Self-Regulation or Government Intervention?

1. Self-Regulation

Rational Expectations

n There are 300 million individual participants in the US economy, all trying to make themselves better off.

Rational Expectations

n Each rationally reacts to actual and expected changes in the economy in order to better himself/herself.

n …or, to protect himself/herself.

Rational Expectations

n Based on:

n experience

n newly gained information

n predictions about future policy,

n People modify their activities in order to better themselves or to protect themselves.

n Collectively, the economy reacts to changing conditions.

n This causes it to move toward the long-run full employment state.

Self-Regulating?

n Can the economy, through rational expectations, work itself out of an overheated situation or an under performing situation … and get back to full-employment?

n If yes … laissez faire (no need for government involvement).

n If no … need government involvement.

Say’s Law

n “Supply creates its own demand.”

n Overproduction or underproduction cannot last long

n Buyers and sellers make necessary adjustments to better (or to protect) themselves.

Say’s Law

Classical Economics

n The economy can “fix” its own problems.

n Laissez faire - Government need not interfere.

n Prices, wages, and interest rates are sufficiently flexible:

n upward to “fix” an inflation problem

n downward to “fix” an unemployment problem

n Product, labor, and credit markets will adjust sufficiently to “fix” all shortages and surpluses.

Three States of the Economy

n The economy could be in equilibrium at a:

n Real GDP equal to Full-employment GDP

n A full-employment economy

Three States of the Economy

n The economy could be in equilibrium at a:

n Real GDP equal to Full-employment GDP

n A full-employment economy

n Real GDP less than Full-employment GDP

n An underperforming economy

n A “recessionary gap”

Three States of the Economy

n The economy could be in equilibrium at a:

n Real GDP equal to Full-employment GDP

n A full-employment economy

n Real GDP less than Full-employment GDP

n An underperforming economy

n A “recessionary gap”

n Real GDP greater than Full-employment GDP

n An overheated economy

n An “inflationary gap”

Long Run Equilibrium: A Full-Employment Economy

n Equilibrium at LRAS is long-run equilibrium.

n Unemployment is at the full-employment rate.

n Inflation is not accelerating upward.

Recessionary Gap: An Underperforming Economy

n Equilibrium to the left of LRAS.

n Equilibrium GDP is less than full-employment GDP.

n Unemployment rate is higher than full employment.

n Inflation is not usually a problem.

Inflationary Gap: An Overheated Economy

n Equilibrium to the right of LRAS

n Equilibrium GDP is higher than full-employment GDP.

n Unemployment rate is lower than full employment.

n Inflation is accelerating upward and is now the big problem.

… But how can an economy be overheated?

n Doesn’t that mean producing a quantity outside the PPF?

n … an unattainable amount?

Revisiting the PPF

n The physical PPF is the maximum output a society could produce if society put all its resources and technology to use.

Revisiting the PPF

n The institutional PPF recognizes that society prefers not to fully use all its resources and technology.

n Laws and customs reduce the amount of labor and capital used.

Revisiting the PPF

If society is operating on its institutional PPF, say at point X, then it is at full employment GDP.

Revisiting the PPF

n If society operates inside (under) its institutional PPF, say at point Y, then it is underperforming.

n Society has a recessionary gap.

Revisiting the PPF

n If society is trying to operate outside (above) its institutional PPF, say at point Z, then it is overheated.

n Society has a inflationary gap.

Revisiting the PPF

n The business cycle is a movement from point Y (trough) to point Z (peak) and back to point Y (trough).

Self-Regulating?

n 300 million participants:

n Act to better themselves

n Act to protect their own interests

n Cause the economy to close either a recessionary gap or an inflationary gap.

n This is the view of classical economists.

What Causes an Underperforming Economy (Recessionary Gap)?

Closing a Recessionary Gap

n Surplus of goods:

n prices fall

n sales rise

n inventory depletes

n factory orders rise.

n Surplus of workers:

n wages fall

n firms hire more workers.

Underperforming economy: Self-Regulation

Closing a Recessionary Gap

n SRAS shifts right.

n Price level falls.

n Real GDP rises.

n Unemployment falls.

n The economy moves from Q1 to Qf.

n The recessionary gap is eliminated.

What Causes an Overheated Economy (Inflationary Gap)?

Closing the Inflationary Gap

n Shortage of goods:

n prices rise

n sales fall

n factory orders fall

n production decreases.

n Shortage of workers:

n wages rise

n firms hire fewer workers.

Overheated economy: Self-Regulation

Closing an Inflationary Gap

n SRAS shifts left.

n Price level rises.

n Real GDP falls.

n Unemployment rises.

n The economy moves from Q1 to Qf.

n The inflationary gap is eliminated.

