Monday, April 27, 2009

Evaluating fiscal policy

When discussing fiscal policy most introductory texts focus on the potential problems that fiscal policy may have. This was probably a result of at least two things. On the one hand, since the early 80s there has been an anti-Keynesian wave in much of academia, in the press and in what most politicians said. On the other hand, the current crisis is the first one after quite some time that not only has resurrected Keynes but even Marx ('Worldwide sales of Das Kapital have shot up: one lone German publisher sold thousands of copies in 2008, compared with 100 the year before'; see this; thanks to my colleague John Tomkinson for bringing the article to my attention)

What are some of the potential advantages of expansionary fiscal policy?

If you were asked to evaluate demand side policies, what points could you make for employing expansionary fiscal policy? A student of mine asked the other day and here is what we came up with:

Fiscal policy is direct: any increase in government spending will automatically increase by at least as much, if not more, national income (but remember the Barro argument I pointed out in an earlier post)

If the multiplier is greater than one, then it is also a powerful tool to lift an economy from recession (but remember the Mankiw - Krugman/Romer disagreement that was pointed out in an earlier post; go to Mankiw and Krugman for lots on this)

In an economy in deep recession (or, depression) interest rates may be at or close to zero so monetary policy is totally ineffective; in such a case policymakers have only fiscal policy to turn to (in the US interest rates are already virtually zero, so there is no room for easier monetary policy)

If the institutional framework of the economy is equipped with unemployment benefits and a progressive income tax system then policymakers have the benefits of built-in stabilizers (concerning unemployment and other benefits, the EZ12 is more equipped than the US is; this was Germany’s and France’s argument against a ‘coordinated’ fiscal push even though they may be just hoping for the US leakages (US imports from the EZ) which are EZ injections (EZ exports to the US))

If the increased government expenditures of a stimulus package include spending on infrastructure (defined as physical capital typically financed by governments that create massive positive externalities i.e. roads, bridges, harbors, telecommunications etc), health and education, then a long run positive supply-side effect will also result

If the increased government expenditures of a stimulus package include spending on the development of ‘green’ technologies than an additional long run benefit will be the improved environment, giving a better chance to sustainable growth.

A decrease in taxes as part of an expansionary stimulus plan may also have beneficial supply-side effects as lower taxes may improve incentives to work and to invest (a well known albeit perhaps somewhat controversial supply-side argument)
Just some ideas. Comments are welcome....

Linking the multiplier and the accelerator...

Linking the multiplier and the accelerator creates problems to most IB economics candidates even though in our watered-down version of things it is pretty simple.

I have prepared and uploaded a few extra notes (beyond what you find in our guide) that may prove useful here.

A very long time ago there has been an essay that focused on exactly this issue:

'Explain how the multiplier and the accelerator might be linked to each other'.

You know when? Back in May 1993 (my 1st IB candidates faced it). Were you guys born?

(OMG, 14 days and 0 hours)

On the crowding out effect - ideas for a short essay

Darlings, in two weeks you will be taking HP1 and HP2 (and SP1, of course). I hope you are doing the work you are expected to do and that you are not sipping your soft drink on a beach....

Here are some ideas on crowding out that you may find useful. Many past IB economics examinations have focused on the issue so it is a good idea to have understood the logic of it. For example there has been this short essay:

Explain how an increase in government spending can lead to crowd-ing out.

Here are a few points to consider. Onnce again, this is NOT a model answer. If you are not my students, please follow the advice of your own teacher.

The essay together with the diagrams can be found at our wiki space if you click here.

Expansionary fiscal policy refers to increases in government expenditures and / or decreases in taxes in order to increase aggregate demand (defined as…) and thus increase economic activity and lower unemployment.

The increase in government spending is by many thought to be a powerful tool to lift an economy out of recession (defined as…). The current Obama stimulus plan whereby the US government is spending an extra 787 billion dollars is an example of such a policy (note that using an example is always a good idea). The expected increase in national income is larger as a result of the multiplier effect. The multiplier effect results from the fact that one’s spending is another person’s income as well as that economic activity takes place in successive rounds.

'Monetarists', on the other hand, claim that the increase in government expenditures is not as effective as described above as a result of the crowding out effect.

