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Unformatted text preview: The. Economy as a Whole: Definitions and Analyses s we have seen, microeconomics is concerned with economic activity at the level of individual markets and generally con— cludes that competitive markets are efficient and work best when not encumbered by government intervention. In rather sharp contrast, macroeconomics is the branch of economics that deals with the relation— ships of large aggregates—all consumption expenditures added up, all exports added up, and so on———in order to analyze the performance of the national economy as a whole. The entire frame of analysis is oriented toward understanding how a central government (in the United States, the federal government) can deliberately manage total effective demand for goods and services through its budget (fiscal policy) and by altering financial conditions (monetary policy). ® CHAPTER 3 Why Macroeconomics? The roots of macroeconomics and the idea that governments need to manage aggregate demand are not difficult to locate. Despite the usual portrayal of the 1920s as a decade of frivolity and good times, it was actu— ally a time of economic instability and difficulty. Some state governments ineffectually attempted to regulate markets, and the federal government in the 1920s did little except to raise tariffs and experiment with a small agricultural price support program. The U.S. stock market crash of 1929 and the onset of the Great Depression drastically altered all of this. The volatility of the international economy, the fragility of domestic financial systems, and the inability to match levels of aggregate demand with output capacity all converged to create the most serious worldwide capitalist crisis ever. Between 1929 and 1934, U.S. production declined by 30 percent and official unemployment rates rose to 25 percent of the workforce. The presidential election of Franklin Delano Roosevelt in 1932 signaled a new era—the New Deal—— of active, interventionist government policies. The short—lived National Industrial Recovery Act (N IRA) of 1933 was an early, ambitious attempt at national industrial planning, and it brought the force of federal law to attempts to stabilize markets. Even though busi— nessmen dominated the councils empowered to make decisions about prices, wages, and output quotas, the NIRA’s failure to bring order into markets soon turned the business community’s initial support into opposi- tion. In any case, the U.S. Supreme Court ruled it unconstitutional in 1935. Two other general policies enjoyed greater successes. The Wagner— Connery Act (1935) established the National Labor Relations Board and legalized protections for union organizing and collective bargaining. The Social Security Act (1935) mandated a national pension system and some limited social insurance, even though it neglected large numbers of poor, minority, and women workers by excluding agriculture and domestic service. Both initiatives were resisted by business interests, and a large 3 :3 El». 3*. THE ECONOMY AS A WHOLE ® part of the entire New Deal endeavor has to be understood as an effort to put the business system back on its feet even if it had to overcome oppo— sition by the business community to do so. Augmenting the three pieces of legislation mentioned above, the New Deal included a myriad of more focused initiatives, ranging from financial market regulation, agricultural price supports, the Civilian Conservation Corps, Works Projects Administration, .and other regula— tory, public works, and relief policies. Nevertheless, the New Deal poli— cies never adequately stimulated aggregate demand, and recovery was slow and uneven. When Hitler’s army invaded the Polish corridor in late 1939, the U.S. unemployment rate was still around 15 percent. World War II, more than any other factor, rescued U.S. capitalism from the Depression. As soon as large federal expenditures for war matériel raised profit prospects and unions agreed to a no—strike pledge, business opposition to federal regulation and control all but evaporated. During the war, the federal government successfully operated a regula— tory regime that went far beyond the NIRA in its comprehensiveness, tight controls, and top—down lines of authority. By—products of the war effort included full employment, new occupational opportunities for women, modest improvements in the distribution of income, and new civil rights possibilities for African Americans. Although most of the direct economic controls were dismantled soon after the war, they and the New Deal had established the foundations for substantial federal economic regulation and intervention (the “mixed economy”). These developments reflected political and economic elites’ general loss of confidence in free markets and their conviction that if left alone, the vicissitudes of unregulated markets could jeopardize the very existence of a capitalist economy. At the same time, the New Deal and World War II controls seemed to show that active government policies of regulation and demand management could stabilize capitalist economies. These two lessons from experience encouraged a newfound faith in the efficacy of discretionary stabilization policies by public authorities. @ CHAPTER 3 The work of the Englishman Iohn Maynard Keynes, in his The General Theory of Employment, Interest, and Money (1936), plausibly justi- fied and systematically mapped interventionist strategies that did not upset the basic principles of a capitalist social order. The book established the theoretical bases of modern macroeconomic analysis, often referred to as “Keynesian economics.”1 The Keynesian approach emphasizes the need for sustaining levels of total (or “aggregate.”) demand adequate for the full employment of productive capacity. The policy tools of demand management are used to promote economic growth, reduce inflation and unemployment, and generally maintain a smoothly functioning economy with satisfactory levels of material prosperity. Advocates of such policies argue that the macroeconomic stability and buoyancy from prudent pub- lic policy are necessary for markets to work efficiently by satisfying some of the conditions, such as full employment and stable prices, that are assumed in microeconomics. Two legislative acts immediately after the war are important to know about. The Employment Act of 1946 formally obligated the fed- eral government to ensure “full employment” and illustrated these new sensibilities. This was followed closely by the Taft-Hartley Act of 1947, which constrained the freedoms that the Wagner-Connery Act had accorded organized labor, strengthened conservative union leaders’ control over rank—and-file members, and mandated purging unions of left—wing influences. In addition to the Cold War, the Taft—Hartley Act was a direct response to the wave of post—World War II strikes often instigated by the rank—and-file membership against the wishes of union leaders. Moreover, employers feared that the Employment Act would weaken the threat of unemployment and strengthen labor’s bargaining position. It is important to understand, then, that the experiences of the Great Depression of the 19305 and World War II led political and economic leaders to have powerful doubts about the stability of free markets. Corresponding to these doubts were their convictions about the need for .33. .r-v-u HI". .' ghg.._';_.;_4.‘.,_‘ 5.39..»— _4I.. THE ECONOMY AS A WHOLE ® active economic guidance by central political authorities, thus leading to the rise of modern macroeconomic policy. How Gross Is the Gross Domestic Product? It is obligatory to begin with some formal definitions, simply sq that we have a decent idea of what we’re talking about. We’ll start with the National Income and Product Accounts’ most aggregate of the economic aggregates: gross domestic product (GDP), which is the total value of all ' goods and services produced in the nation in a year.2 In the early years of the twenty—first century, the GDP of the United States was over $10,000,000,000,000—that’s right, over ten trillion dollars (thirteen zeros), or 10 million millions. One of the key concepts underlying the National Income and Product Accounts and all of macroeconomics is that a buyer’s expendi- tures represent some seller’s receipts. Wages are costs to firms but receipts (income) for workers. Food that workers buy at the supermarket is a cost of living for them but receipts for the supermarket. An exception to this circular interdependence at the national level is that while the purchase of an imported good is a cost to the buyer, it is a receipt for a foreign seller and lies outside the domestic circular flow. The sale of an export is the mirror image: the receipt from the sale enters the national circular flow from the outside. Table 3.1A presents the flow relationships within the nation and lists the GDP’s components. Table 3.1B lists an alternative organization of the same data but by a different system of main headings (“aggregates”). These frequently used aggregates are important, but for now, let’s con- centrate on table 3.1A. The left column of the table shows the expenditures for all final goods and services produced in that year. That is, the list includes the sale value of all goods and services except for those used for further produc- tion (e.g., steel, plastic, and glass for automobiles). The right column Nd .mé in. A Bow =55 £2.55 Eth .o .556 62:3 Egbsfis *0 088.... x2$t£ «Eco... o_nmmo%_o “£03.... mmxfi. Orr—DUE Eran—un— m::=>_ 333...... .3 Eva. uses .32. wEouE .385... Egg m_m:v_>_u:_ o. 35:53 .322. 