Classical economists assumed that economies would operate at the full employment level because prices and wages are flexible. (e.g., the oil price reached the peack of $145 in July 2008, but fell below $40 in 2015.)
If unemployment were present, wages and prices would fall until full employment was restored. The classical economists wrote in the 19th century.
Empirical evidence shows that prices were indeed flexible during that period. Extreme upward and downward movements in prices took place regularly. This was due to the greater importance of agriculture in the 19th century. Agricultural prices were flexible in both directions. During WWI, increased demand (from Europe and Japan) for American goods raised the price. The 1920-21 depression hit American farmers very hard, causing a dramatic fall in the price of raw agricultural products.
This situation was worsened in the 1930s (Great Depression).
The Keynesian Model is more appropriate for describing the world economy since 1930s. (Manufacturing were becoming more important. Manufacturing share was 30% of GDP in 1930, 25% in 1970, but is now 12% (total industry's share = 20%.)
Labor share of agriculture: 74% in 1800, 40% in 1890.
Today, the classical model may be more relevant now than before.
As income grows, the service share of GDP increases, and the economy eventually behaves like a closed economy.
US service share = 79% (Industry = 20%, ag = 1.1%)
(ii) unemployment exists in the labor market.
|The Model||Y = C + I + G + (X - M)
C = C(Y), C' > 0
I = Io
G = Go
(ii) Y = C + S + T
|Paradox of Saving|
I + G + X = S + T + M
(a) No government:
I + X = S + M
(b) No foreign sector
I = S = -a +sY. (s = 1- b).
A decrease in a only reduces Y without raising total savings. (S = I remains unchanged) ⇒ Paradox of Saving.
Y = a + bY + I,
Y = (a + I)/(1 - b)
multiplier = 1/(1 - b)
b = marginal propensity to consume
MPC = 0.77 (US)
|(i) small country||
Foreign trade multiplier
mX = 1/(1 - b + m)
|Exercise||C = 1.5 + 0.6Y
I = .5, X = .5, M = .1Y
Y = 5, multiplier = 2
|(ii) large country||Y = a + bY + I + m*Y* - mY
Y* = a* + b*Y* + I* + mY - m*Y*
multiplier = 1/[s + m - mm*/(s* + m*)] > 1/(s + m)
The multiplier for a large country is greater than that for a small country.
A simple model of the domestic economy consists of the product market and money market.
Product market equilibrium
(unemployment still exists)
|Y= C(Y) + I(r) + G|
When the aggregate demand is equal to the current output, actual inventories are exactly equal to the planned inventories. Since there is no unintended inventory build-up, the product market is in equilibrium.
This yields IS curve, which is the locus of income and interest rate that clears the product market.
IS curve is negatively sloped. An increase in r lowers investment, which reduces GDP (through the multiplier effect).
|Shifts of IS curve||
Since this graph has only two dimensions, r, Y, only their relationship can be shown. If any other factor varies, it causes a shift in the IS curve.
(i) an expansionary fiscal policy, or an increase in foreign borrowing increases income at a given interest rate.
Real Money supply
Ms/P = speculative + transactions + precautionary demand.
| two components: (Nominal) Money demand = L(r¯) +
(Real) Money demand = ℓ(r¯) + kY, k > 0.
Money market equilibrium requires:
Ms/P = ℓ(r¯) + kY
LM curve is positively sloped.
Since the left hand side is fixed, an increase in r lowers the speculative balance, which requires an increase in the transactions balance.
|Shifts of LM curve||
(i) M increases
The labor market does not clear (not shown here). Accordingly, GDP is less than the full employment rate of output).
|What to do||
To attain FE in a closed economy, shift IS or LM curve or both.
A monetary or fiscal expansion is needed to stimulate the economy. Keynesians argue fiscal policy is more effective, while monetarists recommends monetary policy to cure unemployment. A fiscal expansion raises the interest rate, while a monetary expansion lowers it.
The domestic economy consists of three markets:
(i) the product market
(ii) the money market, and
(iii) the external market.
|Product market||Product market equilibrium requires
Shifts of IS curve
An expansionary fiscal policy, an increase in export sales, or devaluation, increases income at a given interest rate.
