ECN202: Macroeconomics

1
ECN202 Macroeconomics

• 1920s Classical Economic Theory and Policy
• "Fashions in economic ideas come and go, like
  fashions in women's clothes....the history of
  economic thought is closer to the history of
  women's fashion than to the history of astronomy
  or physics."

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The Classical View

• The central element in the Classical Model is
  efficient markets so that any disequilibrium is
  quickly eliminated. In the domestic capital
  market any imbalance between the supply and
  demand for funds, which are our savings and
  investment, will be eliminated by a change in the
  interest rate. Any imbalance in the foreign
  exchange market resulting from trade imbalances
  will be eliminated by the flow of gold and price
  level changes. And any disequilibrium in the
  labor market unemployment will be eliminated
  by flexible wages so we always end up at full
  employment. This shows up with the AS-AD curve as
  a vertical AS curve and this means that any
  change in AD has no impact on equilibrium income
  what they call Crowding Out. Now you can look
  at the pieces of the model.

3
The American system What it does

• "the greatness of America has grown out of a
  political and social system and a method of
  control of economic forces distinctly its own -
  our American system - which has carried this
  great experiment in human welfare further than
  ever before in all history. We are nearer today
  to the ideal of the abolition of poverty and fear
  from the lives of men and women than ever before
  in any land." Herbert Hoover Oct 22, 1928

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The American system What makes it work

• "Liquidate labor, liquidate stocks, liquidate the
  farmers, liquidate real estate. It will purge
  the rottenness out of the system. High costs of
  living and high living will come down. People
  will work harder, live a more moral life. Values
  will be adjusted, and enterprising people will
  pick up from less competent people."

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The American system the pieces

• To understand the Classical model we start with
  the National income Identity (AS AD) and then
  with a little rearranging
• (S-M) represents supply and demand in the
  domestic capital market (S Savings (supply of
  funds), I Investment (demand for funds))
• (X-M) - represents supply and demand in the
  foreign capital market (M Imports, X Exports)
  trade deficit
• (T-G) represents the government budget surplus
  (deficit) (T Taxes, G Government outlays).
• If markets force SI and MX, then T G, which
  proves the government should balance its
  budget.

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The Classical Model A Starting point

• National income equilibrium V1.
• Y C I G X - M
• National income equilibrium V2.
• (I - S) (X - M) (T - G)

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Domestic Balance (I - S) 0?
Market for loanable funds / money

• S Savings (supply of funds) as rates rise
  more will be saved
• I Investment (demand for funds as rates rise
  less will be borrowed
• What happens _at_ r1
• What happens _at_ r

S
r
r1
I
Now lets look at two examples.
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Domestic Balance (I - S) 0?
Show how to translate the words into the graph.

• What happens as boomers age and buy more bonds
  (increase savings)?

r
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Domestic Balance (I - S) 0?
Show how to translate the words into the graph.

• What happens as businesses lose confidence in the
  economy?

r
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International Balance (X-M) 0? The words

• We trace through the chain of events that link
  the trade deficit through flows of gold to money
  supply to price levels and then the circle closes
  when this affects the trade deficit by impacting
  exports and imports. In the next slide the links
  in the logic are presented.
• A key to the logic is the purchase of products
  where there are international alternatives. Here
  you can look at the choice of a domestic or
  foreign product to see how it works.

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Where do you make the purchase?

• Where do you buy the computer? 1,000 in US or
  600 in Europe?
• 1. Find exchange rate
• Exchange rate 1 .78 or 1 1.27
• 2. Convert into common currency
• 1,000 788 gt 600 buy in Europe
• 600 782 lt 1,000 buy in Europe

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International Balance (X-M) 0?The words

1. Link between currency and gold (gold prices for
   each currency)
2. Link between international trade and gold supply
   (people want to be paid in gold)
3. Link between gold supply and money supply (money
   is backed by gold)
4. Link between money supply and prices (more money
   higher prices)
5. Link between prices and trade balance (higher
   prices fewer exports more imports)

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International Balance (X-M) 0?The logical chain

• BOT (X-M)
• Gold supply
• money supply
• Price level
• BOT (X-M)

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International Balance (X - M)