98%.... BE 2256ch $3 Eu 9.5.62.1 2.9.8 8.. ,8: 35.2.33 m_m:u_>=.:_ 8 35:3 .328. .55.:qu SE 3322...: B 35:58 9.2.3:. 9.385 Eco... 8552 .25 $53 £05 39598 25:2 AcouuatEQ E95... 8 33:955.. .8 82.58. 3.6.603 o. 55:.qu 38% 2:85 _m_._o_«mz Egan mmocfian 8 £233 SE 8.8.. mmwcfiam 52%5 3:5 63.0... .2932 32 Egg coumnwawv 2.55. 62.0... ficouuz 3.20 .633... 3.3m v3.5 05 :_ 35:53:: :2: E2». 2339.2 3 wESE mass. v85... flcucfigfi .m.: E0: 32mg. wESE SE finmmd : Unto... uwmeon $.20 35:01 me 2.2.5.: was; 0E8... .225: t. 5E9. 2:. .a —.m mime... $238.... .w... .m... .n-.. E .98” is magmam§§u .o xuaam .858 Aug—on S 9.256 Ami—on .6 2.555 «E85 ufiwEoo $20 mmmda Gavan. ufiwEoo $.20 £32. 0.8 — £32. 51 2.2.5.: use... _muo_ “Em 28m wmzwwovcoz count...an 3.5on 8.8... mmoEmsm 62%... ed E...ku «cum . 885.3“. EuEEw>ou «$.35 md mwtoucgfi E mmcmzu mmEEmm .8533. N... mEmso: fincuEmum mvcwvfio 9m. EwEn—Evu .25 E2; 8me muck. . E2...ng 9.2.2098 fan $3.5m mmmtemwazm Eeasucia «.8 £30» «32352 amok. Nd £30» 25959 9%...3 9.5.5.5 mwtmfim .25 3mm; 93 :owaEsmcou 3E8... non—Eon can 325 .2...— ..$ 3.3.153 tau .9 35:85.. as 835 .3222... 82 6:12.. 3.8.5... 395 a... .o $55.58 .< w CHAPTER 3 shows how the receipts from the production and sale of those goods and services were distributed among recipients. The left side may be thought of as being the sales of all final goods and services, and the right side as the costs of producing and selling those goods and services. Even though there is no direct correspondence between individual entries, the sum of the two sides is equal—sales equal receipts; production equals income. This equality does not reflect the balance of an equilibrium condition; it simply expresses accounting definitions. Table 3.1A suggests two ways to calculate the GDP. Look at the left side of the table, which represents one way to calculate the GDP—count up the total sales of only final goods and services. Since the only goods counted here are those that end up with the final users, we avoid the problem of double counting by not counting all the intermediate goods utilized in further pro— duction. For example, the value of the wheat sold to the miller, the value of the flour sold to the baker, the value of bread sold to the supermarket chain, and the value of the bread sold to consumers/shoppers cannot be added up into a meaningful total. One way to avoid double counting is to count only the value of the final product—the bread—which includes the value of the intermediate products used in its production. Table A.1 in the appendix to this book shows the magnitude of intermediate sales, which in several eco— nomic sectors was more than final sales. This demonstrates the need to pre— vent them from being included in the calculation of final product. This is a fairly clear. principle, right? Well, let’s gum it up a bit by not— ing that investment goods constitute a major exception. When a firm buys a metal lathe from another firm, it is considered to be a final pur— chase, because even though the lathe is used for future production, its contribution to future production will occur over a period of years. For accounting convenience, such investment goods are classed as final pur— chases. The left side of table 3.1A represents the final-purchase/end—use strategy of calculating the GDP. An alternative method to calculate the GDP is to add up the value of the wheat (assuming no intermediate products), the value of the flour THE ECONOMY AS A WHOLE 0 minus that of the wheat, the value of the bread minus that of the flour, and the value of the bread sold by the supermarket minus the value of the bread from the baker. That is, each stage of production adds a certain amount of value to the final value, and this value—added approach is what we find in the right column of table 3.1A. After all, the value added at each stage of production is the value of its sales minus the value of the intermediate goods and services used up at that stage of production. Therefore, value added is what was received in wages and salaries, interest, rent, taxes, deprecia— tion (wear and tear on plant and equipment), and profit (positive or negative—it’s a residual) at each stage of production. The two approaches to the calculation of the GDP ought to add up to the same totals, but given the complexity of the calculations, perfect balance always requires adding some sort of statistical adjustment to one side of the account. Now for some observations about what does not go into the GDP or any of the other aggregates. First of all, there is the resale of any good pro— duced in a previous period (a used car, a thirty—year—old house). Although the commissions earned by the used car salesperson and the realtor are current services and thus counted toward this year’s GDP, the sale prices of the car and house are not. Goods produced last year and kept in inven— tories and sold this year are counted at their current value, but that value is offset somewhat by the reduction in inventories, a component of the investment category. Second, goods and services that do not pass through a market, even though currently produced, are generally not counted. One exception is an estimate of the value of food produced and consumed on farms (it used to be much larger), but food grown in your urban backyard and eaten by you at home is not. If your friend drops some books off at the library for you as a favor, that is not counted in GDP, but if you pay him $5.00 for the service, then it should be counted. Third, the value of leisure is not included in the GDP. If economic growth is possible by everyone working 60—80 hours a week, there is no way in the National Income and Product Accounts to acknowledge the ® CHAPTER 3 costs from the loss of downtime. It simply is not measured as economic value in the National Income and Product Accounts. This takes us to one of the more contentious areas: the value of house— work and child rearing is not counted in the GDP unless it is done under commercial auspices, by house cleaning, food, and child care service providers. When I began teaching economics oh so many years ago, many textbooks used the following example to illustrate this: if a man marries his (paid) housekeeper, he reduces the GDP. This once—common exam— ple seems to have become extinct. Then there are genuine market activities that are not counted in the GDP because they are deliberately hidden. Evading taxes is definitely an incentive to under—report income and the value of production even if the economic activity is perfectly legal. Self-employed people are in the best position to evade taxes in this manner, whether they are self-employed professionals, house painters, bodyguards, or whatever. Tips are another income source that often is not reported. Finally, there are illegal economic activities, where the incentive to keep under cover goes beyond chiseling on taxes. Maybe the product is not naughty but the manner of its production is frowned upon (e.g., employ— ing illegal immigrants to make clothes or using unsafe chemicals to bleach paper). Completely illegal activities—the production and trade in amphet— amines and other controlled substances, gambling, prostitution, contract killing, and other thoroughly criminalized economic production—are yet another subset of economic activity that is not noticed in the GDP. Usually lumped together in the category of the underground econ- omy (not the realm of the Hobbits), these market activities respond to the forces of demand and supply, even though the risks, costs, and returns of their illegality significantly condition their demand and supply curves. The very nature of the underground economy makes estimates of its size very tricky, and estimates range from 5 to 25 percent of GDP. Although the actual magnitude of these economic activities is uncertain, there is a suspicion that they are growing. One indication is the increasing amount THE ECONOMY AS A WHOLE w of cash, especially $100 bills, in circulation compared to what people are holding in checking accounts. Returning to the aboveground economy, government services that are not sold on the market (e.g., public education, fire and police protec- tion, tax collection, standing army, most roads) are valued at the cost of