The extra spending will have to be somehow financed. In the loanable funds market the demand for loanable funds will thus increase as illustrated in diagram 1 below from D1 to D2. This extra demand for funds by the government will put pressure on the interest rate (the ‘price’ for using such funds) to increase. Since private investment (I) (defined as spending by firms on capital goods per period) is inversely related to the interest rate, it may decrease (diagram 2).

Aggregate demand which includes C + I + G +NX will thus tend to increase as a result of the increased G but tend to decrease as a result of the lower I. The net effect is that either AD will increase but by less than what the multiplier predicts (to AD’ instead of AD2 in diagram 3) or that it may not increase at all if private investment is completely crowded out.

The extent of the increase in interest rates is not necessarily large as a country may borrow from a much larger globalized loanable funds market (i.e. from foreigners). Also, the responsiveness of investment spending to the change in interest rates is important because if investments depend mostly on expectations any decrease will be small. Lastly, the type of government spending financed is important as if the government uses the funds to spend on infrastructure, education and health then there will be positive long run supply-side effects.

In addition to the above described 'financial crowding' out that works through the change in interest rates there is also the possibility of 'resource crowding' out. The increase in government spending implies that the government will command (use) more scarce resources (more labor, more capital) so less will remain available for the private sector (i.e. private firms) to use.

Hope this helps a bit!

Thursday, April 23, 2009

Ideas on another short essay: Macro (M08)

Here are some thoughts on another macro short essay from a past exam that may even be useful to IB1 students:

A government decides to raise personal income tax rates. Using diagrams, explain one possible demand side consequence and one possible supply side consequence of this decision.

(the file that includes diagrams can be found at our wiki here)

Taxes are divided into direct and indirect where indirect are taxes on goods and on expenditures while direct are taxes on income. Personal income taxes are thus a type of direct taxation which may affect consumption and saving decisions as well as the incentive to work. (serves as a short intro paragraph that sets the framework of the answer and helps keep you focused)

Consumption is defined as spending by households on durable and non-durable goods and services per period of time. It depends on the level of disposable income which refers to income minus direct taxes plus transfer payments (i.e. pensions and unemployment benefits; Yd = Y – T + Tr).

If personal taxes increase then disposable income will decrease and thus consumption expenditures will also decrease. Aggregate demand (total spending on domestic goods & services per period of time; AD C + I + G + NX) will decrease and in the diagram below shift from AD1 to AD2. This will decrease the level of national income from Y1 to Y2 (or, slow down growth) and also may lower any inflationary pressures in the economy.

In this sense, this increase in personal income taxes may be part of a contractionary fiscal policy (could define) that aims at decreasing inflationary pressures.(this wraps up the demand side consequence)

(now the supply-side consequence)
On the other hand, this increase in personal income taxes may have an adverse effect on Aggregate Supply (the planned level of output at different average price levels per period of time) shifting AS to the left from AS1 to AS2, (see diagram) as it may create disincentives to work.

This though is not a necessary consequence as it depends on the relative size of the substitution and income effects.

(description of the substitution effect):
If personal income taxes increase, then leisure becomes cheaper and thus people will tend to substitute leisure for work (they will tend to work less)

(description of the income effect):
On the other hand, the increase in taxes will lower disposable income and thus, as leisure is a ‘normal good’, people will tend to choose less leisure and work more.

It is thus not, a priori, known whether the substitution effect will dominate the income effect and thus decrease labor supply and consequently aggregate supply.

If it does indeed decrease AS, then the capacity of the economy to produce will decrease and any increase in AD will be more likely to prove inflationary.

Lastly, it may be worth noting that as a result of the disincentives that an increase in personal income taxes may create, tax revenues collected by the government may even decrease. This is illustrated by the Laffer curve below which shows that at the higher tax rate t2, tax revenues are lower at T2.

(the usual: not a model answer - the idea of a model answer is rediculous- just some thoughts on this question that may prove helpful)

Tuesday, April 21, 2009

A short essay from a past exam (May 1994.....)

Here are some points on an older short essay, one on buffer stocks:

Using supply and demand curves, explain how buffer stocks might be used to try to stabilize agricultural prices.

