ADVANCED APPLICATION

OF

MACROECONOMIC

THEORY

ACCTG 404B (8:30 – 9:30 MWF)

SUBMITTED BY:

ABESAMIS, JETLLI C.

CHING, HENRI LOMEUS N.

DALURIA, JENNIFER A.

GARIBAY, ARLENE C.

TICMAN, KIMBERLY ROSE R.

SUBMITTED TO:

MILAGROS M. CARDONA, CPA, MBA

MACROECONOMICS

Macroeconomists try to forecast economic conditions to help consumers, firms and governments make better decisions.

- Consumers want to know how easy it will be to find work, how much it will cost to buy goods and services in the market, or how much it may cost to borrow money.

- Businesses use macroeconomic analysis to determine whether expanding production will be welcomed by the market. Will consumers have enough money to buy the products, or will the products sit on shelves and collect dust?

- Governments turn to the macroeconomy when budgeting spending, creating taxes, deciding on interest rates and making policy decisions.

DEFINITIONS

- Macroeconomics (from the Greek prefix makro- meaning "large" and economics) is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets. This includes national, regional, and global economies. With microeconomics, macroeconomics is one of the two most general fields in economics. http://en.wikipedia.org/wiki/Macroeconomics

- The field of economics that studies the behavior of the aggregate economy. Macroeconomics examines economy-wide phenomena such as changes in unemployment, national income, rate of growth, gross domestic product, inflation and price levels. http://www.investopedia.com/terms/m/macroeconomics.asp

- Macroeconomics is focused on the movement and trends in the economy as a whole, while in microeconomics the focus is placed on factors that affect the decisions made by firms and individuals. The factors that are studied by macro and micro will often influence each other, such as the current level of unemployment in the economy as a whole will affect the supply of workers which an oil company can hire from, for example.http://www.investopedia.com/terms/m/macroeconomics.asp

GOVERNMENT POLICY GOALS

Macroeconomics can be used to analyze how best to influence government policy goals.

1. Economic Growth

An increase in the capacity of an economy to produce goods and services, compared from one period of time to another. Economic growth can be measured in nominal terms, which include inflation, or in real terms, which are adjusted for inflation. For comparing one country's economic growth to another, GDP or GNP per capita should be used as these take into account population differences between countries.

Growth is usually calculated in real terms, i.e., inflation-adjusted terms, in order to obviate the distorting effect of inflation on the price of the goods produced. In economics,

"economic growth" or "economic growth theory" typically refers to growth of potential output, i.e., production at "full employment".

Economic growth is usually associated with technological changes. An example is the large growth in the U.S. economy during the introduction of the Internet and the technology that it brought to U.S. industry as a whole. The growth of an economy is thought of not only as an increase in productive capacity but also as an improvement in the quality of life to the people of that economy.

As an area of study, economic growth is generally distinguished from development economics. The former is primarily the study of how countries can advance their economies. The latter is the study of the economic aspects of the development process in low-income countries.

Since economic growth is measured as the annual percent change of gross domestic product (GDP), it has all the advantages and drawbacks of that measure.

2. Price Stability

In 1998, the ECB Governing Council formulated the quantitative definition of price stability: "Price stability is a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability must be maintained over a medium-term perspective." In addition, in May 2003 the Governing Council also clarified that, in the pursuit of price stability, it aims to maintain inflation rates "below, but close to, 2% over the medium term".

Importance of Price Stability

Price stability implies avoiding both prolonged inflation and deflation.

Inflation is a rise in the in the general price level of goods and services in an economy over a longer period of time resulting in a decline in the value of money and purchasing power. Deflation is a decrease in the general price level of goods and services over a longer period of time. Too rapid inflation is negative for many reasons: it complicates the economic decision-making process and slows economic growth. In addition, inflation diminishes the value of savings. Deflation is accompanied by the threat of a slowdown in economic growth, because the general level of prices declines, and thus, people postpone consumption and companies postpone investment. There may emerge an inflationary gap which is very difficult to overcome. The real value of loans that are not repaid increases, which means that borrowers run into difficulty, and loan losses pose a threat to financial institutions as well. Often, enterprises find it hard to lower wages, even if the price of their output declines. This causes an increase in unemployment and in the number of bankruptcies.

Price stability contributes to achieving high levels of economic activity and employment by

a. improving the transparency of the price mechanism. Under price stability people can recognize changes in relative prices (i.e. prices between different goods), without being confused by changes in the overall price level. This allows them to make well-informed consumption and investment decisions and to allocate resources more efficiently;

b. reducing inflation risk premia in interest rates (i.e. compensation creditors ask for the risks associated with holding nominal assets). This reduces real interest rates and increases incentives to invest;

c. avoiding unproductive activities to hedge against the negative impact of inflation or deflation;

d. reducing distortions of inflation or deflation, which can exacerbate the distortionary impact on economic behavior of tax and social security systems;

e. preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation.

Why "below, but close to 2%"?

The inflation rate below but close to 2% is low enough to allow the economy to benefit fully from price stability.

a. It also stresses the Eurosystem's obligation to guarantee the appropriate inflation rate in order to

b. avoid deflation risk. This is important to keep the nominal interest rates above zero. In a deflationary environment monetary policy may not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation. One should also take into account the possibility of HICP inflation slightly overstating true inflation as a result of a small but positive bias in the measurement of price level changes using the HICP;

c. provide a sufficient margin to address the implications of inflation differentials in the euro area. It avoids that individual countries in the euro area have to structurally live with too low inflation rates or even deflation.

3. Full Employment

A situation in which all available labor resources are being used in the most economically efficient way. Full employment embodies the highest amount of skilled and unskilled labor that could be employed within an economy at any given time. The remaining unemployment is frictional.

Frictional unemployment is the amount of unemployment that results from workers who are in between jobs, but are still in the labor force. Full employment is attainable within any economy, but may result in an inflationary period. The inflation would result

from workers, as a whole, having more disposable income, which would drive prices upward.

Many economists have estimated the amount of frictional unemployment, with the number ranging from 2-7% of the labor force.

4. Attainment of Sustainable Balance of Payment

Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers. The BoP accounts summarize international transactions for a specific period, usually a year, and are prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.

When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves or by receiving loans from other countries.

While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the central bank's reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted. The term "balance of payments" often refers to this sum: a country's balance of payments is said to be in surplus (equivalently, the balance of payments is positive) by a certain amount if sources of funds (such as export goods sold and bonds sold) exceed uses of funds (such as paying for imported goods and paying for foreign bonds purchased) by that amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter.

