Economics is like a game and games have rules. Therefore, you need to know the vocabulary, understand the principles, and use logical reasoning. This is why economics is like math. It requires practice. It helps to know that there are three parts to this course: the book, the lectures, and supplemental materials. The book will give you details, the lectures will give you an overview, and the supplemental materials will provide the practice in mastering the concepts.
The key to a free market is self-interest.Consumers receive what they want because of the producer’s self-interest.Profit motivates producers to give consumers what they want, and competition ensures reasonable prices.An entrepreneur is a person who has a dream, who organizes and manages an enterprise, has learned the lesson of delayed gratification, and is willing to risk.
In a free and unregulated economic system, prices transmit information, give incentives, and provide the financial ability to satisfy consumer wants. When the price mechanism dictates a higher price for a good or service, there will be an increase in the quantity supplied of that good or service.The quantity supplied increases because producers can make more money at higher prices. Thus, the price mechanism ensures that markets produce highly valued goods and services.
Since the Depression of the 1930s, we have experienced an ever-larger federal government while expanding our social welfare system and putting more money into a cleaner and safer environment. To pay for this taxes and government spending has increased.
If we grow by, let’s say, ten percent, we can take six percent of this and spend it on social programs and a cleaner environment. This will leave us with four percent to invest in infrastructure and capital to grow the economy. So, it is a win-win situation for everyone and is self-sustaining. As long as the economy grows, the cycle can repeat itself. However, if we grow, by let’s say two percent but want to spend six percent on a cleaner and safer environment, we fall four percent short. This obviously is self-destructive over time.
A free enterprise system uses the price mechanism to transmit information, give incentives, and promote investments.Free enterprise needs a strong central government to enforce laws. The correct laws favor order and growth, disorder and depressions are the result of bad government. Good governments promote a healthy distribution of income and help reduce negative externalities, such as pollution and unsafe working conditions.
We need to modify the free market system, but if the government interferes too much, price signals blur and incentives impaired. Consequently, we experience more inflation, an increase in unemployment, a decline in living standards, a general breakdown of the economic and political systems, and perhaps more violence.
When the federal government becomes too large and intrusive, it can be a detriment to our freedom and security. Through the practice of rent seeking, companies can unduly influence legislation to their benefit.An army of lobbyists in Washington, D.C. who influence legislation can benefit special interest groups while inflicting pain on the rest of us. When political favoritism becomes the norm, moral hazards can eventually destroy our free market system.
We are a democracy in a republic, this means that most of the voters influence legislation, but we have laws that help protect the minority from the majority. However, this is a delicate balance. When most of the voters receive more from the government than they pay in taxes, the majority can take everything away from the minority. When the minority represents business owners and entrepreneurs, the system, as we know it, collapses.
People in a country live well only if they produce well; They produce well only if they save (or use other people’s savings) and make wise investments. By investing in new plants, equipment, and research and development, a nation can increase its productivity, which means that it can produce more with the same or less input.The lower costs lead to lower prices, more growth, and a higher standard of living. Thus, everyone gains – consumers, business, and the government. Government gains because tax revenues increase as the economy grows. The opposite occurs when productivity declines. Now, costs increase, prices increase, consumers buy less, and the economy stagnates. Consequently, a free market retains its vitality if we let the winners win and the losers lose. Everything else being equal, this process of rewarding the winners and punishing the losers ultimately leads to a growing and healthy economy.
Let us suppose that you own a business and you have one million dollars to invest. Do you invest the money? Or, do you hire lobbyists to influence legislation? If you decide that you will get a bigger bang for your buck by putting the money into Washington, D.C. to influence legislation, we call this practice rent seeking.
A moral hazard occurs when the government supports failing companies. This support can lead to several problems, one being that companies have less incentive to make prudent investments. If your investments are successful, you make much money, and if things go wrong, well, that is okay because you do not lose, the government pays the tab. Moral hazard results in privatizing gain, but socializing losses. Business gains when things go right, and the taxpayer loses when things go awry. Ah, the rich get richer and the poor get poorer!
A good or service has value depending on its usefulness and scarcity. Something can be useful, but will not have much value unless it is also scarce. Something can be very scarce, but it will not have value unless it is also useful. The more useful and scarce something is, the greater the market value. Remember, scarce does not mean rare. A good is scarce if there is not enough of it to go around free to everyone who wants it.
Demand and supply curves indicate the usefulness and the level of scarcity of goods and services. The demand curve shows the usefulness of goods and services by revealing how many units consumers are willing and able to buy at various prices. The supply curve indicates the level of scarcity by how many units of a good or service suppliers are willing to supply at various prices.The demand and supply curves together determine the equilibrium price.
