Aggregate Demand and Aggregate Supply

10 Aggregate Demand and Aggregate Supply

Chapter Objectives Aggregate Demand and the Factors That Cause it to Change Aggregate Supply and the Factors That Cause it to Change How AD and AS Determine an Economy’s Equilibrium Price Level and the Level of Real GDP How the AD-AS Model Explains Periods of Demand-Pull Inflation, Cost-Push Inflation, and Recession

AD – AS Model Aggregate Demand-Aggregate Supply Model (AD-AS Model) Aggregate Demand Why the Downward Slope? Real-Balances Effect Interest-Rate Effect Foreign Purchases Effect

Aggregate Demand The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, and the government.

The Aggregate Demand Curve

The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded. The curve is downward-sloping due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. Here, the total quantity of goods and services demanded at an aggregate price level of 8.9, the actual number for 1933, is $636 billion in 2000 dollars, the actual quantity of aggregate output demanded in 1933. According to our hypothetical curve, however, if the aggregate price level had been only 5.0, the quantity of aggregate output demanded would have been $950 billion.

AD – AS Model Aggregate Demand Curve Aggregate Demand Price Level AD Real Domestic Output, GDP

Why Is the Aggregate Demand Curve Downward-Sloping? It is downward-sloping for two reasons: The first is the wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. The second is the interest rate effect of a change in aggregate the price level—a higher aggregate price level reduces the purchasing power of households’ money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending.

Changes in Aggregate Demand Determinants of Aggregate Demand and Multiplier Effect Changes in: Consumer Spending Consumer Wealth Consumer Expectations Household Debt Personal Taxes Investment Spending Real Interest Rates

Changes in Aggregate Demand Expected Returns About Future Business Conditions Technology Degree of Excess Capacity Business Taxes Government Spending Net Export Spending National Income Abroad Exchange Rates

Changes in Aggregate Demand Changes in Aggregate Demand Curve Increase in Aggregate Demand Price Level Decrease in Aggregate Demand AD2 AD1 AD3 Real Domestic Output, GDP

The Multiplier The size of the multiplier, 1/1 − MPC, depends on the marginal propensity to consume, MPC: the larger the MPC, the larger the change in real GDP for any given autonomous increase in aggregate spending.

An autonomous change in aggregate spending leads to a chain reaction, in which the change in real GDP is equal to the multiplier times the initial change in aggregate spending.

Total Increase in GDP from $50 Billion Rise in GDP

Suppose that MPC = 0.6: each $1 in additional disposable income causes a $0.60 rise in consumer spending. In that case, a $50 billion increase in investment spending raises real GDP by $50 billion. The second-round increase in consumer spending raises GDP by another 0.6 × $50 billion, or $30 billion. The third-round increase in consumer spending raises GDP by another 0.6 × $30 billion, or $18 billion. The table above shows the successive stages of increase, where “. . . ” means the process goes on an infinite number of times. In the end, GDP rises by $125 billion as a consequence of the initial $50 billion rise in investment spending.

The Multiplier

A change in expectations that leads to a rise in investment spending shifts the AD curve to the right for two reasons. Holding the aggregate price level constant, there is an initial increase in GDP from the rise in I. Then there are subsequent increases in GDP as rising disposable income leads to higher consumer spending. Panel (a) shows how the rise in GDP at a given aggregate price level takes place. Panel (b) shows how this shifts the AD curve.

Aggregate Supply Amount real GDP produced at each price level Three time horizons Immediate short run Few days to a few months All prices fixed Implicit price agreements Contractual agreements

Aggregate Supply ASISR Price Level Immediate-short-run Aggregate Supply Qf Real Domestic Output, GDP

Aggregate Supply Short run Input prices fixed Output prices variable Real profit changes

Total Input Cost Per-Unit Production Cost = Units of Output Aggregate Supply Aggregate Supply in the Short Run Aggregate Supply (Short Run) Price Level Slope not constant: per unit production cost and firm capacity 0 Qf Real Domestic Output, GDP