public employees’ wages and salaries. What governments buy from pri- vate firms (e.g., macadam, rockets, fire hoses, paper and pencils, surveil- lance equipment) are not considered to be intermediate products but rather final products purchased by the government. Finally, some costs of production are generally not counted or else are severely undervalued in the GDP. Pollution and other sorts of resource degradation from production are the most obvious examples. Once we have some idea of what GDP is, the next step is to figure out how to compare it over a period of time in order to discern growth or recession. This can present a problem, because prices change in different amounts and directions over time. The GDP is the price of each final good and service multiplied by the quantity of the corresponding good and ser- vice. Therefore, when comparing the GDP of 2000 with, say, the GDP of 1996, there is no easy way to know how much of the difference between the two figures is due to price changes and how much to “real” (quantity) changes. For this reason, it is necessary to use GDP at constant prices to compare GDPs over time. The idea is quite simple: use the prices of one period, say that of 1996, to calculate the GDP of 2000; then you can com— pare the two GDPs having avoided the distortions of price changes and isolated the changes in quantities—changes in real GDP. You can see this in table 3.2. The first row is GDP in current prices, and the second row is GDP of each year using 1996 prices. The year-to— year changes of the GDP in the second row are changes only in quanti— ties produced and sold, not of price changes because the same (1996) prices have been used to calculate each GDP. Thus the GDPs in the sec— ond row are known as real GDP. If you want to construct an index num- ber of real GDP in order to be able to read proportional changes more ® CHAPTER 3 an» in Current 'an'rl "constant bulimia-Id Index Numb-in" 1996 I991 1999 1999 2000 GDP in billions of current dollars 7.81 8.32 8.79 9.30 9.96 GDP in billions of 1996 dollars 7.81 8.16 8.52 8.87 9.32 Index of real GDP 100.0 104.5 109.1 1 13.6 1 19.2 GDP implicit price deflator 100.0 102.0 103.2 104.8 106.9 Source: Survey of Current Business (April 2001), pp. D—3 and D-38. easily, you divide each year’s real GDP by 1996 GDP and multiply by 100. For 1996, clearly the result is 100, but for 1997, it is 104.5, which shows that real GDP of 1997 was 4.5 percent greater than real GDP for 1996, and so on, as presented in the third row of table 3.2. GDP in constant prices illustrates the principle that one has to use the same prices (“hold prices constant”) in order to measure changes in quan— tities. The converse is true for measuring changes in prices: quantifies have to be held constant. An example of this is that once we have the 2000 GDP in 1996 prices, we can divide it into 2000 GDP in 2000 (current) prices (and multiply by 100) in order to measure how much prices have changed between 1996 and 2000. The quantities are constant—the goods and ser- vices produced in 2000—and the index so constructed is called the GDP implicit price deflator, which is shown on the fourth row of table 3.2. The Consumer Price Index (CPI) is the most familiar of the price indexes, and we will meet it in the next chapter when talking about inflation. The general idea of standardizing prices for quantity indexes and standardizing quantities for price indexes is all well and good, but there is a problem. My example was to compare the 1996 GDP with the 2000 GDP calculated in 1996 prices in order to measure the changes in real GDP between 1996 and 2000. Fine. But if instead, we were to calculate the 1996 GDP in 2000 prices and compare it with the 2000 GDP in 2000 THE ECONOMY AS A WHOLE ® prices, it would be just as acceptable a procedure. So what’s the problem? The problem is that We would come up with a different figure for the change in real GDP over the period, and the GDP deflator would be dif— ferent. This is because the prices act as relan've weights in a quandty index. It’s time for an example. Let’s pretend that the price of a new Chevrolet Blazer (very precisely specified by model and accessories) in 1996 was twenty times the price of an equally precisely specified Macintosh computer. This means that each Blazer that was produced and sold in 1996 counted as twenty times more important (more heavily weighted) in the quantity index than each Macintosh. In 2000, however, the Blazer’s price was twenty-five times that of the Macintosh. This means that comparing the two GDPs at constant 1996 prices counts changes in Macintosh production as being more important (more heav— ily weighted) relative to Blazer production than when 2000 prices were used as the constant. Exactly the opposite is true for price indexes, in which quantities serve as relative weights for price changes, and the results can vary significantly depending on the year selected. There is no obvious solution to this problem, other than to be clear about it and to name it: the index number problem. Just to nail this idea down, here is a quick exercise. In the liberating tradition of economic abstraction that allows one to make up whole worlds, you are the Minister of Economics of Stagnacia, a small country in which bread and ale are the only two goods produced and consumed. During your two-year term in office, ale production and prices have risen but the output of bread has fallen, although the price of bread has not changed. Now that you are running for reelection, you want to show the maximum increase (or minimum decrease) in total production and the minimum apparent inflation that have occurred while the economy has been under your guidance. Since outright lying and falsification are not feasible, which year’s prices would you use to publish “real GDP,” and which year’s output would you use to calculate the published price index? (Think it over, and if you do not get prices in the second year for the w CHAPTER 3 quantity index and the quantities in the first year for the price index, think it over again.) One way to tackle the index number problem is to calculate the implicit price deflator for both years and then take the geometric mean of the two. Usually when we speak of the mean as one of the averages, we are referring to the arithmetic mean. In this case, you would get the arithmetic mean by adding the two indexes and dividing the sum by two. To obtain a geometric mean, however, you multiply the two and take the square root of the answer. Obviously, this has to be more sophisticated, and the results are called chain—linked price indexes, which have begun to be used more often by the government. One criticism of the procedure is that the final number is a mush of the two procedures that tells you less than what you could figure out from looking at either one of the two individual indexes. These problems and ambiguities suggest neither that it is useless to do the calculations nor that the results should be dismissed. What is sug- gested, however, is that one needs to be straightforward in calculating such indexes and to be careful in interpreting others’ use of them. Effective Demand The focus of macroeconomics is on the left side of the table 3.1A, on the actual market expenditures or effective demand for all goods and ser— vices. The public policy emphasis on managing the levels of demand expresses the Keynesian conviction that aggregate demand is the most important determinant of employment, growth, and inflation. The lack of any consideration of supply conditions reflects the theory’s origins in the Great Depression, when so much idle productive capacity (factories and people) meant that supply could be expected to respond easily to increases in demand. The expenditures (which equal receipts) for final goods and services are divided up primarily by the type of buyer: households (consumption [0]); businesses (investment [1]); government (local, state, and federal THE ECONOMY AS A WHOLE a [G]); foreigners (exports [X]), subtracting the value of imports of foreign— produced goods and services in all categories [Al]. I will go through each of these later, but it is important now to note that the categories are not defined by type of product. An automobile and even a shirt can belong in all of the categories.3 We can express these relationships in shorthand: GDP=C+I+G+X—M. Aggregate expenditures are divided in this manner because it is believed that they are behavioral categories that operate in relatively reg— ular and predictable ways. That is, household decisions about consump— tion purchases are influenced by factors relatively uniform for all households; business investment purchases are predicated on factors dif— ferent from those influencing household consumption levels but common for most businesses; and so on. I discuss exports and imports more thor- oughly in chapter 5, and here I concentrate on the domestic