Under a fixed exchange rate system, the central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from affecting the exchange rate between the country's currency and other currencies. Then the net change per year in the central bank's foreign exchange reserves is sometimes called the balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include a managed float where some changes of exchange rates are allowed, or at the other extreme a purely floating exchange rate (also known as a purely flexible exchange rate). With a pure float the central bank does not intervene at all to protect or devalue its currency, allowing the rate to be set by the market, and the central bank's foreign exchange reserves do not change.

Historically there have been different approaches to the question of how or even whether to eliminate current account or trade imbalances. With record trade imbalances held up as one of the contributing factors to the financial crisis of 2007–2010, plans to address global imbalances have been high on the agenda of policy makers since 2009.

NATIONAL ECONOMY

The historically shaped complex of production sectors in a given country, interrelated through the division of labor.

The national economy includes the sectors of the production sphere, where material social product is created, and sectors of the nonproduction sphere, where non-material services are performed. Material production is in turn divided into those sectors that produce the means of production (subdivision I of social production) and those sectors that produce consumer goods (subdivision II).

The socioeconomic nature of any national economy, as well as its structure and rate of development, is determined by the character of the dominant production relationships in society.

Under capitalism, the national economy as a unified whole first takes shape during the formation of national states. It is a result of the development of productive forces and the division of labor in society, the growing specialization of production sectors, and the emergence of a national market and large-scale mechanized production. Under capitalism, the national economy is based on private ownership of the means of production and on the exploitation of hired labor. In conformity with the economic laws of capitalism, it develops in an anarchical, cyclical manner, always subordinate to the primary purpose of capitalist production, that is, the race for profits. Under this system, primary wealth is owned by a relatively small part of society, the big capitalists. Increasing intervention by the capitalist state in the economy cannot overcome the antagonistic contradictions and uncontrollable character of the capitalist national economy or such periodic crises as currency upheavals, inflation, and unemployment. After the crisis of 1969–71, for example, the rate of economic development in most of the capitalist countries fell. In 1972, between 20 and 25 percent of existing industrial processing capacity alone went unused in the developed capitalist countries. According to official figures, the number of unemployed in these countries in 1973 was about 11 million.

Under socialism, the national economy is based on public ownership of the means of production, on labor without exploitation, on true realization of the right to work, and on the universality of labor. The development of the socialist economy takes place in a planned manner and at a rapid rate on the basis of the economic laws of socialism, with the purpose of “ensuring full well-being and free, all-round development of all the members of society” (V. I. Lenin, Poln. sobr. soch., 5th ed., vol. 6, p. 232). Therefore all the aggregate social product created in the socialist national economy belongs to the working people. A most important characteristic of the socialist national economy is the combination of centralized administration with active participation by production collectives, local bodies, and all

working people in such administration. This makes possible the fullest, most efficient use of available material and labor resources in the interests of all of society and of each of its members. In the USSR, the national economies of all the Union republics are formed and developed as an integrated whole of interrelated economic complexes which, on the basis of a socialist division of labor in society, ensure a combination of the economic interests of each republic with those of the country as a whole.

WORLD ECONOMY

The world economy, or global economy, generally refers to the economy, which is based on economies of all of the world's countries, national economies. Also global economy can be seen as the economy of global society and national economies – as economies of local societies, making the global one. It can be evaluated in various kind of ways. For instance, depending on the model used, the valuation that is arrived at can be represented in a certain currency, such as 2006 US dollars.

It is inseparable from the geography and ecology of Earth, and is therefore somewhat of a misnomer, since, while definitions and representations of the "world economy" vary widely, they must at a minimum exclude any consideration of resources or value based outside of the Earth. For example, while attempts could be made to calculate the value of currently unexploited mining opportunities in unclaimed territory in Antarctica, the same opportunities on Mars would not be considered a part of the world economy – even if currently exploited in some way – and could be considered of latent value only in the same way as uncreated intellectual property, such as a previously misconceived invention.

Beyond the minimum standard of concerning value in production, use, and exchange on the planet Earth, definitions, representations, models, and valuations of the world economy vary widely.

It is common to limit questions of the world economy exclusively to human economic activity, and the world economy is typically judged in monetary terms, even in cases in which there is no efficient market to help valuate certain goods or services, or in cases in which a lack of independent research or government cooperation makes establishing figures difficult. Typical examples are illegal drugs and other black market goods, which by any standard are a part of the world economy, but for which there is by definition no legal market of any kind.

However, even in cases in which there is a clear and efficient market to establish a monetary value, economists do not typically use the current or official exchange rate to translate the monetary units of this market into a single unit for the world economy, since exchange rates typically do not closely reflect worldwide value, for example in cases where the volume or price of transactions is closely regulated by the government.

Rather, market valuations in a local currency are typically translated to a single monetary unit using the idea of purchasing power. This is the method used below, which is used for estimating worldwide economic activity in terms of real US dollars or euros. However, the world economy can be evaluated and expressed in many more ways. It is

unclear, for example, how many of the world's 7.01 billion people have most of their economic activity reflected in these valuations.

In 2012, the largest economies in the world with more than $2 trillion, €1.25 trillion by nominal GDP are the United States, China, Japan,Germany, France, the United Kingdom, Brazil, Russia, and Italy. The largest economies in the world with more than $2 trillion, €1.25 trillion by GDP (PPP) are the United States, China, India, Japan, Germany, Russia, the United Kingdom, Brazil, and France.

MACROECONOMIC MODEL

A macroeconomic model is an analytical tool designed to describe the operation of the economy of a country or a region. These models are usually designed to examine the dynamics of aggregate quantities such as the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the level of prices.

Macroeconomic models may be logical, mathematical, and/or computational; the different types of macroeconomic models serve different purposes and have different advantages and disadvantages. Macroeconomics models may be used to clarify and illustrate basic theoretical principles; they may be used to test, compare, and quantify different macroeconomic theories; they may be used to produce "what if" scenarios (usually to predict the effects of changes in monetary, fiscal, or other macroeconomic policies); and they may be used to generate economic forecasts. Thus, macroeconomic models are widely used in academia, teaching and research, and are also widely used by international organizations, national governments and larger corporations, as well as by economics consultants and think tanks.