How does Self-Regulation Work?

n Economic participants take action to better themselves or to protect themselves.

n Self-regulation acts on the supply-side.

n Changes in incentive and in the capability to produce causes the SRAS to shift.

Summary: Self-Regulation

n An overheated economy:

n Caused by AD shifting too far right.

n “Fixed” by SRAS shifting left.

n An underperforming economy:

n Caused by AS shifting too far left.

n “Fixed” by SRAS shifting right.

So … What’s the Problem?

n Time!

n Waiting for the results of the individual reactions of 300 million participants could take a long time.

n Society becomes impatient and demands that the government - the agent of society - act to speed things up.

Self-Regulation or Government Intervention?

2. Government

Intervention

No More “Laissez Faire”

n Spurred on by the hardships of the Great Depression, the theories of John Maynard Keynes and the actions of Franklin Delano Roosevelt ushered in the modern era of active government involvement in “fixing” the economy.

John Maynard Keynes and the Great Depression

n In 1929-1932, the Great Depression occurred.

n Unemployment rose to 24 percent.

n Deflation occurred.

n Self-regulation could not cope with these problems.

John Maynard Keynes and the Great Depression

n Classical Economics: In a recession,

n Wages will fall (more will be hired)

n Prices will fall (more will be bought)

n The economy self-regulates, and

n Moves back to full-employment GDP

n Keynes’ criticism: In a recession,

n Wages would not fall.

n Prices would not fall.

n Self-regulation could not occur.

n The economy could get “stuck” with high unemployment.

Keynes’ Prescription

n For an economy “stuck” at a high unemployment equilibrium,

n Self-regulation was not working.

n A “jumpstart” was needed:

n An injection of new spending to get the economy moving again.

n The only spender who could do this was Government.

Keynes’ Multiplier Effect

n Any new spending (G) becomes new income (Y) to someone.

n New income (Y) after taxes (T), called disposable income (Yd), is divided into new spending (C) and new saving (S).

n Y = C + S + T

n Yd = Y – T = C + S

n ΔYd = ΔC + ΔS

Keynes’ Multiplier Effect

n New spending becomes new income to someone else and the cycle recurs over and over.

n The “jumpstart” spending by government will generate multiple rounds of spending throughout the economy.

Keynes’ Multiplier Effect

n Keynes showed that people are remarkably consistent on partitioning new after-tax income (Yd) into new spending (C) and new saving (S).

Marginal Propensities

n Yd = C + S

n ΔYd = ΔC + ΔS

n Divide through by ΔYd:

n 1 = ΔC/ΔYd + ΔS/ΔYd

n Define:

n marginal propensity to consume (MPC) MPC = ΔC / ΔYd

n marginal propensity to save (MPS) MPS = ΔS / ΔYd

n MPC + MPS = 1, always

The Multiplier Effect

n In each cycle, part of the new income is set aside as saving (MPS).

n So, the next round of income-spending is smaller than the previous round.

n As new income grows, it ultimately reaches its maximum.

n The power of the multiplier effect is controlled by the size of MPS.

The Multiplier Effect

n Calculate the total change in spending and income due to any “jumpstart” in spending:

n ΔGDP

n = spending multiplier x “jumpstart”

The Multiplier Effect

n Spending multiplier = 1/MPS

The Multiplier Effect

n Another “jumpstart” option available to government:

n Decrease tax revenues (T).

n The effect is not as strong.

n The tax multiplier is one unit smaller than the spending multiplier (and of opposite sign).

The Multiplier Effect

n Tax multiplier = - (spending multiplier - 1)

Summary

n Y = C + S + T Y is national income

n Yd = Y – T = C + S Yd is disposable income

n MPC = ΔC / ΔYd

n MPS = ΔS / ΔYd

n MPC + MPS = 1, always

n spending multiplier = 1/MPS

n tax multiplier = - (spending multiplier – 1)

Applications

n Recessionary Gap = $20 billion

n MPC = 4/5, so MPS = 1/5

n spending multiplier = 5

n tax multiplier = -4

n Gap = multiplier x “jumpstart”

n To close the gap:

n Either increase G by $4 billion,

n Or decrease T by $5 billion.

Applications

n Inflationary Gap = $20 billion

n MPC = 4/5, so MPS = 1/5

n spending multiplier = 5

n tax multiplier = -4

n Gap = multiplier x “jumpstart”

n To close the gap:

n Either decrease G by $4 billion,

n Or increase T by $5 billion.

Is Self-Regulation Dead?

n No.

n Readjusting the economic actions by 300 million economic players occurs but it takes a long time.

n We are an impatient people. We want results now!

n Therefore, we call on government, as agent of society, to DO SOMETHING!