Principles of Macroeconomics
Principles of Macroeconomics ECO 230
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To download the syllabus homework assignments and notes please visit u u r l m 30ecoz30htm DEPARTMENT ECONOMICS AND FINANCE COURSE NUMBER ECO 230 CREDIT HOURS 3 SEMESTER Summer 2006 I TITLE PRINCIPLES OF MACROECONOMICS II INSTRUCTOR Dr Seid Y Hassan OFFICE LOCATION 308C Economics amp Finance Suite PHONE 7624284 OFFICE HOURS M T TH F 830am 1000am W 830 7 1200pm and by appointment 111 CLASSROOM LOCATION AND MEETING TIME 23001 BB301 M T TH F 10301240 Note We will meet on the first Wednesday May 31st IV CATALOGUE DESCRIPTION ECO 230 Principles of Macroeconomics 3 An introduction to the application of the basic principles of supply and demand to issues in aggregate economics such as national income accounting unemployment growth in ation business cycles and the role played by government through its scal and monetary policies V PURPOSE To provide a broad theoretical foundation in basic macroeconomic principles To help the student develop a basic understanding of economic principles relating to the operation of the market the principles and workings of supply and demand in macro sense VI COURSE OBJECTIVES Upon completion of this course the student should be able Upon completion of this course the student should be able 0 To apply the principal economic methodologies and tools including opportunity cost marginal analysis and supply and demand to analyze and critique historical and current economic issues and describe how to use these tools to be responsible citizens 0 To gather and present historical information on and to describe the construction measurement issues and importance of GDP the unemployment rate the in ation rate and the other major national income accounts to society s income and welfare 0 List the major factors that in uence GDP growth in ation and unemployment and describe how changes in the above affect the business environment and the standard of living of the economy s citizens 0 Be able to use Aggregate Supply and Demand to solve for the multiplied impact of spending supply shocks and policies on the nation s GDP and prices 0 Be able to show how changes in foreign country incomes tariffs and exchange rates in uence trade and domestic country income and prices and to describe the differences between competing economic systems 0 Describe the structure of the Federal Reserve how monetary policy is made and how monetary policy choices affect interest rates GDP prices and society s welfare VII CONTENT OUTLINE IN BRIEF Chapter 1 The Nature and Method of Economics Graphs and Their Uses Chapter 2 The Economizing Problem Production Possibilities and some Fundamental Economic Concepts Chapter 3 Supply And Demand and their Applications Chapter 4 The Market System Chapter 7 Measuring Domestic Output and national Income Chapter 8 Introduction to Economic Growth and Instability Unemployment In ation and related Topics Chapter 9 Basic Macroeconomic Relationships Chapter 10 The Aggregate Expenditures Model Chapter 11 Aggregate Supply and Aggregate Demand Chapter 12 Fiscal Policy Chapter 13 Money and Banking Chapter 14 How Banks Create Money Chapter 15 Monetary Policy Chapter 16 In ation Chapter 17 The Business cycle Chapter 19 Trading with the World Chapter 20 International Finance VIII INSTRUCTIONAL ACTIVITIES Classroom lectures online notes visual aids homework assignments discussions and exams IX FIELD AND CLINICAL EXPERIENCES None X RESOURCES Text supplements class handouts and Wall Street Journal etc XI GRADING PROCEDURES There will be four tests to be given as indicated below Most if not all tests will be given on Fridays NO MAKE UP EXAM WILL BE GIVEN I will automatically drop one of the lowest tests PROVIDED THAT YOU HA VE written all tests anal have made a concerted effort to learn the material for each section 1 Composition of Final Grade Test Chapters in test Test Date Percent 2 Homework Assignments Practice problems and exercises reviewing the lecture and reading material will be periodically distributed and assigned throughout the session The purpose of these assignments is to help you understand and practice the material covered in class helping to prepare you for the tests 3 and the nal exam NOTE TO ENCOURAGE TEAM LEARNING YOU WILL BE ASKED TO DO SOME OF THE HOME WORK ASSIGNMENTS AND WITHIN CLASS QUIZZES AND EXERCISES IN GROUPS If You Miss An Exam If you miss an exam and do not receive an excused absence you receive for that exam a zero See below the conditions for an excused absence If you receive an excused absence I may prepare a separate exam for you if I think it is necessary to take the exam I may also ask you to take the two tests together in the same day XII ATTENDANCE POLICY I will take attendance as much as I can Even though there is no direct N E penalty for missing classes you I will reward you if you attend all class periods I will add 2 on your total grade if you attend all classes You should know that the course by nature is a buildingblock and comprehensive and requires that you attend every class You will nd that relying upon someone else s lecture notes is a poor substitute for the real notes ALSO I RESERVE THE RIGHT TO GIVE EASY POP QUIZZES WHEN I FEEL ATTENDANCE IS UNUSUALLY LOW THESE POINTS WILL BE ADDED TO THE FINAL GRADE PLEASE NOTE ALSO THAT MY LECTURES ARE PREDICATED ON THE ASSUMPTION THAT YOU HAVE COMPLETED THE ASSIGNED READINGS EXCUSED ABSENCE To receive an excused absence from an exam or a quiz you must 1 inform my secretary or me