Macro History

Macro History - conomists sometimes disagree with each...

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Unformatted text preview: conomists sometimes disagree with each other. In news interviews. class lec- tures, and editorials, they give differing opinions about even the simplest mat- ters. To the casual observer, it might seem that economics is little more than tesswork, where anyone’s opinion is as good as anyone else’s. But there is acrually more agreement among economists than there appears to be. Take the following typical example: At a time when the economy is performing ell, two disringuished economists appear on CNN Moneylr’rte. In a somber tone, _i_llow Bay——the anchornasks each of them what should be done to maintain the .2 éalth of the economy. “We need to cut taxes,” replies the first economist. “If indi- i__uals can keep more of what they earn, they’ll have more incentive to work. And .iwe lower taxes on business, they’ll have more incentive to invest and grow." it on’t worry if this chain of logic isn’t clear to you yet—it will be by the end of the :xt chapter.) --“No,__no, no,” the second economist might interrupt. “A tax cut would be the 'rst thing we could do right now. The economy is already pumping out just about "many goods and services as it can. A tax cut—which would put more funds into rers’ hands—would only increase spending, overheat the economy, and lead to ' ationary dangers that the 11.5. Federal Reserve would have to prevent.” {You'll 'in learning what’s behind this argument a few chapters later.) ~53 _ Which of these economists would be right? Surprisingly, it’s entirely possible for 1b of them to be correct. But how can this be? Aren’t the two responses con- dictory? Nor necessarily, because each economisr might be hearing—and answer- ——a different question. The first economisr is addressing the likely long-run " act of a cut in taxesmthe impact we might expect after several years have tr sed. The second economist, by contrast, is focusing on a possible short-run im- ct—the effects we might see over the next year. 'I Once the distinction between the long run and the short run becomes clear, - any apparent disagreements among macroeconomiSts dissolve. lf Willow Bay had fed our two economists about the long~run impacr of cutting taxes, borh may "ll have agreed that it would lead to more jobs and more investment by business - ms. If asked about the short~run impact, bOth may have agreed about the poren- danger of inflation. if no time horizon is specified, however, an economist is fly to focus on the horizon he or she feels is most important—something about CHAPTER OUTLINE Mattoetonomit Models: Classitat Versus lteynesian Assumptions ot the Classical Model How Much Output Will We Produce? The Labor Market Determining the Economfs Output The Role of Spending Total Spending in a Very Simple Economy Total Spending in a More Realistic Economy Leakages and Injections The loanable Funds Marktat The Supply of Funds Curve The Demand for Funds Curve Equilibrium in the loanable Funds Market The Loanable Funds Market and Safe Law The Classital Model: A Summary Using the theory: Fiscal Policy in the Classical Model Fiscal Policy with a Budget Deficit Fiscal Policy with a Budget Surplus '_ 596 Classical model A maCroeCOnomic model that explains the long-run behavior of the economy. Chapter 20 The Classical Long-Run Model which economisrs sometimes do disagree. The real dispute, thOugh, is less Over hu ' the economy works and more about what our priorities should be in guiding it. Ideally, we would like our economy to do well in borh the long run and the Sim _ run. Unfortunately, there is often a trade«off between these two goals: Doing better ' the short run can require some sacrifice of long»run goals, and vice versa. The problc for policymakers is much like that of the captain of a ship sailing thtOugh the Nor ' Atlantic. On the One hand, he wants to reach his deStination (his long-run goal}; on t ' " Other hand, he musr avoid icebergs along the way [his short-run goal]. As you mig imagine, avoiding icebergs may require the captain to deviate from an ideal long-m course. At the same time, reaching port might require risking the occasional iceberg. .- The same is true of the macroeconomy. If you flip back two chapters and loo at Figure 4, you will see that there are two types of movements in total output—t " long—run trajectory showing the growth of potential output and the short-run mov merits around that traiecrory, which we call economic flucruations or business it . cles. Macroeconomists are concerned with bOth types of movements. But, as yo : will see, policies that can help us smooth out economic fluctuations may prov harmful to growth in the long run, while policies that promise a high rate ofgrowt might require us to put up with more severe flucwations in the short run. : MACROECONOMIC MODELS: SLBMUAEE_XEE_S&_____ The ClaSSlCal model, developed by economists in the nineteenth and early twentict -:.?' centuries, was an attempt to explain a key observation about the economy: Our: periods of several years or longer, the economy performs rather weli. That is, if we Step back from current conditions and view the economy over a long stretch 0 time, we see that it operates reasonably close to its potential Output. And even whe I it deviates, it does nOt do so for very long. Business cycles may come and go, bu _ the economy eventually returns to full employment. Indeed, if we think in terms 0 decades rather than years or qua rtets, the business cycle fades in significance much% like the waves in a choppy sea disappear when viewed from a jet plane. [n the classical view, this behavior is no accident: Powerful forces are at worlt'é that drive the economy toward full employment. Many of the classical