The price where demand equals supply is the point toward which a free market will move. If the price is above this equilibrium market price, the units supplied will be greater than the units demanded. This will result in a surplus and will encourage the supplier to lower the price. If the price is below the equilibrium market price, the units demanded will be greater than the units supplied. This will cause a shortage and enable the supplier to raise the price.
Because we live in a constantly changing world, the demand and supply curves of goods and services are always changing. Therefore, the equilibrium market price for these goods and services is always changing. The swiftness or slowness of these changes depends on the nature of the market. Government policies and other factors can retard the forces of demand and supply. When this happens, prices are not free to fluctuate and change will take place in other ways.
Congress passed the Federal Reserve Act in 1913, thus creating a central bank for the United States. A central bank is a bank that deals mainly with other banks and the government and assumes broad responsibilities in the interest of the national economy, apart from earning profits. Each of the twelve districts has a Federal Reserve bank and at least one reserve branch bank. These reserve banks carry out the policies and duties of the Federal Reserve, sometimes called the “Fed.”
The United States banking system is composed of Federal Reserve banks and commercial banks that may or may not be members of the Federal Reserve System.The federal government charters all national banks, and all national banks are obligated to follow the rules and regulations of the Fed.For example, member banks have to buy stock in the Federal Reserve System and obey the reserve requirements set down by the Fed. States charter state banks and they have the choice of belonging to the Federal Reserve System or not. Banks must maintain liquidity to retain the confidence of their depositors.Maintaining this liquidity is perhaps the most important constraint in making a profit.
The Federal Reserve helps the federal government by serving as a bank for the government, offering checking services, aiding the Treasury in borrowing money, and keeping currency and coin in good condition. The Fed also acts as a national clearinghouse for checks.
The Federal Reserve has the responsibility of regulating the nation’s money supply. If we are having an inflation problem, the Fed will make it more difficult to borrow money.If people borrow less money, and therefore spend less, the decline in demand will eventually lead to a decline in prices.On the other hand, if unemployment is a problem, the Fed will make it easier to borrow money.Spending, investments, and growth result when people borrow more money. Monetary policies are the collective actions of the Federal Reserve.
The Board of Governors is the central decision-making body of the Federal Reserve System.The Board is composed of seven persons appointed by the President of the United States and confirmed by the U.S. Senate.These seven persons, and the presidents of five Federal Reserve Banks, make up the open market committee of the Federal Reserve System.The president of the New York bank serves as a permanent member of the committee; the presidents of the other banks rotate as members annually. The Federal Open Market Committee authority when it comes to making open market policies, the buying and selling of government securities (bonds).Despite this technical autonomy, because members of the Board of Governors are political appointees, there is usually a working relationship between the Federal Reserve and the federal government. Special circumstances can make the Federal Reserve bow to political pressure.
The three tools of the Federal Reserve are buying and selling government securities, raising or lowering the discount rate, and raising or lowering reserve requirements.The most common is buying and selling government securities and the least is raising and lowering of reserve requirements. Changing reserve requirements can cause instability in the banking system.
Monetary policies are generally more effective against inflation than unemployment.By restricting the money supply, demand eventually has to decline, which will ultimately lead to a decline in prices.It is a different story when we have an unemployment problem. The Federal Reserve can make it easier for people to borrow money, but it cannot force anyone to borrow.There are reasons why people and businesses may not borrow more money during downturns, even at low interest rates.Businesses may not borrow to buy new plants and equipment because of sluggish demand.Even when it comes to inflation, the federal government can impede the Federal Reserve.For example, if the Federal Reserve agrees to help the U.S. Treasury by monetizing the debt, the money supply may increase despite the Fed’s restrictive policies. Another impediment to monetary policies is the foreign sector. If the Fed wants to decrease the money supply, more money can enter from foreign countries. Now the money supply could increase despite the actions of the Fed. Conversely, if the Fed attempts to increase the money supply, but more money is leaving the country, the money supply could decrease instead of increase.
In order for the Federal Reserve to make the correct monetary decisions, it has to know the money multiplier.The demand deposit multiplier formula can approximate the extent of the multiplication process, which is D = 1/R.The demand deposit multiplier, D, is equal to the inverse of the required reserve ratio R. For example, if the demand deposit multiplier is ten, the Federal Reserve would initially try to increase the money supply by $1 billion to create $10 billion in the money supply.
