Other Important Factors

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Other Important Factors

• The level and distribution of individual income.
• The value of the dollar relative to other
  currencies.

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The Twin Deficits

• In this course, well also analyze the so-called
  twin deficits--budget and trade deficits that
  have periodically plagued the United States and
  other countries.

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Major Macro Policy Tools

• In dealing with economic problems such as
  inflation and unemployment, the Federal
  government has a number of policy tools at its
  disposal.
• The two most important tools are fiscal policy
  and monetary policy.

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Fiscal Policy

• Uses increased government expenditures or tax
  cuts to stimulate or expand the economy.
• Uses decreased government expenditures or
  increased taxes to contract the economy and fight
  inflation.

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Monetary Policy

• Uses control over the money supply to achieve
  similar goals.
• Both monetary and fiscal policy are often used in
  conjunction with one another.

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A Double-edged Sword

• Properly practiced, macroeconomic policies can
  help create a climate of prosperity and growth.
• Improperly applied, macroeconomic policies can
  inflict the greatest of miseries and harm.

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In This Course

• We will learn about the enormous impact that
  macroeconomics has on both our personal and
  professional lives.

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The AS-AD Model
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The AS-AD Model
B
C
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Classical Economics

• Dates back to the late 1700s.
• Rooted in the laissez faire writings of Adam
  Smith, David Ricardo, and Jean Baptiste Say.

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Classical Economics

• Unemployment is a natural part of the business
  cycle.
• The economy is self-correcting.
• Most important, there is no need for the
  government to intervene.

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The Classical EconomistsMeet the Great Depression
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The Great Depression

• The stock market crashes in 1929.
• Gross Domestic Product fell by almost a third
  between 1929 and 1933.
• 25 of the work force was unemployed.
• Business investment fell from about 16 billion
  in 1929 to 1 billion by 1933.

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The Birth of Keynesian Economics
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The Keynesian View

• John Maynard Keynes flatly rejected the Classical
  notion of a self-correcting economy and warned
  that patiently waiting for the eventual recovery
  was fruitless because in the long run, were all
  dead.

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The Keynesian View

• Keynes believed that under certain circumstances,
  the economy would not naturally rebound but
  simply stagnate or, even worse, fall into a death
  spiral.

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The Keynesian Cure

• To Keynes, the only way to get the economy moving
  again was to prime the economic pump with
  increased government expenditures.
• Thus, fiscal policy was born and the Keynesian
  prescription became the underlying, if unstated
  philosophy, of Franklin Delano Roosevelts New
  Deal.

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Roosevelts New Deal
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The Keynesian Cure Redux
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The Promise of Fine Tuning

• In President John F. Kennedys Camelot, the
  Chairman of Economic Advisors Walter Heller
  popularized the term fine tuning.
• Heller firmly believed that through the careful
  mechanistic application of Keynesian principles,
  the nations macroeconomy could be held very
  close to full employment with minimal inflation.

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The Kennedy Tax Cut

• In 1962, Heller recommended to Kennedy that the
  President advocate a large tax cut to stimulate
  the sluggish economy.
• Congress eventually agreed, and this Keynesian
  tax cut helped make the 1960s one of the most
  prosperous decades in America.

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The Foundation of Stagflation

• This fiscal stimulus laid the foundation for the
  emergence of stagflation simultaneous high
  inflation and high unemployment.

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The Roots of Stagflation

• The stagflation problem had it roots in President
  Lyndon Johnsons stubbornness.

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The Roots of Stagflation

• In the late 1960s, against the strong advice of
  his economic advisors, Johnson increased
  expenditures on the Vietnam War but refused to
  cut spending on his Great Society social welfare
  programs.
• This refusal helped spawn a virulent demand
  pull inflation.

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Demand-Pull Inflation

• The essence of demand-pull inflation is too much
  Money chasing too few goods, and that exactly
  what happened when the U.S. tried to finance both
  guns and butter--both the Vietnam War and the
  Great Society.

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Demand-Pull Inflation
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Cost-Push Inflation

• Cost-push or supply side inflation occurs when
  factors such as rapid increases in raw material
  prices or wage increases drive up production
  costs.
• This can happen as a result of so-called supply
  shocks such as those experienced in the early
  1970s.
• During this period such shocks included crop
  failures, a worldwide drought, and a quadrupling
  of the world price of crude oil.

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Cost-Push Inflation
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A Budding Paradox

• Prior to the 1970s, economists didnt believe you
  could even have both high inflation and high
  unemployment at the same time.
• If one went up, the other had to go down.
• But the 1970s proved economists wrong on this
  point and likewise exposed Keynesian economics as
  incapable of solving the new stagnation problem.

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The Keynesian Dilemma

• Using expansionary policies to reduce
  unemployment simply created more inflation while
  using contractionary policies to curb inflation
  only deepened the recession.
• That meant that the traditional Keynesian tools
  could solve only half of the stagflation problem
  at any one time -- and only by making the other
  half worse.

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The Rise of Monetarism

• It was this inability of Keynesian economics to
  cope with stagflation that set the stage for
  Professor Milton Friedmans Monetarist challenge
  to what had become the Keynesian orthodoxy.

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Friedmans Monetarist School

• The problems of both inflation and recession may
  be traced to one thing -- the rate of growth of
  the money supply.
• Inflation happens when the government prints too
  much money and recessions happen when it prints
  too little.

