Economics Chap 19 Flashcards
More on macroeconomic theory and policy
What does the AD-AS do?
1.Serves as a guide to policy-making
2.The AD-AS model deals with the general level of prices in the economy etc. consumer price index
3.Deals with the total production of goods and services in the economy etc. the gross domestic product
What do AD-AS show?
AD shows relationship between total expenditure of goods and services and the price level
AS shows the relationship between real production or output and the price level
The AD-AS model differs in two important respects from
the Keynesian model
In the first place it explicitly allows for supply conditions – in the
Keynesian model we simply assumed that aggregate supply
would adjust passively to aggregate spending. Secondly, it also
incorporates a variable price level P. In the Keynesian model
prices were assumed to be constant
There are various possible reasons why a fall in the price level tends to raise the quantity of goods and services
demanded in the economy
The three main reasons for the downward slope of the AD curve are the wealth effect (due to a change in the price level), the interest rate effect (due to a change in the price level) and the
international trade effect (due to a change in the price level)
Wealth effect
When prices fall, the income in consumers’ pockets may be used to purchase more goods and services than before,
that is, the real value of their incomes increases. The real value of all other nominal assets also increases. The real wealth of households thus increases. The fact that they become wealthier encourages households to spend more, with the result that consumption spending C and thus aggregate spending increase
Interest effect
When the price level falls, this may lead to a decline in interest rates, which will stimulate investment spending I.
The result is an increase in the quantity of goods and services demanded
International trade effect
If a fall in the price level results in a decline in interest rates, the latter may result in an increased outflow of capital
in pursuit of higher interest rates overseas and/or a decline in capital inflows, because domestic interest rates are
less attractive than before. This would result in a greater demand for foreign currency and a lower demand for
the rand, which will give rise to a depreciation of the rand against the major currencies. The weaker rand, in turn,
will tend to boost exports X and dampen imports Z, resulting in an increase in the quantity of domestic goods
and services demanded. The change in the prices of domestic goods relative to the prices of foreign goods will
reinforce this effect
There are three possible reasons why a fall in the price level P will tend to increase the quantity of goods
and services demanded Y:
1.Consumers become wealthier, which stimulates the demand for consumer goods and services
2.Interest rates fall, which stimulates the demand for investment goods
3.The currency depreciates, which stimulates the demand for net exports(X-Z)
Fiscal policy vs monetary policy
fiscal policy (government spending and taxation)
monetary policy (interest rates)
Short run AS
AS curve that slopes upward from left to right in the short run
If the price level P should rise, real wages will decrease and this will serve as an incentive for firms to employ more labour and increase production. A higher price level is therefore associated with a higher level of production. This result will, however, hold only as long as nominal wages remain unchanged. When nominal wages adjust, production will return to its original level, resulting in a vertical LRAS
Long run AS
Curve is vertical because nominal wages will be adjusted. Quantity of goods and services supplied in the long run is independent of the price level
The position of the AS curve
The position of the AS curve is determined by the availability, prices and productivity of the factors of production
and the other inputs in the production process gives rise to a shift of the AS curve.
A change in any of these factors will thus give rise to a shift of the
AS curve
1.Wage rate increase. This will raise the cost of producing each level of output, illustrated by an upward(leftward) shift of the AS curve.
2. This will also raise costs of production in the domestic economy, illustrated by an upward(leftward) shift of the AS curve
3. There is a significant increase in labor productivity. Such an increase will reduce the costs of production, illustrated by a downward(rightward) shift of the AS curve
Why is LRAS independent of price level
The reason for this thinking is that total production in the long run depends essentially on the quantity and quality
(productivity) of the available factors of production (natural resources, labour, capital and entrepreneurship)
The long-run level of output is also called potential output, full-employment output or the natural rate of output.
Changes in the availability and productivity of the factors of production will give rise to shifts of the LRAS curve – to the right if their quantity or productivity increases or improves and to the left if they decrease or
deteriorate
Changes in AD
An increase(decrease) in the aggregate demand-expansionary(contractionary) monetary or fiscal policy.
Employment also increases(decreases) since it increases(decreases) with increasing(decreasing) real production and income.
When supply conditions and the
price level are introduced explicitly
The monetary and fiscal authorities now
have to consider the trade-off between increased production and employment (on the one hand) and increased prices (on the
other)
Demand management model
Can be used to achieve one objective(eg increased production and employment) at the cost of the other(eg increased prices)
Expansionary vs Contractionary
If the Reserve Bank and the National Treasury are more worried about unemployment than about inflation, they
will apply expansionary policies. If they are more worried about inflation, they will apply contractionary policies.