components of expenditure: consumption, investment, and government. In chapter 4, I put them together to talk about changes in the level of economic activ— ity and government policies that affect those levels. Households and Consumption Household consumption is the largest of the expenditure components, constituting almost 70 percent of all final purchases of goods and services (GDP): Households are not only the white suburban families of four as depicted in the early TV shows (e.g., Leave It to Beaver). Households include all units that make up some sort of consumer decision unit, whether it is a single person, a three—generation family, a gay family, six recent college graduates sharing a one—bedroom apartment to beat exor— bitant San Francisco rents, or whatever. By definition, households use their income to buy consumer goods and services or to save; with one exception, they do not invest. That exception is the purchase of a new res— idence, a situation in which the stream of future benefits is so long that it is included in the investment category. ® CHAPTER 3 Economists exclude such activities as buying stocks and bonds from the investment category. Most purchases of stocks and bonds are simply transfers of already—existing financial assets that affect GDP only through the brokers’ fees. Even if a household bought newly issued stocks or bonds, an individual household’s purchase of the asset is counted as sav— ings. Only when the business issuing the stock or bond uses the money to buy plant and equipment or add to inventory does it become investment. The distinction between buying a stock and expanding plant and equip— ment is often expressed as the difference between financial investment and real investment. In a similar manner, financial capital includes stocks, bonds, and other financial assets, while real capital denotes plant, machin- ery, and other produced means of production that represent the econ— omy’s productive capacity. Three types of consumer expenditures are listed in table 3.1A. Durable consumer goods are those expected to last three years or more and are usually big ticket items: automobiles, dishwashers, TV sets, fur— niture, and so on. Nondurable consumer goods include clothes, food, cig— arettes, and whatever. Finally, services are intangibles, produced and consumed simultaneously, such as automobile repair, insurance, a con— cert, or lawn care.‘1 Determinants of Consumption Expenditure As in the case of demand curves in chapter 1, it is clear that many factors influence the level of households’ consumption decisions and expenditures. When all is said and done, however, the aggregation process, by which millions of sepa— rate consumption decisions are all added together, cancels out the influ— ence of a fair number of individual idiosyncrasies, whether stemming from nature or nurture. This enables the generalization that household income is the major determinant of consumption expenditures. The income I am talking about is disposable income, which is listed in table 3.1B. As the name implies, it is the after—tax income from whatever source that accrues to households. This excludes all business taxes, depreciation '.=--~.“"--¢r-fire-"aw. ,cf‘r‘Ff '-' .. . '. '. a. ' -' .. , Elflls-rfx:2$'_‘::°fi'c THE ECONOMY AS A WHOLE ® allowances, and corporate retained earnings, and it includes private and public transfer payments (income such as pensions [private and public], insurance reimbursements, and welfare support) that are not compensa— tion for currently rendered productive activity. As after—tax income, it is the income that households are free to “dispose.”5 Disposable income is a reliable predictor of household consumption expenditures. There are two principal ways by which disposable income and therefore household consumption increases (or declines, but since the processes are symmetrical, I accentuate the positive). The first is general economic growth, which lifts all account entries. If the proportion of GDP that trickles down to disposable income does not change radically, a rise in GDP will generate increased disposable income that in turn will induce greater consumption expenditures. The second way for disposable income to grow is through a change in the proportion of GDP received as disposable income. The most obvious source of such a change would be by a reduction in personal income taxes. This would allow households to keep more of their personal income and lead to an increase in disposable income and thus consumption expendi— tures even if there were no increase in GDP. In addition, if corporations were to shovel every available dollar of profit into dividends, disposable income would also increase as a proportion of gross domestic product. The distribution of income, apart from its overall level, also used to be considered an influence on the levels of aggregate household con— sumption expenditures and savings. In the old days (whenever they were), it was believed that the rich saved more than the poor did, so if there were shifts in income to the most well—to—do, aggregate household savings would rise and consumption expenditures would decline. The idea that the rich save more and thus enable investment and general eco- nomic growth has been used as a justification for highly uneven distrib— utions of income. The inefficiency of this mechanism, by which the rich in some sense function as stewards of economic resources for the good of the commonweal, has been revealed by recent history. Even though there ® CHAPTER 3 has been a substantial increase in the concentration of income over the past two decades, the US. savings rate has declined to a fifty—year low. The rich spend almost all of their money, too, and what we have wit— nessed is an explosion of demand for expensive automobiles, restaurants, jewelry, and housing. Interest rates are another secondary influence on household con— sumption expenditures. Interest rates are most important for consumer durables that are most often bought “on time” (i.e., with borrowed money and interest charges). Automobiles are a good example, but house pur— chases are particularly sensitive to interest rate changes. As I noted earlier, buying a new house is technically in the investment category, but house— holds do it. Residential construction and purchase are particularly respon— sive to interest rate changes, because contractors borrow heavily to build houses, and mortgage interest costs are high proportions of total (and monthly) costs for buyers as well. Changes in interest rates, therefore, affect both the supply and demand sides of the market for new housing. Another dimension of interest rate changes in respect to consumption expenditures is through credit cards. The usurious rates of interest charged on the unpaid balances of credit cards is truly breathtaking, but they do go up and down with general movements in interest rates. Interest rates’ influ— ence on the levels of unpaid credit card balances and of consumption expen— ditures in general, however, is not as clear as in the purchase of houses. The Business Sector and Investment As listed in table 3.1A, corporate profits are divided among dividends (paid out to stockholders), corporate taxes, and retained earnings (corpo— rate savings). The depreciation allowance functions as a pool of liquid assets similar to that of retained earnings. The fact that corporate profits are taxed at the corporation level and then dividends are taxed as personal income when received by individuals is a source of chronic whining about double taxation. --'-(':"m¥:v-.=w=vt,.-~.-rfirwBernw'aflsr'r-mzbwwkm-we~.1r.-_"-‘r~ w",- "'£-:.“3= 1». -.=‘:'9-:-.‘<_—::<=.' "=_'=.W'-':_”'.='.‘.‘p!?:t"_j.'