Changes in Aggregate Supply Determinants of Aggregate Supply Changes in: Input Prices Domestic Resource Prices Prices of Imported Resources Market Power Productivity Legal-Institutional Environment Business Taxes and Subsidies Government Regulation

Changes in Aggregate Supply Changes in Aggregate Demand Curve AS3 AS1 Decrease in Aggregate Supply AS2 Price Level Increase in Aggregate Supply Real Domestic Output, GDP

Long-Run Aggregate Supply Curve The long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if: All prices variable Full employment GDP All prices adjust

Aggregate Supply Aggregate Supply in the Long Run ASLR Price Level Long Run Aggregate Supply Real Domestic Output, GDP

Long-Run Aggregate Supply Curve

The long-run aggregate supply curve shows the quantity of aggregate output supplied when all prices, including nominal wages, are flexible. It is vertical at potential output, YP, because in the long run an increase in the aggregate price level has no effect on the quantity of aggregate output supplied.

Actual and Potential Output

The above graph shows the performance of actual and potential output in the United States from 1989 to 2004. The black line shows estimates of U.S. potential output, produced by the Congressional Budget Office, and the blue line shows actual aggregate output. The purple-shaded years are periods in which actual aggregate output fell below potential output, and the green-shaded years are periods in which actual aggregate output exceeded potential output. As shown, significant shortfalls occurred in the recessions of the early 1990s and after 2000. Actual aggregate output was significantly above potential output in the boom of the late 1990s.

Economic Growth Shifts the LRAS Curve Rightward

From the Short Run to the Long Run Leftward Shift of the Short-run Aggregate Supply Curve

The initial short-run aggregate supply curve is SRAS1. At the aggregate price level, P1, the quantity of aggregate output supplied, Y1, exceeds potential output, YP. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short-run aggregate supply curve from SRAS1 to SRAS2.

From the Short Run to the Long Run Rightward Shift of the Short-run Aggregate Supply Curve

At the aggregate price level, P1, the quantity of aggregate output supplied is less than potential output. This reflects the fact that the short-run aggregate supply curve has shifted to the right, due to both the short-run adjustment process in the economy and to a rightward shift of the long-run aggregate supply curve.

Total Output = Productivity Total Inputs Total Output 10 = = 2 Total Inputs 5 Changes in Aggregate Supply Understanding Productivity

Equilibrium and Changes in Equilibrium Tabular View… Real Output Demanded (Billions) Real Output Supplied (Billions) Price Level (Index Number) $506 508 510 512 514 108 104 100 96 92 $513 512 510 507 502 Equilibrium Price Level and Equilibrium Price Level

Equilibrium and Changes in Equilibrium AS Price Level Equilibrium 100 92 b a AD 502 510 514 Real Domestic Output, GDP (Billions of Dollars)

Short-Run Macroeconomic Equilibrium The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded. The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium. Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconomic equilibrium.

Supply Shocks Event that suddenly changes the price of a commodity or service. Caused by a sudden increase or decrease in the supply of a particular good This sudden change affects the equilibrium price.

Negative Supply Shocks Sudden supply decrease Raise prices and shift the aggregate supply curve to the left Can cause stagflation due to a combination of raising prices and falling output An example of a negative supply shock is the increase in oil prices during the 1973 energy crisis

Positive Supply Shocks Increase in supply Will lower the price of said good and shift the aggregate supply curve to the right An advance in technology (a technology shock) which makes production more efficient, thus increasing output

Active stabilization policy, using fiscal or monetary policy to offset demand shocks: Fiscal policy affects aggregate demand directly through government purchases and indirectly through changes in taxes or government transfers that affect consumer spending.

There can be drawbacks, however, because such deficit and erroneous predictions can increase economic policies that may contribute to a long-term rise in the budget instability.

Active stabilization policy, using fiscal or monetary policy to offset demand shocks: Monetary policy affects aggregate demand indirectly through changes in the interest rate that affect consumer and investment spending.

There can be drawbacks, however, because such deficit and erroneous predictions can increase economic policies that may contribute to a long-term rise in the budget instability.

