demand funds for investments in capital and technology (firms) and durable goods and real estate investments (households). The demand for loanable funds is inversely related to the real interest rate in the economy, since higher borrowing costs mean less demand for funds to pay for investment and consumption.

When a government needs to borrow money to pay for its deficit, private savers (represented by Slf above) will find lending money to the government more attractive than saving in private banks, since the relative interest rate on government bonds is likely to rise. This should reduce the supply of loanable funds in the private sector, making them more scarce and driving up borrowing costs to households and firms. This can be seen below:

In the illustration above, a government’s deficit spending crowds-out private spending, as firms and households find higher interest rates less attractive and thus demand less funds for investment and consumption. Private expenditures fall from Qe to Q1; therefore any increase in economic output resulting from the increase in government spending may be off-set by the fall in private spending. Crowding-out has occured.

Another way to view the crowding-out effect is to think about the impact of increased government borrowing on the demand for loanable funds. Demand represents all borrowers in an economy: households, firms and the government. An increase in public debt requires the government to borrow funds from the private sector, so as the supply of loanable funds fall, the demand will also increase, although not from the private sector, rather from the government. The effect this has can be seen below:

In the graph above, both the reduced supply of loanable funds resulting from private savers lending more to the government and the increased demand for loanable funds resulting form the government’s borrowing from the private sector combine to drive the equilibrium interest rate up to IR2. The private quantity demanded now falls from Qe to Qp, while the total amount of funds demanded (from the private sector and the goverment) now is only Qp+g. This illustration thus shows how an increase in government borrowing crowds out private spending but also leads to an overall decrease in the amount of investment in the economy.

Based on the two graphs above, a deficit-financed government spending package will definitely crowd-out private spending to some extent, and in the case of the second graph will even lead to a decrease in overall expenditures in the economy. This analysis could be used to argue against government spending as a way to stimulate economic activity. But this analysis makes some assumptions that may not always be true about a nation’s economy, namely that the equilibrium level of private investment demand and the supply of loanable funds occurs at a positive real interest rate. There are two possibilities that may mean the crowding-out effect does not occur. They are:

If the private demand for loanable funds is extraordinarily low, or
If the private supply of loanable funds is extraordinarily high.

When might these conditions be met? The answer is, during a deep recession. In a recession, household confidence is low, therefore private consumption is low and savings rates tend to rise, increasing the supply of funds in private banks. Also, firms’ expectations about the future tend to be weak, as low inflation or deflation make it unlikely that investments in new capital will provide high rates of return. Home sales are down and consumption of durable goods (which households often finance with borrowing) is depressed. Essentially, during a recession, private demand from borrowers is low and private supply from households is high. If the economy is weak enough, the loanable funds market may even exhibit an equilibrium interest rate that is negative. This could be shown as follows:

Notice that due to the exceedingly low demand and high supply of loanable funds, 0% acts as a price floor in the market. In other words, since interest rates cannot fall below 0%, there will be an excess supply of funds available to the private sector. Such a scenario is known as a liquidity trap. The level of private investment will be very low at only Qd. Banks cannot loan out all their excess reserves, and even though borrowing money is practically free, borrowers aren’t willing to take the risk to invest in capital or assets that may have negative rates of return, a prospect that is not unlikely during a recession.

So what happens when government deficit spends during a “liquidity trap”, as seen above? First of all, the government need not offer a very high rate to borrow in such an economy. Private interest rates will be close to zero, so even a 0.1% return on government bonds will attract lenders. So the supply of loanable funds may decrease, and demand may increase, but crowding-out will not occur because there is almost no private investment spending to crowd out! Here’s what happens:

Here we see the same shifts in demand and supply for loanable funds as we saw in our first graph, except now there is no increase in the interest rate resulting from the government’s entrance into the market. Since private interest rates stay at 0%, the private quantity of funds demanded for investment remains the same (Qp), while the increased government borrowing leads to an increase in overall spending in the economy from Qp to Qp+g. Rather than crowding-out private spending, the increase in government spending has no impact on households and firms, and leads to a net increase in overall spending in the economy.

If the government spends its borrowed funds wisely, it is possible that private spending could be crowded-in, which means that the boost to total output resulting from the fiscal stimulus may increase firm and household confidence and shift the private demand for loanable funds outwards, increasing the level of private investment and consumption, further stimulating economic activity.

So what have we shown? We have seen that in a healthy economy, in which households and firms are eager to borrow money to finance their spending, and in which savings rates are not exceedingly high, government borrowing may drive up private interest rates and crowd-out private spending. But during a deep recession, in which consumer spending is depressed and firms are not investing due to uncertainty and savings rates are higher than what is historically normal, an increase in government spending financed by a deficit will have little or no impact on the level of private investment and consumption. In such a case, governments can borrow cheaply (at just above 0%), and increase the overall level of demand in the economy without harming the private sector.

Crowding-out is a valid economic theory, but its likelihood of occurring must be evaluated by considering the actual level of output and employment in the economy. In a deflationary setting, in which savings is high and private spending is low, government may have the opportunity to boost demand and stimulate growth without driving up borrowing costs in the private sector and decreasing the level of household and firm expenditures.