immediately or let me know before hand if possible and 2 provide proof for the truly unusual circumstances Both conditions must be met SEATING CHART A seating chart is established the secondday class meeting You may claim any seat you can get contingent upon the requirement that the front rows must be filled before sitting in the back rows The seating chart aids me in the recording of attendance and knowing your names as quickly as possible TYPE OF EXAM QUESTIONS ShortAnswer essay type Multiple Choice andor TrueFalse Fill in the Blanks and Short Answer Questions that may involve graphs and calculations XIII REQUIRED TEXT 1 Campbell McConnell and Stanley Brue Macroeconomics Principles Problems and Policies l6Lh Edition McGrawHill Boston MA 2005 2 Access to the EStudy Center using Blackboard XIV PREREQUISITES MAT 117 120 140 or 150 or a Math ACT score of 23 XV XV p 1 XV gt p o ACADEMIC HONESTY POLICY Please be advised that it is the policy of the College of Business and Public Affairs that all instances of academic dishonesty will be punished and the names of the offenders will be reported The honesty policy is posted in each classroom and httpwwwmurraystateeducbpaPDFHonestypdf Students should also be familiar with the collegiate ethics policy which can be found at httpwwwmurraystateeducbpaPDFethicspdf EQUAL OPPORTUNITY STATEMENT Murray State University does not discriminate on the basis of race color national origin sex religion marital status age or disability in employment admission or the provision of services educational programs and activities and provides upon request reasonable accommodation including auxiliary aids and services necessary to afford individuals with disabilities and equal opportunity to participate in all programs and actives For information regarding nondiscrimination policies contact the Office of Equal Opportunity 2708093155 FINAL NOTES I reserve the right to change any part of the class content including adding or omitting chapters as time permits Hints to Obtain a Good Course Grade 1 Attend classes regularly 2 Read the text and other assigned materials before class 3 Work on problems with a maximum of 3 people including yourself 4 Pay attention in class Also you should avoid the following a sleeping in class b talking in class while I am lecturing 5 Take advantage of a my office hours b the homework assignments and solutions In the written portion of my exams that require certainty your strict judgment a sure answer or don t require results of a chance or doubt you should always avoid the eguivocal words and or phrases like probably would probably maybe could be probably s0 possibly etc Responses to questions that suggest doubtfulness on your part will guarantee you ZERO CREDIT ECO 230 Homework quiz November 8 2001 Dr Hassan Instruction Answer the following questions using the data provided on my web site with the le name as 230hmk1101xls Hint you can nd the answers to most of these questions in the textbook lecture notes or a combination of both You can work with one and only one of your classmates on this takehome quiz if you choose to do so Please anticipate that I will incorporate some or a version of these questions in the second test Note also that this takehome quiz will count a lot PART I questions 1 4 On Real vs Nominal GDP and Inflation 60 points 1 10 points Calculate nominal GDP using the expenditure approach and compare your values with the one provided in the table Do this by just plotting the two numbers 2 25 points Calculate real GDP using both the CPI ie using series code name PUNEW and the GDP price de ator ie using series code name GDPD Plot real GDP calculated using the CPI and GDPD and Nominal GDP on the same graph Then a Brie y explain the similarities and differences between the two real GDP measures Which of the two is higher lower0 and why Why has the nominal GDP increased faster than real GDP What would it mean if an economy had real GDP increasing faster than nominal GDP Using PAN total US population calculate per capita GDP What is the meaning of per capita GDP and why is it important to measure per capita GDP Is per capita real GDP a better measure than real GDP If so why What are the drawbacks of per capita GDP c List and brie y discuss why GDP cannot be a measure of economic welfare Fquot 3 15 points On the CPI GDP Price De ator In ation Economic Growth a Plot both the GDP de ator and the CPI on the same graph Then explain the similarities andor differences between them both conceptually as discussed in class and by looking at the graphs Calculate the in ation rate using both the CPI and the de ator and graph both of them using the same axis Do you see any similarities and differences between them Explain brie y Calculate the growth rate of real and nominal GDP What are the similarities and differences between the two Which measure would you like to use and why 4 15 points On Unemployment and Employment a Using the methods shown in class and or your textbook calculate the unemployment rate and compare your result with LHURR and comment Are the same or different Then plot LHURR and the in ation rate calculated using the CPI on the same graph What is the relationship between the two quotmisery indexesquot over time Question 8 page 152 in your textbook Discuss the economic and social consequences of high unemployment Hint see notes Fquot O 09 PART II question 5 5 40 points On In ation unemployment and Interest Rates a 5 points Using the 10year bond rate code named FYGTlO in the data set as the nominal interest rate and the in ation rate