Shifts of the SRAS Curve Stagflation is the combination of inflation and falling aggregate output.

A supply shock shifts the short-run aggregate supply curve, moving the aggregate price level and aggregate output in opposite directions. Panel (a) shows a negative supply shock, which shifts the short-run aggregate supply curve leftward, causing stagflation—lower aggregate output and a higher aggregate price level. Here the short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level rises from P1 to P2 , and aggregate output falls from Y1 to Y2.

Shifts of the SRAS Curve

Panel (b) shows a positive supply shock, which shifts the short-run aggregate supply curve rightward, generating higher aggregate output and a lower aggregate price level. The short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level falls from P1 to P2 , and aggregate output rises from Y1 to Y2. An event that shifts the short-run aggregate supply curve is a supply shock.

Equilibrium and Changes in Equilibrium Increase in Aggregate Demand AS Demand-Pull Inflation P2 Price Level P1 AD1 AD Qf Q1 Q2 Real Domestic Output, GDP

Shifts of Aggregate Demand: Short-Run Effects

A demand shock shifts the aggregate demand curve, moving the aggregate price level and aggregate output in the same direction. In panel (b) a positive demand shock shifts the aggregate demand curve rightward, increasing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2.

Equilibrium and Changes in Equilibrium Decrease in Aggregate Demand AS Price Level b a P1 c P2 Creates a Recession AD1 AD2 Q1 Q2 Qf Real Domestic Output, GDP

Shifts of Aggregate Demand: Short-Run Effects

A demand shock shifts the aggregate demand curve, moving the aggregate price level and aggregate output in the same direction. In panel (a) a negative demand shock shifts the aggregate demand curve leftward from AD1 to AD2, reducing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2.

Long-Run Macroeconomic Equilibrium The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve.

Long-Run Macroeconomic Equilibrium

Here the point of short-run macroeconomic equilibrium also lies on the long-run aggregate supply curve, LRAS. As a result, actual aggregate output is equal to potential output. The economy is in long-run macroeconomic equilibrium at ELR.

Short-Run Versus Long-Run Effects of a Negative Demand Shock Recessionary gap

In the long run the economy is self-correcting: demand shocks have only temporary effects on aggregate output. Starting at E1, a negative demand shock shifts AD1 leftward to AD2. In the short run the economy moves to E2 and a recessionary gap arises: the aggregate price level declines from P1 to P2, aggregate output declines from Y1 to Y2, and unemployment rises. But in the long run nominal wages fall in response to high unemployment, and SRAS1 shifts rightward to SRAS2: aggregate output rises from Y2 to Y1, and the aggregate price level declines again, from P2 to P3. Long-run macroeconomic equilibrium is eventually restored at E3.

Short-Run Versus Long-Run Effects of a Positive Demand Shock Inflationary gap

Starting at E1 a positive demand shock shifts AD1 rightward to AD2, and the economy moves to E2 in the short run. This results in an inflationary gap as aggregate output rises from Y1 to Y2, the aggregate price level rises from P1 to P2, and unemployment falls to a low level. In the long run, SRAS1 shifts leftward to SRAS2 as nominal wages rise in response to low unemployment. Aggregate output falls back to Y1, the aggregate price level rises again to P3, and the economy returns to long-run macroeconomic equilibrium at E3.

Equilibrium and Changes in Equilibrium Recession and Cyclical Unemployment Deflation Downward Price Inflexibility Due to: Fear of Price Wars Menu Costs Wage Contracts Morale, Effort, and Productivity Efficiency Wages Minimum Wage

Equilibrium and Changes in Equilibrium Decrease in Aggregate Supply AS1 AS Cost-Push Inflation b P2 Price Level a P1 AD Q1 Qf Real Domestic Output, GDP

Equilibrium and Changes in Equilibrium Increases in Aggregate Supply – Full-Employment With Price-Level Stability AS1 AS2 P3 b c P2 a P1 Price Level AD2 AD1 Q1 Q2 Q3 Real Domestic Output, GDP

Self-correcting Mechanism In the long run the economy is self correcting: shocks to aggregate demand do not affect aggregate output in the long run. Even Keynes says that???

