Transcript What is the Role of Government in Classical Economics?

Fear the Boom & the Bust
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• Fear the Boom & the Bust
Business Cycles
√ The term business cycle refers to
the recurrent ups and downs in the level of
economic activity, which extend over
several years.
√ Individual business cycles may vary
greatly in duration and intensity.
√ All display a set of phases.
√ Tracked by NBER (National
Bureau of Economic Research)
THE BUSINESS CYCLE
Phases of the Business Cycle
RECESSION
TROUGH
RECOVERY
Level of business activity
PEAK
Time
Level of business activity
PEAK
Time
√ Peak or prosperity phase:
 Real output in the economy is at a
high level
 Unemployment is low
 Domestic output may be at its
capacity
 Inflation may be high.
Level of business activity
RECESSION
Time
√ Contraction/recession phase ((> 2 quarters of declining GDP):
 Real output is decreasing
 Unemployment rate is rising.
As contraction continues, inflation pressure fades.
 If the recession is prolonged, price may decline (deflation)
The government determinant for a recession is two
consecutive quarters of declining output.
Level of business activity
TROUGH
Time
√ Trough or depression phase:
 Lowest point of real GDP
 Output and unemployment “bottom out”
 This phase may be short-lived or prolonged
 There is no precise decline in output at which a
serious recession becomes a depression.
Level of business activity
RECOVERY
Time
√ Expansionary (> 2 quarters of ↑ rGDP):
 Real output in the economy is increasing
 Unemployment rate is declining
 The upswing part of the cycle.
Real GDP
per year
Business Cycle-one cycle through 4 phases
Peak
Peak
Trough
One cycle
Time
MORE BUSINESS CYCLE NOTES:
GDP Quarterly Reports: 3 months of real GDP data + or –
QI = Jan – Mar, QII = Apr – June, QIII = July – Sep, QIV = Oct -- Dec
Depressions ~Traditionally measured as a recession that loses at least 10%, or more, of
the value of real GDP
Stagflation ~ A time of increasing inflation (associated with expansions) and increasing
unemployment (associated with recessions)
A Full Cycle ~ The time of one trough to the next trough (or peak to peak)
Historic Cycles ~ Since the founding of the US, cycles have averaged approximately
6 years from trough to trough
Historic Recessions ~ Since the early 1900’s, US recessions have averaged
14 months in length.
Long Run Growth Assumptions ~ This is known as the Secular Trend. Market
Systems have shown long run growth in real GDP/Standard of Living as the PPF
moves outward over time
Misery Index ~ The number created when the Inflation Rate is added to the
Unemployment Rate
Recessions since 1950 show that duration and
depth are varied:
Period
1953-54
1957-58
1960-61
1969-70
1973-75
1980
1981-82
1990-91
2001
Duration in months
10
8
10
11
16
6
16
8
8
Depth
(decline in real GDP)
— 3.0%
— 3.5%
— 1.0%
— 1.1%
— 4.3%
— 3.4%
— 2.6%
— 2.6%
app. —3.3%
Based on the theory that expectations of future
profits are the motivating force in the economy.
Companies may expand production of goods and
services and investment in new structures and
equipment,when business executives believe that
their sales and profits will rise.
When they believe profits will decline, they reduce
production and investment.
These actions generate the four phases of the
business cycle.
Causes of Fluctuations
Innovation
Political events
Random events
Wars
Level of consumer spending
Seasonal fluctuations
Cyclical Impacts — durable and non durable
An Actual Business Cycle
1981 - 1990 ($ billion, 1992 dollars)
Real GDP
Peak
6000
5200
Peak
4600
Trough
‘80
82
‘85
One Cycle
‘90
The Great Depression
The Great Depression [continued]
Global Depression, 1929-1932
Ave. Unemployment Rate, 1925-1928
Ave. Unemployment Rate, 1929-1933
Percent Decrease in Prices, 1929-1932
3 Theories of Economics
John Maynard Keynes
David Ricardo
Milton Friedman
5 CLASSICAL ECONOMICS BASICS
(Neo-Classical, Supply Side, Trickle Down, Free Trade, Monetarism)
1. In the long run, competition forces companies to be efficient and
develop new technologies. If a company doesn’t, it will lose
market shares to those that do.