The closing thought to this chapter is sobering. Despite all of our efforts in designing and implementing monetary policy, and despite our good intentions - it is all guesswork, educated guesses, but guesses nonetheless. It is also sobering when you realize that policy makers make decisions based on their worldview, which may or may not be how the world really works. Thinking that monetary decisions always have their roots in economics is naive. Despite our efforts to keep monetary policies autonomous, political pressure often determines the outcome.
Public goods are goods that benefit everyone, no matter who pays for them.Public goods are non-divisible. That is, they cannot be broken up or controlled to sell for a profit.One example of a public good is bees.No matter who owns the beehives, the bees are apt to benefit people in a wide area because of their ability to pollinate. Other examples of public goods are public education, national defense, and roads.
A second role of government is to protect people against social costs. Social costs are costs of production for which businesses bear no responsibility, but pass the responsibility onto society.Examples of social costs are pollution, unsafe working conditions, and the depletion of nonrenewable natural resources. In a free market, where there is little government and no unions, there is a tendency toward high social costs. Government’s challenge is to intervene without sacrificing productivity, growth, and personal liberty.
Promoting merit goods is the third role of government.A merit good or service is one that the government considers desirable and, therefore, encourages it by subsidy or regulations.In this aspect, the government is acting as a parent-guardian over its citizens. Public education and healthy foods are examples of merit goods.Sometimes the government will discourage or forbid the sale of unhealthy or dangerous goods, such as street drugs and cigarettes.
Helping poor and disadvantaged people is the fourth role of government. To make sure they receive help, the government has established safety net programs.
A free enterprise system is efficient in producing goods and services and is conducive to economic growth and prosperity. Unrestricted freedom, however, could lead to where monopolies can put the consumer at a disadvantage. Big business can exploit the consumer by charging high prices, producing less quantity, and offering poor quality goods, making it necessary for government intervention to promote competition.The dangers of too much intervention are stagnation and fewer personal freedoms, however. We should always consider the factors of equity, efficiency, and liberty when we modify our economic system.
According to popular beliefs, during the 1800s and early 1900s the economy was self-adjusting. That is, an unrestricted economy would always tend toward a level of full employment and stable prices. Therefore, the federal government should not intervene directly in economic affairs but should practice laissez faire.Serious economic problems always had external causes.
There is an interesting comparison between the depression of 1920 and the depression of the 1930s. The government did not try to get us out of the Depression of 1920 whereas in the 1930s the government was very active. President Warren Harding vacillated as what to in 1920, but by the time he decided, the depression was over.
Because of the Great Depression of the 1930s and the publication of John Maynard Keynes’ book, The General Theory of Employment, Interest, and Money in 1936, popular economic thinking changed.Because of the length and severity of the Great Depression, many people began to doubt the wisdom of laissez faire economics. Thus, the era of demand management economics was born.
To give impetus to this new way of thinking, the United States Congress passed the Employment Act of 1946, which gave the federal government the specific responsibility to use all practical means to promote maximum employment, production, and purchasing power. Government spending as a percentage of the total has increased greatly since the 1930s.
Using the correct discretionary fiscal policies is difficult.For example, the multiplier effect and the accelerator effect make it difficult to know any policy outcome. Most economists agree that automatic stabilizers are useful, but there is disagreement on the validity of discretionary fiscal policies. Some economists believe we should rely on the free market and automatic stabilizers; the opposing group believes that if we just had more knowledge, wisdom, and enough support, discretionary fiscal policies would work.
We define inflation as a pervasive and general rise in the average price level. People on fixed incomes are hurt more than people whose income increases along with prices. Inflation effects society differently depending on whether they anticipate it or inflation is unanticipated.By correctly anticipating the inflation rate, employers and employees can agree on contracts compatible with the expected inflation rate, but unanticipated inflation breeds uncertainty. When inflation is unanticipated, completing contract agreements is more difficult, and whoever estimates the inflation rate incorrectly will suffer.
Inflation hurts vulnerable people the most. The poor, the aged, the disadvantaged, the non-unionized workers and the small business owners suffer the most.In addition, inflation can change society when second and third members of families enter the workforce.Inflation thus distorts price signals throughout the economic system and diminishes its ability to function properly.Inflation can also affect individual freedom, as it enlarges the public sector at the expense of the private sector. Inflation also gives the government the impetus to create additional programs in its attempt to alleviate the problem. Lastly, unemployment eventually worsens because of a decline in consumer demand.
We can have two types of inflation, demand-pull and cost-push. Demand–pull inflation occurs when an increase in aggregate demand pulls prices up. Cost-push inflation occurs when costs to businesses increase, forcing them to raise their prices. Cost-push inflation is more difficult to remedy because of time lags. If prices are high because of high costs, demand must decline a lot and for a long time before prices come down. Cost-push inflation is also more of a problem because it takes time to lower costs, which in turn will take time to translate into lower prices.
