"Fear the Boom and Bust" a Hayek vs. Keynes Rap Anthem

Video: Taxes & the Budget

Taxation (Macro)

direct taxation: taxes paid directly to the government (i.e. income and corporate tax)

indirect taxation: taxes paid to the government via an intermediary (i.e. sales tax, value-added tax - VAT, sin taxes)

progressive taxation: tax rates that increase as income goes up (i.e. most countries income/corporate tax regimes)

regressive taxation: tax rates that decrease as income goes up (all sales taxes are regressive in nature...why?!)

proportional taxation: tax rate that are the same for all (i.e. everyone pays 15% regardless of income, seen in many East European countries like Ukraine).

transfer payments: payment by government as a "gift" or aid, not for g/s and not counted in GDP...a transfer (type of redistribution from richer to poorer includes welfare checks and social security).

Laffer curve: a graph showing the relationship between tax rate and government tax revenue (at zero tax rate, there is zero government revenue, at 100% tax rate, there is zero government tax revenue because no one works...the ideal is somewhere in the middle where revenue peaks).

Phillips Curves! SRPC and LRPC

An economist named Alban Phillips studied the interaction between inflation and unemployment in the mid-20th century and derived the so-called "Phillips curve".  In the short-run, Phillips and his successors argued there was an inverse relationship between the inflation rate and the unemployment rate: as inflation goes up, unemployment goes down, and vice versa.  They made this claim because since wages are so critical to all firms as costs of factors of production, if there are fewer and fewer unemployed people, wage levels (and thus the overall price level) would increase as firms have to pay more for scarcer labor.  This graph shows the short-run Phillips curve (SRPC):

But then, the 1970s occurred.  In this decade, we observed stagflation, or high inflation AND high unemployment.  This caused the SRPC model to fall out of favor and led to a new theory of this relationship by a group of monetarists led by Milton Friedman.  They argued there was no link between inflation and unemployment and, following the analysis of neo-Classical LRAS, said there would be a short-run fixed "natural" level of unemployment that would differ between countries.  In fact, they maintain that if the government intervened to reduce unemployment, the only result would be a higher and higher inflation rate at the same original level of unemployment.  Let's look at the graph:

We can see above that the initial equilibrium is an inflation rate of 2% and an unemployment rate of 4%.  At this level, people expect 2% inflation.  Monetarists would argue that if the government used demand-side policies to reduce unemployment (more demand for g/s means more workers are needed), the the short-run.  As this occurs, the inflation rate increases to 5%, and unemployment will fall to 3% (lower red arrow).  However, people will realize that although the number on their paycheck has increased (nominal figure), the real rate adjusted for inflation did not change, and anger rises.  Some people thus leave their jobs and unemployment returns to 4% (lower blue arrow).  If the government again tries to cut unemployment through expansionary fiscal or monetary policy, the rate will again fall to 3% and workers will again negotiate higher wages.  Here we would be at an inflation rate of 9% with 3% unemployment.  Yet, again the works will realize that their real income hasn't changed and unemployment will again rise to 4%.  This is how the long-run Phillips cuve (LRPC) is derived, and this term is also called natural rate of unemployment (NRU).  We can define the NRU as the rate of employment that occurs when at the full employment level of output (Yfe) and the labor market is in equilibrium.

One more graph.  How can we lower the unemployment rate if we follow neo-Classical theory.  Answer - shift the LRPC in!  Monetarists would argue that a country can decrease it's NRU through achieving economic growth (see neo-Classical LRAS post) which would cause a leftward shift in LRPC.  To do this, they encourage implementing market-oriented policies like reducng taxes and deregulating.

Unemployment - Disequilibrium

The first type of disequilibrium unemployment is called real-wage or neo-Classical unemployment.  Basically, this concept is the same as microeconomic price floors but applied to workers and minimum wages.  A minimum wage, w1, is set above the market-clearing wage, we at quantity q*.  Instead, a minimum wage has been set which guarantees workers a wage above where it would fall if the labor market were left to its own devices.  Thus, there is real wage / neo-Classical unemployment from q1 to q2 at wage w1.  Keynesian economists argue that such minimum wages are needed to protect the most vulnerable in society.  Neo-Classical economists argue there would be no real-wage unemployment without a minimum wage and more people would be working.  Big debate (as per usual with these schools of thought).