10 Appendix The Relationship of the Aggregate Demand Curve to the Aggregate Expenditures Model

Deriving the AD Curve AE1 (at P1 ) AE2 (at P2 ) AE3 (at P3 ) As Price Levels Increase… Aggregate Expenditures (billions of dollars) 45° P3 Real GDP Declines Price Level P2 P1 AD Q1 Q2 Q3 Real Domestic Product, GDP

Aggregate Expenditures 45° Price Level Real Domestic Product, GDP Deriving the AD Curve AE2 (at P1 ) AE1 (at P1 ) Increase in Aggregate Expenditures Increase in Aggregate Demand P1 AD2 AD1 Q1 Q2

Aggregate Expenditures 45° Price Level Real Domestic Product, GDP Deriving the AD Curve AE2 (at P1 ) AE1 (at P1 ) The Shift in the Aggregate Demand Curve is a Multiple of the initial Change in Aggregate Expenditures P1 AD2 AD1 Q1 Q2

15 Extending the Analysis of Aggregate Supply

Chapter Objectives The Relationship Between Short-Run Aggregate Supply and Long-Run Aggregate Supply Applying the Extended AD-AS Model to Inflation, Recessions, and Unemployment The Short-Run Tradeoff Between Inflation and Unemployment (Phillips Curve) Why There is No Long-Run Tradeoff Between Inflation and Unemployment Relationship Between Tax Rates, Tax Revenues, and Aggregate Supply

From Short Run to Long Run Short run Input prices inflexible Upward sloping aggregate supply Long run Input prices fully flexible Vertical aggregate supply The transition? Graphically

From Short Run to Long Run Production above potential output: High demand for inputs Input prices rise Short run aggregate supply shifts left Return to potential output Production below potential output

From Short Run to Long Run Short-Run Aggregate Supply Long-Run Aggregate Supply AS1 ASLR AS2 AS1 a2 a2 AS3 b1 P2 P2 Price Level Price Level a1 a1 P1 P1 a3 a3 P3 P3 c1 Q3 Qf Qf Q2 Real Domestic Output Real Domestic Output

From Short Run to Long Run Equilibrium in the Extended AD-AS Model ASLR AS1 Price Level a P1 AD1 Qf Real Domestic Output

From Short Run to Long Run Demand-Pull Inflation in the Extended AD-AS Model AS2 ASLR AS1 b P3 c P2 Price Level a P1 AD2 AD1 Qf Real Domestic Output

From Short Run to Long Run Cost-Push Inflation in the Extended AD-AS Model If Government Counters Recession With Spending… If Government Ignores Recession… AS2 ASLR AS1 c P3 b P2 Price Level a P1 AD2 AD1 Qf Real Domestic Output

From Short Run to Long Run Recession in the Extended AD-AS Model AS1 ASLR AS2 a P1 b P2 Price Level c P3 AD1 AD2 Q1 Qf Real Domestic Output

Extended AD-AS Model Explaining ongoing inflation Ongoing economic growth shifts aggregate supply Ongoing increases in money supply shift aggregate demand Small positive rate of inflation

Inflation and Unemployment Low inflation and unemployment Fed’s major goals Compatible or conflicting? Short-run tradeoff Supply shocks cause both rates to rise No long-run tradeoff

Annual Rate of Inflation (Percent) Annual Rate of Inflation (Percent) Unemployment Rate (Percent) Unemployment Rate (Percent) The Inflation-Unemployment Relationship The Phillips Curve Inverse Relationship Inflation and Unemployment Concept Empirical Data Data for the 1960s 69 68 66 67 65 63 62 61 64

The Inflation-Unemployment Relationship The Short-Run Effect of Changes on Real Output and the Price Level AS P3 Price Level P2 AD3 P1 AD2 P0 AD1 AD0 0 Q0 Q1 Q2 Q3 Real Domestic Output

