(2) Macroeconomic Policies What are the economic objectives for a government? High and growing real GDP and GDP per capita Low unemployment rate Low and stable inflation rate (Equitable distribution of income) (plus : favourable exchange rate and balance of payments))

GDP Around the World There are 243 countries as of 2013, top 43 countries owns over 90% of the GDP in 2013

Unemployment Rate Around the World

Inflation Around the World The highest inflation rates today are seen in the developing world and in crisis countries e.g. South Sudan highest with 79%, Syria 37%, Iran 32% Zimbabwe in crisis, in 2008 reached 79,600,000,000% monthly inflation rate Former USSR countries transiting to Market Based Economy: Hungary, Poland, Czech Republic, Ukraine, Eastern Germany, etc. also reached record high rates!

Government Reactions MAIN CHOICE: INTERVENTION Vs LAISSEZ-FAIRE

Ultimate Questions: Can we consistently manage growth so that there is also low and stable inflation and low unemployment? Moreover, is equitable growth possible? Growth for all? If not, where do we strike a balance between growth and equity?

In preparation for Development Economics Is the world economy working for all? Looking at the whole world as one (instead of individual countries), is there equality across the globe? What are the roles of International Organizations such as UN, World Bank, IMF, WTO, etc.? Are they doing their job?

Gini Index and Income Inequality

Can High GDP and Income Equality Co-exist Can High GDP and Income Equality Co-exist? Equitable Economic Growth possible ?

Demand-Side (Keynesian) Policies Demand side policies (demand management) focus on changing the AD to achieve potential economic growth, full employment (NRU), and price stability Stabilization or counter-cyclical

Expansionary (EASY or LOOSE) vs Contractionary (AUSTERE or TIGHT) When would each type be used?

Available Policies FISCAL MONETARY 1. Demand Side Policies 2. Supply Side Policies Within Demand-Side Policies: FISCAL MONETARY Expansionary (Loose) Contractionary (Tight)

2 Main Scenarios for Intervention Two Gaps of Macroeconomic Economy Recessionary (deflationary) gap Inflationary gap The key to identifying these gaps were where the current equilibrium level of output ( 𝒀 𝒆 ) is in comparison to the potential level of output ( 𝒀 𝒑 ) Two Responses of Demand Side Policies Expansionary Fiscal Policy and Monetary Policy Contractionary Fiscal Policy and Monetary Policy

Demand Side Policies Non-discretionary policy Discretionary policy Demand side policies (demand management) are policies focused on changing AD = C + I + G + NX Two major types and classifications: Discretionary policy Fiscal Policy Monetary Policy Non-discretionary policy Automatic stabilizers e.g. progressive income tax and UE benefits

Automatic Stabilizers Automatic stabilizers are policies that automatically, without any action by the government, tend to stabilize the economy by reducing the fluctuations of the business cycle Two main types of AUTOMATIC Stabilizers in Fiscal policy: Progressive income tax Income tax (wages, interest, dividend) where as the income increases, the proportion of income paid as taxes increases; there is an increasing marginal tax rate For an increase in real GDP, the tax revenue increases, causing DISPOSABLE income to be lower than it would otherwise be exerting a downward pressure on AD (less inflationary pressure) (and vice versa). (Other taxes such as corporate tax, consumption tax, or special taxes on luxury goods will also tend to rise) Unemployment benefits /pay/ welfare benefits Social insurance provided by the government to provide benefits for those who have been unemployed e.g. to maintain families’ ability to live, reduce the negative externalities of poverty, provide training, etc. For a decrease in real GDP, as workers become unemployed, their consumption will be maintained to some extent as the benefits partially replac their lost income, thus lessoning the downward pressure on AD

Fiscal Policy (Group VI Tues) Fiscal policy refers to manipulations by the government of its own expenditures (G) and revenues (T) to influence the level of AD For the Japanese government’s budget, what were some of the components of their spending? And types of taxes? But fiscal policy also affects the other 3 AD components Consumption (C): consumption and income tax Investment (I): business and corporate tax Net Exports (NX): tariffs and quotas