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The Monetarist Perspective

• Stagflation is the inevitable result of activist
  fiscal and monetary policies that try to push the
  economy beyond its so-called natural rate or,
  more technically, its lowest sustainable
  unemployment rate.

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The LSUR

• This natural rate of unemployment or LSUR is the
  lowest level of unemployment that can be attained
  without upward pressure on inflation.
• According to the Monetarists, expansionary
  attempts to go beyond this lowest sustainable
  unemployment rate may result in short run spurts
  of growth.
• However, after each growth spurt, prices and
  wages rise and drag the economy back to its
  LSUR--albeit at a higher rate of inflation.

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Some Bitter Medicine

• Over time, these futile attempts to push the
  economy beyond its natural rate lead to an upward
  inflationary spiral.
• In this situation, Monetarists believe that the
  only way to wring inflation and inflationary
  expectations out of the economy is to have the
  actual unemployment rate rise above the LSUR and
  that means inducing a recession.

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Inducing a Recession

• This is at least one interpretation of what the
  Federal Reserve did beginning in 1979 under the
  Monetarist banner of setting monetary growth
  targets.
• Under Chairman Paul Volcker, the Fed adopted a
  sharply contractionary monetary policy and
  interest rates soared to over twenty percent.

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A Sweeter Economic Cure

• While the Feds bitter medicine worked, three
  years of hard economic times left a bitter taste
  in the mouths of the American people now hungry
  for a sweeter macroeconomic cure than either the
  Keynesians or Monetarists could offer.
• Enter stage right supply side economics.

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The Coming of Ronald Reagan
WITHOUT
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The Supply Side Philosophy

• On the surface, the supply side approach looks
  very similar to the kind of Keynesian tax cut
  prescribed in the 1960s to stimulate a sluggish
  economy.
• However, the supply siders viewed such tax cuts
  from a very different behavioral perspective.

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The Behavioral Difference
Keynesianism
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The Behavioral Difference
Supply Side
Economics
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A Lower Budget Deficit

• The loss in tax revenues from the tax cut would
  be more than offset by the increase in tax
  revenues from increased economic growth.
• Thus, under supply side economics, the budget
  deficit would actually be reduced.

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The End Result

• Unfortunately, that didnt happen.
• While the economy boomed so, too, did Americas
  budget deficit.
• And as the budget deficit soared, Americas trade
  deficit soared with it.

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George Bushs Burden

• These so-called twin deficits deeply concerned
  Reagans successor George Bush, particularly
  after the budget deficit jumped over 200 billion
  at the midpoint of his term in 1990, and the
  economy began to slide into recession.
• To Keynesians, this recession would have been a
  clear signal to engage in expansionary policy.
  However, in the Bush White House, Reagans Supply
  Side advisors had been supplanted by so-called
  New Classicals.

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New Classical Economics

• New Classical economics is based on the
  controversial theory of rational expectations.
  
• This theory says that if you form your
  expectations rationally, you will take into
  account all available information including the
  future effects of activist fiscal and monetary
  policies.

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Rational Expectations

• The idea behind rational expectations is that
  such activist policies might be able to fool
  people for a while. However, after a while,
  people will learn from their experiences, and
  then you cant fool them at all.
• The central policy implication of this idea is
  profound rational expectations render activist
  fiscal and monetary policies completely
  ineffective so they should be abandoned.

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Some Bad Politics

• Well talk more about whether this theory is good
  economics or not in a later lesson, but it was
  clearly bad politics at least for President
  Bush.
• Indeed, Bushs New Classical advisors flatly
  rejected any Keynesian quick fix to the
  deepening recession.
• Instead, they called for more stable and
  systematic policies based on long term goals
  rather than a continued reliance on
  short-sighted discretionary reactions.

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The Economy Stupid
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Restored Confidence

• What is perhaps most interesting about this
  transition of power is that Bill Clinton actually
  did very little to stimulate the economy.
• The mere fact, however, that Clinton promised a
  more activist approach helped restore business
  and consumer confidence.

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An Easy Re-election

• At the same time, Congressional passage of
  Clintons deficit reduction legislation in 1993
  sent Wall Street a clear signal that his
  Administration was serious about budget balance.
  
• Together, these factors helped accelerate a
  recovery that had already begun by the end of
  Bushs term.
• These factors also set the stage for Clintons
  remarkably easy re-election in 1996 as well as
  the longest economic recovery in peace time
  history.

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On the Bright Side

• As we enter a new millennium, the nations
  macroeconomic magicians appear to be able to keep
  the unemployment rate within a relatively narrow
  band of tolerance.

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• Note how the amplitude of the business cycle has
  been considerably reduced since the wide-scale
  application of macroeconomic policies after World
  War II.

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Macroeconomics Big Questions

• Is there any way to simultaneously stimulate
  economic growth, boost real income, and balance
  both the budget and trade deficits using the
  traditional tools of macroeconomics?
• Or will macroeconomics have to once more evolve
  to successfully solve the increasingly complex
  problems before us?

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Towards the 21st Century

• These are the major macroeconomic issues now
  faced by leaders around the globe.
• We will help you try to understand these
  important questions by teaching you the science
  -- and art -- of macroeconomics.

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In The Meantime

• Economics is not something to be memorized but
  rather something to conceptualize.
• So as you study it, think about it too.
• Your job and your business might just depend upon
  it.

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End of Lesson
Lecturer Peter Navarro Multimedia Designer Ron
Kahr Female Voice-over Ashley West Leonard