-‘ _':'t'..'r'§I|-_€f" '1: :- THE ECONOMY AS A WHOLE ® Regarding the components of investment expenditures, again we find the magic number three. Purchase of new plant and equipment is the most straightforward form of investment expenditure. It is more volatile than consumption expenditures, and the reason for this can be illustrated by a simple example. Let’s say that a company uses ten machines with ten-year life spans, and each year one machine falls apart, is swept up and,thrown away, and then replaced as long as the demand for the company’s product is stable. But one year, there is a 10 percent reduction in sales, so the com- pany does not replace the worn—out machine that year. Therefore, a 10 percent reduction in the demand for the firm’s output becomes magni- fied to a 100 percent decline in its new investment for plant and equip— ment. This process works for both declines and increases and contributes to volatile capital goods markets. Inventories are the second component of investment, and they are a bit trickier. Some inventory investment is deliberate. The normal flow of production requires a reserve of components and materials and a num— ber of finished products. Retailers maintain stocks of goods to keep shelves full. A distiller who sells six—year—old whiskey needs a six—year revolving supply. In addition, a firm may stockpile raw materials to hedge against anticipated price increases or keep back finished products in order to manipulate the market or outlast a labor strike. On the other hand, changes in inventory investment can also be involuntary and unde— sirablle the company is not able to sell all it produces, it unwillingly builds up inventories of finished products, which probably means that it cuts back production in the near future. The inventory component of investment, then, is in a sense a residual category in that it helps ensure that the two sides of the account balance; everything produced is either sold or added to inventory; everything sold is either produced or taken out of inventory. But don’t let this residual balancing of accounts mislead you. Changes in inventories are one of the most important signaling mechanisms in the economy, at both the microeconomic and macroeco— nomic levels. ® CHAPTER 3 Finally, residential construction and sales represent the third category of investment expenditure, and as I described earlier, it is the only way in which household expenditure is counted as investment. Determinants of Investment Expenditures At one level, the motive or cause of investment is very easy: expected profits. Behind the cost-bene- fit calculation of expected profits, however, are a large number of uncer- tainties about the markets for products, credit, intermediate products, labor, shifts in the competitive environment, technological changes, new government policies, and myriad other factors. The volatility of the busi- ness components of investment is a clear sign of the difficulty of identify- ing determinants with any precision. Interest rates are one of the most important factors.6 Even though they bear only on the cost side of the cost-benefit ratio, the heavy expenses and use of borrowed funds (or opportunity costs of already-acquired funds) of investment projects make interest rate considerations very important. For the plant and equipment component, any decline of interest rates (cost of borrowing money) increases the potential profitability of a greater range of investment projects and enhances businesspeople’s willingness to take a shot at them, thus increasing expenditures on plant and equipment. The plant and equipment component of investment is the only cate- gory of expenditures on final goods and services that is a factor of pro- duction. Recalling the discussion of MRP in the previous chapter, the demand for investment goods is governed by the investment goods’ (expected) MRP for real capital. So it is not hard to imagine a well— behaved, downward-sloping demand curve for investment goods in respect to interest rates, as in figure 3.1. This is neat and clean, but the difficulty of determining the MRP of real capital does not stop with uncertainties about future earnings. The problem is that the returns from investments occur over extended peri- ods of time, sometimes many years, and it is necessary to convert the value of those future returns into present money, so to speak. This conversion yuan-3a,... . awr.;.._ .» 1.,» ._— a-e -.-_-1__ .\_—__-»___———_ _.-_-_: :.. 112,:7‘.m_l.g{.)'_1?:l:'.".l_. . .-.--.;.: " . THE ECONOMY AS A WHOLE ® 1 MRP Interest Rates 0.8 1.0 1.2 1.4 1.6 New Plant and Equipment (trillions of dollars) is necessary, because future money, dollar for dollar, is worth less than present money. This is not in order to correct for expected inflation (easy and separate) nor is it a matter of how hard it is to defer gratification, although that may be a part of it (“I want that new car ugh: nowll”). The conversion is required because any comparison between the value of future money and present money needs to take into account that one can earn futuge money with present money. Would you rather have $1,000 right now or one year from now? Any rational, calculating, economic type would jump at obtaining the $1,000 right now, because even if it could not be spent for a year, it could be deposited in a bank and in a year would turn into $1,050 (at 5 percent interest). Therefore, in order to com- pare the value of that one-year-away $1,000 with the immediate $1,000, the value of the future money has to be converted into present money. The actual process requires discounting the value of the future money by the potential earnings it could earn in the time it takes to get from the pre- sent to that future. It turns out that $1,000 in one year is worth $952.39 of ® CHAPTER 3 present money if discounted by 5 percent, which is to say, if you put $952.39 in a bank at 5 percent interest, you will get $1,000 in one year. In the parlance of economics, $952.39 is the present discounted value (PDV) of $1,000 in a year discounted by an interest rate of 5 percent. The formula for calculating the PDV of money one year away is ($171) + (1 + i), where $F1i is the amount of future money one year away, and z' is the rate of discount—for our purposes, the interest rate. If you want to calculate the PDV of a lump of money two years away, you have to discount it for the first year by dividing it by (1 + z') and then for the second year by dividing it again by (1 + 1'). So you end up dividing it by (1 + i)2. The formula is unusually handy, because the exponent (power) of the divisor is simply the number of years away from which the future income will be realized. So if you want the PDV of $7,000 to be received five years in the future, and the relevant interest rate is 6 percent, then you simply divide the $7,000 by (1.06)5. This takes a few punches on the cal- culator, but I suspect that you’re up to it. (You did get $5,230.81, right?) So how about an example to illustrate this fancy new thing? Madeline has been the proprietor of a small dog grooming parlor in Providence for years and has decided to move on to new challenges that do not include ill-mannered dogs and worse-mannered dog owners. So she puts her shop, which is at the end of a small strip mall, on the market. Caitlin, cruising for a good investment opportunity, checks around a bit and realizes that there is no convenience store (e.g., 7—Eleven, Dairy Mart) within six or seven miles of the location. But Caitlin also finds out that Stop 8: Shop, Inc. is going to build a Super Stop 8: Shop in the open space across the street and open it in five years. The possibilities are still intrigu- ing, however, because until the supermarket opens, a convenience store in this neighborhood would be a real moneymaker. Caitlin goes into high gear and figures that it would take a year to buy the grooming parlor, purge it of fleas and smell, and turn it into a convenience store. In the second and third years, however, the store would clear at least $18,000 of profits a year, even if Caitlin hired all it? E- - 3:5; E; ‘. THE ECONOMY AS A WHOLE ® workers and did not have to work in the store at all. Moreover, in the fourth year, the store would make about $24,000 of profits because of the increased business from the workers constructing the Stop 8: Shop across the street. The supermarket would open in the fifth year, and although the convenience store business would be dead in the water, Caitlin figures on being able to sell the location in the mall for about $60,000 to someone interested in opening a video arcade, beauty salon, doughnut shop, mar— tial arts studio, or whatever. Caitlin needs to borrow the money to buy and renovate the store, and Adam, her banker, will charge her an interest rate of 9 percent. Is it really worthwhile? Or more precisely, what is the upper limit that Caitlin could put into buying and fixing up the store and have the investment make good financial sense? Try it out and check your results with table 3.3. Doing the arithmetic is a bit tedious, but presumably you came up with figures somewhere around those in the last row. With a little slippage for rounding off, the total PDV (the sum of the last row’s numbers) is $85,033. So if Caitlin could buy and renovate the place for anything less than that figure, the chances are that she would be on to a good thing. Moving beyond plant and equipment to the inventory portion of investment, it is expensive to hold inventories, whether of finished products " Examplflfl Present muted-Valuetalallallon Year I Year 2 Year 3 Year 4 Year 5 Total Net Income 0 18,000 18,000 24,000 60,000 (dollars) Divided by: (1.09) (1.09)2 (1.09)3 (1.09)4 (1.09)5 =1.l88 =l.295 =1.412 =l.539 Present 0 l 5,1 50 I 3,900 1 6,997 38,986 85,033 Discounted Values (dollars) ® CHAPTER 3 or of raw materials and intermediate products. Even if the company is using its own money, those funds could be used for other purposes. So whether it is an opportunity cost or a direct cost paid to a bank, the cost of having funds tied up in inventories is substantial and varies directly with the interest rate. Despite the