Economic Theories

1. Economic Theories Unit 5 Lesson 5 Activity 48 Master Curriculum Guide in Economics: Teaching Strategies for High School Economic Classes (New York; National Council on Economic Education, 1995) Advanced Placement Economics Teacher Resource Manual. National Council on Economic Education, New York, N.Y

2. Objectives • Explain the different types of lags in making policy and that there are different estimates about the length of these lags. • Describe the idea of crowding-out and that the extent of crowding-out can change depending on the responses of interest rates, consumption spending and business investment. • Explain the reasons why prices and wages do not adjust instantaneously. • Provide examples of conflicts among attaining economic goals.

3. Introduction • Listening to and reading analysis of the various policy proposals can be confusing. • Most economists hold views that cannot be categorized into a particular school of thought but are a combination of different schools. • Activity 48 pulls many policy concepts together and serves to review and summarize stabilization policy.

4. Review: Inside and Outside Lags • The inside lag consists of the time it takes for data to be collected, policy makers to recognize that policy action is necessary, the decision about which policy should be taken and the implementation of the policy. • The outside lag is the time it takes the economy to respond to the new policy.

5. Other Lags! • Recognition lag: The time it takes for policy makers to see that three is a problem with the economy. In general, the recognition lag is three to six months. • Decision or response lag: the time it takes policy makers to decide and implement the policy response to the current economic problem. • This lag differs between monetary between monetary and fiscal policy. • The monetary policy decision lag is usually very short (one quarter), while the fiscal policy decision lag can be several quarters to more than a year. • These combined lags make up the inside lag.

6. Transmission or impact lag (the outside lag): the time it takes the change in policy to have an effect on the economy. • The transmission lag for monetary policy is long and variable because the change in the money supply affects interest rates, which in turn affect interest-rate sensitive components of AD. • The transmission lag for fiscal policy in general is very short because fiscal policy is discussed in the media throughout the implementation process. • People are ready to adjust as soon as the policy is enacted or may even act on the probability of enactment.

7. Why prices and wages do not adjust quickly: • Menu costs: it costs firms money to change their prices – for example, to issue new catalogs or change price tags. • Labor contracts: multiyear contracts prohibit rapid changes in wages and may mandate cost-of-living-adjustments (increases to match inflation). • Firms operating in imperfectly competitive markets worry about changing prices and getting into price wars with their competitors. Thus, firms may be slow to adjust price to changes in costs or demand.

8. From the Short Run to the Long Run Initially the economy is at Y*, potential GDP and P. Aggregate demand increases from AD to AD1 and the economy moves to Y1 and P1. The final equilibrium is Y* and P2. • If the economy is already at full employment but policy makers think the unemployment rate is too high they carry out expansionary monetary policy, inflation will result. • This demonstrates the conflict between the full-employment goal and the price stability goal.

9. Why Economists Disagree • Part A: Understanding the Reasons Why Economists Disagree • It is not unusual to find “experts” disagreeing with each other. Experts disagree about all sorts of matters: unclear power, environmental protection and who will win the Super Bowl. • Why do experts disagree? • How can the average person make sense out of the differing viewpoints and recommendations?

10. Here are several important factors that often lead economists to different conclusion. • Different Time Periods • One economist might state that the current policy of the government will lead to inflation. Another might disagree. Both could be right if they are taking about the effects of the policy on inflation at different times—for example, six months from now compared with two years from now.

11. Different Assumptions • Because an economy is a complex system, it is often hard to predict the effects of a particular policy or event. • Therefore, to be able to make predictions, economists usually must make certain assumptions. But economists often differ in their assumptions. • For example, one economist might assume that the federal budget deficit will become larger next year. Another might not. • These different assumption could be the result of their assumptions about economic growth, tax revenue and government spending.

12. Different Economic Theories • Economists agree on many matters such as, “If the price of beef goes up and nothing the changes, people will buy less beef.” • This is a prediction with which nearly all economists would agree because rests on the generally accepted law of demand. However, economists have yet to settle a number of important questions, especially those concerning macroeconomics. • Macroeconomics deals with the behavior of the economy as a whole or large subdivisions of it, and how to influences macroeconomic behavior. • Economists have several different theories or explanations about what influences macroeconomic behavior. • Until theories are reconciled or until one of them is widely agreed on as best, economists will disagree on macroeconomic questions because the economists are using different theories. The same applies to certain microeconomic questions.

13. Different Values • Economics is concerned with explaining what is happening in the economy. • It is also concerned with predictions. • The economist should be able to say to the president or to Congress, “If you follow Policy One, then X, Y and Z will happen. If you follow Policy Two, then Q, R and S will happen. Pick the policy that gives the results you like better.” • In practice, such statements by economists often contain more than just analysis and a prediction about results. • Their statements often recommend policies they like because the results agree with their own values—in other words, the results they prefer. • For example, some economists will recommend Policy One because X, Y and Z will happen and they favor achieving X, Y and Z. Other economists will recommend Policy Two because they favor achieving results Q, R and S. Such disagreements are basically about which outcomes the economists prefer. The economic policies they recommend are determined by their preferred outcome.

14. Part B: Listening in on a Discussion of Economists • In your groups, read the four distinguished professors of economics discussions on current economic policy held at a luncheon press conference attended by leading reporters of the business news. • Then complete Part C: Analyzing Disagreements Among Economists

15. Analyzing Disagreements Among Economists Tax cut will stimulate economy • Professor T.X. Cut Major point: Time period: Assumptions: Theoretical support: Values: Present and near future (short run) The administration’s budget proposals are not inflationary because tax cuts balanced big spending cuts. Unemployment needs to decrease during a recession. Tax cuts stimulate business investment, as well as spending by all of the private sector and may encourage greater work effort. Economic freedom and distrust of big government

16. Higher interest rates will cause recovery to fail. Next year (medium term) • Professor U. R. Nutts Major point: Time period: Assumptions: Theoretical support: Values: Increases in government spending drive up interest rates, which in turn decreases private investment and interest rate sensitive components of consumption. Government borrowing is so large that it causes interest rates to rise and crowds-out consumers and business borrowing Tax cuts must be fair; and fairness means taxing the wealthier more than the poorer. Government must maintain economic security for Americans with low incomes.

17. Relatively free expansion of money will bring down interest rates and sustain recovery • Professor E. Z. Money Major point: Time period: Assumptions: Theoretical support: Values: Near future (short run) Relatively free expansion of money supply by Fed will sustain the recovery. Fed will support expansionary fiscal policy Lower interest rates increase consumer spending and business investment. The primary effect of lower interest rates is on investment. Growth is more important than inflation. A growing economy is desirable.

18. There will be another recession. Fed will continue past policies – policies that have brought about periods of inflation and recession • Professor Fred Critic Major point: Time period: Assumptions: Theoretical support: Values: One to two years from now (long run) Discretionary monetary policy is destabilizing because of the lags in policy and the precise impact of changes in money supply on the economy. Not enough money growth causes recession; too much money growth causes inflation. Steady economic growth without inflation or recession is desirable.