Transcript Economic Theories

Economic Theories
Unit 5
Lesson 5
Activity 48
Master Curriculum Guide in Economics: Teaching Strategies for High School
Economic Classes (New York; National Council on Economic Education,
1995)
Advanced Placement Economics Teacher Resource Manual. National Council on
Economic Education, New York, N.Y
Objectives
• Explain the different types of lags in making policy and
that there are different estimates about the length of
these lags.
• Describe the idea of crowding-out and that the extent
of crowding-out can change depending on the
responses of interest rates, consumption spending and
business investment.
• Explain the reasons why prices and wages do not adjust
instantaneously.
• Provide examples of conflicts among attaining
economic goals.
Introduction
• Listening to and reading analysis of the various
policy proposals can be confusing.
• Most economists hold views that cannot be
categorized into a particular school of thought
but are a combination of different schools.
• Activity 48 pulls many policy concepts together
and serves to review and summarize stabilization
policy.
Review: Inside and Outside Lags
• The inside lag consists of the time it takes for
data to be collected, policy makers to recognize
that policy action is necessary, the decision
about which policy should be taken and the
implementation of the policy.
• The outside lag is the time it takes the economy to
respond to the new policy.
Other Lags!
• Recognition lag: The time it takes for policy makers to
see that three is a problem with the economy. In
general, the recognition lag is three to six months.
• Decision or response lag: the time it takes policy
makers to decide and implement the policy response to
the current economic problem.
– This lag differs between monetary between monetary and
fiscal policy.
– The monetary policy decision lag is usually very short (one
quarter), while the fiscal policy decision lag can be several
quarters to more than a year.
– These combined lags make up the inside lag.
• Transmission or impact lag (the outside lag): the
time it takes the change in policy to have an
effect on the economy.
– The transmission lag for monetary policy is long and
variable because the change in the money supply
affects interest rates, which in turn affect interestrate sensitive components of AD.
– The transmission lag for fiscal policy in general is
very short because fiscal policy is discussed in the
media throughout the implementation process.
– People are ready to adjust as soon as the policy is
enacted or may even act on the probability of
enactment.
•
Why prices and wages do not adjust quickly:
(A) Menu costs: it costs firms money to change their
prices – for example, to issue new catalogs or
change price tags.
(B) Labor contracts: multiyear contracts prohibit
rapid changes in wages and may mandate cost-ofliving-adjustments (increases to match inflation).
(C) Firms operating in imperfectly competitive markets
worry about changing prices and getting into price
wars with their competitors. Thus, firms may be
slow to adjust price to changes in costs or demand.
From the Short Run to the Long Run
Initially the economy is at Y*,
potential GDP and P.
Aggregate demand increases
from AD to AD1 and the
economy moves to Y1 and
P1.
The final equilibrium is Y*
and P2.
• If the economy is already at full employment but policy makers
think the unemployment rate is too high they carry out
expansionary monetary policy, inflation will result.
• This demonstrates the conflict between the full-employment
goal and the price stability goal.
Why Economists Disagree
• Part A: Understanding the Reasons Why
Economists Disagree
• It is not unusual to find “experts” disagreeing
with each other. Experts disagree about all sorts
of matters: unclear power, environmental
protection and who will win the Super Bowl.
• Why do experts disagree?
• How can the average person make sense out of
the differing viewpoints and recommendations?
Here are several important factors that often lead
economists to different conclusion.
• Different Time Periods
– One economist might state that the current policy of
the government will lead to inflation. Another
might disagree. Both could be right if they are taking
about the effects of the policy on inflation at
different times—for example, six months from now
compared with two years from now.
• Different Assumptions
– Because an economy is a complex system, it is often
hard to predict the effects of a particular policy or
event.
– Therefore, to be able to make predictions,
economists usually must make certain assumptions.
But economists often differ in their assumptions.
– For example, one economist might assume that the
federal budget deficit will become larger next year.
Another might not.
– These different assumption could be the result of
their assumptions about economic growth, tax
revenue and government spending.
• Different Economic Theories
– Economists agree on many matters such as, “If the price of
beef goes up and nothing the changes, people will buy less
beef.”
– This is a prediction with which nearly all economists would
agree because rests on the generally accepted law of demand.
However, economists have yet to settle a number of
important questions, especially those concerning
macroeconomics.
– Macroeconomics deals with the behavior of the economy as
a whole or large subdivisions of it, and how to influences
macroeconomic behavior.
– Economists have several different theories or explanations
about what influences macroeconomic behavior.
– Until theories are reconciled or until one of them is widely
agreed on as best, economists will disagree on
macroeconomic questions because the economists are using
different theories. The same applies to certain
microeconomic questions.
• Different Values
– Economics is concerned with explaining what is happening in
the economy.
– It is also concerned with predictions.
– The economist should be able to say to the president or to
Congress, “If you follow Policy One, then X, Y and Z will
happen. If you follow Policy Two, then Q, R and S will
happen. Pick the policy that gives the results you like better.”
– In practice, such statements by economists often contain
more than just analysis and a prediction about results.
– Their statements often recommend policies they like because
the results agree with their own values—in other words, the
results they prefer.
– For example, some economists will recommend Policy One
because X, Y and Z will happen and they favor achieving X,
Y and Z. Other economists will recommend Policy Two
because they favor achieving results Q, R and S. Such
disagreements are basically about which outcomes the
economists prefer. The economic policies they recommend
are determined by their preferred outcome.
Part B: Listening in on a Discussion of
Economists
• In your groups, read the four distinguished
professors of economics discussions on current
economic policy held at a luncheon press
conference attended by leading reporters of the
business news.
• Then complete Part C: Analyzing
Disagreements Among Economists
Analyzing Disagreements Among Economists
• Professor T.X. Cut
Major point: Tax cut will stimulate economy
Time period: Present and near future (short run)
Assumptions:
The administration’s budget proposals are not
inflationary because tax cuts balanced big spending
cuts. Unemployment needs to decrease during a
recession.
Theoretical support:
Tax cuts stimulate business investment, as well as
spending by all of the private sector and may
encourage greater work effort.
Values: Economic freedom and distrust of big
government
• Professor U. R. Nutts
Major point: Higher interest rates will cause recovery to fail.
Time period: Next year (medium term)
Assumptions:
Increases in government spending drive up interest rates,
which in turn decreases private investment and interest
rate sensitive components of consumption.
Theoretical support:
Government borrowing is so large that it causes interest
rates to rise and crowds-out consumers and business
borrowing
Values:
Tax cuts must be fair; and fairness means taxing the
wealthier more than the poorer. Government must maintain
economic security for Americans with low incomes.
• Professor E. Z. Money
Major point:
Relatively free expansion of money will bring down
interest rates and sustain recovery
Time period: Near future (short run)
Assumptions: Relatively free expansion of money supply by Fed
will sustain the recovery. Fed will support
expansionary fiscal policy
Theoretical support:
Lower interest rates increase consumer spending and
business investment. The primary effect of lower interest
rates is on investment. Growth is more important than
inflation.
Values:
A growing economy is desirable.
• Professor Fred Critic
Major point:
There will be another recession. Fed will continue past
policies – policies that have brought about periods of
inflation and recession
Time period: One to two years from now (long run)
Assumptions: Discretionary monetary policy is destabilizing because of
Theoretical
Values:
the lags in policy and the precise impact of changes in
money supply on the economy.
support: Not enough money growth causes recession;
too much money growth causes inflation.
Steady economic growth without inflation or recession is
desirable.