Tools, Rules, and Policy

1. Tools, Rules, and Policy Chapter 18

2. Laugher Curve Top Five Reasons to Study Economics

3. Laugher Curve Top Five Reasons to Study Economics

4. Laugher Curve Top Five Reasons to Study Economics

5. Models The book introduced both micro and macro models. Micro models begin by analyzing individual markets and build up to an analysis of the entire economy. Macro models begin with the entire economy and build down to an analysis of individual markets.

6. Models Macro avoids the fallacy of composition by focusing on empirical regularities.

7. Models Neither micro nor macro models are the better way to analyze the economy.

8. Micro Models The two primary micro models are the production possibilities model and the supply/demand model.

9. The Production Possibility Model This model shows the possible production of two goods given the technology and institutional structure of the economy.

10. The Production Possibility Model It is bowed out because of increasing marginal opportunity cost and comparative advantage.

11. The Production Possibility Model The curve is relevant to both micro and macro since it captures the trade-off view that is central to economists� policy perspectives (Chapter Objective 1b).

12. The Production Possibility Model When the economy is at its potential output it is operating on its production possibility curve.

13. The Production Possibility Model

14. The Supply/Demand Model This is the primary micro model and also serves as a fundamental building block of macro reasoning.

15. The Supply/Demand Model The model consists of the supply curve and the demand curve placed on a graph.

16. The Supply/Demand Model The supply curve slopes upward while the demand curve slopes downward.

17. The Supply/Demand Model Either curve can more to the right to left. This is caused by a shift factor.

18. The Supply/Demand Model The model plays a central role in macro in discussions of exchange rates.

19. The Supply/Demand Model The common exchange-rate regime is a partially flexible exchange rate system in which government sometimes buy and sells its currency, and sometimes does not.

20. The Supply/Demand Model

21. Macro Models It is dangerous to apply the supply/demand model to macro concerns because of the fallacy of composition.

22. Macro Models

23. Macro Models

24. Macro Models

25. The Long-Run Growth Model

26. Macro Models

27. The Classical Growth Model

28. The Classical Growth Model

29. New Growth Theory

30. New Growth Theory

31. The Quantity Theory Model

32. The Quantity Theory Model

33. The Institutional Theory of Inflation Some economists do not agree with the conclusions of the quantity theory model. They hold an institutional theory of inflation.

34. The Institutional Theory of Inflation According to the institutional theory, inflation is caused by institutional forces.

35. The Institutional Theory of Inflation They argue that increases in prices cause increases in money supply, or MV ? PQ.

36. Short-Run Macro Models There are two important short-term macro models: the aggregate supply/aggregate demand (AS/AD) model and the multiplier model.

37. The AS/AD Model The AS/AD model is a model of the aggregate economy with the price level on the vertical axis and total output (real GDP) on the horizontal axis. It is a model of how income changes.

38. The AS/AD Model The supply/demand model differs from the AS/AD model in what is held constant.

39. The AS/AD Model The shapes of the supply/demand curves is determined by opportunity cost and the possibility of substitution.

40. The AS/AD Model The shape of the AS curve is determined by the price-setting behavior of firms.

41. The AS/AD Model The supply/demand curves shift by the amount of the shift factor while the AD curve shifts by a multiple of the amount of the shift factor.

42. The AS/AD Model The AS/AD model may be used in a variety of ways.

43. The AS/AD Model The AS/AD model may be used to predict what would happen to the price level and real GDP if aggregate demand changes due to an expansionary fiscal policy.

44. The AS/AD Model The AS/AD model may be used to predict how much the AS curve will rise depending on where output is relative to the level of potential output.

45. The Multiplier Model The multiplier model consists of two curves: the aggregate production (AP) curve and the aggregate expenditures (AE) curve.

46. The Multiplier Model The multiplier model looks only at the short-run because prices are held constant.

47. The Multiplier Model It shows the multiplier effect of expansionary demand policy and, using the multiplier equation, gives specific numeric answers to questions:

48. The Multiplier Model The multiplier model does not directly show what effect a rise in the price level will have on the economy.

49. The AS/AD and Multiplier Models

50. Using Models to Understand and Discuss Policy Tools suggest policies but do not lead to policies. In order to apply the tools intelligently, policymakers must use judgment about whether the real-life circumstances sufficiently fit the assumptions of the model.

51. Using Models to Understand and Discuss Policy Different models often suggest different policy advice, especially when decision-makers are considering long-run and short-run models.

52. Policies and Institutions Policies are implemented through real-world institutions so a study of real-world institutions becomes important to a study of macroeconomics.

53. Policies and Institutions The institutions most relevant to macro are financial institutions, fiscal institutions, and international institutions.

54. Financial Institutions It is through the financial system that the Fed controls the monetary policy of the U.S.

55. Financial Institutions The most important monetary policy tool is open-market operations.

56. Financial Institutions Other tools used by the Fed are changing the reserve requirement and changing the discount rate.

57. Financial Institutions The relation between a change in the Fed�s IOUs and the change in the money supply is determined by the money multiplier.

58. Financial Institutions The simple money multiplier, assuming no cash is held, is 1/r, where r is the reserve requirement.

59. Financial Institutions Currently the Fed focuses its policy decision on the Federal funds rate, the rate that one bank charges another for loans of reserves.