The second type of disequilibrium unemployment involves downturns in the economy.  If AD falls from a negative demand shock, AD shifts in causing APL and Y to also fall.  Because output (real GDP) has fallen, less workers are needed to make g/s.  This causes cyclical/demand-deficient/Keynesian unemployment (this new graph above!).  Neo-Classical economists argue that the labor market will go from it's original equilibrium at we, qe to its new equilibrium w2, q2 since workers will accept lower wages.  Keynesians disagree!  They believe there is wage stickiness which means that it's very unlikely workers will accept lower wages due to forces like union power and simple static human behavior and mindsets.  Thus, they believe cyclical unemployment from q1 to q2 will exist at the same original wage rate w1.

Unemployment - Equilibrium

Unemployment is the state in which someone is without work, available to work, and is currently seeking work.  The unemployment rate is the number of people unemployed divided by the total labor force (everyone working plus everyone seeking work but unable or unwilling to take jobs).  There are two types of disequilibrium unemployment: real-wage/Classical and cyclical/demand-deficient/Keynesian.  The graph below shows equilibrium unemployment of which there are three types: frictional, seasonal and structural. Frictional unemployment occurs when a worker moves from one job to another, called job searching.  Seasonal unemployment occurs because production in some sectors varies over the year, like farmers in winter or ski instructors in summer.  Structural unemployment is caused by a mismatch (spatial or skill-based) between jobs offered by employers and potential workers.

In theory, the labor market may be in equilibrium but there may still be unemployment.  When the labor market is in equilibrium, the number of job vacancies in the economy is the same as the number of people looking for work.  Jobs exist, but people are either unwilling or unable to take jobs that are available.  This graph shows the labor force (LF) curve in addition to the aggregate demand for labor (ADL) and aggregate supply for labor (ASL) curves.  The ASL shows the number of people willing and able to work at every given wage rate.  The ADL shows the demand of firms for all types of workers at different wage rates.  Here, the labor force includes the aggregate supply for labor plus everyone unemployed and looking for work, and thus at we, qe, qe to q1 unemployment exists.

Video: Types of Unemployment

Video: Unemployment (general)

Video: Crowding Out & Lags

Deflation: prices going down

Deflation is a persistent decrease in the average price level for a sustained period of time.  Deflation can be good, deflation can be bad.  "Good" deflation occurs when the LRAS shifts out symbolizing economic growth.  Economic growth occurs when the quality or quantity of FoPs is increased.  As we can see in the graph below, a rightward shift in LRAS leads to a fall in APL, showing deflation.

Yet, there is also "bad" deflation.  This occurs when aggregate demand falls in the economy, leading to a decrease in output (meaning more unemployment) and a falling average price level (deflation).  See the graph below:

A neo-Classical economist would argue that in the long run, the fall in the average price level would make the production process cheaper and thus eventually shift the SRAS out so that the full employment level of output is again achieved.

Video: Real Income

Video: Inflation & Price Indexes

Inflation: prices going up

Inflation is defined as a persistent increase in the average price level for a sustained period of time (usually measured yearly).  As prices around people go up, they can lose purchasing power (assuming their income isn't tied to inflation through a cost-of-living adjustment), they can start to feel uneasy and possibly get violent (or, at least strike), and they can switch from saving to spending if interest rates aren't properly adjusted.  Countries with higher inflation see less demand for their products as consumers switch to countries with lower rates of inflation.

There are two main types of inflation besides simply increasing the money supply: demand-pull and cost-push.  The graph above shows demand-pull inflation.  Here, macroeconomic equilibrium starts at average price level APL1 and output level Y1.  Then, the aggregate demand curve shifts out from AD1 to AD2 because of some sort of demand shock (i.e. confidence soars, interest rates fall, the FTSE goes up and stays up).  This leads to a new equilibrium with higher output level Y2 (meaning less unemployment) and a higher average price level, inflation, to APL2.  This is not necessarily bad and quite common over time.

