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Unit 3: Macroeconomic Models

A.  Read the following selection from the Margin Notes by clicking on the link.

Classical and Keynesian Analysis

 

B.  Watch these presentations. When you click on one of the links below, a new screen will pop up. Use the scrollbar on the side of the new screen to navigate. You need Adobe Reader to view PDF files.

[Each may take a few minutes to download.] The Business Cycle Part I The Business Cycle Part II Aggregate Demand and Aggregate Supply Part I

Aggregate Demand and Aggregate Supply Part II Aggregate Demand and Aggregate Supply Part III Aggregate Demand and Aggregate Supply Part IV Aggregate Demand and Aggregate Supply Part V

 

C.  (Optional) Read the following chapters from the textbook.

Chapters 08 - 10

 

D.  The following Optional Links will help you do better in your course but they are not required.

ECON 2301 Activity #2 Rubric Macroeconomics Review Test Yourself: Aggregate Demand and Aggregate Supply (PDF)

Test Yourself: The Keynesian Model (PDF) Test Yourself: Business Cycles and Unemployment (PDF)

 

E.  Activity #2: The Fiscal and Monetary Policy Process (10 points)

As the American economy slid into recession in 1929, economists relied on the Classical Theory of economics, which promised that the economy would self-correct as long as government didn’t interfere.

But as the recession deepened into the Great Depression and no self-correction occurred, economists realized that a revision in theory would be necessary. John Maynard Keynes developed Keynesian Theory, which called for government intervention to correct economic instability. One of the most important functions of our government today is to try to correct inflation and recession in our economy.

In this activity, you will learn about the tools the Congress and the Federal Reserve can use to correct economic problems, and how the use of those tools affects the money supply, interest rates and aggregate demand. Then you will analyze economic data to determine how fiscal and monetary policy should be used to correct economic problems.

 

We can illustrate economic performance through the concepts of aggregate supply and aggregate demand. Aggregate supply is the total supply of goods and services produced in the nation’s economy. It is upward-sloping because at higher prices firms have an incentive to produce more and at lower prices they are likely to produce less. Aggregate demand is the total demand for goods and services in the nation’s economy. It is downward-sloping because at higher prices, consumers, firms, government and foreign customers are less willing to buy, while they will likely buy more at lower prices. The graph below shows aggregate supply and aggregate demand.

Shifts in the aggregate supply and aggregate demand curves can illustrate changes in the performance of our economy. If consumer confidence in the economy falls and people reduce their spending, aggregate demand can fall, reducing real output and prices and possibly dropping the country into a recession. However, if the money supply is too large, excessive consumer demand can push up the aggregate demand, raising real output and prices and possibly pushing the country into serious inflation.

 

For stable economic growth, economists generally look to annual goals of a 2.5-3% GDP growth, a 3-4% inflation rate and an approximately 5% unemployment rate. However, our economy generally follows an economic cycle of recession and expansion every few years. As John Maynard Keynes argued in his 1936 book General Theory of Employment, Interest and Money, nations need not wait for potential economic problems to correct themselves. He advocated that government take an active role in resolving economic issues through the use of two policies – fiscal policy and monetary policy.

Fiscal policy is the use of government spending and taxes to stabilize the economy. Read Amos Web’s explanation of Fiscal Policy.

During periods of recession, Keynes recommended that Congress increase government spending in order to “prime the pump” of the economy. At the same time, he recommended that Congress decrease taxes in order to give households more disposable income with which they can buy more products. Through both methods of fiscal policy, the increase in aggregate demand stimulates firms to increase production, hire workers and increase household incomes to enable them to buy more.

Keynes advocated the opposite positions during times of rapid inflation. In order to slow down the economy, Keynes called for Congress to reduce government spending in order to reduce pressure on aggregate demand. For the same reason he called for tax increases in inflationary times to reduce consumers' disposable income The reduction in aggregate demand brought about by such actions leads firms to produce fewer products, slows hiring and reduces inflationary pressure.

