lecture notes - chapter 8 - week 8 - macro

8/13/2019 Lecture Notes - Chapter 8 - Week 8 - Macro

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Reminder:TEST NEXT WEEK!!!

Chapters 6-8

Chapter 8Perspectives onMacroeconomic Policy


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Chapter 7 explained how the government can use: an easy money policy of lower interest rates, and budget deficits (government spending > tax revenues)

to counter recessions and reduce unemployment,by boosting aggregate demand.

Why, then, has the number of unemployed Canadiansnot gone below 1 000 000 since 1981, and theunemployment rate averaged 9% of the labour forceand only gone below 7% in 5 of those 31 years?

Chapter 8Perspectives on Macroeconomic Policy

Unstable from early 1970s to early 90s

but betterafter late 1990s(until 2009)

Rate ofinflation

Unemploymentrate


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Why Hasnt Canada done better re: Unemployment and Inflation?

A. Partly due to real-world limitationson what can be achieved

B. Partly due to failure of governments in the pastto keep control over two key factors:

1. Obstacles to getting unemployment rate below 7%2. Obstacles to remedying economic prob lems quickly3. International limitations on Canadian economic policies

4. Inflation5. Government budget deficits and debt

The problem of unemployment,and why Canadas unemploymentrate is as high as it is.


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Reasons for Unemployment

1. Cycl icalDue to periodic recessions; adds about 4% points

(700 000 people) to unemployment in recessions .

If govt boosted AggregateDemand:Woulddecreaseconsiderably

2. FrictionalDue to changing of jo bs; br ief. On average, adds about1% point to the unemployment rate .

3. Seasonale.g. agriculture; tourism

Littleeffect

Littleeffect

4. StructuralMismatch of skills required by employers & those ofthe unemployed; can be serious & long-term in nature.

Littleimprovement

Even in a boom , there will still beconsiderable unemployment but how much?

One reason why unemployment is so high is thatcertain groups have a tendency toward highunemployment, and so have high unemploymenteven during economic booms.

In the next 2 slides, we will look atunemployment rates:

(a) in different provinces/regions of Canada, and

(b) among different age groups.


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2.0

4.0

6.0

8.0

10.0

12.0

14.0

U n e m p

l o y m e n

t R a

t e

Unemployment Rates by Province, 2012

0

5

10

15

20

25

Overall (age15+)

15 to 19 years 20 to 24 years 25 years andover

P e r c e n t o

f L a

b o u r

F o r c e

U n e m p

l o y e

d

Unemployment Rates by Age, 2012


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Monetary and Fiscal Policies to Reduce Unemployment

Easy MoneyPolicies

BudgetDeficits

Higher Aggregate

Demand

Increased Employment/Lower Unemployment

Higher Ratesof Inflation,

if

Full employment is considered to have been reached when aggregate demand is high enough to generate inflation that is gaining momentum,or accelerating . At that point, unemployment is as low as it can go.

& but also

But how low an unemployment rate is full employment?

demand nearscapacity

How low can the unemployment rate can go withouta problem of accelerating inflation developing?

In the booms of 2000 and 2007, the unemployment ratereached the lowest monthly levels since the mid-1970s(6.0-6.4%), and without inflation accelerating seriously

Full Employment

There is no one number that is the right answer to thiskey question we have to look at how the unemploymentrate actually gets at the peak of economic booms .

full employment appears to nowbe an unemployment rate in the6.5% range


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Even at the very low unemployment rates of 2000 and2007, more than 1,100,000 Canadians were unemployed.Why so many?

What would have happened if the government had triedto push unemployment lower than 6.0%, by boostingaggregate demand even higher ?A potentially serious inflation problem.

But why cant we get unemployment lower?

UnemploymentRate in 2007

Youth (age 15-19) 14.8%Newfoundland 13.6%Prince Edward Isld 10.3%Nova Scotia 8.0%New Brunswick 7.5%National average 6.0%

High-unemployment regions and groups keep the national average high.

The problem of inflation, andhow we learned the hard waywhy it is important to keepinflation under control.


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The Importance of Keeping Inflation under Control

If not kept at low rates, inflation can accelerate .