The Inflation-Unemployment Relationship Adverse Supply Shocks and the Phillips Curve Stagflation Adverse Aggregate Supply Shocks OPEC Oil Price Shock Stagflation’s Demise

The Inflation-Unemployment Relationship No long-run tradeoff between inflation and unemployment Short-run Phillips curve Role of expected inflation Long-run vertical Phillips curve Disinflation

15 12 9 6 3 3 4 5 6 The Inflation-Unemployment Relationship The Long-Run Vertical Phillips Curve PCLR PC3 b3 PC2 a3 b2 Annual Rate of Inflation (Percent) PC1 a2 c3 b1 a1 c2 0 Unemployment Rate (Percent)

Taxation and Aggregate Supply Supply-Side Economics Tax Incentives to Work Tax Incentives to Save and Invest The Laffer Curve 100 n Laffer Curve Tax Rate (Percent) m m Maximum Tax Revenue l 0 Tax Revenue (Dollars)

Taxation and Aggregate Supply Criticisms of The Laffer Curve Taxes, Incentives, and Time Inflation and Higher Real Interest Rates Position on the Curve Rebuttal and Evaluation

Taxes and Real GDP New findings suggest tax increases reduce real GDP (Romer and Romer 2008) Positive output shocks raise tax revenues Difficult to separate effects of tax changes from other effects Investment falls sharply in response to tax changes

11 Fiscal Policy, Deficits, and Debt

Chapter Objectives Purposes, Tools, and Limitations of Fiscal Policy Role of Built-In Stabilizers in Moderating Business Cycles How the Standardized Budget Reveals the Status of U.S. Fiscal Policy The Size, Composition, and Consequences of the U.S. Public Debt

Government Budget and Total Spending Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. The two types of government spending are purchases of goods and services and government transfers. The big items in government purchases are national defense and education. The big items in government transfers are Social Security and health care programs.

Who Makes Fiscal Policy? The President and Congress make fiscal policy This is complicated and can be time consuming, especially when one political party controls Congress while the president belongs to the other party No one seems to be in charge of making fiscal policy

Fiscal Policy Council of Economic Advisers (CEA) Discretionary fiscal policy Eliminate recessionary or inflationary gap Countercyclical Nondiscretionary fiscal policy Passive or automatic

Fiscal Policy Expansionary fiscal policy Increased spending and/or lower taxes Budget deficit Contractionary fiscal policy Lower spending and/or higher taxes Budget surplus Policy options? G or T

Fiscal Policy Expansionary Fiscal Policy Full $20 Billion Increase in Aggregate Demand $5 Billion Additional Spending AS Recessions Decrease Aggregate Demand Price Level P1 AD1 AD2 $490 $510 Real Domestic Output, GDP

Fiscal Policy and theAD-AS Model Contractionary Fiscal Policy Recessions Decrease Aggregate Demand $5 Billion Initial Decrease In Spending AS Price Level Full $20 Billion Decrease in Aggregate Demand P1 AD4 AD3 $510 $522 Real Domestic Output, GDP

Discretionary v. Automatic Rules governing taxes and some transfers act as automatic stabilizers, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle. In contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.

Built-In Stability Automatic or Built-In Stabilizers Economic Importance Tax Progressivity Progressive Tax System Proportional Tax System Regressive Tax System Transfers

Discretionary Fiscal Policy Making the Automatic Stabilizers More Effective Public Works The main fiscal policy to end the Depression was public works Transfer Payments The government could extend the benefit period for unemployment compensation and increase welfare payments, Social Security, and veteran’s pensions

Discretionary Fiscal Policy Making the Automatic Stabilizers More Effective Changes in Tax Rates To fight inflation, the government can raise taxes To fight recession, the government can cut taxes Corporate incomes taxes can be raised during periods of inflation and lowered when recessions occur Using tax rate changes as a counter cyclical policy tool provides a quick fix, however, temporary tax cuts carried out during recessions should not become permanent

Discretionary Fiscal Policy Making the Automatic Stabilizers More Effective Changes in Government Spending The government increases spending and cuts taxes to fight recessions The government decreases spending and raises taxes to fight inflation In brief, we fight recessions with budget deficits and inflation with budget surpluses