you calculated using the CPI calculate the real interest rate as shown in class andor using the notes Plot the in ation and the real interest rates on the same graph and comment Do they go together or do you think there may be a tradeoff between the two misery indexes Note use the simple approximation formula I showed in class to calculate the real interest rate b 5 points List the costs of unemployment c 5 points quotIn ation is like a taxquot True of false Evaluate this statement based on what you learned in this course d 5 points Does it matter if in ation is anticipated or unanticipated Why or why not Does anticipated in ation rate redistribute income between lenders and borrowers e 15 points Suppose you are the lender and I am the borrower I borrowed 100000 from you at an interest rate of 10 The current in ation rate is 3 The actual in ation ex post is 15 1 What was your expected rate of return 2 What is your actual rate of return Interpret this in layman terms 3 Calculate the real values of the principal and rate of return at the time of the contract and after you collected both of them from me Who gains and who loses from this contract What if the ex post in ation rate was 2 instead Who loses who bene ts Comment f 10 points In ation during the 1970s was much higher than expected when the decade began If so how did this affect l homeowners who obtained fixed mortgage rates homeowners who obtained variable mortgage rates banks that lent the money mostly on frxedrate mortgages banks that lent the money mostly on variablerate mortgages if you are a banker which one would you choose Elk59 Note You can use the notes my lectures and your textbook to answer these questions You can also other Internet sites such as httpwwwblsgov httpwwwbeadocgov httpwwwstlsfrborg especially FRED to learn more about these isssues Chapters 9 and 10 Macroeconomic Relationships and the Aggregate Expenditures Model Bring a copy of these outlines notes to highlight and draw the graphs as go thru them in class Note We construct Aggregate Expenditures and the multipliers by assuming that general price level does not change We will later relax this assumption and derive the aggregate demand curve by changing the price level andor the interest rate If prices are xed then aggregate demand determines the aggregate quantity of goods and services sold which equals real GDP Aggregate Expenditures planned consumption expenditures planned investment planned government expenditures on goods and services planned net exports In the short run all of these are assumed to be xed except the consumption function So if any of these xed expenditures acting as independent variables or acting as autonomous components change consumption changes and the changes in consumption affect output in return We will show that using the Keynesian cross the aggregate expenditureaggregate income GDP relationship Actual Expenditure Planned Expenditure and Real GDP Actual expenditure is always equals to Real GDP but planned expenditure may not be equal to Real GDP Why rms in aggregate may end up with more inventories or with less inventories If planned expenditures equal to real GDP then actual aggregate expenditure equals Real GDP and the economy is in equilibrium Changes in autonomous changes in Investment Government spending taxes imports and exports would change the economy thru the multiplier process When an autonomous component of Aggregate Demand changes equilibrium output will change The change in output will be even larger than the initial change in Aggregate Demand This result for the change in Y to be greater than the initial change in Aggregate Demand is known as the multiplier effect The quot and saving quot quot The Consumption Function illustrates a consumption function shows the relationship between total consumer expenditures and total disposable income holding all other determinants of consumption constant No other factors are considered The consumption function also assumes the relationship between consumption and disposable income is linear The equation for the consumption function is C a MPCDI where C is total consumption a is autonomous consumption MPC is the marginal propensity to consume and D1 is disposable income Autonomous consumption a is the portion of disposable income that is independent of income In other words when disposable income changes autonomous consumption does not change The value for autonomous consumption is shown on the graph where the consumption function intersects the vertical axis Not too much should be made of this value It is primarily a quotstatistical leftoverquot We fit the best possible line between consumption and disposable income and the line has to cross the vertical axis somewhere The point where it crosses the axis is the value for a Consumption Saving Disposable Income Something that is left from taxes and not spent is saved and that is not saved must have spent So the marginal propensity to consume MPC which is change in consumption duet to a fraction of change in disposable income and the marginal propensity of save MPS which the change in saving brought about by a fraction of change in disposable income must sum one That is MPC MPS 1 Draw the consumption and DI relationship about here Noneincome Determinants of Consumption and Saving 1 Wealth 2 Real interest rates 3 Expectations 4 household debt 5 Taxation All of the above shift the curve up or down Draw the Aggregate expenditure model only C on the vertical axis and DI on the horizontal axis about here A Determinimr in the Income Expenditure