fact that businesses sometimes unwill— ingly have to increase inventories, we expect greater caution about grow- ing inventories as interest rates rise. Finally, as mentioned in the discussion about household consumer expenditures, residential construction and purchases are especially sensitive to interest rate changes. All together, the relationship between the volume of investment expenditures and the interest rate (the price of money) looks something like the familiar downward—sloping demand curve of figure 3.1. But since it includes all the components of investment, it would be farther to the right and probably have a different shape. On the expected profit side of the investment decision, general eco— nomic growth also influences investment expenditures for plant and equipment as well as for inventories and residential housing. If economic growth proceeds to the point that it begins to put pressure on existing production capacities, it encourages managers to invest in new plant and equipment beyond depreciation and replacement needs. Moreover, higher levels of output and sales require higher levels of inventories, thus increasing the voluntary levels of investment in new inventories, and higher incomes enable house purchases. The response of investment expenditures to economic growth, graphically represented as an outward shift in the demand curve for loanable funds, is called, in the jargon of economics, the accelerator principle. The Public Sector One of the first things to keep in mind is that in budget preparation, including government budgets, expenditures can be planned and con- trolled with more precision than revenues, whose projections are more of r” :5 r}; L: E-?: THE ECONOMY AS A WHOLE Q an educated guess. A good part of budgetary struggles, therefore, takes the form of disagreements over estimates of projected revenues. The second thing to keep in mind is that economic theory, by and large, considers public sector policies and levels of expenditure to be determined by poli- tics, and thereby the province of another discipline in the academic divi- sion of labor. What “real” economists deal with are the cfiiscts of public policies and expenditures.7 There are three levels of government: local, state, and federal. As shown in table 3.1A, the federal government’s purchases of goods and ser- vices were a bit more than 6 percent of GDP in the late 1990s, while state and local governments’ purchases totaled over 11 percent of GDP. These directly GDP-generating purchases of goods and services, however, do not constitute the whole of government budgets. In addition to purchases of goods and services from private sector businesses, government budgets include transfer payments, such as pen- sions, grants, government subsidies to businesses, various forms of income support (Medicaid, Medicare, food stamps), and other payments not for a currently rendered productive activity (unless social peace and political campaign contributions are regarded as the quid pro quo). Finally, there are the wages and salaries paid to current public employees, and this is regarded as the main portion of the governments’ value added. Microeconomic rationales for government market intervention are couched in terms of market failure, which I discussed in the previous chapter. As noted there, market failure is a matter of markets failing to deliver efficiency, competitiveness, and so on—failures in terms of micro- economic theory’s own variables and emphases. Government policies in public health, defense, anti-trust legislation, environmental protections, and regulation of food, pharmaceutical, and financial operations fall into this category. I also have included the potential of an unregulated market system to generate serious unemployment and serious rounds of inflation as another dimension of market failure. Unlike the other kinds of market failure, ® CHAPTER 3 economic stabilization efforts generally do not usually directly regulate the relations between demand and supply of individual markets. Nevertheless, the economy’s producing at levels close to capacity and with stable prices is necessary for the smooth operation of markets (and assumed in micro— economics). Recession, inflation, and the role of government stabilization policy are the principal subjects of macroeconomics and of this and the next chapter. Another reason for positive government policy, also outside the purview of (and assumed by) microeconomic theory, is the kind of pub— lic good that promotes social cohesion. This includes government activi— ties that enable the economy and society to work in an orderly manner. A police and judicial system to enforce contracts, guarantee the security of private property and persons, maintain public order (e.g., stopping at stop signs), and punish transgressors are minimal levels of these functions. Since the New Deal years of the Great Depression, this category has expanded to encompass Social Security provisions, unemployment and accident insurance, welfare and income supports, Medicare, worker safety, and anti-discrimination legislation. Many of these governmental functions have always been contested by sectors of the society. Some of these activities have been formally diluted in the past two decades, and others have simply been less vigorously enforced. In addition, even for those functions on which there has been at least nominal agreement, more are being performed by private enter— prises (privatized) under contract from local, state, and federal govern— ments. Schools, prisons, hospitals, product testing, solid waste disposal, and the monitoring of eligibility for Welfare payments are some exam— ples, and there is continuing political pressure to turn more of health, education, and social insurance over to the private sector. The downturn of the stock market during 2001, however, has dampened some of the efforts to privatize the Social Security system. Some economists have hoped that the proper domain for government regulation could be neatly and cleanly derived from theoretical founda— I' 3. r. ,. THE ECONOMY AS A WHOLE ® tions, such as public goods and externality principles. But there is no clean and simple boundary between the rights of private production and the larger public good. Such issues as smoking in public places, gun control, environmental preservation, product liability, contagious disease control, airline safety, and even speed limits arouse highly charged political debates around private freedoms versus public regulation that are peri— odically conducted anew. Financing Public Expenditures-Taxation Although all three levels of government derive some revenue from fees for services (driver and auto— mobile licenses, and state and national parks, for example), the majority of government revenues comes from taxes and from borrowing (deficit financing). Table 3.4 outlines the magnitudes of various taxes in the United States. By looking along the row of table 3.4 that shows federal government tax receipts as proportions of GDP, we get a peek at some recent eco— nomic history. The last year of the Eisenhower administration, 1960, was a year of mild recession, which helped John F. Kennedy to be elected to the presidency. The Vietnam War and some war taxes helped boost the 1970 proportion, and the 1980 figures show the great rise in federal gov— ernment revenues in dollar terms with no change in the percentage of GDP, reflecting the inflation of the 1970s. The 1990 decline of federal receipts as a proportion of GDP indicates the 1986 tax reduction of the Reagan administration, a reduction that led to years of massive federal budget deficits. This has recently been reversed, and the sustained growth of the 1990s has generated significant increases in tax revenues. In addi— tion to temporary increases in Social Security tax payments, so much of this income growth was received by people in the upper tax brackets that income tax receipts rose much faster than expected. This created a bud- getary surplus, but President Bush’s massive income tax reductions, a slowing economy, and the responses to the terrorist attacks on the World Trade Center and the Pentagon quickly wiped out the surplus. ® CHAPTER 3 TABLE 3 4 j State, aifi Local-Government 'lh'x Realp'ts'lbllllons of . ' currentdollirs) - 1970 1980 1990 2000 Federal Government Individual income taxes 40.7 90.4 244.1 466.9 1,007.7 Corporation profits taxes 21.5 32.8 64.6 93.5 244.0 Social insurance and retirement 14.7 44.4 157.8 380.0 695.6 Other tax and nontax receipts 15.6 25.2 50.6 91.5 1 18.4 m1 Receipts 92.5 192.8 517.1 1 ,032.0 2,065.7 Percentage of current GDP 17.5 18.5 18.5 17.8 20.6 state and Local Governments Property taxes 16.4 34.1 68.5 155.6 248.5 Sales taxes 1 1 .8 30.3 79.9 177.9 331.7 Individual income taxes - 2.5 10.8 42.1 105.6 216.3 Corporate profits taxes 1.2 3.7 13.3 23.6 40.2 Grants from federal government 7.0 21.9 83.0 136.8 244.6 Other ltax and nontax receipts 1 1.6 30.0 95.5 250.0 148.8 Total Receipts 50.5 130.8 382.3 849.5 1,230.1 Percentages of GDP 9.5 12.6 13.7 14.7 12.3 Sources: Economic Report of the President, 2000, pp. 306, 399, 405; Survey of Current Business (April 2001 ), p. D-9. Now let’s look at the nature of different kinds of taxes. A tax is defined as progressive if its average rate rises with the income of the taxpayer (i.e., marginal tax rates on additional income are higher than the average tax rate on all income). A progressive‘tax does not only mean that more prosperous taxpayers pay more of that tax than do their less prosperous contempo- raries. They do, but in order for a tax to be progressive, more prosperous tax payers have to pay bzghcrpropontiom of their incomes in that tax than do the less well-to-do. The federal income tax is somewhat progressive, although not as much as it had been before the 1986 and 2001 tax reforms. THE ECONOMY AS A WHOLE ® YOU THINK THAT YOU PAY HIGH TAXES! The World Bank, using definitions different from table 3.4, calculates that .i . _--'U.S?