Types of macroeconomic models

Simple theoretical models 

Simple text book descriptions of the macroeconomy involving a small number of equations or diagrams are often called ‘models’. Examples include the IS-LM model and Mundell–Fleming modelof Keynesian macroeconomics, and the Solow model of neoclassical growth theory. These models share several features. They are based on a few equations involving a few variables, which can often be explained with simple diagrams. Many of these models are static, but some are dynamic, describing the economy over many time periods. The variables that appear in these models often represent macroeconomic aggregates (such as GDP or total employment) rather than individual choice variables, and while the equations relating these variables are intended to describe economic decisions, they are not usually derived directly by aggregating models of individual choices. They are simple enough to be used as illustrations of theoretical points in introductory explanations of macroeconomic ideas; but therefore quantitative application to forecasting, testing, or policy evaluation is usually impossible without substantially augmenting the structure of the model.

Empirical forecasting models 

In the 1940s and 1950s, as governments began accumulating national income and product accounting data, economists set out to construct quantitative models to describe the dynamics observed in the data. These models estimated the relations between different macroeconomic variables using (mostly linear) time series analysis. Like the simpler theoretical models, these empirical models described relations between aggregate quantities, but many addressed a much finer level of detail (for example, studying the relations between output, employment, investment, and other variables in many different industries). Thus, these models grew to include hundreds or thousands of equations describing the evolution of hundreds or thousands of prices and quantities over time, making computers essential for their solution. While the choice of which variables to include in each equation was partly guided by economic theory (for example, including past income as a determinant of consumption, as suggested by the theory of adaptive expectations), variable inclusion was mostly determined on purely empirical grounds.

Dutch economist Jan Tinbergen developed the first comprehensive national model, which he built for the Netherlands in 1936. He later applied the same modeling structure to the economies of theUnited States and the United Kingdom. The first global macroeconomic model, Wharton Econometric Forecasting Associates' LINK project, was initiated by Lawrence Klein. The model was cited in 1980 when Klein, like Tinbergen before him, won the Nobel Prize. Large-scale empirical models of this type, including the Wharton model, are still in use today, especially for forecasting purposes.

The Lucas critique of empirical forecasting models

Econometric studies in the first part of the 20th century showed a negative correlation between inflation and unemployment called the Phillips curve. Empirical macroeconomic forecasting models, being based on roughly the same data, had similar implications: they suggested that unemployment could be permanently lowered by permanently increasing inflation. However, in 1968,Milton Friedmanand Edmund Phelps argued that this apparent tradeoff was illusory. They claimed that the historical relation between inflation and unemployment was due to the fact that past inflationary episodes had been largely unexpected. They argued that if monetary authorities permanently raised the inflation rate, workers and firms would eventually come to understand this, at which point the economy would return to its previous, higher level of unemployment, but now with higher inflation too. The stagflation of the 1970s appeared to bear out their prediction.

In 1976, Robert Lucas, Jr., published an influential paper arguing that the failure of the Phillips curve in the 1970s was just one example of a general problem with empirical forecasting models. He pointed out that such models are derived from observed relationships between various macroeconomic quantities over time, and that these relations differ depending on what macroeconomic policy regime is in place. In the context of the Phillips curve, this means that the relation between inflation and unemployment observed in an economy where inflation has usually been low in the past would differ from the relation observed in an economy where inflation has been high. Furthermore, this means one cannot predict the effects of a new policy regime using an empirical forecasting model based on data from previous periods when that policy regime was not in place. Lucas argued that economists would remain unable to predict the effects of new policies

unless they built models based on economic fundamentals (like preferences, technology, and budget constraints) that should be unaffected by policy changes.

Dynamic stochastic general equilibrium models

Partly as a response to the Lucas critique, economists of the 1980s and 1990s began to construct microfoundedmacroeconomic models based on rational choice, which have come to be called dynamic stochastic general equilibrium (DSGE) models. These models begin by specifying the set of agents active in the economy, such as households, firms, and governments in one or more countries, as well as the preferences, technology, and budget constraint of each one. Each agent is assumed to make an optimal choice, taking into account prices and the strategies of other agents, both in the current period and in the future. Summing up the decisions of the different types of agents, it is possible to find the prices that equate supply with demand in every market. Thus these models embody a type of equilibrium self-consistency: agents choose optimally given the prices, while prices must be consistent with agents’ supplies and demands.

DSGE models often assume that all agents of a given type are identical (i.e. there is a ‘representative household’ and a ‘representative firm’) and can perform perfect calculations that forecast the future correctly on average (which is called rational expectations). However, these are only simplifying assumptions, and are not essential for the DSGE methodology; many DSGE studies aim for greater realism by considering heterogeneous agentsor various types of adaptive expectations. Compared with empirical forecasting models, DSGE models typically have less variables and equations, mainly because DSGE models are harder to solve, even with the help of computers. Simple theoretical DSGE models, involving only a few variables, have been used to analyze the forces that drive business cycles; this empirical work has given rise to two main competing frameworks called the real business cycle model and the New Keynesian DSGE model. More elaborate DSGE models are used to predict the effects of changes in economic policy and evaluate their impact on social welfare. However, economic forecasting is still largely based on more traditional empirical models, which are still widely believed to achieve greater accuracy in predicting the impact of economic disturbances over time.

DSGE versus CGE models 

A closely related methodology that pre-dates DSGE modeling is computable general equilibrium (CGE) modeling. Like DSGE models, CGE models are often microfounded on assumptions about preferences, technology, and budget constraints. However, CGE models focus mostly on long-run relationships, making them most suited to studying the long-run impact of permanent policies like the tax system or the openness of the economy to international trade. DSGE models instead emphasize the dynamics of the economy over time (often at a quarterly frequency), making them suited for studying business cycles and the cyclical effects of monetary and fiscal policy.

Agent-based computational macroeconomic models

Another modeling methodology which has developed at the same time as DSGE models is Agent-based computational economics (ACE), which is a variety of Agent-based modeling. Like the DSGE methodology, ACE seeks to break down aggregate macroeconomic relationships into microeconomic decisions of individual agents. ACE

models also begin by defining the set of agents that make up the economy, and specify the types of interactions individual agents can have with each other or with the market as a whole. Instead of defining the preferences of those agents, ACE models often jump directly to specifying their strategies. Or sometimes, preferences are specified, together with an initial strategy and a learning rule whereby the strategy is adjusted according to its past success. Given these strategies, the interaction of large numbers of individual agents (who may be very heterogeneous) can be simulated on a computer, and then the aggregate, macroeconomic relationships that arise from those individual actions can be studied.