Model Investment Investment is the most volatile component of GDP It accounts for approximately 17 of GDP Investment is determined by interest rates business con dence taxes and capacity utilization If interest rates rise other things equal investment falls Why Investment typically requires large amounts of upfront expenditures Businesses must either borrow the resources externally or divert resources internally to the investment project The cost of borrowing these funds is the interest rate When interest rates are high it is more expensive to borrow funds so less investment is demanded When interest rates are low it is cheaper to borrow funds so more investment is demanded The figure titled quotInvestment Demand Curvequot plots the interest rate on the vertical axis and the quantity of investment on the horizontal axis It is downwardsloping Business Con dence expectations plays a large role perhaps the most significant role in determining investment Investment means borrowing now to generate income ows in the future If projections of income in the future are high investment now seems to be worthwhile Future projections of income are often good guesses at best Uncertainty in future conditions makes investment risky and volatile Sudden changes in expectations result in sudden changes in the level of investment Taxes also impact investment The return on investment depends on how heavily investment income is taxed for example the capital gains tax Other things equal higher taxes result in lower investment Technological Change innovation the development of new products improvements in existing products and the creation of new machinery and production processstimulates investment Capacity Utilization is the percentage of the existing plant and equipment that is being utilized If capacity utilization rates are low then the existing plant has room to expand and investment in the future will be lower Conversely if the utilization rates are high then a firm might have to invest immediately to accommodate future growth In our simpli ed model we assume that interest rates are already determined and we assume that all other determinants of investment such as business confidence remain unchanged Given a particular interest rate we can determine the level of investment that will take place in the economy For example suppose that the interest rate is 80 percent and that rate corresponds to 600 of investment We plot the level of investment in the figure titled quotInvestment Levelquot Aggregate expenditures go on the vertical axis while the level of income or GDP Y goes on the horizontal axis The investment line is simply a horizontal line at 600 It has a slope of zero because we assume that investment does not vary with the level of income in the economy Draw the Investment schedule about here Draw the Aggregate expenditure model GDP C Ig with only C and I about here Differentiate the economy s investment schedule Ig which is the amount of investment forthcoming at each level of GDP and investment demand ID in relation to interest rates Government Spending and Taxes Government spending G is assumed to be autonomous An increase in G raises consumption then income then consumption them income etc in this fashion by multiple factors For the time being we assume taxes being lump sum A lumpsum tax is a tax that is a constant amount the tax revenue for the government is the same at all levels of GDP Taxes affect consumption and hence GDP or income in the opposite direction of government spending G Draw the AE and Real GDP relationships here beginning with consumption and adding I G T For example if the MPC is 80 and autonomous investment increases by 200 equilibrium output will ultimately change by 1000 not 200 The simple output multiplier llMPC Calculating the Size of the Multiplier Effect The size of the multiplier effect is given by Change in Output output multiplier x initial change in AD where the simple output multiplier is de ned as llMPC For example with an MPC of 080 the simple output multiplier is ll80 5 so the 200 initial increase in investment ultimately increases output by 5 x 200 1000 The simple output multiplier assumes that there are no proportional taxes that all expenditures are for domestically produced goods and services and that the price level is xed Derive all Simple Multipliers and show that Incomeinduced consumption is the key to understanding the output multiplier a The simple spending multiplier llMPC b The simple investment spending multiplier llMPC c The simple taX multiplier MPClMPC d the simple balanced budget multiplier 1 How and Why the Multiplier Works Consumption is based primarily on disposable income According to the consumption function C a bYT where quotaquot is a constant the intercept of the consumption function and b is the MPC Thus higher income causes higher consumption When G rises it increases income then consumption further raises consumption which further raises income which further raises consumption and so on When consumption rises Aggregate Demand also rises When Aggregate Demand rises output and hence income rise The rise in income allows people to consume more goods and services This is called quotincomeinducedquot consumption and it raises Aggregate Demand even more Let s work through an example Suppose the MPC is 080 A University decides to build a new residence hall worth 100 million Construction workers earn 100 million in income and they spend 80 percentor 80 milliondining out going to the movies shopping and buying new cars The increased spending