Don’t tell me that you think it’s green, me I know it’s red!
Globalisation of Finance has blurred the old distinction between developed and emergent markets, between “the East” and “the West”, turning China into America’s banker – the commie creditor to the capitalist debtor.
What’s the colour of money?
An Overview of Modern Macroeconomics
Some Definitions to Start with
- Inflation is defined as an upward movement of prices from one year to the next.
- It is typically measured by the percentage change in price indices, such as the consumer price index, the producer price index, or the so called GDP deflator.
- Inflation has often been described as The Cruelest Tax because it eats away at our savings and at our paychecks.
- The unemployment rate is measured as the number of unemployed persons divided by the number of people in the labor force.
Economists distinguish between three kinds of unemployment, frictional, cyclical and structural:
- Frictional unemployment occurs as a natural part of the job seeking process
- Cyclical unemployment occurs when the economy dips into a recession
- Structural unemployment occurs when a change in technology makes someone’s job obsolete.
The GDP is defined as the market value of all the final goods and services produced in a country in a given year:
- One is called the flow of product or expenditures approach = consumption, plus investment, plus government expenditures, plus expenditures by foreigners or net exports
- The other is called the flow of cost or income approach = wages earned by workers, plus rents earned by property owners, plus interest received by lenders, plus profits earned by firms.
- Actual GDP represents what we are producing, while potential GDP represents the maximum amount the economy can produce without causing inflation.
- When actual GDP is well below potential GDP, we are in the recessionary range of the economy.
- In contrast, when actual GDP is above potential GDP, we run the strong risk of inflation.
- Nominal GDP is measured in actual market prices
- Real GDP is simply nominal GDP adjusted for inflation, and it is calculated in constant prices for a particular year, say, 1992
- Moreover when we divide nominal GDP by a Real GDP, we obtain the GDP Deflator
- The term business cycle refers to the recurrent ups and downs in real GDP over several years.
- Fiscal policy uses increased government expenditure and tax cuts to stimulate the economy. Alternatively, to fight inflation by reducing government expenditures and raising taxes.
- Monetary policy uses control over the money supply to achieve similar goals
Equilibrium in the Aggregate Supply – Aggregate Demand Model
- The vertical axis measures the general price level for all goods and services.
- The horizontal axis measures the level of real GDP
- The curve labeled AS represents the economy’s aggregate supply, or how much output the economy will produce at different price levels. Note that it slopes upwards meaning that the higher the price level the more businesses will produce.
- The downward sloping AD curve is the aggregate demand curve. It represents what everyone in the economy, consumers, businesses, foreigners and government, would buy at different aggregate price levels. Downwards slope means that as the general price level falls consumers and businesses will increase their demand for goods and services.
- A macroeconomic equilibrium is a combination of overall price and quantity at which neither buyers nor sellers wish to change their purchases, sales, or prices.
The classical economists (Adam Smith, David Ricardo, and Jean Baptiste Say) believe that the problem of unemployment was the natural part of the business cycle. That it was self-correcting and most important, that there was no need for the government to interfere in the free market to correct it.
John Maynard Keynes flatly rejected the Classical notion of a self-correcting economy. Keynes believed that under certain circumstances, the economy would not naturally rebound, but simply stagnate, or even worse, fall into a death spiral. To Keynes, the only way to get the economy moving again, was to prime the economic pump with increased government expenditures.
The essence of Demand-Pull Inflation is too much money chasing too few goods.
- During war time, increased defense spending moves aggregate demand from AD to AD prime.
- And equilibrium output increases from E to E prime as real GDP expands.
However, when real output rises far above potential output, the price level moves up sharply as well, from P to P prime.
Cost-push, or Supply-Side Inflation occurs when factors such as rapid increases in raw material prices or wage increases drive up production costs. This can happen as a result of so-called supply shocks, such as those experienced in the early 1970s. During this period, such shock included crop failures, a worldwide drought, and a quadrupling of the world price of crude oil.
- The higher costs of doing business shift the AS curve up from AS to AS prime. And the equilibrium shifts from E to E prime.
- Output declines from Q to Q prime while prices rise.
- This leads to the phenomenon of stagflation, recession or stagnation combined with inflation. In this situation the economy suffers the double whammy of both lower output and higher prices.
Prior to the 1970s, economists didn’t believe you could even have both high inflation and high unemployment at the same time. One went up, the other had to go down. The 1970s proved economists wrong on this point and likewise exposed Keynesian economics as being incapable of solving the new stagnation problem. Keynesian Dilemma was simply this: using expansionary policies to reduce unemployment simply created more inflation. While using contractionary policies to curb inflation, only deepened the recession. That meant that the traditional Keynesian tools could solve only half of the stagflation problem at any one time. And only by making the other half worse.
Milton Friedman‘s Monetarist School argued that the problems of both inflation and recession may be traced to one thing: the rate of growth of the money supply. To the Monetarists, inflation happens when the government prints too much money, and recessions happen when it prints too little. From this Monetarist perspective, stagflation is the inevitable result of activist fiscal and monetary policies, that try to push the economy beyond its so-called natural rate of unemployment. Or, more technically, its Lowest Sustainable Unemployment Rate (LSUR). This natural rate of unemployment, or LSUR, is the lowest level of unemployment that can be attained without upward pressure on inflation.
In the 1980 presidential election, Ronald Reagan ran on a supply-side platform that promised to reduce the budget deficit. The supply side economists believed that the American people would actually work much harder and invest much more if they were allowed to keep more of the fruits of their labour. The end result would be to increase the amount of goods and services our economy could actually produce by pushing out the economy’s supply curve. Hence, supply-side economics. Most important the supply siders promised that by cutting taxes, and thereby spurring rapid growth, a loss in tax revenue from the tax cut would be more than offset by the increase in tax revenues from increased economic growth. Thus, under supply side economics, the budget deficit would actually be reduced. Unfortunately, that didn’t happen.
New classical economics (not to be confused with neoclassical economics) is based on the controversial theory of rational expectations. This theory says that if you form your expectations rationally, you will take into account all available information, including the future effects of activist fiscal and monetary policies. The idea behind rational expectations is that such activist policies might be able to fool people for a while. However, after a while people will learn from their experiences and then you cannot fool them at all. Central policy implication of this idea is of course profound. Rational expectations render activist fiscal and monetary policies completely ineffective, so this should be abandoned.