Keynes versus Hayek 101 – the debate continues

Jason Welker — Mon, 31 Oct 2011 22:14:46 +0000

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

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”.

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

Measuring the Macroeconomic Objectives: in-class activity for AP Macro

Jason Welker — Thu, 06 Oct 2011 11:26:57 +0000

The activity below is to introduce Economics students to the three primary Macroeconomic objectives of any government or policy making body. These are :

Full employment of the nations work force: This means that nearly everyone who wants to work in the country is able to find a job. It does not mean that there is no unemployment, rather that the unemployment that does prevail in the economy is voluntary, i.e. it exists because workers are simply not willing to work at the prevailing wage rate. If there is involuntary unemployment in the economy, then the country is not meeting its macroeconomic objective, and there is likely a recession caused by a lack of overall demand (aggregate demand) for the nation’s goods and services.

Resources for learning about Full Employment:

Textbook (Welker’s IB Economics for the IB Diploma) pages 286 – 288, 295-299.
Reffonomics – Measuring Unemployment
Reffonomics – the Types of Unemployment
Reffonomics – Unemployment and Employment Quiz

Price level stability: Changes in the average price level of goods and services in the nation are measured by calculating inflation, commonly using a consumer price index to do so. Low and stable inflation is one of the macroeconomic objectives since price level volatility (high inflation or deflation) has several harmful effects on a nation’s households and business firms. Keeping inflation low and stable promotes a healthy environment for achieving business investment, full employment and economic growth

Resources for learning about Price level stability:

Textbook pages 302-303, 306-307, 311-314
Reffonomics – Calculating Inflation using a CPI
Reffonomics – The effects of inflation
Reffonomics – Inflation Quiz

Economic growth: The third macroeconomic objective is to increase the output of the nation’s goods and services year after year. Economic growth refers to the increase in real Gross Domestic Product (GDP) and can be measured by finding the total value of a nation’s output one year, comparing it to the previous year, and adjusting it for any changes in the price level between the years. Economic growth is a desirable goal because it generally means that incomes are rising and people’s lives are getting better. Of course, GDP only measures the physical output of goods and services, and does not include many non-economic variables that also should be considered when measuring people’s well-being. But rising incomes and output are deemed worthy goals since they are associated with rising living standards.

Textbook pages 244, 251-253, 337-340
Reffonomics – Real GDP lesson
Reffonomics – Real GDP Multiple Choice Quiz

Assignment: Complete the readings and online activities above. Then use the data in the table linked below to answer the quesitons that follow.

Questions:

Calculate the unemployment rates for each of the years in the table. Describe what happened to unemployment over the years displayed.
Calculate the inflation rates between each of the years in the table. Describe what happened to inflation over the years displayed.
Calculate the Real GDP for each of the years in the table.
Calculate the Real GDP growth rates between each of the years in the table. Describe what happened to real GDP from one year to the next in the years displayed.
Describe the relationship between the inflation and unemployment rates you calculated for each of the years. Is there any correlation in how the figures change from year to year?
Based on your analysis of the data above, to what extent has the United States succeeded in achieving its three macroeconomic objectives of:

Full employment?
Price level stability?
Economic growth?

Fiscal stimulus, the Swiss way

Jason Welker — Fri, 23 Sep 2011 11:25:03 +0000

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:

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.

Sample IB Economics Internal Assessment Commentary – Understanding the ECB’s bond-purchasing program

Jason Welker — Tue, 13 Sep 2011 19:39:02 +0000

Once again, my IB Economics students are working on yet another Internal Assessment Commentary, this time on syllabus section 3, Macroeconomics. Since they found my sample Microeconomics commentary so helpful, I thought I’d punch out a quick sample of a macro commentary for them and for anyone else who is working on their IB Economcis Internal Assessment.

The commentary below (not including the selection from the article) is 749 words in length. This does NOT include words in the graphs, so let’s not have that debate in the comment section. The new IB economics internal assessment model (first examinations 2013) will not count words on graphs, so this sample commentary is perfectly suited for the new assessment model. If you’re a 2012 student, you would be wise to count words in graphs as part of your word count.

If you like what you see, or have any quesitons, please leave your comments below the post.

Article highlights:

An Impeccable Disaster – NYTimes.com

Paul Krugman clearly explains the problems faced by two or Europe’s largest economies today:

So why is Spain — along with Italy, which has higher debt but smaller deficits — in so much trouble? The answer is that these countries are facing something very much like a bank run, except that the run is on their governments rather than, or more accurately as well as, their financial institutions.

Here’s how such a run works: Investors, for whatever reason, fear that a country will default on its debt. This makes them unwilling to buy the country’s bonds, or at least not unless offered a very high interest rate. And the fact that the country must roll its debt over at high interest rates worsens its fiscal prospects, making default more likely, so that the crisis of confidence becomes a self-fulfilling prophecy. And as it does, it becomes a banking crisis as well, since a country’s banks are normally heavily invested in government debt.

Now, a country with its own currency, like Britain, can short-circuit this process: if necessary, the Bank of England can step in to buy government debt with newly created money. This might lead to inflation (although even that is doubtful when the economy is depressed), but inflation poses a much smaller threat to investors than outright default. Spain and Italy, however, have adopted the euro and no longer have their own currencies. As a result, the threat of a self-fulfilling crisis is very real — and interest rates on Spanish and Italian debt are more than twice the rate on British debt.