Built-In Stability T Surplus Government Expenses, G and Tax Revenues, T G Deficit GDP1 GDP2 GDP3 Real Domestic Output, GDP

Evaluating Fiscal Policy Standardized Budget Full-Employment Budget Cyclical Deficit Recent U.S. Fiscal Policy Budget Deficits and Projections Social Security Considerations

Evaluating Fiscal Policy T Cyclical deficit Fiscal policy neutral a b Government Expenses, G and Tax Revenues, T G $500 $450 c GDP2 GDP1 (Year 2) (Year 1) Real Domestic Output, GDP

Evaluating Fiscal Policy Standardized deficit Expansionary fiscal policy T1 T2 d e Government Expenses, G and Tax Revenues, T G $500 $475 h $450 f g $425 GDP4 GDP3 (Year 4) (Year 3) Real Domestic Output, GDP

The Multiplier Effect of an Increase in Government Purchases of Goods and Services

(2) Actual Deficit (-) or Surplus (+) (3) Standardized Deficit (-) or Surplus (+) (1) Year Recent U.S. Fiscal Policy Federal Deficits and Surpluses – 1996 - 2011 as a Percentage of Potential GDP 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 -1.4% -0.3% +0.8% +1.4% +2.5% +1.3% -1.5% -3.4% -3.5% -2.6% -1.9% -1.3% -3.2% -10.1% -9.0% -8.7% -2.9% -2.9% -2.1% -2.0% -1.2% -1.0% -0.4% +0.1% +1.1% +1.1% -1.1% -2.7% -4.5% -11.1% -9.5% -9.1% Source: Congressional Budget Office

-6 -4 -2 0 2 4 6 GLOBAL PERSPECTIVE Recent U.S. Fiscal Policy Full-Employment Budget Deficits or Surpluses as a Percentage of Potential GDP, 2011 Surpluses Deficits New Zealand Denmark Canada Ireland France Norway United Kingdom United States Japan -8.0 -3.7 -5.0 -10.3 -5.7 +12.5 -9.4 -10.0 -8.9 Source: Organization for Economic Cooperation and Development

Actual Projected (as of March 2012) 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Recent U.S. Fiscal Policy Federal Budget Deficits and Surpluses Actual and Projected, Fiscal 1992-2012 $300 200 100 0 -100 -200 -300 -400 -500 Budget Deficit (-) or Surplus, Billions Source: Congressional Budget Office

Recent U.S. Fiscal Policy Problems, Criticisms, and Complications Problems of Timing Recognition Lag Administrative Lag Operational Lag Political Considerations Political Business Cycle Future Policy Reversals Offsetting State and Local Finance Crowding-Out Effect Current Thinking on Fiscal Policy

Lags in Fiscal Policy In the case of fiscal policy, there is an important reason for caution: there are significant lagsin its use. Realize the recessionary/inflationary gap by collecting and analyzing economic data  takes time Government develops an action plan takes time Implementation of the action plan  takes time

The Public Debt National or Public Debt $15.01 Trillion Ownership U.S. Securities 101% of GDP 69.1% Held Outside the Federal Government and Federal Reserve Graphically…

Debt Clock

The Public Debt Total Debt $16.41 Trillion Debt Held Outside The Federal Government and Federal Reserve (68%) Debt Held by the Federal Government and Federal Reserve (32%) Other – Including State and Local Governments U.S. Banks And other Financial Institutions 3.2% 5.4% 14.2% Federal Reserve 46.1% Foreign Ownership 22% U.S. Government Agencies 8.2% U.S. Individuals Source: U.S. Treasury

Debt and GDP Interest Charges 2011 20.7% of GDP False Concerns Bankruptcy Refinancing Taxation Burdening Future Generations

Debt and GDP Substantive Issues Income Distribution Incentives Foreign-Owned Public Debt Crowding-Out Effect Revisited Burden on future generations Public investment as an offset Graphically…

16 14 12 10 8 6 4 2 0 5 10 15 20 25 30 35 40 Debt and GDP The Investment Demand Curve and the Crowding-Out Effect A Large Public Debt to Finance Public Investment Will Cause… If Public Spending Spurs More Private Investment Will Increase to ID2 b c Real Interest Rate (Percent) a Interest Rate Rise Will Decrease Investment a to b Crowding- Out Effect ID2 ID1 Investment Demand (Billions of Dollars)

Debt and GDP Public Investments and Public-Private Complementarities Public Investments Public Goods Spending Human Capital Spending Reduction on Crowding-Out Effect

Should the Budget Be Balanced? Most economists don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers. Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary.

