With most schools doing their mock exams in both CIE and NCEA here is a mindmap which covers the main points when studying perfect competition. This can be a popular essay in CIE Paper 4 making a comparison with imperfect competition.
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.
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:
- Cannot default on debt denominated in its own currency;
- 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;
- 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;
- 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;
- 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
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
The Economist – A new era of economics – July 25th 2020
Another very good video from Tom Chitty at CNBC. He explains how negative interest rates in theory are supposed to work but also looks at some of the problems that might eventuate. Very good for macro policy Unit 5 CIE and NCEA Level 2 and 3.
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.
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?
Just covering this topic with my A2 class. Part of the CIE A2 macro syllabus focuses on the wage price spiral which relates to the Phillips Curve. Here are some excellent notes that I picked up from Russell Tillson in my early days teaching at Epsom College. As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve.During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.
Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.
Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.
The process can be seen in the diagram below – a movement from A to B to C to D to E
Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:
1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).
2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).
3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.
Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.
Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.
I blogged yesterday regarding the shape of recovery after the coronavirus pandemic and have been reading Paul Krugman who suggests that conventional monetary policy can’t offset an economic shock like coronavirus.. 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 (see graph below) for 8 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.
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
- First, 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.
- Second, 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.
- Thirdly, there’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015). Again, by avoiding these effects a sustained fiscal stimulus would partially pay for itself. Put these things together and they probably outweigh any fiscal effect due to stimulus raising interest rates.
Can the Japanese experience tell us anything?
The policies proposed are similar to those by Japan in the 1990’s but the environment there was unique from what most other developed economies are experiencing. Krugman makes two points:
- Japan allowed itself to slide into deflation, and has yet to convincingly exit.
- Japan’s potential growth is low due to extraordinarily unfavourable demography, with the working-age population rapidly declining.
As a result, Japan’s nominal GDP has barely increased over time, with an annual growth rate of only 0.4% since 1995. Meanwhile, interest rates have been constrained on the downside by the zero lower bound. Even with this Japan still faces no hint of debt crisis.
Therefore according to Krugman, with negative shocks to economies becoming more prevalent it maybe better to implement a productive stimulus plan instead of trying to come up with some short-term measures every time there are shocks to our economy.
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
No doubt you will have heard in most government press conferences the aim of flattening the curve. In trying to flatten the epidemic (epi) curve there will be a trade-off with reduced economic activity. By having a lockdown you reduce the exposure of people to the virus but it also means less employment and consumption.
The graph above shows the following:
- steep red curve shows – (medical outcome) without some sort of lockdown
- latter blue curve – impact on cases of the virus with a lockdown
- flatter red curve shows – the impact on economic activity if there was no lockdown
- steep blue curve shows – impact on economic activity if there was a lockdown
Therefore if you flatten the infections curve you steepen the recession curve.
This unavoidable trade-off is surely behind some leaders delaying containment policies – not wanting to experience a severe recession especially in US as it is election year. It seems that if you don’t act to contain early you pay for it later
These desperate times call for desperate measures – a version of shock therapy. Society has a pressing need for a massive increase in government spending but what we don’t want to happen is a COVID-19 recession gradually turning into a COVID public debt crisis.
Source: Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes. Edited by Richard Baldwin and Beatrice Weder di Mauro
Economists use the term Japanification as shorthand for the situation where economic growth remains stagnant even with significant monetary easing – lower interest rates and increased government spending. With interest rates already at record low levels it seems that a lot of economies are going the same way as Japan. However as discussed in the video below from the FT, Japan is a nice place to live and has a very high life expectancy. The concern for central banks is what other policy instruments do they have after really low interest rates – they are running out of ammunition. To boost growth in the USA is a lot different than in Japan according to Ben Friedman. He states that Japan does not have the problems of widening inequality and the stagnation of the middle income groups.
The question is why Japanese society seems to cope with an economy that doesn’t respond to very low interest rates and increase government spending? The FT look to Robert Pringle’s book ‘The Power of Money’ and suggest three reasons:
- Long established business – 5500-odd companies that are 200+ years old, more than 3,000 are Japanese. They are much more resilient to change and have less of a focus on short-term profits but too service, patience and a disdain for pecuniary motives.
- Immaterialism – unlike a lot of western countries (US in particular) money in Japan is less significant in showing success. Therefore there is less social conflict.
- Japanese version of capitalism – US = individualism and democracy. Japan = individual is part of a group and discourage competition = a stable society.