While both tools are effective, Keynes advocated change in government spending as the more effective fiscal policy tool because any change in government spending has a direct effect on aggregate demand. However, if taxes are reduced, consumers most likely will not spend all of the increase in disposable income. They are likely to save some of it. In the same way, if taxes are raised, consumers are not likely to reduce their consumption by the same amount as the tax. They are likely to dip into savings to cover some of the change in tax rates.

Think about the following questions.

1. According to Keynes, what should the government do regarding taxes and government spending during a period of recession?

2. According to Keynes, what should the government do regarding taxes and government spending during a period of rapid inflation?

Monetary policy is the use of the money supply and credit to stabilize the economy. Read Amos Web’s explanation of Monetary Policy and refer to the graph below.

 

The demand for money consists of consumers borrowing for items such as cars and homes, firms borrowing for items such as factories and equipment, and the government borrowing to finance the national debt. The supply of money is set by the Federal Reserve Board of Governors, the central banking system for the US. The supply and demand for money determine the interest rate paid for the use of borrowed money. If the Federal Reserve increases the money supply, interest rates will fall, making it less expensive to borrow money. In that case, those wishing to borrow money will be more likely to do so -- and be more likely to spend that money on products. If the Federal Reserve reduces the money supply, interest rates will rise, so less will be borrowed and spent (because of the higher cost of borrowing). Think of money as a product and interest rates as the price of money. As a product, money is affected by supply and demand the same as any other product.

The Federal Reserve has three primary tools available to change the money supply. (1) During periods of recession, Keynes recommended that the Fed buy bonds on the open market. By increasing the reserves the banks hold, the banks have more money available to loan and can reduce their interest rates. At lower interest rates, consumers and firms are more willing to borrow to make purchases, and aggregate demand can increase. (2) Keynes recommended that the Fed lower the discount rate. When the Fed reduces the discount rate (the interest rate member banks must pay to borrow from the Fed), banks become more willing to borrow in order to make money available for loans at lower interest rates. In this case, again, consumers and firms are more willing to borrow and spend, increasing aggregate demand. (3) Keynes recommended that the Fed reduce the reserve requirement during a serious recession. If banks can release more of their reserved funds for loans, the lowered interest rate will again entice consumers and firms to borrow funds to make purchases, increasing the aggregate demand.

Keynes advocated the opposite positions during times of rapid inflation: reducing the money supply to raise interest rates, making it less likely consumers and firms will borrow to purchase products.

While these three tools work in similar ways, they differ in the power of their effects. The reserve requirement is extremely powerful and changed only in the event of a serious economic situation. The discount rate is more of a signal of the Fed’s intentions for monetary policy. Open market operations are by far the most widely used tool of monetary policy.

Think about the following questions.

1. How can the Federal Reserve use the reserve requirement, the discount rate and open market operations during a period of recession?

2. How can the Federal Reserve use the reserve requirement, the discount rate and open market operations during a period of rapid inflation?

It’s time to analyze a few economic situations and determine how we should use fiscal and monetary policies to correct economic problems. The Fiscal and Monetary Policy Tools Self Test covers 5 economic situations, each of which is followed by several questions. For each question choose the policy action you think is most likely to correct that economic situation.

You'll get immediate feedback. If you choose the wrong action, you’ll get an “Oops” and should stop and think about why your choice was wrong. If you choose the correct action, keep going to the next question but think carefully about the rationale for your choice and use what you learn when considering the other situations.

It's important that you take the self test and get this experience. With no one watching, you can take as long as you want and start over as often as you want. Before you leave the self test make certain you understand which policy tools are used in which situations and why.

 

In 2001, the US economy slipped into recession. The GDP dropped by more than a 1% annual rate in the third quarter, the inflation rate dropped to below a 2% annual rate in the fourth quarter and the unemployment rate rose to 5.6% in the fourth quarter.

