MACROECONOMICS NOTES

1. Government Size and Economic Freedom

• 100% Government Control: In countries with total government control (like the former Soviet Union, Cuba, and North Korea), there is no private sector; everything is owned and operated by the government.

  • GDP and Growth: These countries have not achieved high GDP per capita.

  • Authoritarian Growth Trade-off: Authoritarianism can initially spur growth but often restricts freedoms.

  • Balance: A mix of government intervention and private sector freedom is generally more sustainable, but there’s no clear answer on the ideal government size.

2. Public Goods and Collective Action Problems

• Public Goods: Services like national defense, roads, and public infrastructure are generally underprovided by the market due to free-rider issues.

  • National Defense Example: While an invading army would negatively impact everyone, individuals may lack the personal incentive to defend the country if they feel their impact is minimal or if defeat seems likely.

  • Environmental Policy Example: A company that adopts costly, eco-friendly practices alone is likely to be at a market disadvantage, highlighting the need for government intervention.

  • Mandatory Participation: Government intervention (e.g., taxes) is often needed to overcome free-rider problems and provide these public goods, despite the discomfort associated with mandatory requirements.

3. Social Security and Paternalism

• Purpose of Social Security: To prevent elderly poverty when individuals fail to save adequately during their working years.

  • Case Study - Chile: Chile privatized Social Security under dictator Pinochet in the 1970s, influenced by the “Chicago Boys” and free-market policies.

    • Outcome: Initially reduced government size, but eventually, the need to assist the elderly led Chile to reintroduce government support due to the negative social impact of poverty among seniors.

  • Challenges of Self-Saving: Many people fail to save due to factors like overconfidence, assuming they will have sufficient resources in retirement.

4. Overconfidence and Social Security

• Overconfidence in Society: People often overestimate their future financial prospects, leading to under-saving for retirement.

  • Survey Example: When judges were asked if they believed they were in the top 10% of performers, 85% said yes.

  • Implications for Social Security: Overconfidence means many won’t save adequately, making a government-enforced savings program (like Social Security) necessary.

• Paternalistic Policy: Social Security is seen as paternalistic, akin to parents enforcing good habits for children, ensuring long-term benefits that individuals might neglect on their own

Labor Demand and Supply

1. Labor Demand:

   • Firms determine hiring based on the marginal product of labor.

   • Wage Influence: Higher wages lead firms to hire fewer workers, while lower wages encourage them to hire more.

2. Labor Supply Curve:

   • The labor supply curve is upward sloping.

   • Wage Impact: Higher wages attract more workers (e.g., offering $30/hour attracts 200 people; offering $40/hour attracts 300 people).

   • Income Tax Impact: If income taxes are high, firms need to offer higher wages to attract the same number of workers (e.g., offering $50 instead of $30 to get 200 workers).

3. Tax Effects on Labor Supply:

   • High taxes reduce the effective wage for workers, shifting the labor supply curve up and to the left.

   • After-Tax Income: Workers focus on after-tax earnings, so higher taxes reduce labor supply as they receive less for the same pre-tax wage.

Production and Taxation:

1. Tax Effects on Production:

   • Less Labor, Less Output: Reduced labor supply (due to higher taxes) results in lower overall production.

   • "Shrinking the Pie": Taxes don't just redistribute income; they can also reduce total economic output.

2. Capital Income and Investment:

   • Growth Dependency: Capital income is essential for investment and growth.

   • Exponential Growth Effect: Even slight reductions in growth rates (from lower investment) can lead to significant long-term effects.

   • Challenges in Taxing Capital: High taxes on capital gains or corporate profits may discourage investment and economic growth.

The Laffer Curve

1. Theory Overview:

   • Revenue-Maximizing Tax Rate: Shows that tax revenue increases up to a certain tax rate, then declines if rates are too high.

   • Analogy to Law of Demand: At 0% tax, revenue is zero; at 100%, there’s also zero revenue as people stop working.