Commentary:

The European Central Bank (ECB) is engaging in a new form of monetary policy in which it buys government bonds directly from the Spanish and Italian governments. Essentially, the goal is to bring down the interest rates on Italian and Spanish government bonds, which should reassure private investors that Italy and Spain will be able to pay them back and thus reduce the upward pressure on interest rates in the Eurozone, a situation which threatens to reverse the already sluggish recovery from the recessions of 2008 and 2009.

Monetary policy refers to a central bank’s manipulation of the money supply and interest rates, aimed at either increasing interest rates (contractionary monetary policy) or reducing interest rates (expansionary monetary policy). The ECB is currently buying government bonds from European governments, effectively increasing the supply of money in Europe with the hope that more government and private sector spending will move the Eurozone economy closer to its full employment level of output, at which workers, land and capital resources are fully employed towards the production of goods and services.

If successful, the ECB’s “quantitative easing”, as the new type of monetary policy is known, should bring down interest rates on government bonds and thereby reallocate loanable funds towards Italy and Spain’s public and private sectors. The increase in supply of loanable funds should bring down the private interest rates available to borrows (businesses and households), making private investment more attractive.

The ECB’s bond purchases make it cheaper for Italy and Spain to borrow, lowering the interest rates on their bonds, restoring confidence among international investors, who may be more willing to save their money in Italy in Spain. The inflow of loanable funds into these economies (seen as an increase in the supply of loanable funds from S1 to S2) should bring down private borrowing costs (the real interest rate), encouraging more firms to invest in capital and more households to finance the consumption of durable goods, increasing aggregate demand and moving the Eurozone economy back towards its full employment level of output, from AD1 to AD2 in the graph on the right.

In certain circumstances, monetary easing like this could be inflationary, but in reality inflation is unlikely to occur given the large output gap in Europe at present (represented above as the distance between Y1 and the dotted line, signifying the full employment level of output). Any increase in aggregate demand will lead to economic growth (an increase in output), but little or no inflation due to the excess capacity of unemployed labor, land and capital resources in the European economy today.

With private sector borrowing costs increasing due to growing uncertainty over their deficits and debts, the Italian and Spanish governments will find expansionary fiscal policies (tax cuts and increased government expenditures) are unrealistic options for achieving the goal of full employment. The ECB, however, as Krugman argues, should continue to play an increasing role in the expansion of credit to cash strapped European governments, with the aim of keeping interest rates low to prevent the crowding-out of private spending that often occurs in the face of large budget deficits. Inflation, always a concern for central bankers, should be a low priority in Europe’s current recessionary environment. Only when consumer and investor confidence is restored, a condition that requires low borrowing costs, will private sector spending resume and the Euro economies can begin creating jobs and increasing their output again.

In the short-term, Italy and Spain should take advantage of the ECB’s bond-buying initiative, and make meaningful, productivity-enhancing investments in infrastructure, education and job training. If their economies are to grow in the future, Eurozone countries must become more competitive with the rapidly expanding economies of Asia, Eastern Europe, and elsewhere in the developing world.

In the medium-term, the Eurozone countries must demonstrate a commitment to fiscal restraint and more balanced budgets. Eliminating loopholes that allow businesses and wealthy individuals to avoid paying taxes, for example, is of utmost importance. Also, increasing the retirement age, downsizing some of the more generous social welfare programs and increasing marginal tax rates on the highest income earners would all send the message to investors that these countries are commited to fiscal discipline. Then, in time, their dependence on ECB lending will decline and private lenders will once again be willing to buy Eurozone government bonds at lower interest rates, allowing for continued growth in the private sector.

Tax progressivity in the US: Do the rich pay more than their fair share? The evidence indicates NO!

Jason Welker — Wed, 24 Aug 2011 07:00:07 +0000

Just How Progressive Is the Tax System? – Economix Blog – NYTimes.com

According to a blog post in the New York Times from April 2009, America’s America’s “progressive” tax system is not as progressive as many may believe it to be:

Research has found that many states and local governments have… regressive tax systems… that might offset the progressiveness of [US] federal tax rates.

The research from Citizens for Tax Justice — a liberal organization that advocates “fair taxes for middle and low-income families” — uses 2008 data for all federal, state and local taxes combined. It found that the average effective tax rate is 29.8 percent, and that including state and local taxes makes the tax curve look much less steep:

In the graph above, the horizontal axis shows the income group. The vertical axis shows the percentage of income that the average member of that group pays in taxes. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

The article continues:

The group also finds that in 2008 the share of total federal, state and local taxes paid by each income group was relatively close to the share of income that that group brings in, at least as compared to comparable 2006 numbers for effective federal tax rates:

The horizontal axis shows the income group. Taxes include all federal, state and local taxes (personal and corporate income, payroll, property, sales, excise, estate, etc.). Incomes include cash income, employer-paid FICA taxes and corporate profits net of taxable dividends.

