Comparative Political Economy

1. Comparative Political Economy Western Industrialized Democracies

2. I. The Classical View of Macroeconomics • Long-run growth determined by population (labor supply), technology, and wealth (supply of capital) • Market self-corrects for deviations from long-run growth rate (no politics, hence no political economy) • Key Assumptions: Flexible Wages, Flexible Prices • Implications: • No one loses a job when demand is low (wages fall, or they get another job with lower wages) • No unsold inventories (suppliers simply lower prices as needed)

3. 24 Unemployment 20 16 12 8 ANNUAL RATE OF INFLATION OR UNEMPLOYMENT (percent) 4 0 – 4 Prices – 8 1900 1910 1920 1930 1940 E. Problem: Ever-larger economic shocks

4. II. Keynesian Macroeconomics: A Simplified Explanation Keynes: “In the long run we are all dead.”  Focus on managing short-run fluctuations • Key Variables • Dependent variables: • Output: Real Gross Domestic Product (GDP) • Inflation: Rate of increase in prices • Unemployment: People looking for work but unable to find it

5. 2. Independent Variables • Consumption Function (70% of US GDP) • Primarily determined by disposable income: Income – Net Taxes • Net Taxes = Taxes - Transfers

6. Consumption and Disposable Income Consumption function C = c0+ C1YD Consumption, c Slope = c1 Disposable Income,YD

7. b. Investment (10% of US GDP)

8. c. Government spending (20% of US GDP after transfers)

9. B. Economic growth in the short run: Supply and Demand • Aggregate Demand • Definition: How much stuff everyone in society buys at a given price level • Demand = Consumption + Investment + Government Spending + Exports – Imports

10. PRICE LEVEL (average price) REAL OUTPUT (quantity per year) Aggregate demand curve Higher prices Lower prices Aggregate demand Less output demanded More output demanded

11. 2. Aggregate Supply • Definition: How much stuff firms choose to produce and sell at each price level • Supply curve determined by income (ability to produce at a given price level)

12. PRICE LEVEL (average price) REAL OUTPUT (quantity per year) Aggregate Supply Curve Higher prices Aggregate supply More output supplied

13. 3. Equilibrium: Where supply meets demand • Best single predictor of economic output.

14. AS AD4 AD3 AD2 b. Equilibrium effects of increases in aggregate demand on output Price level AD1 O Y2 Y3 Y1 Y4 YP fig National output

15. c. What shifts aggregate demand? • Remember the equation: Demand = Consumption + Investment + Government Spending + Exports – Imports • So changes in any one of these independent variables can shift aggregate demand at a given price level (policy levers  political economy)

16. 4. Disequilibrium • Definition: Actual price level is higher or lower than equilibrium point • Equilibrium may be unstable: Example of Great Depression

17. E PRICE LEVEL (average price) REAL OUTPUT (quantity per year) Macro Disequilibrium: Oversupply and Low Demand Aggregate supply P1 PE Aggregate demand QE S1

18. PRICE LEVEL (average price) REAL OUTPUT (quantity per year) c. Equilibrium may be Undesired: Excessive Unemployment Aggregate demand Aggregate supply E PE F P* Equilibrium output Full employment QE QF

19. C. Keynesian Policy Recommendations • Focus on “demand side” by manipulating independent variables such as government spending and taxes • If people demand a product, producers will supply it  get money into people’s hands and production will rise • Spending increases more effective than tax cuts: All of spending is consumption but some of tax cuts will be saved by taxpayers instead of being used for consumption

20. D. The Success of Keynesian Policies: Countercyclical Management

21. III. Alternatives to Keynesian Macroeconomics • Problem: Emergence of stagflation in 1970s • Cause: External force shifted supply curve (firms less willing to supply at a given price) • Leading suspect: Oil price shocks increased costs of production so much that even large increases in price didn’t stimulate more production (simultaneous inflation and unemployment  recession) • Effect – Negated the “Philips Curve”

22. Unemployment and inflation: The Philips Curve (US, 1960s)

23. BUT: High inflation can create expectations of future inflation

24. 3. Why not increase government spending? • Increased spending increased inflation even further (usually not a problem, since inflation is low during recessions) • Very large deficits limited governments’ ability to spend (in US: Vietnam expenses and increased social spending)

25. B. Demand-side alternative: Monetarism • Interest rates and money supply affect people’s willingness to buy at a given price • Shift demand curve by manipulating interest rates or money supply (Interest rates actually easier to manipulate! “We don’t know what money is anymore.”) • Increase interest rates (reduce money supply) to cut inflation at expense of increasing unemployment (induce a recession to prevent stagflation). Key is to alter expectations of future inflation. • Cut interest rates to lower unemployment at expense of increasing inflation (economic stimulus)

26. 5. Example: The US Monetary System • The Federal Reserve Board: Created in 1913 to act as a central bank (mixes public appointees with private banks)

27. b. Functions of the Federal Reserve • Conduct Monetary Policy • Formal mandate: Low inflation and Low Unemployment • Actual policy emphasizes low inflation over full employment or economic growth • Serve as a lender of last resort to commercial banks within the District • Issue Currency – “In God we Trust” • Provide Banking Services to the U.S. Government • Supervise and regulate financial institutions

