1 “ The Economic Way of Thinking ” 12 th Edition Chapter 15: Economic Performance and Real-world Politics

2 Chapter Outline The Great Depression What Happens in a Recession? A Cluster of Errors Monetary Mismanagement, Monetary Miscalculation Monetary Equilibrium When is Monetary Policy Effective?

3 Chapter Outline The Case for Fiscal Policy The Necessity of Good Timing The government Budget as a Policy Tool The Horizons and the Sequence of Effects Deficits Unlimited Why Not Government at All Levels? Discretion and Rules Who is at the Controls?

4 Introduction What difference does it make whetheer the quantity of money in the hands of the public grows rapidly or slowly? A comon view  An excessive rate of growth in a society’s stock of money will cause inflation

5 Introduction Questions  What constitutes an excessive rate of growth?  Is there such a thing as an insufficient rate of growth?  Does too little growth cause deflation （通货紧 缩）, or recession?

6 Introduction  Even if we know the appropriate rate to prevent these undesireable outcomes, does anyone have the ability to bring it about?  Are there other (perhaps better) ways to prevent undesirable fluctations in the aggregate level of economic activity?

7 The Great Depression GDP fall: % % % % Since WWII output declined in 2 consecutive years only once: % %

8 The Great Depression In 1939 output reached 1929 level. Per capita after tax income fell by:  30% to 1933  7% to 1939 Unemployment rate= 19% average in 1930’s Unemployment rate= 25% in 1933

9 The Great Depression Marx and Engels (Communist Manifesto)  Predicted calamity due to epidemic of overproduction （源于生产过剩瘟疫的灾难）  Claimed the epidemic would bring an end to capitalism.

10 What Happens in a Recession? Recession – to recede (retreat) Recession  Entail unintended and, thus, disruptive slowdowns  The result of frustrated expectations （预期落空）  Occurs when, for some reason, the number and depth of the disappointments increase without any compensating increase in the quantity and quality of delightful surprises

11 What Happens in a Recession? Production – undertaken in anticipation of a demand for the product or service Recessions occur when demand falls short of expectations When recession occurs, production and employment are reduced.

12 A Cluster of Errors （错误的集群） Recessions – accumulated mistakes  A cluster of errors among participants throuthout the economy  Thousands of entrepreneurs misread price signals provided by the market process Recessions – correction to prior period accumulation of mistakes  Production curtailed  Workers laid off  Capital liquidated at a loss

13 A Cluster of Errors Questions  Why would mistakes accumulate in an economic system?  Why wouldn’t overly pessimistic decisions roughly cancel out overly optimistic decisions?  How could so many people be mistaken?

14 A Cluster of Errors Great Depression  Worldwide in scope US – deeper and longer Great Depression questions:  Cause of the cluster of errors  Length and severity

15 A Cluster of Errors Authors contend the cause of errors  Expansionary monetary policy of 1920’s Credit expansion  Boom to Bust

16 A Cluster of Errors Milton Friedman ( ) University of Chicago Nobel Prize Winner 1976 Murray N. Rothbard ( ) University of Nevada Dean of the Austrian School economics

17 A Cluster of Errors Rothbard’s America’s Great Depression and Friedman’s A Monetary History of the US  Chanllenge the popular perspective That the Great Depression was caused by the collaplw of the self-organizing properties of the market system  Provide arguments and evidence That the cause, and length and severity of the Great Depression was a consequence of government policy

18 Monetary Mismanagement, Monetary Miscalculation Credit expansion fueled by money expansion  lowers interest rates  Over-investment  Unsustainable boom  If savings increase generated - sustainable Recessionary bust  Investment projects revealed as mistakes

19 Monetary Mismanagement, Monetary Miscalculation Credit expansion by central bank  Lowers market rate of interest  Investors engage in projects previously unprofitable (at higher cost of capital) The investment bite is bigger than the economy’s chew, so the system chokes

20 Monetary Mismanagement, Monetary Miscalculation There is no logic reason why the bust need be lengthy and severe  The adjustment process, while painful, can be relatively quick During the Great Depression, this process of adjustment was thwarted by government policies that  slowed down the process of adjustment  or actually set in motion new disturbances