Apply the skills you honed in the self test to a real world situation. Take on the role of an economic advisor to the Congress and to the Federal Reserve. It’s 2001. What do you recommend the US Congress do with its fiscal policy tools? What do you recommend the Fed do with its monetary policy tools? How will the tools work to help improve aggregate demand?

After you have decided on your recommendations, visit the following websites to see the actual 2001 fiscal policy actions taken by the President and the Congress, and the actual 2001 monetary policy actions taken by the Federal Reserve.

Federal Reserve Bank of Boston Speeches: Asset Bubbles and Systemic Risk

Federal Reserve Release; Press Release

Did the 2001 fiscal policy actions or the 2001 monetary policy actions agree with your recommendations? If they differed, why do you think that is?

 

Economists learned much from the experience of the Great Depression, and most economists today advocate a role for government in creating economic stabilization policy. Although economists may disagree about which particular tool is most appropriate, or about the timing or strength of the tool used, most economists recognize the advantages of using fiscal and monetary policy for the prevention of extreme inflation or depression in our economy.

[This activity is based on work from – but no longer maintained by – EconEdLink.]

 

When you've finished the online work, I will expect you to send me a summary of your work that includes the 4 points below. Your answers should be thorough, specific, include relevant concepts from the course material and be free of spelling and grammar errors. [NOTE: As I've done below, I almost always list the things you need to include in your assignment so you won't miss anything. However, you should never write an assignment as a list unless the instructions specifically tell you to do so (as in your first assignment). Lists encourage short, quick responses, and they don't usually require much thought or much attention to spelling and grammar. They also won't earn you many points! Instead, write your assignment in complete sentences and paragraphs, using the list only to be certain you cover everything. Do your best to make your writing thorough, thoughtful and organized. Don't try to be concise ,,, Try to be complete.]

1. What should the government do with (a) taxes and (b) government spending during (a) a period of recession and during (b) a period of rapid inflation, according to Keynes? Write a brief essay that answers those questions. Do not copy-and-paste. Explain to me what you learned in your own words.

2. How can the Federal Reserve use (a) the reserve requirement, (b) the discount rate and (c) open market operations during (a) a period of recession and during (b) a period of rapid inflation. Write a brief essay that answers those questions. Do not copy-and-paste. Explain to me what you learned in your own words.

3. I asked you above to answer three questions: (a) In response to the 2001 economic situation the assignment described, what do you propose Congress do with its fiscal policy tools? (b) In response to the 2001 economic situation the assignment described, what do you propose the Fed do with its monetary policy tools? (c) How do the government’s and Fed’s actual policies compare to your recommendations in (a) and (b). Write a brief essay that explains your recommendations and how they compare to the government's and/or the Fed's actions.

4. Make specific and detailed connections to the course material you have been studying. Always include course concepts in your work. If you're reading your margin notes and watching the presentations, you'll have plenty of material from which to choose on every activity. (When it comes to making specific and detailed connections to the course material, I always show some leniency in the first assignment. With this second assignment, you need to begin to approach this item in a more scholarly fashion. This is the part of each assignment in which you should show off how much you know. You should have already completed margin notes and presentations that deal with relevant theoretical concepts so it should be easy to make those connections. If you don't, then you miss the purpose of the assignment and cannot expect to earn full points for it.)

I am not asking you to write separate essays. I'm asking you to send me one thoughtful in-depth piece covering the topics given. It ought to all fit together.

If you have trouble with spelling and grammar, find someone to help you edit your work before you send it. Don't hide great ideas with poor writing habits.

 

Activity Submission Instructions

By the deadline shown in the Course Schedule on the main page of your syllabus:

• Send your summary containing the 4 items requested in the body of a new email to dramyglenn@gmail.com.

• Put only your name and Activity #2 at the beginning of your email.

• Be careful to use the correct subject line.

• Late responses lose one point per day late, including weekends and holidays.