Long-Run Implications of Fiscal Policy U.S. government budget accounting is calculated on the basis of fiscal years. Persistent budget deficits have long-run consequences because they lead to an increase in public debt.

Problems Posed by Rising Government Debt This can be a problem for two reasons: Public debt may crowd outinvestment spending, which reduces long-run economic growth. And in extreme cases, rising debt may lead to government default, resulting in economic and financial turmoil.

Deficits and Debt in Practice A widely used measure of fiscal health is the debt–GDP ratio. This number can remain stable or fall even in the face of moderate budget deficits if GDP rises over time.

Should the Budget be Balanced? Most economists don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers. Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary.

The Federal Budget Deficit & The Business Cycle The budget deficit as a percentage of GDP tends to rise during recessions (indicated by shaded areas) and fall during expansions. These Deficits help end the recessions

HOW CRONY CAPITALISM AND THE FEDERAL RESERVE ARE UNDERMINING OUR PROSPERITY
How does the government interfere with private incentives?

The market economy is the social system of the division of labor under private ownership of the means of production. Everybody acts on his own behalf; but everybody’s actions aim at the satisfaction of other people’s needs as well as at the satisfaction of his own. Everybody in acting serves his fellow citizens.Ludwig von Mises Free Enterprise,Prosperity and Liberty

A bird’s eye view of a free market economy
Production…goods and services (based on savings and investment)… Purchase of money… Sale of money for goods and services (consumption) A harmony of interests: Government to protect individual rights (law) and nonprofit sector to provide social services

Free Enterprise vs. Crony Capitalism Free-market capitalism is a network of free and voluntary exchanges in which producers work, produce, and exchange their products for the products of others through prices voluntarily arrived at.(Economic means) State capitalism consists of one or more groups making use of the coercive apparatus of the government — the State — to accumulate capital for themselves by expropriating the production of others by force and violence. (Political means) Murray Rothbard

Laissez Faire or ??? If one rejects laissez faire on account of man’s fallibility and moral weakness, one must for the same reasons also reject every kind of government action. Ludwig von Mises

Money, Banking and the Economy What is money? A useful commodity—gold, silver, copper, etc. “Paper” Money—substitute for real money in safekeeping Deposit Banking-100% reserves or fractional reserves Loan Banking—noninflationary financial intermediary

Central Banking: Protecting the Banks Setting reserve requirements Directing the inflation: creating money “out of thin air” Manipulating interest rates Lender of last resort

The Fed’s Monetary Legacy

Is the CPI Accurate?

Taxation: lifeblood of the State Taxes are what we pay for a civilized society. Oliver Wendell Holmes Robbery is the taking of a man’s property by the use of violence or the threat thereof, and therefore without the victim’s consent. And yet what else is taxation?Murray Rothbard To fund “public goods”—internal improvements, entitlement programs Used to subsidize “connected” businesses, e.g., tariffs Indirect versus direct taxes

Tax Rates, Debt and the Economy

Alexander Hamilton: Founding Father of Crony Capitalism The American System: American version of British mercantilism—corporate welfare, protectionism and central banking The National Debt: A public blessing “We need a government of more energy” Invented notion of implied powers

Unlimited Government "the commerce power + the war powers + the power to tax and spend for the general welfare x the loosest possible reading of the words ‘necessary and proper." Clinton Rossiter Hamilton’s Curse

