Category Archives: Macro

A2 Economics – The Accelerator

Just been covering this topic with my A2 class. The accelerator will come up either as a multiple-choice question or part of an essay. The accelerator theory states that investment is determined by the RATE AT WHICH INCOME, AND HENCE OUTPUT, CHANGES OVER TIME. The principle states simply that unless the rate of increase in consumption is maintained, the previous level of investment will not be maintained.

This theory assumes that firms try to maintain some constant relationship between the level of output and the stock of capital required to produce that output. In other words, we assume a constant capital-output ratio which can be expressed in either physical terms or money terms. The accelerator helps us to understand how small changes in demand in one sector can be magnified and spread throughout the economy. The example below assumes that the firm starts with 8 machines each year and 1 machine wears out each year and that each machine can produce 100 units of output per year. In the second year, demand rises for capital goods rises by 200% (from 1 to 3). When the rate of growth of demand for consumer goods slows in year 4, demand for capital goods falls. In year 6 demand drops and they is no requirement for any investment.


Limitations of Accelerator:

* Firms can meet output with stocks – may not need investment
* Changes in technology may mean firms don’t need to invest in as much capital as before
* Firms need to be convinced that demand is long-term to warrant investment
* Limited supply of technology available

Adapted from CIE AS and A Level Economics Revision Guide by Susan Grant

Consumption Function Cake

Went through the consumption function this morning with my A2 class and I recalled the superb cake that A2 student Lara Hodgson made for the class a few years ago – here’s hoping for a similar cake this term. Remember that the standard Keynesian consumption function is written as follows:

C = a + c (Yd) – where:

  •   C = total consumer spending
  •    a = is autonomous spending
  •    c (Yd) = the propensity to spend out of disposable income

Autonomous spending (a) is consumption which does not depend on the level of income. For example people can fund some of their spending by using their savings or by borrowing money from banks and other lenders. A change in autonomous spending would in fact cause a shift in the consumption function leading to a change in consumer demand at all levels of income. The key to understanding how a rise in disposable income affects household spending is to understand the concept of the marginal propensity to consume (mpc). The marginal propensity to consume is the change in consumer spending arising from a change in disposable income. The higher the mpc the steeper the gradient of the consumption function line. As you can imagine the consumption of cake was fairly rapid.

Addressing savings glut needs more than monetary policy

Today central banks have a limited toolkit and the powers to deal with the savings glut (see image below), lack of investment, climate change and income inequality. There is a lot of money in the system but the velocity of circulation is slow – MV=PT – and this is one reason why we have little inflation.

Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:

M x V = P x T

M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output

Add to this COVID-19 and the impact it has had on especially developing economies and we have economic stagnation.

Source: Bloomberg Economics

Some economists have suggested the need for more expansionary fiscal policy as well as structural reform to achieve economic growth. The latter being a long-term policy can take the form of price controls, management of public finances, financial sector reforms. labour market reforms etc. Although the US Federal Reserve is adopting a flexible average inflation target to avoid a disinflationary environment it will not be enough to deal with secular stagnation.

Secular stagnation
Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap for eight of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.

Paul Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors

  1. When the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
  2. If the investment is productive, it will expand the economy’s productive capacity in the long run.This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost (Hoynes and Whitmore Schanzenbach 2018).
  3. There’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015).

Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro

Bloomberg Economics – Yellen, Summers Say Central Banks No Match for Savings Glut

OCR – LSAP – FLP = New Zealand’s Monetary Policy Toolkit

Below is a useful flow diagram from the ANZ bank which adds Large Scale Asset Purchases (LSAP) and Funding for Lending Programme (FLP) to the Official Cash Rate (OCR – Base Rate)

LSAP – this is the buying of up $100 billion of government bonds – quantitative easing
FLP – this gives banks cheap lending based on the Official Cash Rate – could be about $28 billion based on take up
OCR – wholesale interest rate currently at 0.25%. Commercial banks borrow at 0.5% above OCR and can save at the Reserve Bank of New Zealand (RBNZ) at 1% below OCR.

With FLP and more LSAP this will mean lower lending rates and deposit rates. This should provide more stimulus in the economy and allay fears of future funding constraints making banks more confident about lending. Add to this a third stimulus – an OCR of 0.25%. The flow chart shows the impact that these three stimulus policies have on a variety of variables including – exchange rates – inflation -unemployment – consumer spending – investment – GDP. Very useful for a class discussion on the monetary policy mechanism.

Eight body problem in economics

Physicists and mathematicians have puzzled over the three-body problem – the question of how three objects orbit one another according to Newton’s laws. No single equation can predict how three bodies will move in relation to one another and whether their orbits will repeat or devolve into chaos.