Strengths and weaknesses of DSGE and ACE models

DSGE and ACE models have different advantages and disadvantages due to their different underlying structures. DSGE models may exaggerate individual rationality and foresight, and understate the importance of heterogeneity, since the rational expectations, representative agent case remains the simplest and thus the most common type of DSGE model to solve. Also, unlike ACE models, it may be difficult to study local interactions between individual agents in DSGE models, which instead focus mostly on the way agents interact through aggregate prices. On the other hand, ACE models may exaggerate errors in individual decision-making, since the strategies assumed in ACE models may be very far from optimal choices unless the modeler is very careful. A related issue is that ACE models which start from strategies instead of preferences may remain vulnerable to the Lucas critique: a changed policy regime should generally give rise to changed strategies.

IMPORTANT CONCEPTS IN MACROECONOMICS

A. National Income

The total net value of all goods and services produced within a nation over a specified period of time, representing the sum of wages, profits, rents, interest, and pension payments to residents of the nation.

B. Output

Output in economics is the "quantity of goods or services produced in a given time period, by a firm, industry, or country," whether consumed or used for further production. The concept of national output is absolutely essential in the field of macroeconomics. It is national output that makes a country rich, not large amounts of money. 

C. Consumption

Consumption is a major concept in economics and is also studied by many other social sciences. Economists are particularly interested in the relationship between consumption and income, and therefore in economics the consumption function plays a major role.

Different schools of economists define production and consumption differently. According to mainstream economists, only the final purchase of goodsand services by individuals constitutes consumption, while other types of expenditure — in particular, fixed investment, intermediate consumption, and government spending — are placed in separate categories. Other economists define consumption much more broadly, as

the aggregate of all economic activity that does not entail the design, production and marketing of goods and services (e.g. the selection, adoption, use, disposal and recycling of goods and services).

D. Inflation

The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum. 

As inflation rises, every dollar will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year. 

Most countries' central banks will try to sustain an inflation rate of 2-3%.

E. Savings

According to Keynesian economics, the amount left over when the cost of a person's consumer expenditure is subtracted from the amount of disposable income that he or she earns in a given period of time.

For those who are financially prudent, the amount of money that is left over after personal expenses have been met can be positive. For those who tend to rely on credit and loans to make ends meet, they will have negative savings. Savings can be turned into further increased income through investing.

F. Investments

In economics, investment is related to saving and deferring consumption. Investment is involved in many areas of the economy, such as business management and finance whether for households, firms, or governments.

In finance, investment is putting money into something with the expectation of gain, usually over a longer term. This may or may not be backed by research and analysis. Most or all forms of investment involve some form of risk, such as investment in equities, property, and even fixed interest securities which are subject, inter alia, to inflation risk.

In contrast putting money into something with a hope of short-term gain, with or without thorough analysis, is gambling or speculation. This category would include most forms of derivatives, which incorporate a risk element without being long-term homes for money, and betting on horses. It would also include purchase of e.g. a company share in the hope of a short-term gain without any intention of holding it for the long term. Under the efficient market hypothesis, all investments with equal risk should have the same expected rate of return: that is to say there is a trade-off between risk and expected return. But that does not prevent one from investing in risky assets over the long term in the hope of benefiting from this trade-off. The common usage of investment to describe speculation has had an effect in real life as well: it reduced investor capacity to discern investment from speculation, reduced investor awareness of risk associated with speculation, increased capital available to speculation, and decreased capital available to investment.

G. International Trade

International trade is the exchange of capital, goods, and services across international borders or territories. In most countries, such trade represents a significant share of gross domestic product (GDP). While international trade has been present throughout much of history (see Silk Road, Amber Road), its economic, social, and political importance has been on the rise in recent centuries.

Industrialization,advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system. Increasing international trade is crucial to the continuance of globalization. Without international trade, nations would be limited to the goods and services produced within their own borders.

International trade is, in principle, not different from domestic trade as the motivation and the behavior of parties involved in a trade do not change fundamentally regardless of whether trade is across a border or not. The main difference is that international trade is typically more costly than domestic trade. The reason is that a border typically imposes additional costs such as tariffs, time costs due to border delays and costs associated with country differences such as language, the legal system or culture.

Another difference between domestic and international trade is that factors of production such as capital and labor are typically more mobile within a country than across countries. Thus international trade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital, labor or other factors of production. Trade in goods and services can serve as a substitute for trade in factors of production.

Instead of importing a factor of production, a country can import goods that make intensive use of that factor of production and thus embody it. An example is the import of labor-intensive goods by the United States from China. Instead of importing Chinese labor, the United States imports goods that were produced with Chinese labor. One report in 2010 suggested that international trade was increased when a country hosted a network of immigrants, but the trade effect was weakened when the immigrants became assimilated into their new country.

International trade is also a branch of economics, which, together with international finance, forms the larger branch of international economics. For more, see The Observatory of Economic Complexity.

H. International Finance

International finance (also referred to as international monetary economics or international macroeconomics) is the branch of financial economics broadly concerned with monetary andmacroeconomic interrelations between two or more countries.International finance examines the dynamics of the global financial system, international monetary systems, balance of payments, exchange rates, foreign direct investment, and how these topics relate to international trade.

Sometimes referred to as multinational finance, international finance is additionally concerned with matters of international financial management. Investors and multinational corporations must assess and manage international risks such as political risk and foreign

exchange risk, including transaction exposure, economic exposure, and translation exposure.

Some examples of key concepts within international finance are the Mundell–Fleming model, the optimum currency area theory, purchasing power parity, interest rate parity, and the international Fisher effect. Whereas the study of international trade makes use of mostly microeconomic concepts, international finance research investigates predominantly macroeconomic concepts.

5 BASIC MACROECONOMIC DECISIONS

A. How many people will work and how much work will they do?B. What proportion of the national resources shall be devoted to the production of

capital goods?C. What are the consumer goods to be produced and how many of each kind should be

produced?

- People or households choose between spending and saving their money. When they decide to spend more, this would entail the nation’s need to produce more consumer goods. On the other hand, if the consumers choose to save their money, we know that money can be made available for investments or for the creation of capital goods.

D. What production methods shall be used to produce the capital goods and consumer goods?

E. How are the goods to be distributed among the people?

RESOURCE ALLOCATION AND THE NATION’S PRODUCTION POSSIBILITIES CURVE (PPC)

PPC is a graphical representation of the alternative choices of a society, along which it can choose between the production of a good or another, under the following conditions:

1. Constant state of technology2. Fixed supply of resources3. Full employment and full production

In Macroeconomics, these two goods are capital goods and consumer goods.

Assuming: X=capital goods; Y=consumer goods

Y

X

The production point or combination of capital goods and consumer goods that a nation produces can be inside the curve, on or along the curve , or outside the curve.