_residents paid less than 20 percent of GNP (gross national product) in 199750: a sense of perspective, it is worthwhile to look at those __ -_for_:_s'ome nations with per capita incomes close to or greater _' I the unitedéstates..-rftjigng[e high-income anomalies such a's " en5:for.'li1e.'-very- nah-urge; __ small societies floating ' " i I. i ' '_Bélgiurr;,_t11e Netherlands, at raésjgwere raged? one-third of the ng'qp'm; arid around 25 nc'o'rne fin-all countries teasing-e: ’ A regressive tax is the opposite: the poor pay higher proportions of their incomes for a regressive tax than do those with higher incomes. Sales taxes on clothes and food at the grocery store are good examples. State lotteries, which are surrogate taxes, have also been found to have a regressive impact. As I mentioned in chapter 2, figuring out who actually bears the bur— den of a particular tax—its incidence—is difficult. Often the nominal taxpayer who writes the check to the taxing authority can effectively shift the acmaLburden on to someone else. It is especially difficult to determine the incidence of property taxes, which account for almost 80 percent of local government tax revenues. How much of the tax is passed on to renters in higher rent? If property taxes rise, do the current property owners bear the entire burden of the increase because any future buyer will discount the value of the property by the amount of the higher tax? One argument used to defend a corporate profit tax is that it is difficult for the firm to shift this tax to consumers. That argument has obviously not carried the day, since corporate profit taxes have been steadily declin— ing as a proportion of all taxes. ® CHAPTER 3 ""1-"r’ .'.':'L '. '-_'I. .31“; "Other folks have to pay taxes, too, Mr. Herndon, so would you please spare us the dramatics!” © The New Yorker Collection 1972 George Booth from cartoonbank.com. All Rights Reserved. Another issue is whether taxes should be more oriented toward user fees, like the sewage and water bills in towns and cities. That is, why should poor people from the East Coast pay taxes to support a national park in Montana that they will never visit? Should those who send their children to private schools pay for public schools? Needless to say, the pol— itics of taxation are highly fraught, and patterns of taxation are a first- order indication of who has how much political influence. A final observation about taxation is the idea of tax expenditure, a somewhat oxymoronic—sounding term. A tax expenditure is ‘a tax credit or deduction to encourage some particular spending or saving activity. Tax breaks that reward those involved with individual retirement accounts, health insurance, college savings accounts, income from municipal bonds, and interest payments on home mortgages are examples of tax expendi— tures. The expenditure part of the term expresses the fact that each one of these tax breaks costs the federal government in forgone tax revenues and THE ECONOMY AS A WHOLE ® therefore are parallel to policies that require explicit public expenditures. For example, the home mortgage interest deduction costs $100 billion a year in reduced revenues, and that cost should be considered in the same light as the money that the government actually spends, say, on creating anrdable housing, even though it comes from the other side of the ledger. Nevertheless, legislators do not scrutinize tax expenditures with the same rigor as explicit expenditures, and they seldom challenge their effec- tiveness in stimulating the rewarded activities. Tax expenditures too eas- ily appear to be costless and painless. This illusion of bargain—basement benefits is one reason that tax expenditures seem to have become the prin- cipal tool of social policy. Instead of expanding federal housing programs, expand tax credits for home ownership. Instead of universal health insur- ance, award people tax deductions for purchasing health insurance. Instead of helping pay for college education, permit tax-free savings accounts for college costs. And so on down the list. Another factor contributing to the political popularity of tax expen- ditures is that while they sound comprehensive and equitable, they dis- proportionately benefit those with the highest incomes. This prosperous stratum spends more money, saves more money, and pays more taxes. It is inevitable, therefore, that tax expenditures do much more for them than for anyone else.8 Financing Public Expenditures—Deficit Finance The second principal source of revenue, especially for the federal government, is borrowing. The U.S. Treasury can borrow from the private sector or it can borrow from the Federal Reserve System (the Fed). Borrowing from the Fed effectively creates new money. Both kinds of borrowing accumulate and increase the national debt, but they have different implications, which I describe later in this chapter. Much of the agitation about the federal government deficit subsided with the economic expansion of the 19903 that produced such tax rev- enues that the federal government budget went into surplus. When that ® CHAPTER 3 debate was going on, however, proponents of such an amendment fre— quently sounded the theme that the federal government should adhere to the financial discipline of households and business enterprises that have to limit expenditures to income or net receipts. This analogy is fatally flawed. As table 3.5 shows, both household and nonfinancial corporate expenditures are not limited to current income; in fact, both carry more debt than the federal government. But the major problem with the formulation is that it does not distinguish between cap— ital expenditures and consumption (or current) expenditures. Although both households and businesses soon get into difficult straits if current expenditures are greater than current income for an extended period of time (and both often do), households and businesses both depend on bor— rowing (that is, spending more than their income). Households engage in deficit financing (borrowing) in order to invest in a future stream of important consumer services (for example, automobile transportation and housing). Businesses routinely have to borrow in order to expand or . .. ;.'Malor€ompon.enu-oroemn imam (billions. of dollars) Publlc Debt Private Debt the United States at Your End.- Non- Shte Home Consumer financial Financial Federal aloul Mortgages‘ Debt Corporations Sectors 1970 299.5 1 50.3 274.3 133.7 367.4 1 27.8 1980 735.0 744.4 904.6 355.4 91 1.6 578.1 1990 2,498.1 992.3 2,461 .3 805.1 2,522.5 2,61 5.8 2000 3,385.2 1 ,279.3 5,021 .9 1 ,568.8 4,740.8 8,430.8 Source: Board of Govemors of the Federal Reserve System, Flow of Funds Accounts of the United States: Flows and Oustandings, Fourth Quarter 2000, p. 8. *111ese figures do not include commercial and agricultural property. The combined value of those mortgages was about one-third or one-quarter the value of home mortgages. THE ECONOMY AS A WHOLE ® even maintain productive capacity (plant and equipment) to take advan— tage of long—term profit prospects. The corresponding types of public investment are constructing schools, roads, bridges, airports, and health clinics as well as ensuring clear air and clean water. All of these hold promise of promoting future economic growth, and therefore future tax revenues, as well as reducing the cost of some public services, such as health services and perhaps police and prisons. A considerable amount of the murkiness that surrounds discussions about the federal government’s expenditures and their significance would dissipate if there were greater'respect for the distinction between current versus capital expenditures. There would, of course, be continuing dis— agreements over whether a particular item should be in the capital or cur— rent category, but at least the conversation would have a