of 80 million becomes income to the owners and employees of the restaurants movie theatres shopping malls and car dealers In turn these people spend 80 percent of the new 80 million or 64 million on other goods and services The 64 million becomes income to others in the community and the process continues Table 1 shows the impact of the multiplier through various rounds When all the effects are totaled up output will increase by 500 million because the value of the output multiplier is equal to ll2 5 Remember that the initial increase in Aggregate Demand for the new residence hall was just 100 million The above table can be summarized as follows and introduces you to the multiplier process I Initial change in Government purchases I AG Which is equal to 100 above I First change in consumption I MPC X AG Second change in consumption MPC2 X AG Third change in consumption MPC3 X AG Fourth change in consumption MPC4 X AG AY 1 MPC MPC2 MPC3 MPC4 AG So that the govemmentpurchase multiplier is AYAG 1 MPC MPC2 MPC2 This eXpression is in the form of an in nite geometric series and with 0 lt MPC lt1 it can be written as AYAG 11MPC1 The Multiplier Effect and a Permanent Change in Aggregate Demand If the government or any other private investor funds an ongoing project like nancing a school the impact is much larger than that of a temporary increase Suppose for simplicity that the government spends 100 to construct a new school and then spends 100 each year to operate the school So the government is injecting 100 into the economy permanently Derive the AD curve by changing the price level about here see pp 27071 1 Mathematical n z l X X n Multiply both sides of the equation by X ZX X X2 X3 Subtract the second equation from the first z ZX l or zl X l or z ll X This completes the proof ote The geometric series can be proved as follows Let Chapters 12 and 18 Fiscal Policy and De cits Fiscal Policy is the way the government manipulates its budget position with a goal of stabilizing prices promoting growth and minimizing unemployment This is done by changing taxes and government spending or both The role of the Federal Government has increased substantially since the Great Depression and many perceive that the government is largely responsible for providing economic assistance in times of recession Fiscal Policy may be divided into two major categories 1 Discretionary scal policy a policy initiated by the action of the Congress and the president For example Congress may decrease taxes or increase spending or a little of both to decrease unemployment This is called expansionary scal policy To ward off in ation and rapid economic expansion they do the opposite This is called contractionary scal policy Automatic Fiscal Policy or Non discretionary Fiscal Policy is triggered by the state of the economy itself The US progressive tax rate system where tax payments go up and down with income brings more tax revenue as GDP rises and vice versa Progressive tax taxGDP rises with GDP If tax contributions did not go up as income increases the economy could expand too rapidly The increase in taxes may create a surplus for the government If this surplus is not spent the surplus sterilizes the economy Moreover consumption rises by less than the increase in income since some of it goes to taxes and some of it goes to saving Furthermore transfer payments such as unemployment compensation welfare payments and subsidies decrease during economic expansion and decrease during economic contraction All of these are called automatic or nondiscretionary fiscal policy instruments They are also called automatic or built in stabilizers In general the more progressive the tax rate the greater is the economy39s builtin stabilizers Unless we change the tax system amending the Constitution to balance the budget every year makes not economic sense at all Note if the tax system was proportional or regressive then automatic fiscal policy may not work and balancing the budget may not be detrimental to the economy With a proportional tax system the average tax rate remains constant with income With Regressive tax system the average tax rate decreases as GDP rises A consumption tax system proposed by some supply side politicians will disproportionately affect the poor and it is in general regressive Stabilization Policy is an attempt to stabilize the business cycle in order to achieve low in ation and low unemployment The two organizations which conduct stabilization policy on a large scale are the federal government and the Federal Reserve See chapter 15 The govemment s attempt to stabilize the economy is know as Fiscal Policy while the Fed39s policy is known as Monetary Policy Uses of Fiscal Policv closing 39 v and v Gaps A recessionary gap occurs when actual output Y lt Yp and fiscal policy can be used to close the gap The amount of the recessionary gap is the difference between potential and actual output There is excess unemployment in this case the economy is in a recession An In ationary gap occurs when actual output Y gt Yp and scal policy can be used to close the gap The amount of the in ationary gap as illustrated in Figure 2 is the difference between actual and potential output In this case the unemployment rate is below the natural rate which puts upward pressure on wages and hence prices Again there is room for scal policy to slow the economy and reduce the in ationary pressure Figure 2 Expansionary scal policy increases output by shifting AD to the right use the Keynesian AS curve here By increasing gov t expenditures the gov t can