economisna went even further, arguing that these forces operated within a reasonably short pe-e riod of time. And even today, an important group of macroeconomists continues to? believe that the classical model is useful even in the shorter tun. Until the Great Depression of the 19305, there was little reason to question these:- classical ideas. True, output fluctuated around its trend, and from time to time there were serious recessions, but output always returned to its porential, full-employment level within a few years or less, iust as the classical economists predicred. But during. the Great Depression, output was stuck far below its potential for many years. For 50me reason, the economy wasn‘t working the way the classical model said it should. In 1936, in the midSt of the Great Depression, the British economist john May- nard Keynes offered an explanation for the economy’s poor perFOrmance. His new model of the economy—soon dubbed the Keynesian model—changed many ecOno- mists‘ thinking.‘ Keynes and his followers argued that, while the classical model ' Keynes‘s attack on the classical model was presented in his book The General Theory of Employ. recent. interest and Money ll936l. Unfortunately, it's a very difficult book to read. though you may want to try. Keynes‘s assumptions were not always clear, and some of his text is open to multiple interpreta- tions. As a result, economists have been arguing for decades about what Keynes really meant. Macroeconomic Models: Classical Versus Keynesian 597 ‘xp I "ti the economy’soperation in the long run, the long run could be a very _ _e , riving. ln'the meantime, producrion could be Stuck below its poten- 's "rhea to be during the Great Depression. ' ideas became_'inc_re_asingly popular in universities and government : ageiigte during the 1940s and-l9505. By the mid-19605, the entire profession had ee nover _ Macroeconomics was Keynesian economics, and the classical model -\ v I (fled from virtually all introductory economics textbooks. You might be oride" ', n, why we are bothering with the classical model here. After all, it’s -.'piaq'm-ad-a of the economy, One that was largely discredited and replaced, just I he Ptolemaic view that the sun circled the earth was supplanted by the more I Coperhican view. Right? - 7: é: . l5: . - I? " it 1;: e' nti'mics in modern clothing, but in Other cases significant new ideas have enad ed. By studying classical macroeconomics, yOu will be better prepared to der'stahd'th'e controversies centering on these newer schoolsofth ought. = The seCOri'g—and more important—reason for-us to study the classical model is sefuli'ieSS in'understanding the economy Over the long run. Even the many econ. ists who find the classical model inadequate for understanding the economy in a. . a r short run‘ find it extremely useful in analyzing the economy in the long run. "is is whywe will use the terms “classical view” and “long-run view” interchange- . , in the resiof the book; in either case, we mean “the ideas of the classical model '. to ex the econOmy’s long-run behavior.” III C 3 'U 3 O 2 In D m _| I H! h F h V! E H. b . F 3 O U PH 1- satdatis: nun einember from Chapter 1 that all models begin with assumptions about the world. “l e clasSical model'is no exception. Many of its assumptions are simplifying—they e the modelmore manageable, enabling us to see the broad outlines of eco- 1C behavior Without getting lost in the details. Typically, these assumptions in— "aggregation, such as ignoring the many different interest rates in the economy I nsteadfr'eferring to a single intereSt rate, or ignoring the many different types 1 abor indie-economy and analyzing instead a single aggregate labor market. ese simplifications are usually harmless—adding more detail would make our k more difficult, but would not add much insight; nor would it change any of central conclusions 'of the classical view. There is, however, one assumption in the classical view that goes beyond mere _ plifica'tion. This is an assumption about how the world works, and it is critical '-_1 __t e conclusions we will reach in this and the next chapter. We can state it in two _ : markets clear. on. - .. i‘. 21-? a} In Market clearing Adjustment 01 prices until quantities supplied and demanded are equal. 598 Chapter 10 The Classical Long-Run Model Does the market-clearing assumption sound familiar? It should: It was the basic id ' behind our Study of supply and demand. When we look at the economy through i _ classical lens, we assume that the forces of supply and demand work fairly wcl throughour the economy and that markets do reach equilibrium. An excess supply a -. anything traded will lead to a fall in its price; an excess demand will drive the price it - -_' The market-clearing assumption, which permeates classical thinking about th economy, provides an early hint about why the classical model does a better in' over longer time periods (several years or more] than shorter ones. In many ma . kets, prices might nOt fully adiu5t to their equilibrium values for many months 0- even years after some change in the economy. An excess supply or excess deman '_ might persisr for some time. Still, if we wait long enough. an excess supply in a ma ket will eventually force the price down, and an excess demand will eventually driv . the price up. That is, eventually, the market will clear. Therefore, when we are tr ing to explain the economy‘s behavior over the long run, market clearing seems t ' be a reasonable assumption. In the remainder of the chapter, we‘ll use the classical model to answer a variety. of important questions aboat the economy in the long run, such as: 0 How is toral employment determined? - How much output will we produce? e What role does toral spending play in the econOmy? o What happens when