greater likelihood of being meaningful. Economists’ Criticisms of Public Expenditure Economists have several ways to cast suspicion on the efficacy of the public sector’s role in the econ— omy. This reflects a general tenet of classical liberalism: the market is a realm of freedom and efficiency, and government is a realm of coercion and inefficiency. One of the most frequently heard criticisms is at the micro— economic level: the public sector is more or less sheltered from the “disci- pline of the market,” decisions are not profit motivated, and employment in the public sector does not contain sufficient numbers of carrots and sticks to be efficient. This includes the organization of public agencies, the moti— vations of individual employees, and insulation from strict accountabil— ity.9 The evidence for these claims is, to be charitable, mixed, but this has very little to do with the frequency and intensity of the assertions. Another oft—heard criticism at the microeconomic level is that the public sector competes unfairly with private businesses in providing goods and services in certain markets. Unlike the public sector, private firms have to pay taxes and full market prices for their resources, and they bear the risk of personal investments. ® CHAPTER 3 On the other hand, it is politically acceptable for the federal govern- ment to spend large amounts of money on armaments. Such expenditures do not compete with private interests at either the national or local level but definitely benefit a number of domestic corporations, employees, and regional economies. As recently as the late 1980s, the military portion of the federal government’s purchases of goods and services was three and half times the nonmilitary portion. Even though the end of the Cold War certainly has led to reduced proportions of expenditures for “defense,” the increased spending for the National Missile Defense Shield and the war on terrorism may help to restore those former ratios. The increasing privatization of public services, including education, health, and incarceration, has been a response to these criticisms. In this sec- tion, however, I am going to discuss two less obvious but important criticisms of public sector economic activity: crowding out and public choice theory. Crowding Out Much of the controversy about federal revenues and expenditures revolves around how much the federal government’s activities crowd out private economic activity, and here, I do not mean only the previously mentioned public production that competes with pri— vate enterprise. In order to look more closely at this phenomenon, let’s posit a situation in which all economic resources are fully employed and, therefore, the economy is not able to expand output. By definition any increase in the public sector’s command over goods and services has to crowd out private expenditure by an equal amount—a 100 percent crowding out. In order to understand the mechanisms by which this occurs, we need to look back at how the federal government is financed. The most straightforward crowding out mechanism is for the gov- ernment to raise taxes by an amount equal to the increased expenditure. This is simply a matter of taking purchasing power away from the pri— vate sector and using it in the public sector. When raising taxes is not feasible or desirable, the federal govern- ment can engage in deficit financing. If the government borrows by sell- ing its bonds to private purchasers, it competes with private borrowers for THE ECONOMY AS A WHOLE @ investable funds, and when the government bids those funds away from private borrowers, thus raising interest rates, this becomes the crowding out effect. On the other hand, if the deficit is financed by the sale of government bonds to the Fed, the Fed credits the amount of the bonds to the Treasury’s account, and when the Treasury spends that money, it increases the total amount of money in the economy. In this situation, the crowding gut effect comes through the public sector bidding goods and services away from prospective private buyers, thus raising prices in product markets. It is important to remember that the clarity of the operation of these' three dimensions of crowding out—taxation, financial markets, and product markets—is due entirely to the original assumption: that all eco— nomic resources were fully employed and the economy was incapable of expanding output. When there is a recession and substantial unemploy- ment, augmented government expenditures probably increase produc- tion and income and crowding out is substantially lower. In addition, a good amount of the inflow of foreign funds (especially from Japan a few years ago) went into U.S. government bonds and helped alleviate public sector debt from crowding out domestic private investment. Public Choice Theory One of the more interesting criticisms of the public sector’s economic activities comes from public choice theory. One of the key ideas here is that many government policies and expenditures benefit very specific interest groups, but that the costs of these group-spe- cific policies and expenditures are diffused among the entire tax-paying population. Therefore, when particular special interest groups mobilize campaigns to achieve the desired policy or expenditure, there is very little resistance to them. The cost for an individual is almost negligible, and indifference reigns. It is argued, then, that the politics of concentrated ben- efits and widespread, low per-person costs systematically produce a series of public policies and expenditures not justified by general public benefits. Building on this background, the next chapter continues the macro- economics discussion by focusing on the tools of fiscal and monetary pol- icy used to stabilize the economy and stimulate economic growth. ® CHAPTER 3 Notes 1. Keynes’s theoretical formulations also created the categories for the National Income and Product Accounts through which national levels of eco— nomic activity are measured. 2. Instead of measuring all (gross) final production, a better indication of the significance of that year’s production would be to subtract (net) from that total the reduced productive capacity from the wear and tear on productive resources resulting from that year’s production. Look at table 3.1B for GNP minus depre— ciation—the Net National Product (N NP). The difficulty of measuring real depreciation, however, and its sensitivity to changes in tax codes make it such an unreliable number that GDP is generally preferred. 3. The idea of a shirt as an investment good sounds a bit odd, but in a given year, it could be added to a producer’s or retailer’s inventory, which is a compo— nent of investment. 4. There is a certain counter-intuitive quality to the highly manufactured Big Mac being counted as a service. Restaurants technically combine both goods and service production but are generally counted as services. 5. Discretionary income is substantially less than disposable income; it is the income after subtracting necessary expenditures such as food, clothing, shelter, and transportation. 6. Occasionally I speak of “the interest rate,” which stands for an array of inter— est rates that vary primarily by the length of time and amount of risk of the loans. 7. The principal caveat to this generalization is the theory of public choice, for which its major proponent, Iames Buchanan, received a Nobel Prize in eco— nomics. I describe aspects of this theory later in this chapter. 8. Tax accountants and lawyers also benefit from tax expenditures and the resulting increased complexity of the tax codes. 9. The “rational choice” branch of political science employs microeconomic assumptions of individual maximizing motivations to analyze public policy and its implementation. This rapidly growing field in political science is another example of the extent to which the economics paradigm is penetrating other social sciences. Fiscal Policy, Monetary Policy, Recession, and Inflation his chapter describes the principal means by which the federal government deliberately affects the level of economic activity in order to reduce adverse fluctuations. As I have already mentioned, the federal government does this through managing the level of aggregate demand. Fiscal policy is the government’s intentional use of its budget, including both the revenue and expenditure sides, to affect the levels of aggregate demand and therefore of general economic activity. The sec— ond principal tool of demand management is monetary policy, which I describe after fiscal policy. Fiscal Policy: Taxing and Spending It does not take years of intense study to figure out that without an unlikely 100 percent crowding out, if the federal government increased A ...
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Reading - The Economy as a Whole Definitions and Analyses...

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