John Mauldin of Mauldin Economics wrote about the eight-body problem in economics in which we cannot predict how the economy will react when eight variables change. He lists the following:

What is certain is that as government fiscal intervention starts to lose its effectiveness it will be inevitable that monetary policy will continue to remain very accommodating with bond buybacks and record low interest rates. COVID-19 has turned conventional economic thinking upside down.

Macroeconomic Policy – where we’ve been and where are we going?

The Economist ‘Briefing’ recently looked at what now for macroeconomic policy in the global economy. The GFC of 2008 and outbreak of COVID-19 has got policymakers scratching their head as what can be done to stimulate aggregate demand.

Keynes’ ideas of government involvement in managing the economy in the business cycle – spend in recessions and pay of debt in booms – was flavour of the month in the post-war period. However by the1970’s this policy was in trouble which the spectre of stagflation – high inflation accompanied by high unemployment. According to Keynes the two variables should move in opposite directions. In 1976 the UK Prime Minister James Callaghan in his speech at the Labour Party Conference said:

We used to think that you could spend your way out of a recession, and increase employ­ment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of infla­tion into the economy, followed by a higher level of unemployment as the next step. Higher inflation followed by higher unemployment.

The 1980’s saw monetarist ideas enter the scene with a focus on the control of inflation though constraining the money supply. University of Chicago economist Milton Friedman and US Federal Reserve Chairman Paul Volcker knew that in order the get inflation down that the economy would have to go through a recession and very higher unemployment in the short-run. However once inflation started to drop the Central Bank could relax monetary policy (interest rates) and then encourage more economic activity in the economy and thereby reducing unemployment. Previously policy had focused on equality of incomes which had a large impact of economic efficiency. Price stability was now the primary focus of a central bank and it was in New Zealand with the 1989 Reserve Bank Act that the first central bank became independent from government. Gone were the days where the Minister of Finance could get on the phone to the Reserve Bank Governor to change interest rates. Central banks had inflationary targets whilst fiscal policy was to keep government debts low and to redistribute income as the government saw fit.

This policy came unstuck after the GFC as central banks dropped interest rates to record levels and implemented a series of quantitative easing (QE) measures to no avail. Growth was stagnant for a long time but eventually demand for labour picked up. This would have normally been accompanied by higher inflation but it wasn’t the case. Just like in the 1970’s inflation and unemployment were not behaving according to the theory but at this time both were favourable – low inflation and low unemployment. However inequality was now gripping the attention of economists and there was concern about the monopoly position of some firms. The rich have a higher tendency to save rather than spend, so if their share of income rises then overall saving goes up and lower interest rates and QE were driving up inequality by increasing house and equity prices.

Once COVID-19 hit it was government’s fiscal policy which has been used to try and stabilise the economy and boost growth. Fiscal stimulus – government spending with running up large deficits might be required for a long period of time in order to support the economy. This is more acceptable amongst economists as low interest rates enable the government to service much larger debts and with such low inflation it is unlikely that rates will increase anytime soon. This resembles Modern Monetary Theory (MMT) – the situation where the government can create its own money therefore:

  1. Cannot default on debt denominated in its own currency;
  2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
  3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
  4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
  5. Does not need to compete with the private sector for scarce savings by issuing bonds. Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

Negative interest rates

Some governments have gone the way of negative interest rates (see graphic) to try and stimulate more aggregate demand. This would discourage saving and see a potential withdrawal of cash from the banking system leaving less money to lend out. Avoiding this scenario might involve abolishing high-denomination bank notes and making the holding of large amount of cash expensive and unfeasible. However in order to keep money in the banks might renege on interest rate cuts as customers might move their money to rival banks therefore high negative interest rates would severely dent banks’ profits.

The current economic environment may make negative interest more plausible as:

  • Cash is in decline.
  • Banks are becoming less important to finance.
  • Central bankers are looking at creating their own digital currencies

Final thought

Greater government intervention is what the majority of economists want but it does carry with it risks of significant debt and high inflation. There is an opportunity to rethink the economics discipline and as stated in The Economist:

A level-headed reassessment of public debt could lead to the green public investment necessary to fight climate change. And governments could unleash a new era of finance, involving more innovation, cheaper financial intermediation and, perhaps, a monetary policy that is not constrained by the presence of physical cash. What is clear is that the old economic paradigm is looking tired. One way or another, change is coming

Sources:
The Economist – A new era of economics – July 25th 2020
http://www.britishpoliticalspeech.org/speech-archive.htm?speech=174

What causes a recession? TED-Ed

Showed this to my IGCSE class today – great video which is well put together with good examples that explain a recession and its causes. Particularly apt for today’s economic environment. Makes good use of supply and demand graphs as well as supply side and demand side variables. Detailed explanation of the business cycle. Useful for NCEA Level 2 growth standard.

Macroeconomic Policies – Mind map

Just covering macro policies / conflicts with my A2 Economics class and produced this mind map in OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4.

My question would be what policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives?

Adapted from Susan Grant – CIE AS and A Level Revision