Expansionary vs Contractionary on AD
When contractionary monetary and fiscal policies are applied, aggregate demand will decrease. This is illustrated by a leftward shift of the AD curve. In this case the price level P declines but real production Y also declines, and since employment is positively related to real production, employment will also decrease (ie unemployment will increase)
Changes in short-run aggregate supply
An increase in the cost of producing the total product (eg GDP) results in higher prices, lower production, income
and employment and higher unemployment. What we have
here is a situation of stagflation, which describes a situation of stagnation plus inflation
How to deal with stagflation
In other words, demand management policies can be used to counteract the effects of a supply shock on production,
income and employment but only at the cost of even higher inflation
Upward shifts of the AS curve are often referred to as
adverse supply shocks. They present policymakers with a difficult situation
How to avoid inflation when dealing with supply shocks
The solution is to take steps to lower costs of production. The aim would therefore be to shift the AS curve downward (to the right). Lower costs of production require a reduction in factor prices (ie lower wages, salaries, profits, etc) and/or increased productivity without a corresponding increase in remuneration.
Technically, what is required is an anti-inflationary incomes policy. The aim of such a policy is to establish a balance between the growth in incomes and the growth in productivity. The problem is that while the solution is simple in principle, it is very difficult (sometimes virtually impossible) to achieve in practice
however, that this will be achieved only if the remuneration of the factors of production remains unchanged, or if productivity increases faster than the remuneration of the factors of production
Monetary transmission mechanism
The way in which changes in
the monetary sector are transmitted to the rest of the economy is called the monetary transmission mechanism
Endogenous vs exogenous
exogenous (ie under the control of the monetary authorities)
endogenous(in the sense of being determined by the interaction between the interest rate and the demand for money)
Changes in the monetary sector are triggered by?
changes in the interest rate (which is for all practical purposes determined by the central bank) and not by (exogenous) changes in the money stock. In other words, the monetary transmission mechanism starts with a change in interest rates, not a change in the money “supply
A key element of the transmission mechanism
is the relationship between the interest rate (i) and investment spending (I), which is an import ant component of aggregate spending (A) and aggregate demand (AD)
What depends on the size of the supplier?
For a given increase in investment (‘I) the extent of the increase in total production and income (Y) will depend on the size of the multiplier
A change in the interest rate leads to a change in investment spending, a change in aggregate spending and a change in total production or income
The monetary transmission mechanism with variable prices and wages (ie in terms of the AD-AS model) can
be summarised as follows:
A change in the interest rate leads to a change in investment spending, a change in aggregate spending and a change in aggregate demand. The change in aggregate demand results in a change in total production or income and a change in the price level. The split between ‘Y and ‘P depends on aggregate supply conditions in the economy (represented by the slope of the AS curve)
First link(interest rate and investment spending)
If changes in the interest rate do not affect investment spending, the chain
breaks down. In other words, if investment demand is completely interest inelastic (illustrated by a vertical
investment demand curve) a change in the interest rate will not have any impact on investment spending
Second Link(Aggregate demand and the price level and total production or income)
When aggregate demand (AD) changes, the relative impact on the price level (P) and the level of total production or income (Y) will depend on aggregate supply conditions. For example, if the aggregate supply (AS) curve is relatively flat, an increase in AD will result in a relatively large increase in Y and a relatively small increase in P. On the other hand, if the AS curve is relatively steep, an increase in AD will cause a relatively large
increase in P and a relatively small increase in Y. The opposite will occur in both cases when AD decreases.
Summary of links
The smaller the interest elasticity of investment demand, and also the steeper the AS curve, the less effective an expansionary monetary policy will be as a means of stimulating the economy. However, the steeper the AS curve, the more effective a contractionary monetary pol icy will be as a means of combating inflation.
When the SARB changes the repo rate, a number of variables are affected, including
The domestic market interest rates
The quantity of money
Expectations
Asset prices
Exchange rates
The interest rate channel
The SARB raises the repo rate:
1. Market interest rates (i) increase.
2. Investment spending (I) and consumption spending (C) decrease.
3. Aggregate demand (AD) decreases.
4. The relative impact on the price level (P) and real output (Y) depends on aggregate supply (AS) conditions.
The exchange rate channel
The SARB raises the repo rate:
1. Market interest rates (i) increase.
2. If foreign interest rates remain unchanged, there will be an increase in net capital inflows (stimulated by the
increase in domestic interest rates).
3. The rand appreciates against other currencies (because of the greater demand for rand).
4. Exports decline and imports increase.
5. Aggregate demand (AD) decreases.
6. The relative impact on P and Y depends on AS conditions
The asset price channel
The SARB raises the repo rate:
1. Market interest rates (i) increase.
2. Equity (share) prices and property prices fall.
3. Firms and consumers become (or feel) poorer and spend less – in other words, there is a decline in investment
spending and consumer spending via the wealth effect.
4. Aggregate demand (AD) decreases.
5. The relative impact on P and Y depends on AS conditions.
The credit channel
The SARB raises the repo rate:
1. Market interest rates (i) increase.
2. Bank loans decrease.
3. Investment spending (I) and consumption spending (C) decrease.
4. Aggregate demand (AD) decreases.
5. The relative impact on P and Y depends on AS conditions
In all these channels expectations can have a significant (albeit often uncertain) effect. Four aspects of this modern view of the monetary transmission mechanism have to be emphasized:
- The link between the interest rate and investment spending, is still a crucial part of the mechanism
- It is a complex transmission mechanism which works through various channels(in contrast to the relatively simple transmission mechanism)
- The outcome of the process is uncertain(more so than in the case of the simpler transmission mechanism
4.The time lag between the policy action(a change in the repo rate) and its eventual impact on the price level(P) and real output (Y) is also variable and uncertain.