The research discussed above poses several interesting questions about the make-up of a nation’s tax revenues. Despite popular belief, it appears that the rich in America do not pay “more than their fair share”, as many argue is the case. Study the graphs carefully, and answer the questions that follow:

Discussion Questions:

Based on the data above, do the rich in America pay an unfair proportion of the total taxes the US government collects? Why or why not?
Why do the richest 5% in America actually pay a lower level of tax on average than the 5% below them?
How much of America’s total income is earned by the richest 1% compared to the poorest 20%? Does America’s progressive tax system destroy the incentive for Americans to work hard and become rich? Why or why not?
Use the data to construct a Lorenz Curve for the United States. Does the gap between the richest and the poorest Americans surprise you? What kinds of changes could be made to the tax system to narrow the gap between the top income earners and the middle and low income earners in America? Should this be done, why or why not?

The battle of ideas: Hayek versus Keynes on Aggregate Supply

Jason Welker — Fri, 08 Apr 2011 09:44:52 +0000

Introduction: The two models below represent two very different views of a nation’s aggregate supply curve. The theories behind the two models represent the ideas about the macroeconomy of two economists, John Maynard Keynes and Friedrich von Hayek.

Instructions: The videos introducing Keynes’ and Hayek’s theories can be found here: “Commanding Heights: the Battle for Ideas”. We will watch them in class, but if you need to review them you may watch them again from home. Once you’ve watched the videos and read chapter 17 from your Course Companion, answer the questions that follow each of the two models below.

Figure 1: the Classical AD/AS model

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?
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.
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?
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

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

prices”?
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?
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)?
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.

Figure 3: Our IB Economics AD/AS model

The diagram above represents a compromise between the classical AD/AS model and the Keynesian AD/AS model. This graph is the one we will use throughout the IB and AP Economics course when illustrating a nation’s macroeconomy. Answer the questions that follow about the diagram.

How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?
Why are there two aggregate supply curves? What is the difference between the two?
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?
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?
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 Big “C” – America’s crisis of confidence and the Great Recession

Joe Hauet — Tue, 24 Aug 2010 19:48:38 +0000

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:

Why is consumer spending and confidence so important for businesses?

What role does business investment into capital play in the economy and why is it so important in leading the economy towards recovery?

Is there any benefit in the economy for consumers to save and pay off their debts now? Is this a rational decision given the current economic conditions?

If fiscal and monetary policies along with lower taxes for corporations are not the answer, then what is? What other possibilities are available for the government to implement?

To continue stimulus or to pursue austerity, that is the question

Jason Welker — Tue, 24 Aug 2010 10:35:14 +0000

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:

Click here to view the embedded video.

Discussion Questions:

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?
What are three characteristics of an economy in a “depression” according to Krugman?
What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?
Why is deflation dangerous according to Krugman?
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”:

Click here to view the embedded video.

Discussion Questions:

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

The Great Economic Experiment – for all year 2 IB Econ students

Joe Hauet — Sun, 15 Aug 2010 12:35:52 +0000

Dear year 2 IB Economics students,

Welcome back and I hope you enjoyed your time off. Before breaking for summer we were in the midst of our unit on Macroeconomics, just beginning our debate on whether or not government intervention in the economy in order to kick start activity during a deep recession was a good or bad idea. In other words, would the economy correct itself or would government stimulus be necessary to get our economy moving again.

As you all know, exactly a year and a half ago, the US government decided that in order to a avoid a recession as potentially devastating as the Great Depression of the 1930’s, government interaction into the economy was necessary. 787 billion dollars was put aside for government sponsored projects, transfer payments and decreases in taxes. The hope was that this spending would not only help people maintain their current jobs but also create jobs for those who had recently become unemployed. A year and a half later, proponents of the stimulus package, Keynsians if you will, believe that this great experiment has been a success and that if nothing had been done the economy would be in much worse shape. Opponents of the spending believe that the bill has simply postponed the self correcting forces in the economy and has instead created what economists call a double dip recession where the increase in government spending only creates a temporary, unsustainable increase in economic activity. In fact many of these opponents say that we are worse off now as the government is now further in debt due to the spending.

Has the great experiment thought up by John Maynard Keynes over half a century ago been a success or was it a solution that has caused more harm than good, potentially making the recession worse than it would have been? The radio show Plant Money recently dedicated a show to addressing this very issue. In order to get a balanced look, they interviewed two prominent economists, Tyler Cowen, a Professor of Economics at George Mason University and Mark Zandi, Chief Economist at Moody’s Analytics. Cowen, a skeptic of Keynesian spending, believes that we would now be better off if the government had not intervened in the economy. Zandi, on the other hand, is adamant that the US economy would be much worse off if the government had done nothing. Two economists analyzing similar data and coming up with very different conclusions. This is where economics becomes both complex and fascinating.

Click play on the podcast player below, listen to the whole podcast, and then answer the following questions.

Discussion Questions:

How does an economy “self correct” itself once it has entered a recession?
What are the arguments put forth by Tyler Cowen and Mark Zandy about the effectiveness of government stimulus? Is one more convincing than the other? Why?
What are automatic stabilizers and why does Tyler Cowen believe they are better solutions than the government creating new jobs?
According to Tyler Cowen, why is it dangerous for economists to become “wed to only one theory”?
What does this podcast teach you about the importance of being able to evaluate economic theory and its effectiveness? Can we ever have an economic theory that is true under any circumstances? Why or why not?