Prices of agricultural products (corn, wheat, coffee, corn etc) are characterized by significant short run fluctuations: they vary a lot from one period to the next. This is the result of their low price elasticity of demand (few substitutes for buyers) for farm products and the fact that short run supply is perfectly price inelastic (vertical) as a result of the long time lags of their production process and also greatly affected by random factors like weather. {this paragraph explains why agricultural prices fluctuate from period to period - in the short run}

In the diagram the price varies between P’ and P’’ as supply in the short run is unstable and varies between S’ and S’’.

(insert diagram here; a file these points and the diagram can be found at our wiki here)

As these price fluctuations create uncertainty and instability in farmers' incomes (and often these farmers are developing countries with a significant concentration of exports in only one or two primary products), buffer stocks have been used in attempt to stabilize these prices.

The idea is simple: an authority will buy and stock the good (coffee, for example) when there is oversupply (effectively increasing demand) or will sell from stocks when supply is below normal (artificially increasing market supply).

In the diagram it is assumed that the target price is at P*.

Given demand conditions, if output is at Q (supply at S) there is no reason to intervene as the market will lead to the desired target price P*.

If good weather leads to Q’ units (of cocoa, coffee, corn: some non-perishable product) produced (supply is at S’) then authorities must buy and stock QQ’ units (effectively increasing demand to D’).

If bad weather leads to only Q’’ units produced (supply at S’’) then for the price not to rise the authority would have to sell Q’’Q units from stocks (effectively shifting supply back to S).

In this way the price is, in principle, stabilized. Farmers’ incomes though are not. Incomes vary directly with output. Higher output means higher income for farmers. No matter how much they produce, someone will buy their output. If output is at Q’ then their revenues are at area (0Q’AP*) whereas if output is at Q’’ then they earn area(0Q’’BP*) i.e. less.

An incentive to overproduce is thus created and thus misallocation of scarce resources. The authority will have to continuously buy the commodity so it will run into financing problems. This explains why buffer stock schemes have all collapsed.

Keep on walking....

Thursday, April 16, 2009

Long Essay Micro Higher Economics November 2007

Final exams are approaching, there are no more classes so here are some ideas on an old higher level long essay. No diagrams are posted (as I don't know how to incorporate diagrams in a post...!). This is the question:

(a) Explain the difference between short run equilibrium and long run equilibrium in monopolistic competition (10 marks)

Monopolistic Competition is a market structure with:

• very many small firms (e.g. hairdressers etc)
• differentiated product (and the differences may be ‘real’ or ‘imaginary’)
• no entry barriers

Since each firm produces a differentiated product it faces a negatively sloped demand, as if it increases price it will not lose all of its customers. Short run equilibrium is thus analytically identical to that of a monopoly firm. If supernormal profits are made (explain the term), entry of new firms will be induced.

As new firms the market enter (as more hairdressers establish in the same area/ market) , demand for each firm ‘shrinks and tilts’ i.e. it decreases (as at each price, quantity demanded will fall) and it becomes more price elastic (as consumers will now face more substitutes to choose from). (Draw short run and long run diagrams - the long run one is a pain to get right; use a pencil and an eraser in the final May exams; REM that you can use a colored pencil BUT NOT A RED OR A GREEN AS THESE ARE USED BY EXAMINERS......)

The process continues until economic profits become zero i.e. each firm makes only normal profits (define).

(Conversely, if losses are made --> exit, so demand each faces increases and becomes more price inelastic until economic profits become zero i.e. normal)

The main difference is thus that in the SR a firm in such a market may make positive, negative or zero economic profits but in the long run it will be forced to make only zero (normal) as a result of free entry.