The graph above shows cost-push inflation.  Here, macroeconomic equilibrium starts at average price level APL1 and output level Y1.  Then, the short-run aggregate supply curve shifts in from SRAS1 to SRAS2 because of some sort of supply-side shock (i.e. oil prices soar, natural disaster).  This leads to a new equilibrium with a lower output level Y2 (meaning more unemployment) and a higher average price level, inflation, to APL2.  This is usually bad.

Evaluation - How can these two types of inflation be treated?  Don't forget the battle...Keynesians vs. neo-Classicals!  Why is it hard to measure inflation?

Business Cycle, Multiplier and Accelerator

In the economy, we observe patterns of rising and falling growth that fluctuate around an upward-sloping line of best fit of LR potential growth.  We can start at the peak, or boom, then fall down during a recession (contractionary period) until hitting rock bottom at the trough and then rising again in recovery (or expansionary period) until reaching a new (usually higher) peak.  This is the business cycle.  At a boom, the difference between the actual growth (which the squiggly line represents) and the line of best fit (potential growth trend) is a positive output gap and at a trough, the distance is a negative output gap (where actual growth is less than potential growth).  During a downturn, we see a fall in aggregate demand which leads to unemployment.  This pattern reverses itself during and upswing.  A recession is technically defined as two consecutive quarters (three months plus three months) of negative GDP growth (-x%).

The multiplier, calculated by taking 1/1-the marginal propensity to consume or mpc), tells economists inevitably how big a governmental injection in monetary terms will be when expansionary fiscal policy occurs.  Basically, income for people becomes the income for other people when the original people spend it.  They can also save, be taxed and buy imports (all people), but some money will be consumed.  This occurs again and again over time until the multiplier effect runs its course.  This means a $10 million injection can turn into a $20 million injection if the pc is .5.

The accelerator describes how a small increase in aggregate demand can lead to a proportionally bigger increase in induced investment.  Induced investment occurs when firms actively add to the capital stock of the economy to meet increasing demand for their products.  This is contrasted with replacement investment which replaces capital that has depreciated over time and always takes place, even during recessions. 

Lastly, the marginal propensity to save (mps) measures the percentage of income saved by consumers, the marginal propensity to tax (mpt) measures the percentage of income taxed by the government and the marginal propensity to import (mpm) measures the percentage of income used by consumers to buy imports.  Algebraically, mpc + mps + mpt + mpm = 1.

Video: Macroeconomic Viewpoints

LRAS - A fight between Keynesians (K) and neo-Classicals (NC)!

For Keynesian economists, in the short run where FoPs are more or less fixed, the economy has what's called "spare capacity" when some resources are not be used to their maximum potential.  This is represented by the perfectly elastic part of their LRAS curve.  Thus, when aggregate demand (AD) increases, say from AD1 to AD2 above, the national output (real GDP - Y) increases (Y1 to Y2) but the average price level (APL) doesn't increase (APL1).  As spare capacity is used up, there is inflationary (upward) pressure on all prices because firms have to start paying higher wages and more money to get scarcer FoPs.  In this "intermediate" section, both the output (Y2 to Y3) and the average price level are increasing (APL1 to APL3).  The final part of the Keynesian LRAS curve which is perfectly inelastic is just like the entire neo-Classical LRAS curve.  Here, the economy is at the full employment level of output (Yfe) and any increase in AD will merely increase the average price level (inflationary gap, slightly above APL3 to APL4).  There is no effect on real GDP (Yfe).  The distance between a level of output that is below full employment and full employment is called a deflationary gap.  Evaluative implications – to increase real output during a time of spare capacity, Keynesians would propose the government undertake expansionary fiscal and/or monetary policy. 

For neo-Classical economists, we are already at the full employment level of output.  If AD increases (here from AD1 to AD2), output increases beyond the full employment level of output (to Y2) which also increases the average price level (to APL2).  Because the price level includes all goods and services including the FoPs (especially labor), the costs of producing g/s increase and SRAS shifts in (SRAS1 to SRAS2) so the new equilibrium is simply an even higher price level (APL3) with no change in output (Yfe).  Conversely, if output falls below the full employment level of output, the price level also falls making production of all g/s cheaper and thus shifting SRAS out back to equilibrium at Yfe and an even lower APL (not shown).  This is why neo-Classicals don't promote government intervention in the macroeconomy per se.