The role of taxes in income re-distribution – another preview of my textbook

Jason Welker — Tue, 18 May 2010 11:23:13 +0000

Inequality in the distribution of income is an inevitable result of an economic system that rewards the households with the highest skills, best education and most access to capital with higher wages and incomes in the marketplace.

The existence of poverty, both relative and absolute, poses several obstacles to the improvement of well-being for a nation’s people. Social unrest among the poorest members of society can lead to political and economic instability for a nation as a whole. The hardships experienced by society’s poorest members are ultimately felt by the rest of society as the needs of the poor must be met in one way or another, and in extreme circumstances may lead to a violent struggle between economic classes.

The existence of absolute poverty poses the greatest obstacle to national economies and society as those who experience it are unlikely to contribute whatsoever to national output and economic growth given the desperate state of their health and education. Without promoting some degree of equality in the distribution of income, governments run the risk of undermining their accomplishment of other social and economic objectives. So how do governments achieve more equal income distribution? Before we look at the modern mechanisms by which this objective is achieved, it is important to examine the historical ideology that frames modern economic policy.

For centuries the role of government has been debated among economists. The extent to which it is the government’s job to assure equality in the distribution of income has never been fully agreed upon by policymakers, whose opinions differ depending on the school of economic ideology to which they prescribe. On the far left of the economic spectrum is Marxist/socialist ideology, which believes that households’ money incomes should be made obsolete and each household’s level of consumption should instead be based on the “use-value” of the output which it produces. In a pure Marxist or socialist economy, money incomes do not matter since the output of the nation will be shared equally among all those who contribute to its production. Private ownership of resources and the output those resources produce is wholly abolished in a socialist economy and the ownership and allocation of resources, goods and services is in the hands of the state and production and consumption is undertaken based on the principle of equality.

The slogan “from each according to his ability, to each according to his need”, made populate by Karl Marx, summarized the view that a household’s consumption should be based on its level of need. To take this idea to its logical conclusion, all households in a nation have essentially the same basic needs therefore household incomes should be equal across the nation.

On the other extreme of the economic spectrum is the laissez faire, free market model which argues that the only role the government should play in the market economy is in the protection of private property rights, which assures that the private owners of resources, including land, labor and capital, are able to pursue their own self-interest in an unregulated marketplace where their money incomes are determined by the “exchange-value” of the resources they control. In a laissez-faire market economy, the level of income and consumption of households varies greatly across society as the exchange-value of the resources owned by households determines income, rather than the principle of equality underlying socialism. Each individual in society is free to pursue his monetary objectives through the improvement of his human capital and the subsequent increase in its exchange-value in the labor market.

In today’s world, there exists neither a purely socialist economy nor a purely laissez fair free market economy. In reality, all modern national economies are mixed economies in which governments do much more than simply protect property rights, but do not go so far as to own and allocate all factors of production. The role of government in the distribution of income in today’s economies is relegated to the collection of taxes and the provision of public goods and services and transfer payments.

A tax is simply a fee charged by a government on a person’s income, property, or consumption of goods and services. Taxes can be broken into two main categories: direct and indirect.

Direct taxes: These are taxes paid directly to the government by those on whom they are imposed. An income tax is a direct tax because it is taken directly out of a worker’s earned income. Corporate and business taxes are also direct taxes based on the revenues or profits of firms. Direct taxes cannot be legally avoided since they are based on the earned income of each individual. The burden of direct taxes is born entirely by the households or firms paying them.
Indirect taxes: These are the taxes paid by households through an intermediary such as a retail store. The consumer pays the tax at the time of his purchase of a good or service and the amount of the tax is usually calculated by adding a percentage rate to the price of the item being purchased. Indirect taxes include sales taxes, value added taxes (VAT), goods and services tax (GST) as well as ad valorem taxes (or excise taxes) which are placed on specific goods such as cigarettes, alcohol or petrol. Indirect taxes can be avoided simply by not consuming certain products or by consuming less of all products. The burden of indirect taxes is born by both households and firms, the proportion born by each is determined by the price elasticities of demand and supply (as demonstrated in chapter 4).

Taxes can be either progressive, regressive or proportional in nature, meaning that different taxes place different burdens on the rich and the poor.

Proportional tax: A tax for which the percentage of income taxed remains constant as income increases is a proportional tax. The rich will pay more tax than the poor in absolute terms, but the burden of the tax will be no greater on the rich than it is on the poor. A household earning 20,000 euros may pay 10% tax to the government, totaling 2,000 euros. A rich household in the same country pays 10% on its income of 200,000 euros, totaling 20,000 euros in taxes, but the burden is the same on the rich household as it is on the poor household. Proportional taxes are uncommon in advanced economies, although some “payroll taxes”, which are those collected to support social security or welfare programs, are payed by employers based on a percentage of employees’ incomes up to a certain level. For instance, the US social security tax is 6.2% of gross income up to $108,000. Regardless of a person’s income below $108,000, he or she will pay 6.2% to the government to support the country’s social security program.