shift Aggregate Demand to the right Expansionary policy is implemented Via some combination of these three tools increase Government Expenditures 2 decrease taxes 2 increase transfer payments or 3 a combination of the above Figure 3 Contractionary scal policy decreases output by shifting AD to the left use the Keynesian AS curve here By increasing By increasing taxes the government can shift Aggregate Demand to the left Contractionary policy is implemented via some combination of these three tools decrease Government Expenditures increase taxes decrease transfer payments or a combination of the above bP N By increasing transfer payments the gov t can shift Aggregate Demand to the right Summary The Tools of Fiscal Policy are Change in the level of government expenditures Change in taxes Change in transfer payments and Changes in combination of the above 9 89 An increase decrease G shifts the AD curve to the right left An increase decrease in taxes shifts the Aggregate Demand curve to the left right Transfer Payments Tr are distributions of income to individuals who do not directly work for the income If the government increases decreases transfer payments disposable income rises and thus consumption increases Fiscal Policy with an upward sloping AS Curve If the AS curve is upward sloping and the government implements expansionary fiscal policy two things are different from the horizontal AS case 1 An increase in G increases output and the price level see the graph 2 Output multiplier effects will be smaller because some of the impact will be felt in higher prices decreasing Aggregate Demand The closer that the economy is to its potential output the smaller the impact on output and the larger the impact on prices Draw the Figure about here Discretionary Policy again Discretionary Policy is policy that must be deliberately enacted by Congress andor the President For example a change in laws impacting unemployment insurance welfare or taX rates qualify as discretionary scal policy There are inherent dif culties in conducting good discretionary scal policy First there are severe time lags Lags result from any of these three sources 1 Recognition lag the time needed for legislators to recognize that policy needs to be changed due to a change in the business cycle Implementation Administrative lag the time needed to change the policy Because of partisan politics this lag can be considerable Decisions on taxes transfer payments and government spending are usually made with more concern for politics than for economics Impact Operational 0r Effectiveness lag the time elapsed between the implementation of the changed policy and its impact on the economy It is possible that by the time deliberate scal policy is enacted and impacts the economy the reason for the action has already passed The average recession lasts for 11 months It is possible that the lag time for scal policy is longer than 11 months Second the growth in the budget de cit has made discretionary scal policy less of an option Deliberate increases in government spending are not popular because they increase the budget de cit Although this concern has diminished in the late 1990s the fear of a return to high de cits may be enough to dampen the effectiveness of scal policy Automatic Stabilizers again Automatic Stabilizers are policies that increase government outlays and decrease taxes automatically during recessions and reduce government outlays and increase taxes automatically during in ationary periods No deliberate government action is required Examples are welfare payments unemployment insurance and proportional income taxes Automatic stabilizers automatically dampen the business cycle When the economy goes into recession spending on poverty programs and other transfer programs increase while taX revenues decrease These policies are free from recognition and implementation lags and they are also free from politics Partially because of automatic stabilizers budget de cits increase during recessions and decrease in times of growth and recovery Supply Side Economics wishes to conduct policy with the goal of shifting the Aggregate Supply curve to the right Supply Side Economics An Introduction Supplyside economics is a school of thought that challenges the emphasis of Keynesian economics on the demand side of the economy As the following Figure illustrates supplysiders wish to increase economic growth and spur the economy by stimulating the supply side of the economy In its simplest form supply side economics wishes to conduct policy with the goal of shifting the Aggregate Supply curve to the right Such a policy leads to higher output and a lower price level or in the real world lower rates of in ation The outcome seems to be the best of both possible worlds a world of high employment and low in ation Supplyside economics has a colorful but controversial history in the United States President Kennedy first advocated and enacted a modest supplyside policy in the early 1960s President Reagan followed suit in the early 1980s with a much more substantial policy change In a run for the 1996 Presidency Senator Dole advocated supply side policies to stimulate the economy The theory of supplyside economics is not very controversial but the implementation and impact of supply side economics is vigorously contested Here we examine the main propositions of these policies By decreasing taxes the gov39t releases constraints on the economy IY 39 39 Labor and Capital Resources One of the supplyside themes is that government regulations and high taxes