2. Historical Context:

   • Arthur Laffer’s idea, popularized during the 1970s, argued that the U.S. was over-taxed, and lower rates could increase revenue.

3. Practical Application Challenges:

   • Tax Rate Differences: Different taxes have unique dynamics (income, sales, corporate, etc.).

   • International Competition: Local property tax rates, for example, are sensitive to neighboring regions’ tax rates.

Capital Income and Taxation Difficulties

1. Distribution of Capital Income:

   • Capital income (roughly 1/3 of GDP) is largely owned by the wealthiest percentiles.

2. Corporate Tax Rates and Capital Gains:

   • Raising corporate taxes can lead companies to relocate or adjust their capital structures.

   • International cooperation (e.g., G7’s 15% minimum corporate tax) is crucial to reduce tax competition among countries.

Generational Effects and Fiscal Policy

1. Debt and Future Generations:

   • Current policies favoring debt over taxes can pass the financial burden onto future generations.

2. Social Security and Medicare:

   • Funding Issues: Social Security is a pay-as-you-go system facing future funding shortfalls as the Baby Boomer generation retires.

   • Projected Deficit: Without intervention, the Social Security trust fund may be exhausted by 2030.

   • Potential Solutions: Raising taxes, increasing retirement age, or reducing benefits.

3. Examples of Fiscal Crisis Responses:

   • Greece’s Debt Crisis: Demonstrates the impact of severe austerity measures, where pension cuts and reduced government spending led to a prolonged economic depression.

1. When Is the Tax Rate Too High?

• The Role of the Laffer Curve: The Laffer Curve suggests there’s a point at which higher tax rates reduce total tax revenue by discouraging productivity and reducing the tax base. Higher taxes may lead to tax avoidance, especially if they affect mobile assets or income, reducing the government’s revenue.

• The Case in Spain: Spain’s Supreme Court once ruled that taxes exceeding 50% could be deemed “confiscatory,” implying that taxing over half of income might be too burdensome, though this figure is more of a policy benchmark than one from economic analysis.

• High-Need Scenarios: In cases of war, economic crisis, or debt repayment, higher taxes may be temporarily necessary. Governments often adjust rates to match fiscal needs, balancing with issues like inequality and public investment opportunities.

2. Social Security’s Financial Outlook

• The Aging Population and Funding Challenges: Social Security, the largest U.S. government program, was originally set up with surplus funding when the baby boomers were younger. As they retire, payouts now exceed contributions, causing the Social Security Trust Fund’s reserves to deplete.

• Projected Shortfalls: In 2014, a projected shortfall of $68 trillion indicated future challenges unless laws change. If no action is taken, by about 2034, the fund will be exhausted, and benefits could face cuts or require increased taxes to sustain current levels.

• Potential Solutions and Popularity: Means-testing, which limits Social Security benefits based on recipients’ wealth, is one proposed solution but is often unpopular among voters who expect a return on their lifelong contributions.

3. U.S. National Debt Concerns

• Debt Composition and Recent Increases: As of recent estimates, the U.S. public debt is around 100% of GDP, reflecting significant growth, especially following the Great Recession. Treasury bills, bonds, and other forms of debt held by the public comprise about $28 trillion, while internal holdings make up another $7 trillion.

• International Comparisons and the “90% Rule”: High debt can lead to slower growth, though research on the precise threshold, like Reinhart and Rogoff’s “90% rule,” has been scrutinized due to data issues. Countries like Japan and the UK have managed higher debt-to-GDP ratios but are exceptions based on economic size and stability.

• Debt Maturity and Rollover Risks: Debt maturity influences rollover risk; short-term debt needs constant refinancing, while long-term debt allows smaller annual rollovers. Having longer-term debt, therefore, reduces the risk of an investor confidence crisis.