(b) ‘Perfect competition is a more desirable market form than monopolistic competition’. Discuss. (15 marks)

--> Explain perfect competition using diagrams: very many small firms, homogeneous product, meaning that the product is considered identical across consumers, no entry barriers as well as perfect information and perfect factor mobility; market demand and market supply determine the market price which each firm will take (‘price takers’) thus facing a perfectly elastic demand curve for its product which is also the marginal and average revenue curve; assuming profit maximization, the typical firm will choose that output level q for which marginal revenue is equal to marginal cost (and MC is rising); entry and exit ensure that in the long run profits are driven to zero which means that each firm is making normal profit (the minimum it requires to remain in business)

--> Explain the long run efficiencies that characterize perfectly competitive markets:
Allocative efficiency results because all units for which price (the valuation by consumers) is bigger than marginal cost (how much society sacrifices for the production of each extra unit) are produced up until and including that unit for which P=MC: just the right amount of the good is produced from society’s point of view and thus there is no resource misallocation

Productive (technical) efficiency results as production takes place with minimum average cost i.e. resource waste

--> Explain that in monopolistic competition neither allocative not technical efficiency are achieved (draw long run equilibrium diagram or refer to the one in (a) and that excess capacity characterizes such firms (empty tables in restaurants most of the time) (as neither condition holds)

--> But, consumers have variety and this is considered very important. Each consumer has a better chance of finding exactly what he or she wants. Higher average costs may be the result of differentiation and of (local) advertising and in this sense may not be as wasteful.

It seems that even though the efficiency properties of perfect competition make it theoretically more desirable, the product variety of monopolistic competition and the fact that the price charged can not exceed marginal cost by much while profits are driven down to normal make it an attractive alternative.

Neither though can lead to product innovation (new products and/or new processes) as both models require free entry.

This is not a 'model' answer. Remember that IB examiners are always instructed to accept any answer that is theoretically sound. More to come (perhaps..!)

Study hard, my dear friends - this is it!

PS: This essay with diagrams can be found at our wiki here

Sunday, April 5, 2009

Sen on the current crisis

My colleague Vassilis Kyrtatas brought to my attention an exceelent article by Amartya Sen published in the New York Review of Books.

I urge my graduating IB economic students to read it (or, at least save it and read it sometime later). This is just a short quote to whet your appetite:
While Adam Smith has recently been much quoted, even if not much read, there has been a huge revival, even more recently, of John Maynard Keynes. Certainly, the cumulative downturn that we are observing right now, which is edging us closer to a depression, has clear Keynesian features; the reduced incomes of one group of persons has led to reduced purchases by them, in turn causing a further reduction in the income of others.

However, Keynes can be our savior only to a very partial extent, and there is a need to look beyond him in understanding the present crisis. One economist whose current relevance has been far less recognized is Keynes's rival Arthur Cecil Pigou, who, like Keynes, was also in Cambridge, indeed also in Kings College, in Keynes's time. Pigou was much more concerned than Keynes with economic psychology and the ways it could influence business cycles and sharpen and harden an economic recession that could take us toward a depression (as indeed we are seeing now). Pigou attributed economic fluctuations partly to "psychological causes" consisting of variations in the tone of mind of persons whose action controls industry, emerging in errors of undue optimism or undue pessimism in their business forecasts. It is hard to ignore the fact that today, in addition to the Keynesian effects of mutually reinforced decline, we are strongly in the presence of "errors of...undue pessimism."
The article is found here.

Friday, April 3, 2009

A great resource for IB Development Economics!

Atlas of Global Development (2nd edition)
I just got my hands on a copy of the above 2009 World Bank publication. I think it’s fabulous for IB Economics (Higher and Standard Level) students. It is jammed with easy to read and understand data (uses maps of the world and tables) on a variety of issues that help the reader better understand the world we live in. The Table of Contents includes these headings:

• Classification of economies
• Rich and poor (measuring income; growth and opportunity; how poor is poor?)
• People (global trends in population)
• Education (education opens doors; children at work; gender and development)
• Health (children under 5 – struggling to survive; improving the health of mothers; communicable diseases – too little progress)
• Economy (Structure of the world’s economy; governance; infrastructure for development; investment for growth; the integrating world; people on the move; aid for development external debt)
• Environment (the urban environment; feeding the world; a thirsty planet gets thirstier; protecting the environment; energy security and climate change)
• Statistics (key indicators of development; ranking of economies by GNI per capita; the need for statistics; millennium development goals, targets and indicators; definitions, sources)

It is not a textbook but there is a page or two on each issue as well as a list of important facts. In addition there is a list of internet links which is very useful.

The book is about $23.00. The link is here.