things change? Keep in mind that, in our discussion of the classical model, we will focus ori mall: variables: real GDP, the real wage, real saving, and so on. These variables are typi--«‘ cally measured in the dollars of some base year, and their numerical values change only when their purchasing power changes. HOW MUCH OUTPUT Will. WE PRODUCE? Over the Ian decade, on average, the US. economy produced about $7.5 trillion worth of goods and services per year {valued in 1996 dollars]. How was this aver- age level of output determined? Why didn’t we produce $10 trillion per year? Or iust $2 trillion? There are so many things to consider when answering this ques- tionw—variables you constantly hear about in the newshwages, interest rates, in- veSIment spending, government spending, taxes. and more. Each of these concepts plays an important role in determining toral Output. and our task in this chapter is to show how they all fit together. But what a task! How can we disentangle the complicated web of economic in- teractions we see around us? Our starting point will be the first step of our four-step procedure, introduced toward the end of Chapter 3. To review, that first step was to characterize the marketuto decide which market or ma rkets best suit the problem being analyzed, and then identify the buyers and sellers who interact in that market. But which market should we start with? The classical approach is to start at the beginning, with the reason for all this production in the firsr place. In the classical view. all production arises from one source: our desires for goods and services. Of course. we cannor buy goods and ser- vices if we don‘t have income. And with that fact comes an important implication: Haw Much Output Will We Producei ' tartan matter Real Hourly Excess Supply _ ol Labor 100 million = Full Employment .4. Number of Workers :..-. has. _ Thus, a logical place to start is with the markets for resources—markets for la» gr; r, land, and capital. To keep things simple, however, we’ll concentrate our atten- Ion on jusr one type of resource—labor. in our- classical world, we assume that rims are making use of all the capital and land that are available in the economy. _ e only question is: How much labor will firms employ to produce goods and rvices? MoreOver, since we are building a macroeconomic model, we’ll aggregate 6 I the different types of labor——office workers, construction workers, teachers, taxi rivers, waiters, writers, and more—into a single variable, called labor. as lABOR MARKET =1 - e classical labor market is illustrated in Figure l. The number of workers is meas- ed on the horizontal axis, and the real hourly wage rate is measured on the vertical 'is. Remember that the real wage—which is measured in the dollars of some base ar——tells us the amount of goods that workers can buy with an hour’s earnings. - Now look at the two curves in the figure. These are supply and demand curves, tinilar to the supply and demand curves for maple syrup, but there is one key dif- __rence: For a good such as maple syrup, households are the demanders and firms " 'e suppliers. But for labor, the roles are reversed: Households supply labor, and _tms demand it. '- The curve labeled L5 is the labor supply curve in this market; it tells us how any people will want to work at each wage. The upward slope tells us that the {carer the real wage, the greater the number of people who will want to work. y does the labor supply curve slope upward? " The answer comes from Key Step #2, in which we identify the goals and con raints of decision makers in a market. Think ab0ut your own decision about whether to work—~10 supply labor. Your 'l—at the mosr general level—is to be as well off as possible. You value both in- ' me and leisure time, and in the best of all possible worlds, you'd have a lm of 'th. However, in the real world, you face a constraint: To earn income, you must '. IO work and give up leisure. Thus, each of us will want to work only if the in - me we will earn at least compensates us {Or the leisure that we will give up. 599 fIGURE I The equilibrium wage rate 0! $15 per hour is deter- mined at point E, where the upward-slaping labor sup- ply curve crosses the downward-sloping Iab0r demand curve. A1 any other wage. an excess demand or excess supply oi labor will cause an adjustment back to equilibrium. ' T Characterize the Market labor supply curve Indicates how many people will want to Will at various wage rates T Identify Goals and (unstraints 600 Labor demand turve Indicates how many workers firms will want to hire at various wage rates. Identify Goals and Constraints T Find the Equilibrium T Chapter 20 The Classical Long~Run Modei Of course, peeple differ in the way that they value income and leisure. Thus. for each of us. there is some critical wage rate above which we would decide that we‘re better off working. Below that wage, we would be better off nor working. Thus, in Figure 1, er . . as. affifi ' The curve labeled L0 is the labor demand curve. which shows the number of workers firms will want to hire at any real wage. Why does this curve slope downward? Once again. we use Key Step #2. In deciding how much labor to hire, a firm's goal is to earn the greatest possible profit—the difference between sales revenue and costs. If a firm’s owners could choose. they‘d like the firm‘s revenue to be in- finite and its costs to be zero. However, each firm faces a constraint: To earn more revenue, it must produce and sell more output. and this requires it to hire [and pay wages to] more workers. A firm will want to keep hiring additional workers as long as the output produced by those workers adds more to revenue than it adds to cosrs. NOW think about what happens as the wage rate rises. Some workers that added more to revenue