constrain the growth of the supplyside of the economy Production comes form combining labor and capital with a level of technology If income taxes are too high for example many people may choose not to work in the market It is not worth the opportunity cost of the time spent at work if say 50 cents on every dollar goes towards taxes By reducing taxes more labor will be attracted to the market thus shifting the AS curve to the right A similar argument holds for capital formation Excess regulations and taxes diminish the incentives for saving and investment By lowering the tax rates and simplifying regulations incentives for investment increase and more capital formation occurs The increased level of capital in the economy shifts the AS curve to the right The Laffer Curve What about the de cit The reduction in taxes means that the taX revenue raised to nance government spending is diminished With the same amount of government expenditures the de cit must increase One could argue that the larger de cits crowd out private investment and slow economic growth possibly reversing the goal of supplyside policies There are two responses to this objection First supplyside policies typically advocate a smaller role for the government they recommend a reduction in government spending to offset the lower tax revenues The second response is that cutting taX rates does not necessarily lead to lower taX revenues How can this be If the taX reductions stimulate enough growth in GDP by increases in labor and capital supply then the taX base for the economy increases over time Therefore taX revenues may actually increase A rise in shortterm de cits is likely but over the longer term the economy39s growth will more than offset the decline caused by lower taX rates The theory was popularized by economist Arthur Laffer and the graphical representation termed the quotLaffer Curvequot is plotted here Three points on the curve are labeled Point A lies at the origin because a zero taX rate produces zero taX revenue Point C is at the 100 percent taX rate which also produces zero taX revenue becasue if our income were taxed at a 100 percent level we would have no incentive to produce All income would be taken by the government Point B shows the taX rate in the economy that maximizes tax revenue In this chart it is arbitrarily drawn at 70 percent but it could be lower or higher The important point is that if the economy is to the right of point B a decrease in the taX rate actually increases taX revenues because the increase in taxes from new output and income offsets the taX losses from the lower taX rate If the economy is to the left of point B a decrease in the taX rate decreases taX revenues and leads to larger budget de cits Where was the economy at in the early 1980s After the enactment of the Reagan tax cuts budget de cits increased to record levels and remained high through the mid1990s This suggests that the economy was to the left of point B when the tax cuts were enacted Is There Consensus Most economists do not argue about the theory of supplyside economics It is agreed that lower tax rates and less regulation will stimulate labor and capital formation The argument is about the size of these impacts Many Keynesian economists argue that the impact on the supply side of the economy is minor The economy may grow slightly faster but it is not nearly enough to offset the loss of tax revenues Moreover much of the controversy over supplyside policies results from differences in societal values Advocates of supplyside economics typically wish to see government programs and regulations reduced They also wish to see income taxes for the poor and the wealthy reduced Opponents do not Supplyside advocates tend to be Republican in political alliance many Democrats oppose supplyside policies for the same reasons that they oppose the platform of the Republican party So much of the debate comes down to differences over the proper role of government in our lives Perhaps the common belief is that the Reagan tax cuts and fiscal policies in the 1980s increased economic growth reduced the nondefense portion of government spending and increased budget deficits The debate is over whether or not these changes were good for the economy and society B Political Problems Fiscal Policy is created for other purposes and this complicates matters For example politicians may use fiscal policy instruments in order to 1 provide public goods and redistribute income 2 maximize the of votes expansionary Bias 3 Unintentionally create political Business Cycle by destabilizing the economy BUDGET DEFICIT AND THE PUBLIC DEBT 1 De nitions A budget de cit is the amount by which the federal government s outlays exceed its revenue in a given year The national debt is the federal govemment s total indebtedness at a moment in time It is the result of the accumulation of previous de cits De cit G T gt 0 excess spending over taxes Debt the accumulation of the total de cits over time Because of the strong US economy budget de cits have disappeared since 1998 In 1998 the US government ran a surplus of 69 billion the rst surplus on record since 1969 Surpluses have mounted since then topping 236 billion in 2000 These surpluses are in sharp contrast to the large de cits the US government recorded in the latel980s and early 1990s As illustrated in the gure titled quotBudget De citquot de cits increased signi cantly in the mid1980s and peaked in the early 1990s Economists blame several factors for the increased de cits of the 1980s First outlays for government