• 1.  Link between currency and gold
• Establish 1 oz of gold 20
• Establish 1 oz of gold 10
• 20 10
• 2 1
• 1/2

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International Balance (X - M)
2.  Link between trade and gold

• 1 oz of gold
• 20 10
• 1 shirt
• 20 or 15
• 1 shirt __ oz of gold in UK and __ oz of gold
  in US

price of ounce of gold price of shirt in terms of currency price of shirt in term of gold 
10 15 1.5 ounce
20 20 1 ounce
UK US
Fill in the table
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International Balance (X - M)
2.  Link between trade and gold

• 1 oz of gold
• 20 10
• 1 shirt
• 20 or 15
• 1 shirt __ oz of gold in UK and __ oz of gold
  in US

price of ounce of gold price of shirt in terms of currency price of shirt in term of gold 
10 15 1.5 ounce
20 20 1 ounce
UK US
How does this compare with yours?
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International Balance (X - M)
2.  Link between trade and gold summary

1. 1 shirt 1.5 oz of gold in UK and 1 oz of gold
   in US
2. Shirt cheaper in US so UK shoppers buy in US
3. US has BOT surplus (X gt M)
4. Gold flows into US because of cheaper price

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International Balance (X - M)
3.  Link between gold and money supply

• Summary
• UK buys US shirts - pay with gold
• US shirt sellers take gold to FED and ask for s
  they can use
• US Fed prints new money (s) equal to increase in
  gold and supplies it to US shirt sellers

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International Balance (X - M)

• 4.  Link between money supply and prices
• Quantity Theory of Money
• Money is medium of exchange because there is no
  reason to hold money since it earns nothing, if
  the Fed increases the money supply people will
  use it to buy things, which will result in more
  spending either higher prices or more stuff.

Classical economists assumeMore money higher
prices
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Quantity Theory of Money

• m v p y
• where
• m D in money supply
• v D velocity
• p D price level (inflation rate)
• y D real output

Faster money growth (m) faster inflation (p)
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International Balance (X - M)
4.  Link between money supply and prices

• summary
• US uses new s to buy things
• When they buy new things there is shortage
• In response to shortage sellers raise prices

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International Balance (X - M)

• 5.  Link between prices and trade
• US balance of trade surplus (X-Mgt0) means gold
  flows into US.
• Inflow of gold means more money printed in US
• More money in US means higher prices in US making
  US goods more expensive
• US buyers buy from UK (imports (M) increase)
• UK buyers stop buying from US (exports (X)
  decrease)
• US trade surplus (X-M) disappears as US exports
  fall and imports rise

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Gold Standard when US has BOT Surplus

• BOT (X-M gt0) surplus
• Gold supply
• money supply
• Price level
• X and M BOT
  surplus

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Macro policy implications of Classical model
Fiscal policy (crowding out)

• Government cuts taxes (T) or raises spending (G)
• Increased G raises budget deficit (G-T increases)
• Bigger budget deficit increased borrowing
• Increased borrowing increased demand for funds
  (I curve shifts out)
• Increased demand raises interest rate
• Higher interest rate lowers private spending (C
  and I)
• Conclusion higher borrowing by the government
  reduces private spending - no net increase in
  demand or income

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Macro policy implications of Classical model
Monetary policy (BIG story was Germany
hyperinflation)

• To stimulate economy Fed prints more money
• Increased money increases spending
• Increased spending raises prices since already
  producing at capacity (no unemployment since
  wages flexible)
• Conclusion Printing of money creates higher
  prices and not higher income

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AS-AD model

• AD negative curve
• AS as price level rises no more employment so
  no more output vertical curve

Price level
P
Q
output
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Summary of 1920s Classical Model

• Economic Theorist (Adam Smith)
• Macro policy implication (Crowding Out)
• Monetary policy prices only
• Fiscal policy interest rates only
• AS-AD implication
• Vertical AS curve
• Implications
• AD policies worthless
• GDP depends upon AS
• Supply-side Economic Policies
• Fiscal - Tax cuts for wealthy, balanced budgets
• Monetary - gold standard

P
Q
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The CRASH

• October 29, 1929
• Stock Prices Slump 14,000,000,000 in
  Nation-Wide Stampede to Unload Bankers to
  Support Market Today
• THE NEW YORK TIMES