Regressive tax: A tax that decreases in percentage as income increases is said to be regressive. Such a tax places a larger burden on lower income households than it does higher income earners since a greater percentage of a poor household’s income is used to pay the tax than a rich household’s. You may be wondering what kind of government would levy a tax that harms the poor more than it does the rich, but in fact almost every national government uses regressive taxes to raise a significant portion of its tax revenues. Most indirect taxes are actually regressive, which may not make sense at first, since a sales tax is a percentage of the price of products consumed consumed. The regressiveness is apparent when the amount of the tax is compared to the income of the consumer, however.

To demonstrate how a sales tax is regressive, imagine three different consumers who purchase an identical laptop computer for 1,000€ in a country with a value added tax of 10% added to the price of the computer.

Income of buyer	Amount of tax paid	% of income taxed
10,000€	100€	1%
50,000€	100€	0.2%
100,000€	100€	0.1%

The higher income consumer pays the same amount of tax as the lower income consumer, but the the tax makes up a lower percentage of her income than it did the lower income consumer’s. Although they appear to be fair since everyone pays the same percentage of the price of the the goods they consume, indirect taxes such as VAT, GST and sales taxes are in fact regressive taxes, placing a larger burden on those whose ability to pay is lower and a smaller burden on the higher income earners whose ability to pay is greater.

Progressive tax: This is a tax for which the percentage of income taxed increases as income increases. The principle underlying a progressive tax is that those with the ability to pay the most tax (the rich) should bear a larger burden of the nation’s total tax receipts than those whose ability to pay is less. Lower income households not only pay less tax, but they pay a smaller percentage of their income in tax as well. Most nation’s income tax systems are progressive, the most progressive being those in the Northern European countries which, not surprisingly, also demonstrate the most equal distributions of income. Of the various types of taxes, a progressive income tax aligns most with the macroeconomic objective of increased income equality.

A progressive income tax typically consists of a marginal tax bracket in which the increasing tax rates apply to marginal income, rather than to total income. In such a system, the average tax a household pays increases less rapidly than the marginal tax, since the higher marginal rate only applies to additional income beyond the upper range of the previous bracket.

United States marginal tax rateshttp://www.moneychimp.com/features/tax_brackets.htm

Income range	Marginal tax rate	Tax paid by someone at top of bracket	Average tax rate
$0-$8,375	10%	$837.5	10.00%
$8,375-$34,000	15%	$4,681.25	13.77%
$34,000-$82,400	25%	$16,781.25	20.37%
$82,400-$171,850	28%	$41,827.25	24.34%
$171,850-$373,650	33%	$108421.25	29.02%
$373,850 -$500,000 (and above)	35%	$152,643.75 (on $500,000)	30.53%

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:

For workers in each of the income brackets above, the average rate of taxation is always lower than the marginal rate of taxation, since tax increases only apply to additional income earned beyond the previous bracket. The graph below shows the marginal (in blue) and the average (in red) rates of taxation for individuals earning between $0 and $500,000 in the United States in 2010.

Marginal and average tax rates in the US

The main argument against progressive income taxes is that taxing higher incomes at higher rates creates a disincentive to work, in effect punishing any increase in productivity or effort among the nation’s workers. However, the fact that higher rates only apply to marginal income, rather than total income, assures that a worker’s after tax income will always be an increasing function of gross income; therefore there will always be an incentive to increase income by working harder, longer, or more efficiently since the increase in taxes will always be less than the increase income.

A progressive income tax system provides governments with an effective means of re-distributing the nation’s income since those with the greatest ability to pay (the rich) provide the nation with far more of its tax revenue than those with the least ability to pay (the poor). The graph below shows the total amount of tax revenue generated by each of the five quintiles of income earners in the United States in 2006. While the lowest 20% of income earners accounted for around 1% of total tax receipts, the top quintile contributed nearly 70% to America’s tax revenues.

Progressive income tax burden:data source:http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?DocID=558&Topic2id=20&Topic3id=22

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.

Canada’s tax revenueshttp://www.fin.gc.ca/pub/fm-rf-index-eng.asp

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

Arguments against progressive income taxes – the Laffer Curve:

The primary argument against the use of progressive income taxes as a means to redistribute national income comes from the “supply-side” school of macroeconomic thought. Supply-siders, whose views are formed by the classical theory of macroeconomics based on the belief that a free market economy left entirely to its own devices will always gravitate towards a level of production corresponding with full employment of the nation’s resources, believe there is a certain level of taxation at which a nation’s total tax receipts will be maximized. Beyond this point, further increases in the tax rat actually lead to a decline in the amount of taxable income due to the disincentive created by the higher tax rate. The Laffer Curve demonstrates the relationship between tax rate and tax revenue graphically:

At a tax rate of 0% households and firms will keep 100% of their gross income and there will be no tax revenue for the government. At a tax rate of 100%, however, there will also be no tax revenue since no rational individual will choose to work if the government takes everything he or she earns. The supply of labor falls as the tax rate increases since fewer individuals will be willing to work as the government collects higher percentages of their earned income. Therefore there will be no income for the government to tax when the tax rate is 100%.