4. The U.S. Dollar as a Reserve Currency

• Global Demand for U.S. Debt: The U.S. dollar’s status as a global reserve currency creates constant demand for Treasury bonds, reducing risks tied to high debt levels. If the U.S. lost this position, it could face economic instability as the currency and asset values adjust.

• Competition and Alternatives: While countries like China or assets like gold are mentioned as alternatives, each has its own limitations, such as China’s regulatory unpredictability or gold’s lack of scalability for modern economies.

• Gradual Diversification Risks: A gradual diversification by foreign investors away from U.S. debt could weaken the dollar’s position as the primary global reserve, though no immediate or singular alternative appears likely.

5. Automatic and Discretionary Fiscal Stimulus

• Automatic Stabilizers: In recessions, automatic stabilizers increase spending on unemployment benefits and reduce tax revenue as incomes fall. This mechanism helps cushion economic downturns without new policy interventions.

• Discretionary Stimulus: Discretionary fiscal policy, like a stimulus package, requires legislative approval. It can be used to boost demand by increasing government spending or cutting taxes, though political gridlock often delays action.

• Fiscal Multipliers and the Keynesian Chain: The fiscal multiplier measures the effect of government spending on overall demand. When a government spends money, it generates income for one sector, which then spends that income in another, creating a cycle of increased economic activity.

6. Challenges of Fiscal Policy Implementation

• Lags in Fiscal Policy: Fiscal policy faces three types of lags—recognition lag (identifying the need), lawmaking lag (gaining legislative support), and impact lag (time taken for the policy’s effects to materialize). These delays make timely intervention challenging.

• Political Challenges: In divided governments, fiscal measures can become political bargaining chips, leading to delays that harm the economy. Even with clear economic indicators, competing priorities can stall necessary fiscal adjustments.

• Crowding Out and Ricardian Equivalence: Increased government borrowing may lead to higher interest rates, crowding out private investment. Ricardian Equivalence suggests that people save in anticipation of future taxes needed to repay government debt, though this theory is debated for its real-world accuracy.

7. Size of the Economic “Pie” vs. Distribution

• Tax Cuts vs. Spending for Stimulus: Tax cuts often benefit higher-income earners, who may save more rather than spend. Spending, on the other hand, has a direct impact on lower-income individuals, who are likely to spend additional income quickly.

• Trade-offs in Distribution vs. Growth: Economists debate whether to prioritize a larger overall economy (the “pie”) or to focus on redistributing wealth. Higher taxes might dampen growth but improve inequality, while lower taxes might spur growth but increase wealth disparity.

Book Notes

1. Taxes and Aggregate Supply

• Labor Income Taxes: Taxes on wages create a wedge between labor costs and worker take-home pay, leading to:

  • Lower employment levels

  • Reduced real GDP

• Capital Income Taxes: Taxes on interest income create a wedge between borrowing costs and lending returns, resulting in:

  • Reduced savings and investment

  • Slower real GDP growth rate

• Tax Cuts: Reducing taxes can:

  • Increase real GDP and its growth rate

  • Boost employment

  • Supply-side effects from tax cuts are typically larger than demand-side effects, making the tax multiplier much larger than the government expenditure multiplier.

2. Government Expenditure and Crowding Out

• Borrowing for Government Expenditure: When government spending is financed by borrowing:

  • It raises the demand for loanable funds and thus the real interest rate.

  • Higher interest rates reduce private investment.

• Crowding-Out Effect: Increased government spending leads to decreased private investment, thus lowering future real GDP.

• Effectiveness of Fiscal Stimulus:

  • A stimulus with more tax cuts and minimal government spending is more effective in boosting production and creating jobs.

  • Government spending alone has limited effectiveness in stimulating the economy.

3. Challenges in Fiscal Stimulus Implementation

• Magnitude and Timing: Calculating the recessionary gap and applying multipliers to eliminate it is complex.

• Timing is critical for fiscal stimulus to be effective.