Evaluation - Compare Keynesian and neo-Classical views of the economy?  How does this impact normative economics?

Video: Monetary Policy

Video: Fiscal Policy

Video: AD & AS

Aggregate Demand (AD) / Aggregate Supply (AS) Model

Aggregate demand (AD) is the total demand for final goods and services in the economy at a given time and (average) price level (APL).  An aggregate demand curve is the sum of individual demand curves for different sectors of the economy : AD = C (consumption) + I (investment) + G (government) + (X-M) net exports.   Consumption is the total spending by consumers on domestic g/s, investment (I) is the addition of capital stock to the economy done by firms, government spending (G) is money (from taxpayers) spent on g/s and is altered by fiscal and monetary policy, and net exports (NX) are exports (domestic g/s bought by foreigners) minus imports (foreign g/s bought by domestic households, firms and/or government).  

Aggregate supply (AS) is the total supply of goods and services that firms are prepared to sell at a given time and (average) price level (APL).  In the short run, the SRAS is upward-sloping because as more output is produced, firms must pay higher production costs (i.e. pay more for overtime, bid higher prices for scarcer raw materials), and firms pass these higher prices off in the form of a higher average price level.   Short run macroequilibrium occurs at the price level APL* when all the output produced by the country’s firms is consumed (Y1).  Firms have no incentive to raise prices or increase output.

Circular Flow of Income

Above, we see a diagrammatical representation of the circular flow of income in the most basic two sector economy of households and firms.  In this model, the households give firms the factors of production (land, labor, capital and enterprise) and the firms take those FoPs, combine them in different ways, and return them to households as goods and services (inner blue circle).  To pay for these goods and services, households pay the firms through spending (expenditure).  In return, the firms pay the households for their FoPs in wages (for labor), rent (for land), interest (for capital) and profit (for enterprise).  This is shown by the outer black arrows.

Money can enter (injections) and leave (leakages) the circular flow.  The three purple arrows show the three basic injections: investment (I), government spending (G), and exports (X).  When firms spend money to add to the capital stock of the economy, that causes an injection of funds into the flow.  Similarly, governments spend for projects and programs which also puts money into the economy.  Lastly, when foreigners buy domestic g/s, that represents an injection into the circular flow of income. The three red arrows show the three basic leakages: savings (S), taxes (T), and imports (X).  Money leave the economy (or "leaks" out) when households put their money in banks for a later ("rainy") day, when the government takes out taxes from peoples' paychecks and when households buy foreign goods.  Another note: savings is required for investment (banks need money to lend) and governments spend with taxpayer money.

Video: Real GDP

Video: GDP

GDP or GNP? What’s the difference? How is it calculated?

Gross domestic product (GDP) is the total value of all the final g/s produced in an economy/country, regardless of who owns the FoPs, in a given time period, usually one year. For example, in Switzerland, we count all firms doing business within the borders…the Swiss ones, the Canadian ones, the Thai ones, etc.

Gross national product (GNP), on the other hand, counts the value of all the final g/s produced by an economy’s/country’s owned FoPs, regardless of where they are situated. For example, we take all the Swiss owned productive assets in Switzerland, minus all the foreign ones in the country, plus all those in Germany, South Africa, China, etc.

Net national product (NNP) takes the GNP and subtracts the depreciation of all the capital in that year. Nominal GDP is the number calculated that year for GDP, whereas real GDP takes that number and adjusts it for inflation compared to a base year. When we divide the GDP by the population, we get GDP per capita, one of our (many) indicators of economic development.

How is national income measured?  Via calculating output, expenditure, and/or income, all of which should be equal.  For the output method, the total value of all g/s from each sector is added.  For the expenditure method, the spending by households (C - consumption), firms (I - investment), the government (G) and net exports (NX - exports minus imports) is added.  For the income method, all the wages, rent, interest and profit is added.  Remember, national output = national expenditure = national income!

Evaluation - What are the many limitations of national income data?