DISCRETIONARY STABILISERS using the BUDGET EXPANSIONARY: ………………….. G and/or ………………….. T CONTRACTIONARY: For both PLUS………MULTIPLIER effects. (Also consider the TAXATION Multiplier and the BALANCED BUDGET Multiplier)

Discretionary policy to fill a deflationary (Group VI) OR inflationary gap 1) Government must estimate the gap between the equilibrium output and “full employment” output (potential output). 2) It must estimate the value of the multiplier so it can judge the suitable increase/decrease in AD that is necessary to inject into the economy in order to fill the gap. But consider analogy of driving (steering) a car with no front windows (cannot forecast) or side windows, and the brake and accelerator are unpredictable and LAGGED . Could it crash or overheat?

= 𝑚𝑝𝑐 1−𝑚𝑝𝑐 Taxation Multiplier Implication: (formula is optional) = 𝑚𝑝𝑐 1−𝑚𝑝𝑐 Implication: Impact of a change in taxation is……………….than impact of a change in govt. expenditure

 Balanced Budget Multiplier If government raise G by $1000 and, at the same time, raise T by $1000…. What is the effect on… 1) The budget?............................... 2) National Income (output/expenditure)?…………………………  size of Balanced Budget Multiplier=…………?

Need to consider………. The higher the withdrawals (taxes, imports and savings), the …………………… the multiplicative effect of any given increase in government spending. Lower interest rates will …………. the MPS, lower income taxes will ………. the MRT barriers to trade will …………… the MPM. All will lower the MPW and thus …………..the value of the multiplier.

Output Gap (Actual – Potential Output)

Gov Expenditure and Revenue Together: Japan Consider whether the BUDGET is in SURPLUS, DEFICIT or BALANCED

United States

? Fiscal and Monetary Policy In face of deflationary/recessionary gap, what would you do? Fiscal policy:………… BUDGET moves towards a…………….. (Monetary policy:…………………………………)

Review: Fiscal and Monetary Policy In face of inflationary gap,what would you do? Fiscal policy:………… BUDGET moves towards a…………….. (Monetary policy:…………………………………)

Summary of Fiscal Policy Fiscal policy refers to the government changing its expenditures (G) and revenues (T) to influence the level of AD But fiscal policy also affects the other 3 AD components Consumption (C): consumption and income tax Investment (I): business (corporate or company) taxes Net Exports (NX): tariffs and quotas Need to calculate the multiplier to determine the correct amount of change in G or T Also distinction between: Discretionary policy and Non-discretionary policy (Automatic stabilizers e.g. progressive income tax and unemployment benefits)  Consider whether the BUDGET is …….. in SURPLUS, in DEFICIT or BALANCED  Review page 6 on H/0 (New Classical vs Keynesian) + Formative WS (2) + Paradox of Thrift (Page 10)

Keynesian Demand-Side policy - EVALUATION Group III (after finishing Page 6) PROS CONS Can ”fine-tune” the economy so that it can grow at close to its potential rate without booms and slumps. Counter-cyclical and stabilisation Risk of inflation unless there is spare capacity (an almost horizontal AS curve) Can reduce Keynesian/demand-deficient/cyclical* unemployment (*unemp. > NRU) Expansionary policies  need to have a budget deficit need to borrow (see next slide)

Keynesian Demand-Side policy - EVALUATION PROS CONS Can “fine-tune” the economy so that it can grow at close to its potential rate without booms and slumps (counter-cyclical/stabiliszing) Risk of inflation unless there is spare capacity (an almost horizontal AS curve) Can reduce Keynesian/demand-deficient/cyclical* unemployment (*unemp. > NRU) Expansionary policies  need to have a budget deficit  need to borrow (by issuing bonds) national debt rises  costs of financing (servicing) debt As real GDP rises, tax revenues rise and G expenditure on unemp. pay falls deficit will eventually narrow (Page 10 of H/)0 Risk of crowding out of firms’ investment (if interest rate rises). But will not rise if increase in Money supply (quantitative easing) OR if excess savings