4. Case Study: 2009 Fiscal Stimulus Package

• Tax and Spending Breakdown:

  • Tax cuts: $300 billion

  • Government spending increase: $500 billion

• Expected vs. Actual Multipliers:

  • Christina Romer’s Estimate:

    • Expected government expenditure multiplier: 1.5

    • Goal: To close a $1 trillion output gap by 2010

  • Robert Barro’s Estimate:

    • Government expenditure multiplier: 0.5

    • Expected increase in aggregate expenditure: Only $250 billion due to private spending reduction (crowding-out)

  • Harald Uhlig’s Estimate:

    • Government expenditure multiplier: 0.3 to 0.4

    • Expected increase in aggregate expenditure: Between $150 billion and $200 billion

• Tax Multiplier: Higher agreement on tax multipliers, as tax cuts enhance both aggregate supply and demand by incentivizing work and investment.

Labor Demand and Supply

• Labor Demand:

  • Comes from the marginal product of labor.

  • Follows the law of diminishing marginal returns.

• Labor Supply:

  • Shifts left/up when there’s a tax:

    • Example: If employers offer $30 but taxes take $10, fewer workers will accept jobs at that wage.

    • This does not shift the production function but is a movement along it.

• Impact of Taxes on Potential GDP:

  • Taxes reduce the full employment level of labor.

  • Potential GDP decreases because the economy can’t produce as much output at lower labor participation.

Fiscal Policy: Budget and Structural Surplus

• Balanced Government Budget:

  • Receipts = Outlays; no overall surplus or deficit.

• Structural vs. Cyclical Surplus:

  • Structural Surplus: Would exist if GDP was at potential.

  • If budget is balanced and there’s a structural surplus, the cyclical budget is in deficit.

  • Indicates a recessionary gap (real GDP < potential GDP).

Introduction to Money and Banking

• Defining Money:

  • Economics vs. Everyday Definition:

    • Economics considers cash and bank balances as money.

    • Wealth (stocks, bonds, real estate) isn’t considered money.

  • Money must be widely accepted for payment.

• Purpose and Universality of Money:

  • Anthropologists note that as groups grow, they typically adopt a form of money.

  • Yuval Noah Harari’s Insight:

    • Money enables cooperation in large societies by standardizing value.

  • Contrast with Barter:

    • Barter requires a "double coincidence of wants."

    • Money simplifies trade by acting as a medium of exchange.

Functions of Money

• Medium of Exchange:

  • Simplifies transactions between parties.

• Store of Value:

  • Money maintains value over time if inflation is low.

  • Hyperinflation undermines this (e.g., Venezuelan bolivars losing value quickly).

• Historical Examples:

  • Sparta: Iron money discouraged commerce.

  • Commodity Money: Many societies used items like gold, silver, and cigarettes as money.

Types of Money

• Commodity Money:

  • Physical assets like gold and silver.

• Fiat Money:

  • Currency without intrinsic value, declared by government as legal tender.

  • US Dollar (since 1970s) and modern British Pound: no longer backed by metals.

Measuring Money Supply

• Monetary Aggregates:

  • M0: Cash in circulation.

  • M1: M0 + checking accounts and other liquid deposits.

  • M2: M1 + time deposits (e.g., certificates of deposit under $100,000).

  • M3, etc.: Adds less liquid assets as you go up.

• Changes Over Time:

  • Savings accounts added to M1 in 2020, making M1 and M2 more similar.

  • M2 increased significantly during the pandemic, coinciding with inflation rise.

Inflation and Money Supply

• Inflation and Hyperinflation:

  • Increasing money supply can drive inflation (e.g., pandemic stimulus).

  • Hyperinflation examples show that money loses its store of value function.

1. Role of Money in Society

• Money enables trade by allowing people to exchange goods and services with strangers, without needing a double coincidence of wants (barter).

• The evolution from commodity money (backed by precious metals) to fiat money (no intrinsic value) allows for easier transactions. Today’s currency is fiat, meaning it's not backed by physical commodities like gold.

