Unit 4 Notes-2

First, let me strongly recommend reviewing the PowerPoints that accompany chapters 11, 12, and 13.   I think that you will find the summaries and diagrams quite helpful. 

Second -- Spoiler Ahead -- most economists in the US accept what is called the Neoclassical Synthesis, that the macroeconomy can be well described in Keynesian terms in the Short Run, and then best described with Classical features in the Long Run.   In my view, textbooks tend to over-emphasize the difference between Keynesian and Classical (or Neo-Classical) approaches.  In practice, economists like those who work at the Federal Reserve use models that include Keynesian and Classical insights, and in the context of statistics and probability.  

About aggregate demand, the equation to keep in mind is GDP = C + I + G +NX, where the terms AD or Y can be substituted for GDP.  (The use of Y stands for "national income" -- some traditional variable in economics don't make all the much sense.)  About the elements of GDP: 

  • Consumption spending by households depends a lot on Disposable Income (meaning income after taxes), and on Expectations,  the amount of optimism or pessimism about the foreseeable future.   The Consumer Confidence Index (CCI) is used to forecast optimism and pessimism.  
  • Investment spending by businesses on capital equipment, so "real" investment in goods and services used to produce things, not financial investment in stocks and bonds. Investment spending depends on business Expectations (like formal forecasts) and on costs, including costs of actual inputs, but also costs like interest on loans for business expansion. 
  • Government spending, at all levels, but we will be focusing more on Federal spending.  Some government spending is fixed, like Social Security entitlements and payments on the debt, but other spending is discretionary, so not fixed.
  • Net Exports (with X for exports), just imports minus exports.  (We won't say anything else about NX here.) 

About Federal Economic Policy, the key is to prevent recessions, or if caught in a recession, to try and make it mild and short-lived.  

  • Fiscal Policy -- via the President and Congress -- lower taxes (to increase Disposable Income and nudge Consumption) and increase Government Spending -- which boosts GDP, but also Consumption and Investment via the multiplier effect. 
  • Monetary Policy -- via the Board of Governors of the Federal Reserve -- decrease interest rates to nudge (mostly) Investment spending by business and Consumption spending by households. 

Here are some possible issues, however.

  • Lower taxes will nudge lower and middle income households to spend more, but higher income households just put the extra money into savings.  (After all, if they wanted to buy something, then they are wealthy enough just to do so, without a tax break. )   
  • Increased government spending is sometimes difficult to implement quickly, since projects need to be developed and planned, and by the time the project is designed and the funding proposal submitted, the recession might be over.  That is why policy-makers sometimes talk about "shovel ready" projects, that can be started quickly if/when government spending is increased to counteract a recession.  
  • Lower interest rates nudge companies to begin projects and programs which would have been turned down if interest rates were high.  This assumes that a company has a set of potential opportunities that they have yet to fund.  It also assumes that current interest rates are high enough for decrease to be effective.  So if the Federal Funds Rate is 2%, as it is in late 2019, there isn't much "wiggle room" for a decrease.  

Because of these sort of issues, it can take some time to come out of a recession.