Risk of crowding out of firms’ investment (if interest rate rises). PROS (con) Cons Automatic stabilizers Risk of crowding out of firms’ investment (if interest rate rises). But will not rise if increase in Money supply (quantitative easing) OR if excess savings IF extra investment generated as AD and GDP increase-----SUSTAINED GROWTH AS LRAS MOVES RIGHT GDP stats unreliable and forecasts change. Parameters (eg mpc) change Can be used to DECREASE inflation (CONTRACTIONARY or TIGHT Policies) Lags -- possibly cycles are amplified

Crowding Out Effect

Is “crowding out” happening in Japan?

Corporate Tax Rates

Consumption Tax Rates

Personal Income Tax (varies by level of income)

To sum, Is it such an easy task? Not quite so … One intervention has multiple mechanisms in affecting the various demand components. Ceteris paribus is critical! But in the dynamic reality, hard to make such assumption and therefore hard to predict and forecast and it can get out of control! The multiplier effect The national income will/should increase by more than how much the government will spend as the increase in spending circulates the economy The two schools of thought Quite different on the implications on price and real GDP level (monetarist believe no effects on real GDP, only on avg prices) We considered only the Demand Side, also need to consider the Supply Side Policies  Macroeconomic Management is difficult!  formative WS 2 (pp 11-12 of H/0) and to Monetary Policy

Is it such an easy task ? (continued) Fiscal Policy Pro: can pull economy out of recession (e.g. Great Dep ‘30); deal with escalating inflation; ability to target sectors (e.g. spending on education, infrastructure) with some supply side effects Con: time lags; hard to forecast their impacts and the causal mechanisms; political constraints with so many factors and components of G and T; crowding out effect (as G increase, need to borrow, interest rate increases lessening C and I); tax cuts increase savings rather than C; hard to target and fine tune as AD determined by multiple factors

Inflation Rate Headline inflation rate – unlike core inflation rate (underlying, long run inflation rate) includes the price changes of food and energy

The Components of AD

Consumption

Investment

Exports

Imports

Net Exports

Government Expenditure (G)

Government Revenue (T)

But……………………. Sunday, May 29, 2011 JAPAN TIMES Kan government struggles to raise reconstruction funds John Maynard Keynes , the British economist who advocated government intervention to regulate financial health, has lately been cited in the Japanese press in reference to the current administration's plan to raise the consumption tax . When he held the post of finance minister for five months right before becoming prime minister in June of last year, Naoto Kan famously remarked that he didn't understand Keynes, who believed in the multiplying effect of stimulus: If you inject spending into the economy, either through subsidies or tax cuts, people will spend that money and the economy will expand in many ways. Before the March 11 earthquake and tsunami, the consumption tax argument was centered on public welfare — more exactly, how to take care of Japan's rapidly aging society. Now the argument is doubly urgent, since funds are desperately needed for reconstruction. Kan has already proposed issuing new bonds and raising the consumption tax from 5 percent to 8 percent for three years. The bond proposal has received mixed reactions since it would increase Japanese debt, which is already the highest in the world, thus further undermining international confidence in Japan. But the main discussion in the media is about taxes. Would an increase do more harm than good? On the TV Asahi talk show "Morning Bird," several economists discussed the wisdom of a hypothetical ¥10 trillion tax cut. Based on the Keynesian model, such a reduction could be expected to grow the economy by ¥1.2 trillion, which would be great. However, a tax cut means the government takes in less money and the debt would also grow. Moreover, the Japanese public has been skittish about spending, especially when the general psychological mood tends toward uncertainty about the future, a situation exacerbated by the disaster. There's no guarantee that people wouldn't just take the tax cut and stash it away