A. On or along the curve. The economy works under the basic assumptions of the PPC and this entails the following:

- No idle resources- Law of substitution applies- Principle of opportunity cost is implied

B. Within or inside the curve. The economy does not fulfil the full employment and full production condition. This refers to a situation of unemployment and underemployment and this entails the following:

- Idle or unutilized resources- Resource substitution does not necessarily apply- Opportunity cost is not necessarily present-

Y The points outside the curve represent unemployment and underemployment.

X

C. Outside the curve. This cannot be attained given the three assumptions of the PPC unless there is an increase in resources both in quantity and quality, and improved technology such that the nation’s PPC becomes larger. This entails the following:

- More goods produced- The three assumptions still hold with the larger PPC- The new curve now represents maximum efficiency- Any point below the new PPC now entails unemployment and

underemployment*O here is the original curve. A, or B, represents expansion.

Y

O A B XECONOMIC SYSTEMS AND THEIR CHARACTERISTICS

Economic systems or economic organizations refer to the institutional arrangements that make the basic macroeconomic decisions. Not one of the polar economic systems exists in pure form but most of the nations of the world lean more towards the market economy. There are basic three types which are as follows:

A. Planned Economy/ Centrally-Planned Economy/ Command Economy/ Communist Economy

In a planned economy, the factors of production are owned and managed by the government. Thus the Government decides what to produce, how much to produce and for whom to produce.

Centrally planned economies assume that the market does not work in the best interest of the people, and that in order for social and national objectives to be met a central authority needs to make decisions. The state can set prices for goods and determine how much is produced, and can focus labor and resources on industries and projects without having to wait for private investment capital.

Most modern economies are a mixture of centrally planned economies and market economies, with governments controlling some aspects of the economy and the private sector controlling others.

Features:a. All resources are owned and managed by the government.b. There is no Consumer or producer sovereignty.c. The market forces are not allowed to set the price of the goods and services.d. Profit in not the main objective, instead the government aims to provide

goods and services to everybody.e. Government decides what to produce, how much to produce and for whom

to produce.

Advantages:a. Prices are kept under control and thus everybody can afford to consume

goods and services.b. There is less inequality of wealth.c. There is no duplication as the allocation of resources is centrally planned.d. Low level of unemployment as the government aims to provide employment

to everybody.e. Elimination of waste resulting from competition between firms.

Disadvantages:a. Consumers cannot choose and only those goods and services are produced

which are decided by the government.

b. Lack of profit motive may lead to firms being inefficient.c. Lot of time and money is wasted in communicating instructions from the

government to the firms.

Examples of Planned Economies:a. North Koreab. Cubac. Turkmenistand. Myanmare. Belarusf. Laosg. Libyah. Irani. Iraq (until 2003)

B. Market Economy/Capitalistic Economy/Market-Based Economy/ Laissez-Faire Economy

Features:a. Most productive resources are owned by individuals.b. Economic decisions are highly decentralized.c. The market operates at an equilibrium.d. There is a wider variety of goods in the market.

Advantages:

a. Competition between different firms leads to increased efficiency, as firms do whatever is necessary—including laying off workers—to lower their costs;

b. Most people work harder (the threat of losing one's job is a great motivator);c. There is more innovation as firms look for new products to sell and cheaper

ways to do their work;d. Foreign investment is attracted as word gets out about the new

opportunities for earning profit;e. The size, power, and cost of the state bureaucracy is correspondingly

reduced as various activities that are usually associated with the public sector are taken over by private enterprises;

f. The forces of production, or at least those involved in making those things people with money at home or abroad want to buy, undergo rapid development;

g. Many people quickly acquire the technical and social skills and knowledge needed to function in this new economy;

h. A great variety of consumer goods become available for those who have the money to buy them; and

i. Large parts of the society take on a bright, merry and colorful air as everyone busies himself trying to sell something to someone else.

Disadvantages:

a. Distorted investment priorities, as wealth gets directed into what will earn the largest profit and not into what most people really need (so public health, public education, and even dikes for periodically swollen rivers receive little attention);

b. Worsening exploitation of workers, since the harder, faster, and longer people work—just as the less they get paid—the more profit is earned by their employer (with this incentive and driven by the competition, employers are forever finding new ways to intensify exploitation);

c. Overproduction of goods, since workers as a class are never paid enough to buy back, in their role as consumers, the ever growing amount of goods that they produce (in the era of automation, computerization and robotization, the gap between what workers produce—and can produce—and what their low wage allows them to consume has increased enormously);

d. Unused industrial capacity (the mountain of unsold goods has resulted in a large percentage of machinery of all kinds lying idle, while many pressing needs—but needs that the people who have them can't pay for—go unmet);

e. Growing unemployment (machines and raw materials are available, but using them to satisfy the needs of the people who don't have the money to pay for what could be made would not make profits for those who own the machines and raw materials—and in a market economy profits are what matters);

f. Growing social and economic inequality (the rich get richer and everyone else gets poorer, many absolutely and the rest in relation to the rapidly growing wealth of the rich);

g. With such a gap between the rich and the poor, egalitarian social relations become impossible (people with a lot of money begin to think of themselves as a better kind of human being and to view the poor with contempt, while the poor feel a mixture of hatred, envy and queasy respect for the rich);

h. Those with the most money also begin to exercise a disproportional political influence, which they use to help themselves make still more money;

i. Increase in corruption in all sectors of society, which further increases the power of those with a lot of money and puts those without the money to bribe officials at a severe disadvantage;

j. Increase in all kinds of economic crimes, with people trying to acquire money illegally when legal means are not available (and sometimes even when they are);

k. Reduced social benefits and welfare (since such benefits are financed at least in part by taxes, extended benefits generally means reduced profits for the rich; furthermore, any social safety net makes workers less fearful of losing their jobs and consequently less willing to do anything to keep them);

l. Worsening ecological degradation (since any effort to improve the quality of the air and of the water costs the owners of industry money and reduces profits, our natural home becomes increasingly unlivable);

m. With all this, people of all classes begin to misunderstand the new social relations and powers that arise through the operations of a market economy as natural phenomena with a life and will of their own (money, for example, gets taken as an almost supernatural power that stands above people and orders their lives, rather than a material vehicle into which people through their alienated relations with their productive activity and its products have poured their own power and potential; and the market itself, which is just one possible way in which social wealth can be distributed, is taken as the way nature itself intended human beings to relate to each other, as more in keeping with basic human nature than any other possibility. As part of this, people no longer believe in a future that could be qualitatively different or in their ability, either individually or collectively, to help bring it about. In short, what Marx called "ideological thinking" becomes general);