60. Fiscal Institutions Fiscal policy involves changing taxes or expenditures to affect the level of income in the economy. Lowering taxes or increasing expenditures shifts the AD curve to the right. Raising taxes or decreasing expenditures shifts the AD curve to the left.

61. Fiscal Institutions There are fierce political fights in the implementation of fiscal policy.

62. Fiscal Institutions The movement from a budget deficit to a budget surplus occurred because of:

63. International Institutions The U.S. economy is financially connected to the world through a system of international treaties and agreements.

64. International Institutions The U.S. is a member of the:

65. International Institutions The U.S. exchange-rate system is a partially flexible system.

66. Worldviews and Policy Long-run and short-run models have certain biases built into them by their assumptions.

67. Worldviews and Policy Long-run models tend to guide toward a laissez-faire policy.

68. Worldviews and Policy Short-run models have a bias in the opposite direction: they tend to direct toward an activist policy.

69. Worldviews and Policy These failures can be corrected by government.

70. Keynesian and Classical Policy Views Although most economists consider themselves to be eclectic -- that is, neither Keynesian nor Classical -- the distinction is still important.

71. Keynesian and Classical Policy Views Democrats are more likely to be Keynesian than Republicans.

72. The Classical View Classicals have a profound distrust of government and the political process. Real-world government is likely to do more harm than good.

73. The Keynesian View Keynesians want the government to play activist role in the economy. They believe government is not only able to recognize what is wrong but is able to correct it. Keynesians feel that the benefits of government outweigh the costs.

74. Monetary and Fiscal Policy The primary short-run tools of macro policy are monetary policy and fiscal policy.

75. Monetary and Fiscal Policy Monetary policy is the more important short-run stabilization tool.

76. Monetary and Fiscal Policy Monetary policy has problems but is more flexible and less influenced by politics.

77. Monetary and Fiscal Policy Automatic stabilizers such as unemployment compensation have a built-in automatic fiscal response to fluctuations in the economy.

78. The Tradeoff View of Macro Policy The primary goal of these macro policies is to maintain the economy with as high growth rates and as low unemployment rates as are consistent with low inflation.

79. The Tradeoff View of Macro Policy Government uses monetary and fiscal policy to keep these elements in check.

80. Agreement About Macro Policy Most economists agree with the following six statements regarding macro policy.

81. Agreement About Macro Policy Expansionary monetary and fiscal policies have short-run stimulative effects on income.

82. Agreement About Macro Policy In the long run, expansionary fiscal policy (running budget deficits) tends to slow the economy down because it means less saving.

83. Agreement About Macro Policy Expansionary monetary and fiscal policies have potential long-run inflation effects.

84. Agreement About Macro Policy Expansionary monetary and fiscal policies tend to increase trade deficits.

85. Policy Process and Credibility Expectations complicate models and policymaking enormously. Changes in expectations can shift the AD curve. Expectations of inflation can cause inflation.

86. Rational Expectations Some economists define rational expectations to mean those consistent with economic models, but that definition is a technical one.

87. Rational Expectations People generally act rationally in the sense that they are forward looking.

88. Rational Expectations For example, if the public is convinced that the Fed is deadly serious about its goal of cooling down the economy, the policy will work.

89. Uncertainty About the Effects of Policy The central role of expectations means that there is a great deal of uncertainty in the economy. There are a multiplicity of expectational strategies which can shift rapidly.

90. Uncertainty About the Effects of Policy This undermines the ability to develop deterministic models of the economy which gives the economy an unpredictability that precludes fine tuning.

91. Uncertainty About the Effects of Policy Depending on the beliefs that individuals have, monetary and fiscal policy will work in different ways.

92. Policy Regimes and Expectations A policy regime is a rule. It is a predetermined statement of the policy that will be followed in various circumstances.

93. Policy Regimes and Expectations A policy is a one-time reaction to a problem. It is chosen without a predetermined framework.

94. Policy Regimes and Expectations At various times, policy statements in the Economic Report of the President emphasize credibility as the primary effect modern theoretical work has had on macroeconomic policy.

95. Has the Economy Entered a New Era The 1990s have been a trying years for macroeconomics� trade-off view. Low inflation, low unemployment, and decent growth were not predicted by economists.

96. Economists� View of the New Era Low inflation was caused by the Fed following economists� policy recommendations and achieving low inflation regardless of what the unemployment consequences might be.

97. Economists� View of the New Era We are currently in the short run, and that the long run will be coming but has been slightly delayed.

98. Economists� View of the New Era Most economists hope that the new economy has arrived, but they are concerned that policymakers will come to believe that the economy will always be good, and will forget the tradeoffs.

99. Explanations of the New Era Economists are lousy predictors, but excellent explainers of after-the-facts events.

100. Explanations of the New Era Economists now focus on new growth theory which emphasizes technology as it affects productivity.

101. Explanations of the New Era They also invoke international competition which keeps U.S. wages low with the implied threat that if they get too high, the work will be exported.

102. Explanations of the New Era Some point to evolving governmental policy � decreasing regulation, opening the economy to trade, maintaining a balanced budget, and carefully limiting expansionary monetary policy.

103. A Potential Problem for the New Era The one major drawback of this rosy economy is the large and growing U. S. trade deficit.

104. A Potential Problem for the New Era Some economists are not alarmed at large and growing U. S. trade deficit.

105. Tools, Rules, and Policy End of Chapter 18