entitlement programs especially Social Security and Medicare surged in thel980s Second the productivity growth rate of the economy slowed somewhat inexplicably after 1973 see Chapter 18 Economic Growth and Productivity reducing the nation39s tax base Third President Reagan simultaneously passed tax cuts and increased signi cantly expenditures for defense Congress rejected most of the planned budget cuts that Reagan proposed The combination of higher spending and lower tax revenues led to higher budget de cits The de cits of the early 1990s were compounded by the recession of 199091 Not until 1993 did de cits begin to shrink Who Does the Government Owe the Debt To The US federal government is about 57 trillion in debt Who does it owe the money to As it turns out most of the debt is owed to domestic corporations individual citizens foreign investors and the government itself The gure titled quotOwnership of US National Deb quot breaks down ownership of the debt by entity as of December 2000 The Federal government and the Federal Reserve are by far the biggest owners of the debt accounting for 50 percent of the total Foreigners own another 21 percent followed by pension funds 7 percent and mutual funds 6 percent Individual citizens own 185 billion in savings bonds accounting for just 3 percent of the total debt The idea that the government owns some of its own debt seems odd at rst The mystery is cleared up by considering that some government accounts are in surplus while others are in de cit Social security revenues for example exceed Social Security expenditures The surpluses however do not sit in the socalled quotlockboxquot they go into the general revenue fund which the government spends for other programs like education and defense The government spends this Social Security money by issuing government bonds that the Social Security Trust Fund purchases Thus the Social Security surplus is actually a pile of Treasury bonds Who Does the Government Owe the Debt To III The Public Debt Causes Historical evidence has shown that the major causes of huge de cits and debt are 1 Major Wars such as WWII and the Vietnam War 2 Economic Recessions 3 Tax Cuts such as the Reagan tax cuts of the early 1980s Why the Debt and01 De cit Burden May be Overstated Many times the press presents alarming news of the national debt We hear how our children are born into massive debt and how if we pile the debt up in 1 bills it would stretch far into the skies Indeed the debt is large in absolute numbers But there are several reasons to believe that concerns about the debt and de cit are overstated lMuch of debt about 25 is owned by the US government itself As discussed above when one branch of the government runs a surplus and simply buys federal securities with the excess revenue the total debt doesn39t really rise except on the books We could have just as easily apportioned the surplus tax dollars of one program to a budget category that was in de cit and eliminated the need to borrow This is the current situation now with the surplus in the Social Security Trust Fund 2 The de cit to GDP and the debt to GDP ratio are more accurate measures of the quottruequot size of the de cit A nation39s debt is in many ways similar to an individual s debt 3 In ation makes the real interest payments smaller When the government borrows money it pays the money back at a future point in time The purchasing power of that money is less than when the government rst borrowed it because of in ation What we really want to measure is the govemment s real debt so we must correct the de cit for the effects of in ation 4 Many state and local governments run surpluses In fact most states are prohibited by law from running de cits If we are adding up total government de cits why not subtract the size of the state and local government surpluses Current reporting practices however separate national accounts from state and local accounts 4 The accounting rules for the federal government are different than those for private businesses Accounting methods in the private sector separate current expenditures generally expenditures in which the purchased item is used up within one year from capital expenditures longterm purchases or investments For example when a University purchase of paper is a current expenditure for which the cost is fully deducted as an expense in the year the paper was purchased But if the University purchases a new building that will last 100 years the full cost of that building does not show up on that year39s expenses Only a portion of the building can be deducted as an expense The building is depreciated over time say ten years When the federal government purchases a new building however the full amount of that purchase is deducted in the year the building was purchased There is no separate capital account in federal accounting This makes the federal government39s expenses look higherand thus deficits look largerthan they otherwise might IV Economic Implications False Issues A Can the government go bankrupt No because it can 1 refinance the debt by issuing new bonds doesn t have to RETIRE the debt 2 increase the tax rate 3 print money 4 do a combination of the above B Can the debt be burden to our children No because 1 the public debt is also a PUBLIC CREDIT since we owe almost all the debt to ourselves 2 our children also benefit from the leftover infrastructures that we invested for them 3 In ationary accounting V Economic Implications Substantive Issues 1 EXtemal Debtis a burden 2 Crowding out effects and the stock of capital