n. The same market experiences develop a set of anti-social attitudes and emotions (people become egotistical, concerned only with themselves. "Me first", "anything for money", "winning in competition no matter what the human costs" become what drives them in all areas of life. They also become very anxious and economically insecure, afraid of losing their job, their home, their sale, etc.; and they worry about money all the time. In this situation, feelings as well as ideas of cooperation and mutual concern are seriously weakened, where they don't disappear altogether, for in a market economy it is against one's personal interest to cooperate with others);

o. With people's thoughts and emotions effected in these ways by their life in a market economy, it becomes very difficult for the government, any government, to give them a true picture of the country's problems (it is more conducive to stability to feed people illusions of unending economic growth and fairy tales of how they too can get rich. Exaggerating the positive achievements of society and seldom if ever mentioning its negative features is also the best means of attracting foreign investment. With so much of the economy depending on "favorable market psychology", the government simply cannot afford to be completely honest either with its own people or the rest of the world on what is really happening in the country);

p. Finally, the market economy leads to periodic economic crises, where all these disadvantages develop to a point that most of the advantages I mentioned earlier simply dry up —the economy stops growing, fewer things are made, development of the forces of production slows down, investment drops off, etc. (a close look at the trends apparent in the disadvantages of the market should make clear why such crises are inevitable in a market economy). Until an economic crisis occurs, it is possible to take the position that the advantages of a market economy outweigh its disadvantages, or the opposite position, and to develop a political strategy that accords with one's view, whatever it is. But if a crisis does away with most of the important advantages associated with the market, this is no longer possible. It simply

makes no sense to continue arguing that we must give priority to the advantages of the market when they are in the process of disappearing.

Examples of Market Economies:

There is no purely market economy existing in the world. But the following countries tend to lean more on this side:

a. United Statesb. Brazilc. Kenyad. Indiae. United Kingdomf. Nicaraguag. Peru

C. Mixed Economy/ Democratic Socialist Economy/ Liberal Socialist Economy/Mixed Capitalism/ Regulated Capitalist Eonomy

A mixed economy is an economic system that incorporates aspects of more than one economic system. This usually means an economy that contains both privately-owned and state-owned enterprises or that combines elements of capitalism and socialism, or a mix of market economy and planned economy characteristics. This system overcomes the disadvantages of both the market and planned economic systems.

Features:

a. Resources are owned both by the government as well as private individuals. i.e. co-existence of both public sector and private sector.

b. Market forces prevail but are closely monitored by the government.

Advantages:a. Producers and consumer have sovereignty to choose what to produce and

what to consume but production and consumption of harmful goods and services may be stopped by the government.

b. Social cost of business activities may be reduced by carrying out cost-benefit analysis by the government.

c. As compared to Market economy, a mixed economy may have less income inequality due to the role played by the government.

d. Monopolies may be existing but under close supervision of the government.

CIRCULAR FLOW OF INCOME

Two-sector Barter Economy

This model existed at the time of the nomadic tribes, in traditional economies before the creation of money. In this model, it is necessary that coincidence of wants between household and business takes place. If one is to trade labor for a produce, the owner of a produce must want the labor offered, otherwise, no transaction will take place between the two sectors.

Two-sector Monetary Economy

This model existed when forms of money such as gold, silver, and other prescious metals were used and measurements of goods sold had already been established such as shekel for barley among the Sumerians. This also reflects that transactions already take place among the markets.

Three-sector Economy/ Close Economy

This model already includes the government sector, which is essentially a consumer of goods and services from the business sector, a buyer of household resources and a producer of public goods and services. It is a close economy as the three sectors rely on each other for their needs without interference from the other economies.

This model is essentially the model for Japan before the Meiji Restoration period, East Germany before the collapse of the Berlin Wall, Union Soviet Socialist Republics before glasnost and perestroika, and presently, North Korea.

Four-Sector Model/ Open Economy

This model already includes the foreign sector or the rest of the world so that a nation in this model relies not only internally for its needs but also externally. In the same manner, its market is not only domestic but also international. Both these changes affect its economic situation far more widely that it can perfect.

This model is currently used by most countries. Most of the rich countries have the same model. Some of them have gone to the extent of forming international economic alliances known a economic integration which takes the form of free trade area, custom union, and common market. The more popular integrations are that of AFTA, NAFTA, EU, APEC, and WTO.

The four-sector model is the basis of the Gross National Product and other relevant national income accounts but it is not perfect. It has advantages, disadvantages, and limitations which have to be considered before one is to identify the parts and learn how to measure these national accounts.

Advantages:- It allows everyone to understand how most economies operate.- It allows everyone to see the symbiotic relationship among the major sectors

of an economy.- It brings out the idea of the importance of trade relations among the major

sectors of an economy.- It brings about the idea of the importance of trade relations with other

countries.- It gives a bird’s eye view of how a global economy operates.- It gives you a complete view of all markets that occur, of all buying and

selling activities that take place in an economy and in the world.

Disadvantages:

- The direct transactions between government and the rest of the world are not reflected.

- The direct transactions on labor exports between the household sector and that of the rest of the world are not also reflected.

- The sources of income of government are not reflected.- The different types of saving/dissavings occurring in the different sectors are

not reflected.- The details of transactions, whether in domestic currency or foreign

currency, as well as other institutions directly connected to such transactions are not shown.

- The diagram only presupposes legal and registered transactions, such that underground economy, smuggled and pirated products, illegal drugs among others, are not included.

Gross National Product (GNP) and Gross Domestic Product (GDP)

Gross Domestic Product – the total output produced within the geographical boundaries of the country regardless of the nationality of the entities producing the output.

Gross National Product – the country’s output of all final goods and services for an accounting period (valued at market or purchasers’ price), which is the Gross Domestic Product plus all incomes of Filipinos from abroad.

The Gross National Product is based on the four-sector model of the circular flow of income particularly the money flow. In the money flow, there are givers and recipients of money. If the GNP is measured from the givers’ perspective, that is known as the incomes approach. If it is measured from the perspective of the recipients, that is known as the incomes approach. Both approaches must yield equal GNP as the two approaches are but two sides of the same transaction. Essentially, the GNP refers to the monetary value of all goods and services produced by the constituents of the nation regardless of where they are.

The expenditures approach includes the expenditures of the four sectors – the household, business, government, and the rest of the world.

The incomes approach includes the incomes of al economic resources coming from the household, taxes earned by the government, and the capital consumption allowances accumulated by the business.