Since both 0% tax and 100% create zero tax revenue, the Laffer Curve theory holds that at some tax rate (m) in between 0% and 100% the government’s total tax receipts will be maximized.The Laffer Curve is often cited by supply-side advocates as an argument for reducing marginal income tax rates on the top income earners. If, for instance, the tax rate is at y, it is possible that a lower tax rate could lead to higher tax revenue if the falling taxes incentivize individuals to join the labor force and existing workers to work harder and longer hours, creating more taxable income. In addition, entrepreneurs may be more inclined to start businesses and firms to increase their investments in physical and human capital, both activities contributing further to increases in national output and taxable income. At lower tax rates, argue the supply-siders, the level of taxable income may increase leading to higher tax revenues for the government.

It is not clear from the Laffer Curve at what precise level of taxation tax revenues are maximized. The model is most commonly employed by supply-siders to justify their desire for lower income and corporate taxes and a general reduction in the interference of the government in the functioning of the free market. The supply-side argument holds that lower taxes lead to an increase in the supply of labor and capital as households and firms are incentivized to become more economically active, leading to increases in the nation’s aggregate supply and thereby promoting the accomplishment of the macroeconomic goals of full employment and economic growth.

Practice calculating marginal and average rates of taxation in France (2010)http://www.french-property.com/guides/france/finance-taxation/taxation/calculation-tax-liability/rates/:

Marginal Income Brackets	Marginal rate of taxation	Worker’s gross income	Tax paid	Average rate of taxation
0-€5,875	0%	€5,000	€0	0%
€5,876 – €11,720	5.5%	€10,000	-	-
€11,721 – €26,030	14%	€20,000	€1,480.675	7.4%
€26,031 – €69,783	-	€50,000	-	19%
€69,783 and above	40%	€100,000	€27,537.575	-

Calculate the total amount of tax paid by a French worker earning €10,000 per year.
Calculate the average rate of taxation the same worker pays. Which is greater, the marginal rate of taxation or the average rate of taxation? Explain.
What will a French worker earning €50,000 pay in taxes?
Calculate the marginal rate of taxation for for a worker whose income increases from €20,000 to €50,000.
What is the average rate of taxation for a French worker earning €100,000 per year?
Evaluate the claim that a progressive income tax decreases the incentive among workers to work harder improve their productivity.

When Spain’s unemployment problem gets ugly

Andrew McCarthy — Wed, 12 May 2010 15:54:52 +0000

With more than four million Spanish people out of work this week, the eighth largest economy in the world finds itself once more in a perilous position. In the last twelve months the number of unemployed people in Spain has doubled. Spain now has as many unemployed people as France and Italy combined, and the unemployment rate is nearing the historic highs of 1993.

Click here to view the embedded video.

The type of unemployment in an economy can be classified in different ways. The main types are cyclical or demand deficient unemployment but other forms exist such as real-wage unemployment and equilibrium unemployment. Some economists also refer to unemployed people as structural, frictional, seasonally or cyclically unemployed.

From the graph below we can see that unemployment in Spain has been high for at least the last 20 years, compared to other countries within the European Union.

Source: OECD Factbook 2009: Economic, Environmental and Social Statistics

The cause of growing Spanish unemployment in 2008 to 2010 is related to the collapse of the domestic building boom and the wider global recession. In 2006, Spain enjoyed low interest rates and therefore cheap loans, this allowed developers to build new apartment blocks, houses and commercial buildings with a relatively low cost of borrowing. Spanish people could afford mortgages at low interest rates and therefore purchased houses contributing to the building boom. However, when the flow of “cheap money” ran out in mid 2008 the building stopped and the flow on effects of spending dried up. Falling tourism receipts and less foreign investment have also exacerbated the issue leading to unemployment doubling between 2008 – 2010.

We can classify the form of unemployment, illustrated in the Spanish example as demand-deficient unemployment. It is related to a downturn in the economic cycle. This concept is explained below.

Effects and Solutions

The social and economic impacts of 20.7% unemployment are obvious, but the solutions are less so. Climbing unemployment creates two evils; falling tax revenue as workers no longer earn wages and the increased burden of paying benefits to the four million unemployed citizens. In addition, a series of social problems are often intertwined with high unemployment, these include depression; lose of skills, poverty and higher crime rates. Spain therefore has a few problems to solve this summer. Whilst Spanish people may enjoy a summer by the beach, and a glass of sangria, the government will be hitting the books to find a solution to the problem. Here are a few suggests to get the politicians thinking.

Use fiscal stimulus to boost consumer and government spending, thereby increasing the demand for jobs. Spain could plan for a budget deficit (expansionary fiscal policy) and fund spending increases though increased government borrowing. Spain’s current level of public debt is 67% of GDP, which is well below stricken Greece at 124%. However, Spain now has to borrow money from international bond markets, which are skeptical about Spain’s ability to pay back this debt. This is despite assurances and favourable rates offered from the European Union this week. Increasing government debt in a period of European financial crisis is a risky option.

Use loose monetary policy (lowering central bank interest rates) to encourage Spanish people to increase their consumer spending through increased borrowing. If you understand the complexities of the European Union, you understand that all 21-member countries use the same currency and follow the lead of one central bank. Despite one country wishing to lower interest rates, other countries may think differently. Europe can be compared to a train rolling along on a set of rails, with 21 separate carriages. Each European country must follow behind the big engine, there is no room to deviate from the central banks interest rates and all of the countries must move together. Many people have wondered how long the European train would run, before one of the carriages derailed.