21 Monetary Mismanagement, Monetary Miscalculation The Great Depression should be viewed  Not as an indictment （控诉） of the market economy  But as the major lesson in history on how monetary policy disturb the coordination process in economic life, both through expansion and contraction of the money supply

22 Monetary Equilibrium Coordination central to the economic system Although there may be macroeconomic questions, there are in the end only microeconomic answers What matters is the incentives and information that individuals face  That will lead them to successfully coordinate their actions with others in the market  Or direct them to activities which result in coordination failures

23 Monetary Equilibrium The monetary system is at the center of any advanced economy Money by its nature cannot be “neutral” （中立） because  It provides the link to all exchange relationships throughout the economy Imbalance of the monetary system  Have an impact on the pattern of exchange and production in an economy

24 Monetary Equilibrium From a monetary equilibrium perspective  Goal of monetary policy should be to strive for: Monetary neutrality by keeping Quantity supplied = quantity demanded Then Price stability, or stability of the purchasing power of money No seriously relative price distortions

25 When Is Monetary Policy Effective? The dominant opinion among economicsts  Monetary policy might be effective in preventing inflation  But it is largely ineffectively in countering recession

26 When Is Monetary Policy Effective? Monetary authorities can increase excess reserves,but cannot compel banks to extend loans Larger money stock may not produce increase in spending Recession can create a confidence crisis Central Bank efforts may be for naught

27 The Case for Fiscal Policy （财政政策） How can the the central bank or some other agency of government persuade people to borrow and spend? One way would be  to enhance confidence of households and business decision makers

28 The Case for Fiscal Policy How can the government help stimulate spending at a time when fear and timidity rule?  Public policy designed to enhance public confidence  Increase spending directly with fiscal policy

29 The Case for Fiscal Policy Fiscal Policy  Using government budget to bring about desired levels of spending.  The Keynesian Revolution The General Theory of Employment, Interest and Money (1936) Proposed controlling aggregate demand for fiscal policy to counteract recessions

30 The Case for Fiscal Policy Fiscal Policy options  Changing government spending  Changing taxes

31 The Case for Fiscal Policy Questions:  Did WWII confirm the power of fiscal policy?  How?  Why?

32 The Necessity of Good Timing Effective fiscal policy requires knowledge  Status of the economy Recognition time lag （认识上的时滞）  Where the economy is headed Diagnostic time lag （诊断上的时滞）  When policy will impact the economy Implementation time lag （实施方面的时滞）

33 The Necessity of Good Timing Effective fiscal policy requires knowledge of the future, but…  Predicting the future changes the future, because people read the predictions and act accordingly  This is the paradox with which sciences of human behavior must live

34 The government Budget as a Policy Tool Congress has little control over the budget Fiscal Policy requires agreement  Congress  President Haste makes for increased risk of mistakes

35 The government Budget as a Policy Tool Question  Why not give the President and Council of Economic Advisors the authority to implement fiscal policy?

36 Time Horizons and Politics （任期与政 治） The time horizons of those who are entrusted to construct and implement public policy is important for the selection of the economic policies that will in fact be pursued by the government

37 Time Horizons and Politics Changes in Aggregate Demand  Affects output and employment before affecting prices Politically  Expansionary policy is preferred over contractionary policy because…

38 Time Horizons and Politics Politically  Favor policies yielding benefits on Well organized and well informed interest groups In the short run At the expense of costs borne by unorganized and ill- informed mass of voters The standard pattern in democratically governed societies  More frequent and severe recessions along with a rising rate of inflation

39 Time Horizons and Politics Milton Friedman (Nobel Prize winner in 1976) and James Buchanan (Nobel Prize winner in 1986)  Both suport “tying the government’s hands”  Both argued that rules would outperform discretion in generating good economic policy  Friedman argued for a monetary rule  Buchanan argued for constitutional rules that called for a balanced budget

40 Deficits Unlimited （无限赤字） Why do budget deficits persist when there is a majority support for a balanced budget? Answer  There is no way to reduce the total budget while expanding each individual item in it.

41 Why Not Government at All Levels? Why don’t local governments do not produce chronic （长期的） deficits? Answer  Local governments do not have control over the medium of exchange

42 Why Not Government at All Levels? Why did national governments not produce such chronic deficits within peacetime before 1970? Why has it only been within recent years that other industrialized democracies started to make deficits the rule rather than the exception?