GNP BY Expenditures Approach1. Personal Consumption Allowance (e.g. durable and non-durable goods, services)2. Gross Private Domestic Investment (e.g. machinery tools, equipment, inventory)

3. Government Purchases (e.g. wages and salaries of gov’t employees, national government spending)

4. Net Exports (total exports – imports)

GNP BY Incomes Approach1. Compensation of Employees/ Wages, Salaries, and their Supplements2. Rental Income3. Interest Income4. Proprietors’ Income5. Corporate Profit which includes Corporate Income Taxes, Dividends, and

Undistributed Corporate Profit6. Indirect Business Taxes Less Subsidies (e.g. excise taxes, amusement tax, licenses)7. Capital Consumption Allowances (sum of all depreciation allowances)

Price IndicesPrice indices reflect changes in price based on a base period.

1. GNP/GDP Deflator – When the value of GNP Deflator is higher than one or more than 100%, this means that inflation has occurred in the current year. GNP Deflator reflects the real purchasing power of money and the real increase in production.

GNP Deflator= GNP at Current PricesGNP at Constant Prices

2. Consumer Price Index – reflects the price changes of the usual market basket or typical bundle of goods that consumers in an economy usually purchase

3. Implicit Price Index – used in the Philippines to compare the prices of a given sector in a given year with its prices in 1985, the base year in Philippine accounts.

Implicit Price Index = GNP of a Specific Sector at Current PricesGNP of same Sector at Constant Prices

4. Producer Price Index/Wholesale Price Index – conceptually similar to CPI, however, it includes goods that are raw materials and semi-finished products, or what are popularly known as intermediate products.

5. Retail Price Index – conceptually similar to CPI, however, it only includes items sold in retail stores and which can be bought by piece.

Methods of Computing the Price Index

1. The Simple Aggregate Method

This method presents the total commodity prices in a given year as a percentage of total commodity prices in the base year.

PI = ∑❑Pn

∑❑PoPn = Prices at current year; Po = Prices at Base Year

2. Weighted Aggregate Methods

2.a. Laspeyres’ Price Index = ∑❑PnQo

∑❑PoQoPn = Prices at current yearPo = Prices at Base YearQo = Quantity in Base Year

2.b. Paasche’s Index = ∑❑PnQn

∑❑PoQn

Pn = Prices at current yearPo = Prices at Base YearQn = Quantity in Current Year

2.c Fisher’s Ideal Index = √ ∑❑PnQo

∑❑PoQo∗∑❑PnQn

∑❑PoQn

2.d. Marshall-Edgeworth Index = ∑❑Pn(Qo+Qn)

∑❑Po (Qo+Qn)

Limitations of Price Indices:1. All sectors change their spending patterns.2. The composition of the market basket, the list of wholesale goods, and the list of

retail goods change.3. Substitution bias between goods takes place whenever there is inflation.4. Cost of living in different regions varies.

BUSINESS CYCLE

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production, trade and economic activity in general over several months or years in an economy organized on free-enterprise principles.

The business cycle is the upward and downward movements of levels of GDP (gross domestic product) and refers to the period of expansions and contractions in the level of economic activities (business fluctuations) around its long-term growth trend.

These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession).

Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite being termed cycles, these fluctuations in economic activity can prove unpredictable.

The first systematic exposition of periodic economic crises, in opposition to the existing theory of economic equilibrium, was the 1819 Nouveaux Principes d'économie politique by Jean Charles Léonard de Sismondi.  Prior to that point classical economics had either denied the existence of business cycles, blamed them on external factors, notably war, or only studied the long term. Sismondi found vindication in the Panic of 1825, which was the first unarguably international economic crisis, occurring in peacetime. Sismondi and his contemporary Robert Owen, who expressed similar but less systematic thoughts in 1817 Report to the Committee of the Association for the Relief of the Manufacturing Poor, both identified the cause of economic cycles as overproduction and underconsumption, caused in particular by wealth inequality. They advocated government intervention and socialism, respectively, as the solution. This work did not generate interest among classical economists, though underconsumption theory developed as a heterodox branch in economics until being systematized in Keynesian economics in the 1930s.

Sismondi's theory of periodic crises was developed into a theory of alternating cycles by Charles Dunoyer, and similar theories, showing signs of influence by Sismondi, were developed byJohann Karl Rodbertus. Periodic crises in capitalism formed the basis of the theory of Karl Marx, who further claimed that these crises were increasing in severity and, on the basis of which, he predicted a communist revolution. He devoted hundreds of pages of Das Kapital (1867) to crises. In Progress and Poverty (1879), Henry George focused on land's role in crises – particularly land speculation – and proposed a single tax on land as a solution.

MONETARY POLICY

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by loweringinterest rates in the hope that easy credit will entice businesses into

expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.

Monetary policy can produce real effects on output and employment only if some prices are rigid—if nominal wages (wages in dollars, not in real purchasing power), for example, do not adjust instantly. Otherwise, an injection of new money would change all prices by the same percentage. So Keynesian models generally either assume or try to explain rigid prices or wages. Rationalizing rigid prices is a difficult theoretical problem because, according to standard microeconomic theory, real supplies and demands should not change if all nominal prices rise or fall proportionally.

FISCAL POLICY

Fiscal policy is the use of government spending and taxation to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groups—a tax cut for families with children, for example, raises their disposable income. Discussions of fiscal policy, however, generally focus on the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that are “revenue neutral” may be construed as fiscal policy—and may affect the aggregate level of output by changing the incentives that firms or individuals face—the term “fiscal policy” is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the gap between them.

Fiscal policy is said to be tight or contractionary when revenue is higher than spending (i.e., the government budget is in surplus) and loose or expansionary when spending is higher than revenue (i.e., the budget is in deficit). Often, the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit from $200 billion to $100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit.

The most immediate effect of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion, for example, raises aggregate demand through one of two channels. First, if the government increases its purchases but keeps taxes constant, it increases demand directly. Second, if the government cuts taxes or increases transfer payments, households’ disposable income rises, and they will spend more on consumption. This rise in consumption will in turn raise aggregate demand.

Fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing bonds. In doing so, it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise interest rates and “crowd out” some private investment, thus reducing the fraction of output composed of private investment.