Force Spanish firms to employ more people. Firms have no requirement to hire more people. They may choose to employ more people but will logically offer everyone lower wages to maintain profitability.

Use supply side policies to bring greater efficiencies to firms though increased on the job training and worker education. This is a long-term solution, which will require large structural adjustments, how Spain produces goods and services and exactly what is does produce. A startling statistic is that the average Spanish university graduate will find their first job at the age of 27, long after they have graduated.

Discussion Questions:

How do economists measure unemployment?
Explain the causes of increased unemployment in Spain?
Explain in a few sentences how expansionary fiscal policy could reduce the rate of unemployment?
How could supply side policies be used to reduce the level of unemployment in Spain?

Economics in plain English: Understanding Argentina’s budget woes

Jason Welker — Fri, 05 Feb 2010 14:09:53 +0000

Argentina’s reserves and its debts: Central Bank robbery | The Economist

I received the following email from an Econ teacher who wonders if I had any insight on a question posed by one of his students:

The email reads: “I have alittle query i was hoping you could help clear up for me..a year 13 student has asked a question relating to Argentina’s prime minister, Cristina Fernandezde De Kirchner’s, decision to sell the central bank’s dollar reserves to fund part of the country’s decifit against the advice of the director of the central bank who resigned.”

The student’s question is on the following passage from the Economist article above:

Fernández (Argentina’s president”) justified her raid on the reserves by saying that the Central Bank had more than it needed, because they exceeded the size of the monetary base. Economists disagree about what is an appropriate target for the reserves, but Mr Redrado’s view is that a highly dollarised emerging economy like Argentina’s needs an abundance of Treasury bonds (the form in which most reserves are held) as insurance. Even if Ms Fernández might find support from some economists for her argument, her plan to swap the dollar reserves for a non-transferable government bond would not.

The student’s question is: “I do not know what a monetary base is, nor why Argetina needs treasury bonds.”

This article really caught me off guard at first as well. One thing I love about the Economist newspaper is its use of economic jargon that requires a real understanding of the subject to be able to interpret. The first time I read the article, I will be honest I was completely confused as to what the Argentinean president was up to. But after some reflection and rough sketches of graphs on scrap paper, I think I have “translated” the article’s jargon into plain English.

Below is my reply to the teacher and his student:

Hello,

The president of Argentina wants to sell the country’s US dollar reserves, which are held in the form of US treasury bonds, and then use the US dollars she receives to buy Argentinean government bonds in order to finance her own government’s budget deficit. In essence she wants to swap Argentina’s central bank reserves of US debt (considered a very stable and safe asset due to America’s low inflation rate and relative solvency of the US government) for Argentinean government debt (less stable and safe, especially in the wake of the country’s 2002 default on its debt). Argentina’s central bank would then hold fewer transferable, stable US bonds and more “non-transferable”, Argentinean government bonds. And since the bonds represent Argentina’s government debt, the country as a whole reduces its assets and increases its liabilities.

It is important for a developing country like Argentina to keep large reserves of US dollar-denominated assets (i.e. US treasury bonds) in reserve in order to assure foreign investors that the country would be able to stabilize its currency’s value in the face of a currency crisis such as that which Argentina experienced in 2001-2002. If the value of the peso began to decline on foreign exchange markets (due, for instance, to a decline in international investor confidence in the government’s ability to pay the interest on its foreign debt or inflation fears caused by excessive monetary growth or government spending) then the central bank could use its large dollar reserves to intervene in the forex market and stabilize the value of the peso, reestablishing investor confidence and maintaining the government’s ability to attract foreign creditors in the Argentinean bond market. A collapse of the peso would have ripple effects throughout Argentina, driving up imported products and raw materials and causing spiraling inflation, forcing the government to print more money to finance its budget in the face of falling demand for its debt in domestic and international bond markets.

Argentina must be sure to keep its balance sheet (i.e. its liability to asset ratio) in check. Its assets are US government bonds, its liabilities are the Argentinean bonds it issues to finance its budget deficits. If this ratio become too heavy on the liability side, foreign investors and speculators will lose confidence in the both peso and the Argentinean government’s solvency and dump their holdings of Argentinean currency, assets, and bonds, driving interest rates through the roof and the exchange rate through the floor, grinding the economy to a halt.

The article says,

Argentina’s economy is on course to rebound this year and grow at 3-5%. But the government is spending money so fast that this growth will not finance current spending on its own, says Daniel Marx, a former finance minister. Ordinarily, a government faced with a shortfall would turn to domestic and international bond markets. But this has been difficult since Argentina defaulted in 2002.

The country cannot count on private creditors to make up its budget shortfall, so the president is planning to finance her country’s deficit by buying Argentinean bonds with the country’s own US dollar reserves. Such behavior concerns economists because it could send a message to international investors that the country is on the path towards another unsustainable build-up of debt that could culminate in another default and economic collapse. The article is a word of caution to the president that all leaders should heed: balanced budgets are a good idea, and debt is dangerous!