Possible remedies for inflation include a reduction in the monetary growth rate, fiscal restraint, a mandatory wage-price freeze, a voluntary wage-price guideline program, an elimination of trade restrictions, and an increase in productivity.
Just as inflation has one cause, unemployment has one cause, excessive inventories. Because of a decline in demand, or for several other reasons, a business can find that it is producing more goods than consumers are buying. When this happens, the priority for the business is to get production in line with sales, so the business will cut back production and lay off resources, one resource being labor. Now if the business continues to have a surplus problem it will lower prices, but notice that this happens after a cut back in production.
What can cause excessive inventories? Business greed and bad government’ policy can make a bad situation worse. This is what happened in the Great Depression of the 1930s and the financial collapse of 2007-2008.
For many years, economists believed a tradeoff existed between inflation and unemployment.That is, inflation is normally high when unemployment is low and inflation is low when unemployment is high. In other words, we could cause lower prices with more unemployment or increase employment at the expense of inflation.However, in the 1970s we had these problems simultaneously, what gives?
Three explanations tell the tale for this “worst of both worlds” predicament (1) there was an increase in cost-push type of inflation; (2) structural unemployment existed; and (3) the public had a growing expectation of ever-higher prices. Because cost-push inflation is not very responsive to a decline in demand, typical Keynesian policies were not effective against inflation in the short-run.Instead, many prices remained high, despite a lower demand because of the higher costs. Prices came down eventually with a prolonged decline in demand, but this aggravated the unemployment problem.
Structural unemployment was more of a factor.Demand for highly skilled and well-educated workers increased; yet, many new entrants into the labor force consisted of unskilled teenagers, women without specific job skills, and many people whose job skills had become obsolescent through technological advances.
If workers believe that inflation will worsen, they bargain for pay raises compensating them for the expected higher prices.As they succeed in gaining wage increases, the higher wages push prices up, which in turn encourage workers to bargain for even higher wages.Thus, we are faced with a self-fulfilling prophesy.
This phenomenon of rising prices and growing unemployment poses a policy dilemma for monetary and fiscal authorities.If they use discretionary monetary and fiscal policies to depress the economy in hopes of bringing down prices, the unemployment problem can get worse without any appreciable effect on prices in the short-run.If, on the other hand, they stimulate the economy to create additional jobs, the inflation problem gets worse as demand pulls prices up.The inflation problem can eventually lead to more unemployment as some people’s real income declines.
To have inflation or unemployment is bad enough, but to have both problems is much worse.All economists agree that a large part of the solution would be to revitalize the industrial base.If investments in capital goods were to increase productivity, we could solve the twin problems of inflation and unemployment. However, this solution is not as simple as it sounds.If we were having an inflation problem in the double digits, increasing productivity enough to bring down prices is difficult.The best thing to do, therefore, is to encourage an increase in productivity by giving business more incentive to make capital investments and to spend more money on research and development.This would help revitalize the economy over the long run.However, this is difficult in an anti-business atmosphere. When politicians pit one group against another group in their attempt to win votes in the next election, sound economic policies are not even on the radar.
When considering monetary and fiscal policies there are two differing viewpoints. Taking an activist approach by using discretionary monetary and fiscal policies to fine tune the economy is the first approach. The second is to strive for fixed rules to encourage economic stability over the long run.
Whether one favors active policies or stable policy settings, there tends to be an agreement on three things:First, we should pay more attention to lag effects.Second, we should avoid any sharp changes in economic policies to promote stability.Third, more attention should be paid to the long-term effects of policy, especially as they deal with inflation.
Despite the many advantages of free trade, trade restrictions are the norm.Trade restrictions exist for the following reasons to:
(1) protect an industry for national defense reasons.
(2) protect specific domestic jobs.
(3) protect some domestic industries from cheap foreign labor.
(4) diversify a country’s economy
(5) protect infant industries
(6) protect some domestic industries from dumping.
Arguments are pro and con for each of these six reasons for trade restrictions. We must consider each separately to learn if it is a good argument or not. Inflation can result when a domestic producer or supplier has to pay more for raw materials because of trade barriers. These higher costs may diminish the producer’s ability to compete with foreign companies.The higher prices also affect the consumer indirectly by forcing up the price of some domestic goods. For example, many American companies find it difficult to compete globally because sugar is so much more expensive in the United States than anywhere else in the world.