Risingrate ofinflation

Inflation psychology

Larger paydemands labour costs rise

Buy nowbehaviour demand rises

Rate of inflationcan spiral upwards

0

2

4

6

8

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12

14

70 71 72 73 74 75 76 77 78 79 80 81

R a

t e o

f I n f l a

t i o nThe experience of

the 1970s:inflation that accelerated

How inflation Affects Interest RatesLender/investor earning 6% interest on a loan/investment of $100:

If the rate of inflation were 3%:Your interest incom e would be

While inflation would reduce thepurchasing pow er of your $100 by

$6

-3

For a net gain (before tax) of +$3

If the rate of inflation were 8%:Your in terest income woul d be $6While inflation would reduce thepurchasing pow er of your $100 by

For a net gain (before tax) of

-8

-$2(loss)

What could/would investors do about such losses due to inflation?

They would require higher in terest rates. 11% interest rate- 8% loss to inflation

= 3% real return

CAUSE

HIGHER(EXPECTED)

RATES ofINFLATION

HIGHERINTEREST

RATES


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Inflation, Taxes and the Saving-Investment Process

Economy with low

inflation (3%) & lowinterest rates (6%)

Interest income $6.00

LessLoss to inflation - 3.00= Real return 3.00

Economy with high

inflation (8%) & highinterest rates (11% )

$11.00

- 8.003.00

- 4.40

-$1.40

Discourages business investment spending

Discourages saving

Rapid inflation damages the saving-investment process that is vital to prosperity, by reducing incentives both for people to save and for businesses to invest.

LessIncome tax (33%)

= Return afterinflation & taxes: $1.00

- 2.00

Why High Rates of Inflation became Unacceptable

1970s& 80s:High ratesof inflation

High interestrates & lowreturns to savers

Hurts theeconomically

weak

Less abilityto competeinternationally

Governmentpolicies tocombatinflation

Depressed saving &investment slower productivity growth

Higher unemploymentin export & import-competing industries

Social strains

Eventualrecession(1981-82, 1990-92)


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Inflation Targets

Since 1993, the Bank of Canada & federal government haveagreed upon a target for the rate of inflation of 1 to 3% peryear, with the objective of preventing inflation from againbecoming the problem that it became in the past.

Due to:

this objective requires that the Bank of Canada takeearly action (in the form of higher interest rates) as soonas signs of inflationary pressures appear in the economy.

the long time lags with which anti-inflation policies work

the tendency of inflation to gain momentum

The question of governmentfinances, and how we learnedthe hard way why it is importantto keep budget deficits from

becoming excessively large.


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Year GovtSpending TaxRevenues BudgetDeficit NationalDebt20x1 $50 $50 $0 $100

20X2 60 55

20X3 70 56

20X4 78 68

20X5 76 72

Government Budget Deficits and Debt

What does it take for the government to reduce its debt?Budget SURPLUSES (taxes > government spending)

5 105

14 119

10 129

4 133

Government budget deficits, borrowing and debt are

NOT always badThere are good reasons for governments to borrow :

1. For periodic anti-recessionprograms (Chapter 7)

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2

2.1

2.2

2.3

2.4

2.5

1 2 3 4 5 6 7 8

G o v

' t D e b

t

Recession(G > T)

Boom(G < T)

Govt Debt

2. To finance social assets(hospitals, schools, etc) ,with the debt paid downover the life of the asset

0

0.2

0.4

0.6

0.8

1

1.2

1 2 3 4 5 6 7

G o v

' t D e

b t

Repay Debt

However,

(offset by budget surpluses duringbooms that are used to pay downgovernment debt)

Borrowonce


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However,Regular annual budget deficits (such as Canada had from themid-1970s to the mid -19 90s) are a very di fferent situation:

These will lead to an upwardspiral of governmentborrowing and debt:

Largeannualdeficits

Steadilygrowinggovt debt

Rising Interest Expenditures

0

2

4

6

8

10

12

14

16

1 2 3 4 5 6 7 8 9 10

GovtDebt

InterestPayments

0

10 0

20 0

30 0

40 0

50 0

8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4

$ b i l l i o n s

TotalDebt

AnnualDeficits

Federal Government Budget Deficits & Debt

How long can such a situation continue?