Thomas Jefferson’s Vision for America Sometimes it is said that man cannot be trusted with the government of himself. Can he, then, be trusted with the government of others? Or have we found angels in the forms of kings to govern him? Let history be the answer to this question.First inaugural address A loose confederation of states—states’ rights Nullification and unconstitutional laws Tenth Amendment—decentralize decision making Laissez faire economics Government needs to be “bound by the chains of the constitution”

Crony Capitalism in the Early Republic Turnpikes, canals and railroads First and Second Banks of the United States Land grants Tariffs

The War Between the States Centralization—states’ rights demolished Paper Money-greenbacks Income tax National Banking Act

The Progressive Era The Real Robber Barons Income Tax Federal Reserve System “the financial elites of this country . . . were responsible for putting through the Federal Reserve System, as a governmentally created and sanctioned cartel device to enable the nation’s banks to inflate the money supply . . . without suffering quick retribution from depositors or noteholders demanding cash.” Murray Rothbard

World War I Collectivism Making the world safe for democracy Bailing out the financial elites Creating the statist paradigm for America—Council for Foreign Relations

The Roaring Twenties: Prelude to the Great Depression The Depression of 1920 The Boom and Bust of the 1920s Hoover’s New Deal The Great Depression

FDR’s New Deal Economic interventionism Going off gold Social Security

World War II, the Cold War and the Drive for Empire Total War: Response to the Great Depression Cementing the military-industrial complex Coups, intervention, and intrigue in a postwar world

War and Debt for 100 Years

Federal Debt and the Economy

The Spending Explosion

The Power Elite’s Global Organizations The Council of Foreign Relations Does it run the U.S. government? The Trilateral Commission Running the world’s major governments? The Bilderberger Group What are they up to?

Insights About Power, Money and the Economy Socialism, like the ancient ideas from which it springs, confuses the distinction between government and society. As a result of this, every time we object to a thing being done by government, the socialists conclude that we object to its being done at all.FrédéricBastiat

Insights… If Tyranny and Oppression come to this land, it will be in the guise of fighting a foreign enemy.James Madison An evil exists that threatens every man, woman and child of this great nation. We must take steps to insure our domestic security and protect our homeland. Who said it? Even if it were desirable, America is not strong enough to police the world by military force. If that attempt is made, the blessings of liberty will be replaced by coercion and tyranny at home. Our Christian ideals cannot be exported to other lands by dollars and guns.Howard Buffett

Insights… An honest man can feel no pleasure in the exercise of power over his fellow citizens.... There has never been a moment of my life in which I should have relinquished for it the enjoyments of my family, my farm, my friends and books. Thomas Jefferson He who is unfit to serve his fellow citizens wants to rule them. Ludwig von Mises

Insights… The state -- or, to make matters more concrete, the government -- consists of a gang of men exactly like you and me. They have…no special talent for the business of government; they have only a talent for getting and holding office. Their principal device to that end is to search out groups who pant and pine for something they can't get, and to promise to give it to them. Nine times out of ten that promise is worth nothing. The tenth time it is made good by looting 'A' to satisfy 'B'. In other words, government is a broker in pillage, and every election is a sort of advanced auction on stolen goods. H.L. Mencken

Insights… The argument that the two parties should represent opposed ideals and policies, one, perhaps, of the Right and the other of the Left, is a foolish idea acceptable only to the doctrinaire and academic thinkers. Instead, the two parties should be almost identical, so that the American people can 'throw the rascals out' at any election without leading to any profound or extreme shifts in policy.…Carroll Quigley

Insights… In the long run even the most despotic governments with all their brutality and cruelty are no match for ideas. Eventually the ideology that has won the support of the majority will prevail and cut the ground from under the tyrants feet. Then the oppressed many will rise in rebellion and overthrow their masters. Ludwig von Mises

Recommended Readings Economics in One Lesson, Henry Hazlitt The Law, Frederic Bastiat The Mystery of Banking, Murray Rothbard The Income Tax: Root of All Evil, Frank Chodorov Middle of the Road Policy Leads to Socialism, Ludwig von Mises

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Aggregate Demand and Aggregate Supply

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