Expansionary and contractionary monetary policy
An expansionary monetary pol icy is implemented when the central bank (eg the SARB) reduces the interest rate (eg the repo rate) at which it provides credit to the banks. In terms of the AD-AS model
this is illustrated by a rightward (upward) shift of the AD curve. Monetary policy is contractionary when the central bank raises the interest, illustrated by a leftward (downward) shift of the AD curve
Expansionary and contractionary fiscal policy
An expansionary fiscal policy is applied when the government (in the person of the Minister of Finance) increases government spending (G) and/or reduces taxes (T). This is illustrated by a rightward (upward) shift of the AD curve. Fiscal policy is contractionary when government spending is reduced and/or taxes are increased, illustrated by a leftward (downward) shift of the AD curve
Recognition lag
This is the lag between changes in economic activity and the recognition or realization that the changes have
occurred. Economic data do not become available immediately. The recognition lag is the same for monetary and fiscal policy
Decision lag
Once it has been established what is happening, the authorities have to decide how to react. In the case of fiscal
policy this means that ministers and officials from different departments, and eventually the Cabinet, have to
meet to discuss matters and to consider various policy option.
With monetary policy the lag is generally much shorter. At the time of writing, the MPC of the SARB was meeting six times a year to consider possible changes in the repo rate. However, nothing prevents the
Governor of the SARB from convening a meeting of the MPC at any time, and decisions can be taken within a
day or two
Implementation lag
Time taken to implement the appropriate policy which authorities decided on. Longer for fiscal
fiscal policy, government
spending and taxes cannot be changed overnight. Plans have to be drawn up and parliamentary approval usually
has to be obtained before the plan can be put into action
In contrast, the implementation lag associated with monetary policy is very short. In fact, when a change in the repo rate is announced, it comes into effect immediately
Impact lag
Time it takes for implemented policies to have actual impact on the economy. Longer for monetary. fiscal policy, an increase in taxes will, for example,
not have its full impact on the economy immediately. The same applies in the case of a change in government spending
monetary policy the impact lag
is very long. Most economists estimate that it takes between 12 and 18 months (and even up to 24 months) for
a change in the repo rate to have its full impact on prices, production, income and employment
Impact lag referred as
The impact lag is often referred to as the
outside lag, to distinguish it from the first three types of lags, which together constitute the inside lag (ie the delay from the time a need for action arises until the appropriate policies are
implemented).
The relative effectiveness of monetary and fiscal policy
Fiscal policy has generally been more successful in stimulating a depressed economy, while monetary policy can be employed with greater assurance to dampen an overheated economy in which inflationary pressures are severe
What are the policies subject to?
Fiscal policy is subject to parliamentary approval and the decisions in this respect are normally taken by politicians. Monetary policy, on the other hand, is formulated by the central bank (the Reserve Bank in South Africa), which enjoys a greater degree of autonomy
Note
Increases in income above YB will be accompanied by increases
in the deficit
How could the dilemma be possibly solved
The dilemma can, of course,
be resolved if current account deficits are financed by net inflows of foreign capital, that is, by surpluses on the financial
account of the balance of payments
Monetarism
Originates from classical economics’ assumption of classical dichotomy-money have no impact on real variables like real production, income and spending
The key elements of this debate
can be summarized as follows:
1.The monetarists generally believe that a free-market economy is intrinsically stable and effective in achieving macroeconomic objectives. In contrast, Keynesians believe that the free-market economy is inherently unstable
2.Monetarists therefore believe that government intervention should be restricted to the minimum
3.Monetarists believe that inflation is caused by excessive increases in the quantity of money
Note
MV=PY
The monetarists believe the following:
- The money “supply” is an important determinant of nominal production or income(PY)
- Movements in the quantity of money are the best indicator of the stance of monetary policy
- The velocity of circulation of money(V)(and therefore also demand for money) is stable
- Changes in the quantity of money can affect real production or output(Y) only in the short run
5.Changes in the quantity of money affect only the price level(P) in the long run
Supply-side economics
No single theory, place greater emphasis on microeconomics(particularly tax incentives)
Emphasis on AS, focusing on policies that increase AS
Recommend cut in G(transfer of resources to the private sector(privatization)believed to be more efficient), deregulation(remove red tape restricting entrepreneurship) and reduction of T(incentives working, saving and investing)
New classical economies
Macroeconomics must have solid microeconomics foundations
Assume that all economic agents have rational expectations and markets always clear. Wages and prices are completely flexible
These assumptions have implications for the effectiveness of monetary and fiscal policies
New Keynesian Economics
Argue for solid microeconomic foundations, accept rational expectations. However, favor the nation of wage and price stickiness and policy intervention
No consensus as to which policy is desirable