Until lenders become so concerned about the borrowersdebt that they demand changes.

$28 billion deficit in 1990 debt rises by $28 billion


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1993: The Critical Point1992-93:

Massive government budget deficits, heavy borrowing fromforeign lenders, government debt rising rapidly; danger ofa debt spiral due to heavy interest payments.

foreign lenders very concerned; credit ratings ofsome provinces downgraded; interest rates increaseddue to risk.Governments were forced to take action to cut deficits:

increase taxes or

Major cuts to government spendingover the 1994-98 period.

reduce government spending

Government Spending Cuts, 1994-98

FederalGovernment

Transfer Payments

ProvincialGovernments

Healthcare

Postseceducation Welfare

The federal governmenttransfers billions of $of its revenues to theprovincial governments,which are responsible formajor social spendingprograms such as healthcare, postsecondaryeducation, and welfare.

When the federal government was forced to cut itsspending, most of the cuts were to transfer paymentsto the provinces cuts to health care, postsecondary education, & welfare


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Cuts in government spending 1994-98+ a surge in government tax revenues due to

rapid economic growth

The Great Budget Turnaround

-50.0

-40.0

-30.0-20.0

-10.0

0.0

10.0

20.0

30.0

Budget Defic its (-) and Surpluses (+)

Budget SURPLUSES after 1997

After 1997, the federal government had budget surpluses (i. e., government revenues in excess of expenditures) for overa decade.What are the three possible uses of such surpluses?

Pay down government debt .

Increase government spending.(eg health care; education)

Reduce taxes.(eg personal & business income taxes)

Federal Government Budget Surpluses


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The Turnaround inFederal Government Finances

1996:66% ofGDP &rising

2008:32% ofGDP

0100200300400500600700

Net Federal Government Debt (Billions of $)

Why the increase in debt after 2008?The recession

Past (Actual) Projected (Future)

But because of the recession, budget deficits occurred.


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The deficits were large in dollar amount, but as a percentageof GDP, appear to be manageable.

The Problem of Time Lags (No quick cures)

Problem (recession or inflation) arises

Problemis clearly recognized

Corrective policies enacted

Policestake effect on economy

RecognitionLag

ImpactLag

(6-12 months)

PolicyLag

Total of these time lags can be 1-2 years.

Implications for government policymakers:

1. Take longer-term view;do not change policies in reaction to short-term situations.

2. Take policy action as soon as possible, to prevent problemsfrom becoming worse.

3. Do not make mistakes and be patient!


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International Limitations on Canadian Economic Policies

In todays globalized world economy, competition between countries for

exports, business i nvestment and skilled people is stronger than ever.

In order to:1. make Canadian industry competitive internationally,2. make Canada attractive to foreign investors, including businesses,3. make Canada an attractive location for skilled people,

Canadian governments have to:

keep taxes (personal & business) reasonable

keep government deficits/borrowing/debt under control keep inflation low (& thus interest rates reasonable)

1. By year 4, the main economic problem is __________________.2. The basic cause of this problem is _______________________.3. The appropriate fiscal policy is _____________,

which would ________________________ aggregate demand.4. The appropriate monetary policy is _____________,

which would _____________________ aggregate demand.5. The undesirable side-effect of these policies is that if used

too strongly, they would _________________.

unemploymentlow aggregate demand

budget deficits

stimulate (increase)Easy Money

stimulate (or increase)

risk of high inflation


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1. By year 4, the main economic problem is _________________.2. The basic cause of this problem is ______________________.3. The appropriate fiscal policy is _________________________,

which would ____________________ aggregate demand.4. The appropriate monetary policy is _______________,

which would ____________________ aggregate demand.5. The undesirable side-effect of these policies is that they

would _______________________________________.unemployment / could push into a recession

high aggregate demandbudget surplus

depress (or decrease)Tight Money

depress (or decrease)

risk of high inflation

Next:Chapter 9: International Trade

Do the Self-Check questions on SLATE.Do the Review Questions and CriticalThinking questions at the end of Chapter8, and check your answers in theappendix to the text.

lecture notes - chapter 8 - week 8 - macro

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