Ms/P = ℓ(r) + kY
|External Market||Current account + Capital Account
|Shifts of BP curve||
an increase in X ⇒ BP curve shifts to the right
an increase in foreign income.
devaluation increases X.
Under clean float (without intervention by any government) exchange rates are determined at the rates where BP equilibrium occurs.
A Balance of Payments disequilibrium occurs under the fixed exchange rate system, or under dirty float.
|BP Equilibrium||The economy might be in balance of payments equilibrium
as shown below:
|BP surplus||However, there is no reason for the economy to be
in such an equilibrium state. For example, an economy may have a BP
surplus or deficit as shown below.
Figure 7. Balance of Payments surplus
|Policy options in a Closed economy||In a closed economy, policymakers can use monetary or fiscal policies, or a suitable combination of both policies to correct unemployment in the labor market and reach the full employment output in the product market.|
In an open economy, policy makers still have the option of using monetary and fiscal policies. However, openness also means a possible disequilibrium in the foreign sector.
To correct a problem in the balance of payments, there are four policy options:
(i) monetary policy,
(ii) fiscal policy,
(iii) balance of payments policy,
(iv) laisses-faire (nonintervention, do-nothing).
Lao Zi (or Lao Tsu), a Chinese philosopher around 550 BC, advocated for non-intervention. Later, the classical economists of the 19th century called it laissez-faire.
From the "Sayings of Lao Zi" (by Tsai Chih Chung), Courtesy of Asiapacbooks.com.
|Figure 9 illustrates what happens when the policymaker does nothing. whereas BP deficit gradually raises interest rate. This explains for instance why interest rate in Japan is lower than in the US.|
In a full employment economy, BP surplus lowers the interest rate.
(i) initially the internal economy attains
its full employment equilibrium at point e.
Policymakers in surplus countries often do not feel obligated to do anything to correct surpluses in their balance of payments. They think that deficit countries should cure their deficit problems, even though the policies of surplus countries may cause deficits of their trading partners.
Thus, consider the effect of "do nothing" (nonintervention) policy of a surplus country.
(i) BP surplus increases money supply since commercial banks experience an increase in reserves (exporters convert foreign currency earnings into the domestic currency) and the monetary base increases, which through the money multiplier, increases money supply. The LM curve shifts to right.
(ii) Interest rate falls along the IS curve, which has an expansionary effect on the economy. However, due to full employment, price rises.
(iii) A price increase shifts the LM curve to the left a little, and shifts the IS curve to the left, since due to inflation imports become relatively cheaper. Increased imports and decreased exports also shift the BP curve upward.
|Automatic adjustment to BP surplus|
cut money supply.
Cutting money supply will defnitely raise the interest rate and reduce the BP deficit.
However, policies are not always symmetric.
Increasing money supply may not be effective in the presence of a liquidity trap (when increasing money supply does not lower interest rate).
In recent years, since Alan Greenspan became the chairman of the Board of Governors for Federal Reserve System, the US has adopted interest rate fixing policy, which meant flat LM curves for all operational purposes.
|or cut interest rate|
The deflationary policy increases unemployment. This policy might be unpopular when the country has both unemployment and BP deficit.
A decrease in money supply or a rise in the interest rate increases unemployment. (Not a good option during recession)
It might be acceptible if the economy is overheated and the inflation rate is high.
|Deficit||Deficit: decrease Government spending? Not when unemployment is a problem.|
|Assume: interest rates are fixed (US, Europe or Japan)|
Neither monetary nor fiscal policies are effective to cure BP deficits, as they could cause a more serious problem in the domestic economy. The best remedy is found at the source.
To cure a deficit, you have the following 5 options:
(e) increase liabilities to foreign central banks.
In addition, to control trade deficits
(f) tariffs and quotas
For instance, devaluation improves the country's balance of payments.
Developed economies: Japan permitted a rise in yen (USD fell to about 110 yen from 280 yen in 1985). This move reduced Japan's BP surplus while reducing US BP deficit.
LDCs: Exchange controls are often used in LDCs.