than to cosr at the lower wage will now COSt more than they add in revenue. Accmdingly, the firm wili net want to employ these workers at the higher wage. ' In the classical view, off markers death—including the market for labor. That is, the classical model tells us to apply Key Step #3 in a particular way: The real wage adiusrs until the quantities of labor supplied and demanded are equal. In the labor market in Figure 1. the market-clearing wage is $15 per hour, since that is where the labor Supply and labor demand curves interseCt. While every worker would prefer to earn $20 rather than $15, at 520 there w0uld be an excess supply of labor equal to the distance AB. With not enough iobs to go around, competition among workers wOuld drive the wage downward. Similarly, firms might prefer to pay their workers $10 rather than $15, but at $10, the excess demand for labor (equal to the disra nce Hj} would drive the wage upward. When the wage is $15, however, there is neither an excess demand nor an excess supply of labor, so the wage will neither increase nor decrease. Thus, $15 is the equilibrium wage in the economy. Reading along the hori- zontal axis, we see that at this wage, 100 million people will be working. Norice that, in the figure, labor is fully employed; that is, the number of work- ers that firms want to hire is equal to the number of people who want iobs. There- fore. everyone who wants a job at the market wage of $15 should be able to find one. Small amounts of frICtional unemployment might exist, since it takes some time for new workers or job Switchers to find iobs. And there might be Struetural unemployment. due to some mismatch between those who want iobs in the ma rket How Much Output Will We Produce? ' iand the types of jobs available. But there is no cyclical unemployment of the type ' we discussed two chapters ago. . t Full employment of the labor force is an important feature of the classical model. sins long as we can count on markets (including the labor market] to clear, govern- _ tnent anion is not needed to ensure full employment; it happens automatically: _... o-wr Automatic full employment may strike you as odd, since it contradicts the cycli- cal unemployment we sometimes see around us. Fer example, in the recession of the early 19905, millions of workers around the country, in all kinds of professions and labor markets, were unable to find jobs for many months. Remember, though, that [the classical model takes the long-run view, and over long periods of time, full em-oyment is a fairly accurate description of the U.S. labor market. Cyclical unem- Jloyment, by definition, lasts only as long as the current business cycle itself; it is no: a permanent, long-run problem. far, we’ve focused on the labor market to determine the economy’s level of em- loyment. In our example, 100 million people will have jobs. Now we ask: How much output will these 100 million workers produce? The answer depends on two ings: {1) the amount of other resources [land and capital} available for labor to 'se; and {2) the state of technology, which determines how much output we can 5-. roduce with given inputs, as well as the types of inputs available (horse-drawn :t'vagons or trucks; pencil and paper or a laptop computer). "" In the classical model, we treat the quantities of land and capital, as well as the state of technology, as fixed during the period we are analyzing. This certainly makes 5'1. ense in the case of land: Total acreage is pretty much fixed in a country, and there is ittle that anyone can do to increase it. But what about technology and capital? The tate of technology changes with each new invention or discovery. We can already is, redict, for example, that over the next decade, genetic engineering will lead to com— : 'letely new drugs and Other medical treatments and change the way many existing 1 rugs are produced. And our capital stock changes rapidly as well, since we are con- ' tantly producing new capital—more tractors, fiber-optic cable, computers, and fac- " -' i cry buildings. How can we treat these as fixed, especially since the classical model is long-run model? The answer is: We assume that technology and the capital stock are constant not cause we believe that they really are, but because doing so helps us understand what ta'ppens when they change. We divide our classical analysis of the economy into two I ueStlons: {1] What would be the long-run equilibrium of the macroeconomy for a inert state of technology and a given capital stock:- and [2} What happens to this equi~ ibrium when capital or technology changes? In this chapter, we focus on the first ques- 'ion only. in the next chapter, on economic growth, we’ll address the second quesfion. ince we are assuming, for now, a given state of technology, as well as given quantities "f land and capital,-there is only one variable left that can affect tetal output: labor. So t's time to explore how changes in total employment affect toral production. :th Production Function. The reiationship between the quantity of labor em- ' loved in the economy and the total quantity of output produced IS called the ggregale produCtion functiOn: 691 . blips/l For the latest 0n economic out- put, visit the Economic Statistics Briefing Room at mum Wm!- Aggregale production funttion The relationship showing how much total output can be produced with ditietent quantities of label, with land, capital, and technology held constant ...
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This note was uploaded on 05/07/2008 for the course ECON W1105 taught by Professor Musatti during the Spring '07 term at Columbia.

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Macro History - conomists sometimes disagree with each...

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