In an open economy, fiscal policy also affects the exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. In their attempt to get more dollars to invest, foreigners bid up the price of the dollar, causing an exchange-rate appreciation in the short run. This appreciation makes imported goods cheaper in the United States and exports more expensive abroad, leading to a decline of the merchandise trade balance. Foreigners sell more to the United States than they buy from it and, in return, acquire ownership of U.S. assets (including government debt). In the long run, however, the accumulation of external debt that results from persistent government deficits can lead foreigners to distrust U.S. assets and can cause a deprecation of the exchange rate.

Fiscal policy is an important tool for managing the economy because of its ability to affect the total amount of output produced—that is, gross domestic product. The first impact of a fiscal expansion is to raise the demand for goods and services. This greater demand leads to increases in both output and prices. The degree to which higher demand increases output and prices depends, in turn, on the state of the business cycle. If the economy is in recession, with unused productive capacity and unemployed workers, then increases in demand will lead mostly to more output without changing the price level. If the economy is at full employment, by contrast, a fiscal expansion will have more effect on prices and less impact on total output.

This ability of fiscal policy to affect output by affecting aggregate demand makes it a potential tool for economic stabilization. In a recession, the government can run an expansionary fiscal policy, thus helping to restore output to its normal level and to put unemployed workers back to work. During a boom, when inflation is perceived to be a greater problem than unemployment, the government can run a budget surplus, helping to slow down the economy. Such a countercyclical policy would lead to a budget that was balanced on average.

Automatic stabilizers – programs that automatically expand fiscal policy during recessions and contract it during booms – are one form of countercyclical fiscal policy. Unemployment insurance, on which the government spends more during recessions (when the unemployment rate is high), is an example of an automatic stabilizer. Similarly, because taxes are roughly proportional to wages and profits, the amount of taxes collected is higher during a boom than during a recession. Thus, the tax code also acts as an automatic stabilizer.

But fiscal policy need not be automatic in order to play a stabilizing role in business cycles. Some economists recommend changes in fiscal policy in response to economic conditions—so-called discretionary fiscal policy—as a way to moderate business cycle swings. These suggestions are most frequently heard during recessions, when there are calls for tax cuts or new spending programs to “get the economy going again.”

Unfortunately, discretionary fiscal policy is rarely able to deliver on its promise. Fiscal policy is especially difficult to use for stabilization because of the “inside lag”—the

gap between the time when the need for fiscal policy arises and when the president and Congress implement it. If economists forecast well, then the lag would not matter because they could tell Congress the appropriate fiscal policy in advance. But economists do not forecast well. Absent accurate forecasts, attempts to use discretionary fiscal policy to counteract business cycle fluctuations are as likely to do harm as good. The case for using discretionary fiscal policy to stabilize business cycles is further weakened by the fact that another tool, monetary policy is far more agile than fiscal policy.

Whether for good or for ill, fiscal policy’s ability to affect the level of output via aggregate demand wears off over time. Higher aggregate demand due to a fiscal stimulus, for example, eventually shows up only in higher prices and does not increase output at all. That is because, over the long run, the level of output is determined not by demand but by the supply of factors of production (capital, labor, and technology). These factors of production determine a “natural rate” of output around which business cycles and macroeconomic policies can cause only temporary fluctuations. An attempt to keep output above its natural rate by means of aggregate demand policies will lead only to ever-accelerating inflation.

The fact that output returns to its natural rate in the long run is not the end of the story, however. In addition to moving output in the short run, expansionary fiscal policy can change the natural rate, and, ironically, the long-run effects of fiscal expansion tend to be the opposite of the short-run effects. Expansionary fiscal policy will lead to higher output today, but will lower the natural rate of output below what it would have been in the future. Similarly, contractionary fiscal policy, though dampening the output level in the short run, will lead to higher output in the future.

A fiscal expansion affects the output level in the long run because it affects the country’s savings rate. The country’s total saving is composed of two parts: private saving (by individuals and corporations) and government saving (which is the same as the budget surplus). A fiscal expansion entails a decrease in government saving. Lower saving means, in turn, that the country will either invest less in new plants and equipment or increase the amount that it borrows from abroad, both of which lead to unpleasant consequences in the long term. Lower investment will lead to a lower capital stock and to a reduction in a country’s ability to produce output in the future. Increased indebtedness to foreigners means that a higher fraction of a country’s output will have to be sent abroad in the future rather than being consumed at home.

Fiscal policy also changes the burden of future taxes. When the government runs an expansionary fiscal policy, it adds to its stock of debt. Because the government will have to pay interest on this debt (or repay it) in future years, expansionary fiscal policy today imposes an additional burden on future taxpayers. Just as the government can use taxes to transfer income between different classes, it can run surpluses or deficits in order to transfer income between different generations.

Some economists have argued that this effect of fiscal policy on future taxes will lead consumers to change their saving. Recognizing that a tax cut today means higher taxes in the future, the argument goes, people will simply save the value of the tax cut they receive now in order to pay those future taxes. The extreme of this argument, known as Ricardian equivalence, holds that tax cuts will have no effect on national saving because changes in private saving will exactly offset changes in government saving. If these economists were right, then my earlier statement that budget deficits crowd out private investment would be wrong. But if consumers decide to spend some of the extra disposable income they receive from a tax cut (because they are myopic about future tax payments, for example), then Ricardian equivalence will not hold; a tax cut will lower national saving and raise aggregate demand. Most economists do not believe that Ricardian equivalence characterizes consumers’ response to tax changes.

In addition to its effect on aggregate demand and saving, fiscal policy also affects the economy by changing incentives. Taxing an activity tends to discourage that activity. A high marginal tax rate on income reduces people’s incentive to earn income. By reducing the level of taxation, or even by keeping the level the same but reducing marginal tax rates and reducing allowed deductions, the government can increase output. “Supply-side” economists argue that reductions in tax rates have a large effect on the amount of labor supplied, and thus on output. Incentive effects of taxes also play a role on the demand side. Policies such as investment tax credits, for example, can greatly influence the demand for capital goods.

The greatest obstacle to proper use of fiscal policy—both for its ability to stabilize fluctuations in the short run and for its long-run effect on the natural rate of output—is that changes in fiscal policy are necessarily bundled with other changes that please or displease various constituencies. A road in Congressman X’s district is all the more likely to be built if it can be packaged as part of countercyclical fiscal policy. The same is true for a tax cut for some favored constituency. This naturally leads to an institutional enthusiasm for expansionary policies during recessions that is not matched by a taste for contractionary policies during booms. In addition, the benefits from expansionary policy are felt immediately, whereas its costs – higher future taxes and lower economic growth – are postponed until a later date. The problem of making good fiscal policy in the face of such obstacles is, in the final analysis, not economic but political.

SOURCES:

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