Principles of Macroeconomics Welcome to Day 27 Principles of Macroeconomics

Chapter 17 – Government Budgets and Fiscal Policy Chapter 18 – The Impacts of Government Borrowing.

For every year since 1969 (except 1999 and 2000) we have added to the national debt. But really matters is the size of the deficit or national debt compared to GDP

Just like what really matters for you is the size of your debt compared to your income. Someone with a $10,000 debt and no income is in trouble. Someone with a $10,000 debt and million dollar income is not in trouble at all.

The U.S. will be able to borrow money as long as lenders believe they can pay it back. If they believe the debt is too big even for an economy the size of the United States, then they would stop lending.

Of course, nations actually should always be able to pay their bills because they have the power of printing up money. But this will cause inflation which means lenders will only lend at a higher interest rate.

This could lead to a borrowing death spiral.

Keynesianism and the Problem of Crowding Out.

Here is a graph of the credit market where saving does not depend on the interest rate. Supply (savings) 5% Demand (borrowing) $10 Billion Loanable Funds

Now the government borrows $5 billion Now the government borrows $5 billion. Demand moves $5 billion to the right. Has overall borrowing increased by $5 billion? Interest rate Supply (savings) 5% D2 D1 $10 Billion Loanable Funds

Equilibrium borrowing remains at $10 billion. How is this possible? Supply (savings) 7% 5% D2 D1 $10 Billion Loanable Funds

The government borrowing has “crowded out” private borrowing and spending through a higher interest rate. The government borrows $5 billion more. Ford, IBM, etc. borrow $5 billion.

Private companies and individuals are dropping spending as fast as the government increases it. GDP = C + I + G

Keynesian table with crowding out.  G  I  C  GDP Round 1 Keynesian table with crowding out.  G  I  C  GDP Round 1 $100 -$100 $0 $0 Round 2 $0 $0 $0 $0 Round 3 $0 $0 $0 $0 Round 4 $0 $0 $0 $0 And so on … … … … Total $100 -$100 $0 $0

Let’s translate the table to the AD/AS diagram. P SRAS AD0,1,2,…,F Q0,1,2,…F Q

When does does crowding out occur When does does crowding out occur? When the money the government borrows and spends would have been spent by someone else if the government had not borrowed it.

This happens when: 1) The government borrows money someone else was going to borrow and spend, and now they don’t. 2) The person who lends the money to the government was going to spend it, but lent it to the government instead.

Crowding out does not occur when people lend the government “cookie jar” money, or money they were not going to spend on either goods or bonds.

So if you think of the Great Depression as being caused by low AD because of people sitting on large cash stashes they are afraid to spend or lend to private companies, the government can borrow it from them and spend it for them, increasing AD

People (usually conservatives) opposed to the Obama stimulus package point out “the money must have come from somewhere”. Shouldn’t spending drop wherever it came from?

Keynesians point out that even if it came from somewhere, as long as it wasn’t being spent in that somewhere, spending will rise.

M x V = P x Q Pure Keynesianism can be done without an increase in M M x V = P x Q Pure Keynesianism can be done without an increase in M. By borrowing V=0 money and spending it, V is increased and AD goes up.

If crowding out is true, then V will not increase If crowding out is true, then V will not increase. Monetarists, in general, believe in crowding out. That is why they say there must be an increase in M to increase AD.

Republican’s Favorite Graph

Crowding out private investment doesn’t just cause fiscal policy to not work. It also lowers long-term growth.

One cause of growth is new factories and investment spending.

Much investment spending is financed by borrowing Much investment spending is financed by borrowing. If government borrowing raises interest rates, then there will be less private investment, which could lower growth.

Principles of Macroeconomics Welcome to Day 28 Principles of Macroeconomics

Chapter 20 – International Trade Chapter 16 – Exchange Rates

Why trade with other countries Why trade with other countries? Because both countries can have more of everything.

U. S. Japan Wheat Rice. Wheat Rice A 0 30. A. 0 90 B 45 15. B U.S. Japan Wheat Rice Wheat Rice A 0 30 A* 0 90 B 45 15 B* 15 45 C 90 0 C* 30 0 Start with no trading and both countries at B and B*. U.S. has 45W and 15R while Japan has 15W and 45R.

Now the U.S. specializes in what it is best at, and Japan specializes at what it is best at. The U.S moves to C and Japan moves to A*. Why couldn’t they do this before?

U. S. had 90 Wheat and 0 Rice. Japan has 90 Rice and 0 Wheat. U. S U.S. had 90 Wheat and 0 Rice. Japan has 90 Rice and 0 Wheat. U.S. trades 30 W to Japan for 30 R. U.S. has 60 W and 30 R. Japan has 30 W and 60 R. How does this compare to before trade?

Where is this extra quantity of everything coming from so that each country can have more than before?

It is efficient production It is efficient production. Just like back in chapter 2 when we talked about building our carriers in Maine and our Wheat in Kansas. Except now it is our rice in Japan and our wheat in the United States.

Comparative advantage versus absolute advantage Comparative advantage versus absolute advantage. If one country can make everything better than every other country, should it still trade?

Does overall unemployment go up in these countries when they trade like this?

In the U. S. , wheat employment goes up and rice employment goes down In the U.S., wheat employment goes up and rice employment goes down. In Japan, wheat employment goes down and rice employment goes up.

Last topic (Yay!) – Let’s talk about exchange rates.

When you buy things from Japanese companies, you have to pay with Japanese yen. This is true if you are in Japan yourself or an importer. This means you have to buy yen with dollars.

There will be a price in this market, like in any market There will be a price in this market, like in any market. The price is the exchange rate.

The price will create an equilibrium where the amount of yen that people want to sell for dollars equals the amount of yen that people want to buy with dollars. On Friday, Nov. 24, 2017, it was 111.57 yen = 1 dollar.

Suppose people want to buy a lot more yen at that price Suppose people want to buy a lot more yen at that price. The price of yen will go up. So will more yen or less yen = $1?

When the yen is more valuable, the amount of yen equal to $1 goes down When the yen is more valuable, the amount of yen equal to $1 goes down. Just like when IBM stock gains in value, the amount of stock equal to $1 will go down. The number of dollars it will take to buy a yen will go up.

The yen has appreciated and the dollar has depreciated The yen has appreciated and the dollar has depreciated. So what is the equilibrium exchange rate likely to be. There are multiple theories, the most basic is the Purchasing Power Parity (PPP) theory of exchange rates.

Imagine a table costs $40 in America and the exact same table in Japan costs 2,000 yen. Also imagine that the current exchange rate is 100 yen = $1. Is this sustainable?

If you are an American importer you can: 1) Take $20 and buy 2000 yen If you are an American importer you can: 1) Take $20 and buy 2000 yen. 2) Buy a table in Japan. 3) Ship it to America and sell it for $40 When people realize this, what is going to happen in the foreign exchange market?

There will be a rush to buy yen There will be a rush to buy yen. What will the new exchange rate have to be for this rush to buy yen to stop? $40 = 2000 yen, or $1 = 50 yen.

The Purchasing Power Parity Theory of Exchange Rates – The exchange will adjust so that the price of traded goods are the same across countries.