43 Why Not Government at All Levels? Answer  The demise of the once-strong prejudice against government deficits (i.e., regarded as immoral)  Strong majority convictions influence public policy

44 Why Not Government at All Levels? How did Keynesian economics impact our willingness to accept federal budget deficits?

45 Why Not Government at All Levels? Keynesian （凯恩斯主义） analysis  budgets don’t have to be balanced from year to year  they need noly to be balanced over the course of the business cycle, with surpluses in periods of prosperity making up for deficits in periods of recession Popular belief among economists in 1960s and 1970s  Anyone insisting on a balanced government budget just did not understand “modern economics”

46 Why Not Government at All Levels? The trouble with the new doctrine  Its effect is to permit perennial （持久的） deficits  There is no fiscal period that can be identified with “the course of the business cycle”  The surplus that is supposed to balance the deficit never has to be balanced, it can always be promised for the next year or the year after  The bias of the democratic political process takes over and makes deficits the rule rather than the exception

47 Why Not Government at All Levels? Milton Friedman  Inflation is everywhere and always a monetary phenomenon We can modify Friedman’s dictum （名言）  Hyperinflationa are everywhere and always the consequences of fiscal imbalances

48 Discretion and Rules （自行决定和规则） Evidence from US in the 1970s suggest that  The use of discretionary fiscal and monetary policy to stabilize the economy actually increased its instability But many people still believe that  We do posses the knowledge and skills required to achieve milder recessions and greater price stability through aggregate-demand management  It failed only cecause the right people won’t in charge

49 Discretion and Rules However, institutions should be evaluated  Not on the assumption that angels （天使，品行高 尚的人） will run them  Rather on the assumption that Government policies wil be controlled by politicians Monetary and especially fiscal policies will be formulated in the same political context that produces decisions on import tariffs, highway construction

50 Discretion and Rules An Alternative to Discretionary Fiscal and Monetary Policy 1. Government expenditures without reference to a stabilization goal

51 Discretion and Rules An Alternative to Discretionary Fiscal and Monetary Policy 2. Tax rates set to balance the budget over a normal period

52 Discretion and Rules An Alternative to Discretionary Fiscal and Monetary Policy 3. The Fed should maintain a steady hand on the stock of money, either holding it constant or allowing it to increase by some definite, known, uniform, and moderate rate

53 Who Is at the Controls? Would a balanced budget amendment eliminate deficit spending and help stabilize the economy? Answer  A difficult task

54 Who Is at the Controls? A budget is a prediction Also, it wouldn’t prevent politicians from timing and allocating transfer payments, government purchases, or tax-law changes in ways that destabilize the economy but improve the reelection prospects of incumbents

55 Who Is at the Controls? The functioning of the economy, along with the functioning of government and every other social institution, depends finally on  Our mutual ability to secure cooperation

56 Who Is at the Controls? Some instability seems to be an inherent characteristic of a free enterprise system in which  Decisions are decentralized  No one knows what everyone else is doing or will do  Most transactions occur throuth the medium of money

57 Who Is at the Controls? Big-picture questions:  How smoothly and quickly do prices adjust to changing conditions of demand or supply?  How smoothly and quickly do resources move about in response to the new information that changing prices present? These kinds of questions are notoriously hard to answer to everyone’s satisfication Our judgements about what is possible are subtly colored by our visions of what is desirable

58 Once Over Lightly The Great Depression (1930) and changes in economic theory. Uncertainty Economic collapse – recession Changes in the volume of money Cluster of errors – miscalculations Policy of monetary equilibrium

59 Once Over Lightly Post WWII recessions and government policies. Federal Funds Rate Fiscal Policy and Monetary Policy Time Lags and Fiscal Policy Economic forecasting and people behavior Political delays cause timing problems

60 Once Over Lightly Policymakers controlled by political processes Stabilization policies affected by short time horizons Unanticipated change in rate of growth of demand will affect output and employment before costs and prices

61 Once Over Lightly Political process tends to produce chronic budget deficits Government contribution to economic stability might be to do “less” Discretion stabilization policy vs. fixed rules Economic failures in late 1990’s renewed debate over roles of governments and markets