2. Money Supply Definitions

• Money supply is categorized into levels (M0, M1, M2, etc.), each including progressively less liquid assets:

  • M1: Highly liquid assets like cash and checking deposits.

  • M2: Includes M1 plus less liquid assets like savings accounts and small-time deposits (e.g., CDs).

  • M3: Extends M2 further with even less liquid assets.

• Differences in definitions and tracking can vary across countries.

3. Federal Reserve's Role and Monetary Policy

• The Federal Reserve (Fed) controls the monetary base (the foundation of the money supply) and influences the broader money supply through commercial banks via money multiplication.

• Monetary Policy: Countercyclical approach:

  • Stimulate economy when it’s weak (more money, lower interest rates).

  • Restrain growth to prevent inflation when it’s strong (less money, higher interest rates).

4. Key Principles and Rules in Monetary Policy

• The Taylor Rule: Fed’s interest rate adjustments often reflect changes in unemployment and inflation:

  • Lower rates when unemployment is high and inflation low.

  • Raise rates when unemployment is low and inflation high.

• Phillips Curve: Highlights the trade-off between inflation and unemployment. Policy is simpler when inflation and unemployment move in opposite directions (along the curve).

5. Special Economic Conditions

• Growth without Inflation (2009-2019): Economy grew with low inflation, allowing the Fed to cautiously raise rates to prepare for future downturns.

• Stagflation: Both high unemployment and high inflation, presenting a dilemma for policymakers.

6. Fed’s Monetary Policy Tools

• Open Market Operations: Fed buys or sells government bonds to manage interest rates (primarily the Federal Funds Rate).

• Discount Window: Banks can borrow directly from the Fed, although reluctance due to potential stigma exists.

7. Quantitative Easing (2008 Onwards)

• Due to interest rates hitting zero in 2008, the Fed began buying long-term securities to lower long-term interest rates and support the housing market.

• Forward Guidance: Introduced for transparency under Ben Bernanke, it signals Fed’s future plans to stabilize markets.

• Bailouts and New Lending Facilities: The 2008 crisis saw mandatory bailouts for major banks to prevent stigma and runs on individual banks.

1. Role of Banks in the Economy

• Deposits & Loans: When people deposit money in a bank, it doesn’t just sit there. Banks use this money to make loans (e.g., for real estate, businesses) and to invest.

• Investment Examples:

  • Real Estate Loans: Residential (houses) and commercial (offices, malls).

  • Government & Corporate Bonds: Banks often invest in Treasury and mortgage-backed securities.

  • Risk Limitation: Banks avoid high-risk assets (like stocks or crypto) due to regulatory restrictions. This is to safeguard depositor funds.

2. Reserve Requirements

• Reserve Concept: Traditionally, banks needed to hold a portion of deposits as cash reserves.

• Current U.S. Reserve Requirement: Set to 0% since the pandemic, though reserve requirements remain in other countries.

3. Bank’s Financial Structure

• Balance Sheet:

  • Assets: Include loans, bonds, cash, and trading assets.

  • Liabilities: Deposits and other borrowings.

  • Capital (Equity): The difference between assets and liabilities, providing a cushion against losses.

• Capital Requirements: Banks must hold a minimum level of capital as a buffer to protect against potential losses.

4. Types of Banks

• Commercial Banks: Deal with deposits and loans, following strict regulations.

• Investment Banks & Hedge Funds: Engage in higher-risk investments using investor capital rather than public deposits.

5. Money Creation Through Banking

• Fractional Reserve Banking:

  • Banks lend out a portion of deposits, keeping only a fraction in reserve.

  • This allows banks to fund investments and loans, boosting economic activity.

• Money Multiplier Effect:

  • Bank lending increases the money supply: when banks lend out deposits, the same money can be spent multiple times.