International trade differs from internal trade because of trade barriers and different currencies. International trade requires the exchange of currencies in the international exchange market according to current exchange rates. Foreign exchange markets deal in many currencies and the transactions can be complicated.
Demand and supply determine the value of major currencies. If the demand for a currency increases compared with the supply of that currency on the international market, the value of that currency will increase.If the demand for a currency declines compared with the supply of that currency, the value of the currency will decline. A clean float occurs when the laws of supply and demand determine values.A dirty float occurs when countries interfere with these market forces. Alternatively, some countries peg the value of their currencies to a major currency. If the U.S. is having an unemployment problem, we want the value of the dollar to decline. If inflation is the problem, we want the value of the dollar to increase.
Because of the effects of international trade on employment and prices, a country should have a “balance” in its balance of payments over the long run. If a country experiences a favorable balance of payments problem over an extended time, the large influx of money could cause inflation. Alternatively, if a nation experiences a chronic unfavorable balance of payments problem, unemployment can result.
A perfectly free international monetary system is self-adjusting over time.If a country is experiencing either inflation or unemployment, the forces of demand and supply of a country’s currency will adjust to alleviate the problem. Over the long run, money leaving a country equals money entering.A country can influence the value of its currency in the following ways, it can:
(1) sell reserves of foreign currencies kept on hand.
(2) decrease the supply of its currency abroad.
(3) use monetary and fiscal policies.
(4) can seek help from the International Monetary Fund.
A healthy domestic economy is best over the long run. If foreigners have faith in a country, they will have faith in the country’s currency.A strong and stable currency promotes stability all the way around.
Change is inevitable, and the boom and bust cycle of the economy is a natural process. The consumption sector helps stabilize the economy while the investment sector is more volatile. Interest rates can decline, but if investors are pessimistic, the low interest rates may not lead to an increase in investments. To increase investments, investors have to be confident of the future; however, unlimited factors can change these expectations.
The multiplication process takes place when money changes hands. The accelerator occurs when any increase in spending will ultimately lead to secondary investments. The money spent on a new highway will lead to more motels, restaurants, gas stations, etc. This multiplication process results in a volatile market.
During boom times, a decline in the growth rate will usher in a recession. Once in a recession, all that is necessary to cause recovery is for demand to decline at a slower rate. Therefore, a slow but a steady growth rate is the best for a stable economy.
A lack of knowledge may accentuate the business cycle. How can we expect policy makers to make the right decisions if they do not understand the problem? Lag effects lessons the preciseness of fiscal policies. The recognition lag, decision lag, and action lag tend to make any policy pro-cyclical rather than counter cyclical. This is why automatic stabilizers tend to be more beneficial than discretionary fiscal policies.
The foreign sector complicates monetary and fiscal decisions. Foreign wars, revolutions, bad weather, bankruptcies, oil spills, and the actions of big business pose a nightmare for policymakers. For example, what happens if Iran blocks the flow of oil through the Strait of Hormuz? The Strait of Hormuz is only 21 miles at its narrowest point and it is the world’s most important oil-trade route.
Another problem with monetary and fiscal policies is that other considerations may be more important than growth. Goals of national defense, equity, minimizing negative externalities, redistributing the wealth, fairness, or simply looking good for the next election may take precedence over stability and growth.
The 2,700-page national health care bill and the 2,300-page financial reform bill are controversial. However, the causes of disagreement are not health or finances; it is freedom and government control. Excessive taxes and debt can enslave us. In addition, when the federal government becomes the largest single source of revenue for states, states trade their freedom of choice for dollars. This is why the attorney general of Virginia is challenging the insurance mandate of the national health care bill. Can the federal government mandate that all persons buy health insurance?
The length and complexity of the health care bill puts all the power in the hands of the federal government. For example, the national health care bill mandates that insurers spend a certain percentage of premium dollars on benefits, but does not specify what is a benefit. Remember the “tie” versus “beautiful tie” example? A handful of regulators is now choosing which benefits qualify. This gives all the power to federal agencies and nullifies actions of private enterprise and even Congress. This is a centralization of power is the very thing that the authors of our Constitution hoped to avoid.
Let me leave you with one parting idea. Why do you feel safe and do not fear someone bursting into your home, doing you bodily harm, and stealing all your property? You feel safe because we have laws against such things and a law enforcement authority to back up the laws. When I taught in the inner city of Detroit years ago, I remember the words “Protectors of Liberty’ etched on the side of every police car. We make laws to protect our liberties, and the centralization of power, or a flagrant ignoring of the law, are a threat to our freedom.