2. In the long run, competition encourages companies to reduce
prices. If a company doesn’t, it will lose market shares to those
that do.
3. In the long run, competition encourages companies to create better
wages and working conditions. If a company doesn’t, workers will
move to companies that do.
4. In the long run, competition will create self correcting stability and
prosperity.
5. If stability is lost, suppliers can correct the surpluses and shortages
with new prices, production goals, and wage rates. For shortages:
raise prices, produce more, pay more to extra workers. For
surpluses: lower prices, produce less, pay less to fewer workers.
What is the Role of Government in Classical Economics?
 Protect private property rights that allow the incentive to profit.
 Protect economic law and order to allow competition without
cheating.
 Defend the nation to allow open competitive markets.
 Promote free trade to allow competitive forces to benefit all
nations.
 Lower taxes to restrict governmental interference and encourage
industrial development.
5 Keynesian Basics
(Protective Tariffs, Neo-Keynesian)
1. In the long run, competition can create better standards of living for
market economies.
2. However, societies don’t live in the long run. The immediate, short
run is critical for making a living, taking care of families, putting food
on the table. In the short run, all competitive markets have flaws that
create one crisis after another.
3. Businesses often are not efficient and many fail, therefore they
always under-employ the workforce.
4. Say’s Law of suppliers balancing the economy is mythical.
Businesses can’t always jettison workers, cut salaries, reduce prices
because resources didn’t get more plentiful and society will reject
these “solutions”. Wages are usually “sticky” when forced
downward. This all is known as the “Ratchet Effect”.
5 Keynesian Basics
(Protective Tariffs, Neo-Keynesian)
5. Consumers will fear both inflation and unemployment. When
they fear inflation, they will panic buy to beat the price
increases, thus causing worse inflation. When they fear
unemployment, they quit buying and cause surpluses, thus
creating more unemployment.
What is the Role of Government in Keynesian Economics?
• Focus on the short run. In the short run there will be flaws. “In the long
run, we are all dead.”
• Forget the Supply solutions to problems, create the correct amount of
demand.
• During the inevitable recessions, lower taxes to boost consumption
spending and raise government spending to create jobs. Run deficits as
needed (and assumed).
• During the occasional inflation spirals, raise taxes to dampen consumption
spending and decrease government spending to slow job growth. Run
surpluses to pay off older debts and then get ready for the next recession.
• Create stabilizers to dampen the effects of the next crisis. Protect the
elderly with social security programs and slow the panic of the unemployed
with compensation. Give subsidies to key industries to keep technology
developing and keep jobs plentiful.
5 Monetary Policy Basics
(Central Bank, Federal Reserve, Fine Tuning)
1. Competitive markets can flourish but need goals of stable growth
and low inflation rates.
2. Keynesians policies fail to work quickly enough to help with tax cuts
and job programs. By the time the “stimulus” plan is debated and
passed by any legislative body, the recession that caused the policy
debate has probably ended on its own.
3. Keynesian policies really collapse during times of inflation because
legislative bodies won’t raise taxes and cut government job
programs. The tax increases get leaders removed from office and
the job programs are usually entrenched in fiercely protective
bureaucracies and lobby groups.
4. Stagflation creates a crisis that no elected government can easily
solve. Fight the excessive unemployment and increase the inflation
even more. Fight the inflation and increase the excessive
unemployment even more.
5 Monetary Policy Basics
(Central Bank, Federal Reserve, Fine Tuning)
5. Inflation is always more damaging to any economy than
unemployment. Unemployment hurts the jobless; inflation
hurts everyone in the society.