6. Demand for Money & Interest Rates

• Money Demand: People balance between holding cash and earning returns from other assets.

• Interest Rate Influence:

  • High interest rates reduce cash holdings as people prefer higher returns elsewhere.

  • Low rates encourage cash holdings.

7. Other Financial Concepts

• Velocity of Money: The rate at which money circulates in the economy.

• Non-Money Assets: Stocks, bonds, real estate, art, and wine are alternative stores of value but are not classified as money.

8. Historical Context

• Usury Laws: Originally, lending at interest was prohibited, making banks mere safekeeping institutions.

• Fractional Banking Evolution: Over time, banks began lending deposited funds to earn interest, evolving into the fractional reserve system.

1. Banking System and Money Supply Process

• Deposit Multiplication: Banks use deposits to create loans, leading to a money supply several times larger than the monetary base.

• Money Supply Multiplier Example: A base of 5 trillion can grow into a 20 trillion money supply.

• Vulnerability: The money supply is vulnerable if many depositors demand withdrawals simultaneously. Banks can’t immediately liquidate long-term assets like mortgages or large investments, leading to potential liquidity crises.

2. Bank Runs and FDIC Insurance

• Liquidity Mismatch: Bank assets are often long-term (e.g., mortgages) while liabilities (deposits) are short-term and callable by depositors.

• FDIC Insurance: Protects deposits up to $250,000 per account to prevent bank runs. However, in recent crises (e.g., Silicon Valley Bank), the government covered amounts above this limit, setting a difficult-to-reverse precedent.

• Global Comparison: Many countries have unlimited deposit insurance, unlike the U.S.’s $250,000 limit.

3. Historical Background of the Federal Reserve

• Panic of 1907: Triggered by the 1906 San Francisco earthquake, which led to withdrawals and the near-collapse of major New York banks.

• Role of JP Morgan: Averted a complete banking collapse by coordinating with major bankers to provide liquidity.

• Creation of the Federal Reserve (1913): Established as the lender of last resort to prevent future bank panics and given exclusive authority to issue currency.

4. Evolution of U.S. Banking

• Early Monetary Challenges: In the 1800s, the “free banking era” allowed any bank to issue currency, leading to a confusing variety of banknotes with inconsistent value.

• Panic of 1907: Demonstrated the need for a central bank, as the financial system relied heavily on JP Morgan’s influence.

• Federal Reserve Act of 1913: Aimed to stabilize the currency and financial system, curbing the issuance of non-federal banknotes and eventually linking currency issuance to the Federal Reserve.

5. Structure and Operation of the Federal Reserve System

• Federal Open Market Committee (FOMC): Includes seven governors, the New York Fed president (permanent voting member), and rotating presidents from other regional banks.

• Regional Influence: The New York Fed manages market operations; Richmond is a backup if New York fails. Regional disparities (e.g., San Francisco’s economic prominence vs. Cleveland’s decline) reflect the 1913 industrial landscape.

6. The Monetary Base and Money Supply

• Definitions:

  • Monetary Base: Currency and reserves held by banks.

  • Money Supply: Currency in circulation plus bank deposits.

• Money Multiplier Effect: Loans create new deposits, multiplying the initial monetary base.

• Reserve Requirements: Traditionally, a 10% reserve-to-deposit ratio was required, but this was set to 0% during the pandemic to encourage lending.

7. Monetary Policy Tools and Responses

• Interest Rates vs. Reserve Requirements: Countries sometimes adjust reserve requirements instead of interest rates (e.g., Turkey) to control money supply.

• Great Depression Insight: The Fed failed as a lender of last resort, causing banks to hold onto reserves and the public to hoard cash, reducing the money supply and worsening the depression.

8. Dual Mandate of the Fed (Since the 1970s)

• Goals: Achieve maximum employment and price stability.

• Inflation and Employment: Originally absent in the Federal Reserve Act, this focus emerged with high inflation in the 1970s.