29. c. The FRB Toolkit • Buying/selling government securities • Stimulation: Fed purchases U.S. Government Securities in the bond market (U.S. Treasury Notes) – Raises bond prices; reduces interest rates • Cash flows from the Fed to sellers of bonds; sellers deposit cash in their banks, thereby increasing the nation’s deposits and the excess reserves of the banking industry • Restraint: Fed sells U.S. Government Securities in the bond market (U.S. Treasury Notes) – Lowers bond prices; increases interest rates • Cash flows from the banks to buyers of bonds and ultimately to the Fed, thereby reducing the deposit accounts and restricting the ability of commercial banks to loan money

30. ii. Alter the Fed Funds or Discount Rates • Fed Funds Rate: the interest rate commercial banks must charge one another to lend or borrow on an overnight basis for reserve management purposes • Discount Rate: the interest rate commercial banks must pay the Fed to borrow directly from the Fed for reserve management purposes

31. iii. The reserve rate: The Fed’s ultimate weapon • Amount of cash banks have to keep on hand to cover withdrawals • Use of this tool would be perceived as a reaction to extraordinary events • Fed will be very cautious and publicize its intentions well in advance • Last time required reserves changed – 1980 – resulted in a credit crunch that plunged the economy into the worst recession since the Great Depression

32. 6. The role of Banks in Monetary Policy a. Banks Create Money: Banks can be viewed as counterfeit operations authorized by the government, and are an essential tool in affecting monetary policy • Banks lend money that they don’t have -- so they are essentially minting their own currency! • Reserve requirements set by the government determine the extent to which banks can counterfeit

33. b. Banks depend on confidence • Customers could bankrupt a bank simply by asking for all of their reserves back, which they can do at any time. • Customers don’t ask for their money back when “counterfeiting” is profitable and they earn a part of the returns (interest) • Customers will tolerate the behavior only as long as they believe that the bank is reputable in this activity

34. c. Money creation through fractional reserves • The money creation process: Making one loan creates the opportunity to make another loan, a process which continues in perpetuity. • Step 1: Bank issues a promissory note for which there is no “direct” reserve. (ie. the bank makes a loan and gives the borrower a receipt against that banks reserves) • Step 2: This receipt (loan) is traded for a good or service (promissory note is passed on to a new holder) • Step 3: The promissory note is deposited back into a bank by the new holder, creating a new deposit (bank liability). • Step 4: The promissory note is available once again to be loaned.

35. A bank receives $100 Million in deposits, keeps $20 million in reserve. • But the $80M in loans returns to the banking system somewhere else -- the second generation bank Money Creation Example The third generation bank receives $64 million of new loan deposits, allowing another $51.2 million in loans

37. 7. Is Monetary Policy Effective? • Easy to curb inflation (excess money) -- at cost of lower growth / recession and increased unemployment • Harder to stimulate growth • Example: Fed can lower interest rates, increase the banks’ deposits BUT • It cannot force a broke person (business) to borrow • Good risks in prosperous times become poor risks in recessionary times • Central banks’ ability to stimulate often compared to problem of trying to push a string – no matter how much effort you give it, it just doesn’t move much

38. C. Supply-side economics • Adverse shift in supply curve means BOTH higher prices (inflation) AND lower output (recession and unemployment) • Demand-side shifts cannot simultaneously boost production and lower inflation • Solution: Shift supply curve by altering ability and willingness of firms to produce at a given price point • Policy levers: Corporate tax cuts, deregulation, increased labor supply (immigration), lower tariffs on raw materials, education and training (increases in per-worker productivity) etc.

39. D. Comparison: Keynes, Monetarists, and Supply-Siders

40. 1. Responding to Recession

41. 2. Responding to Inflation

42. E. Conclusions • Economics has become political: Few classical economists around anymore, and they don’t get to stay in office! • Political choices (fiscal policy, monetary policy, trade policy, immigration policy, etc) affect economic outcomes • Political Business Cycle: Desire to stimulate economy before election at expense of slowdown/recession after election

44. Jobs Internal market forces Prices External shocks Growth Output Policy levers International balances 4. Summary: The Macro Political Economy DETERMINANTS OUTCOMES MACRO ECONOMY

45. V. Characteristics of Monetary Policy • The Choices • Central Bank dependence vs independence

46. The Time Inconsistency Problem • Policymakers have incentives to promise low inflation (economic stability, prevent more inflation) • Policymakers have incentives to renege on promises of low inflation to increase growth/employment (political business cycle) • Problem: Private actors know these incentives and therefore anticipate high inflation by raising wages and prices, so short-term stimulus fails to do anything except further increase inflation • Solution: Central bank independence makes low-inflation promises credible, prevents political manipulation

49. I. Characteristics of Monetary Policy • The Choices • Central Bank dependence vs independence • Exchange rate regimes: fixed vs. floating

50. Exchange Rates: Fixed vs. Floating • Floating: Government has more autonomy because has no duty to pay specific amount for own currency (not backed with gold or other reserves) • Fixed: Government promises to exchange specific amount of gold/reserves for currency. Government cannot release too much money or speculators may try to cash in and “break the bank”