Economics in Minutes

by Niall Kishtainy

  In a hysteresis situation, the natural rate of unemployment rises with the actual rate of unemployment, as seen in this graph of Australian unemployment figures.

  Liquidity trap

  Some economists believe that countries can become stuck in a liquidity trap in which monetary policies become ineffective. Normally, during downturns governments attempt to boost the economy by cutting interest rates to encourage investment. But if interest rates are already very low, it may not be possible to reduce them any further. In this case expansionary monetary policy (see Monetary policy) will do nothing to help the economy recover: money is simply held onto as cash, rather than being lent out to fund investment.

  An example of a possible liquidity trap was Japan in the 1990s, when interest rates were low and the economy stagnated. It has also been argued that during the economic troubles of the last few years many leading countries have become stuck in liquidity traps. One solution to such a trap is inflation: while nominal interest rates can’t fall below zero, encouraging inflation can make real interest rates negative, which may help stimulate the economy by encouraging investment.

  Central bank increases money supply. Interest rate does not fall, so economy is not stimulated.

  The costs and benefits of inflation

  The inflation crisis that hit Zimbabwe around 2008 reached an estimated monthly peak of 80 billion per cent, and eventually forced an abandonment of the currency.

  If all prices and incomes rise by 3 per cent then no one is made worse off, so why do people say that inflation is a bad thing? Inflation erodes the value of money, so one cost of inflation is that you tend to hold less cash and have to make more frequent trips to the bank. Firms also have to bear the costs of repricing their goods. If they do this at different times, the relative prices of goods change, and since markets work by responding to relative prices, inflation can distort them and upset efficiency. Another major cost is uncertainty: when inflation is high it also tends to be volatile, which makes investment planning much more difficult. All of these costs may be small when inflation is low and stable, but they can cripple an economy during hyperinflation (see Hyperinflation).

  However, inflation can be a sign of a healthy, growing economy, and is often part of the process of recovery from recession. By reducing real interest rates and real wages it helps to stimulate investment and demand for labour by employers.

  Demand-pull and cost-push inflation

  The causes of inflation are often ascribed to the overall level of demand (demand-pull) or supply (cost-push). Consider an economy running at close to full capacity and suppose that the demand for goods rises. This extra demand could come from consumers, from the government wanting to spend more money or even from overseas residents demanding more of the country’s exports. The economy could not, in the short run, produce many new goods, so the outcome would be too few goods being chased by too much cash, resulting in rising prices.

  Another cause of inflation would be if the economy’s supply capacity was hindered. This could happen if there were rises in the cost of firms’ inputs of raw material and labour. Firms would be unable to maintain the same level of profit at current levels of production and would pass the cost increases on through increased prices. The inflation of the 1970s has been linked in part to the cost-push effects of oil price shocks.

  Oil prices, 1970–1985

  The cost of living

  When the cocoa harvest fails, the price of chocolate naturally rises. Aside from consumers who spend most of their money on chocolate, this will not affect the overall cost of living very much, and at the same time other prices may well be falling. The cost of living as a whole goes up when many of the goods bought by consumers rise at the same time – as during periods of inflation.

  The consumer price index is a way of capturing this. It is calculated by first compiling the basket of goods – apples, shirts, electricity, bus tickets and so on – bought by a ‘typical’ consumer, and calculating its total cost. Changes in the cost of living can be tracked over time by comparing the cost of the basket in different years. One complexity in measuring the cost of living arises from the fact that the typical basket of goods changes over time: in 1850 the basket would have contained lamp oil and candles, by 1980, these would have been replaced by electricity and televisions sets.

  The quantity theory of money

  When prices are high people need a lot of money to pay for goods. When money supply rises, money is worth less and prices increase.

  Imagine that one day everyone is given £10,000 in cash. People rush to the shops to spend their windfall, but the same number of goods are available as before. One outcome of the windfalls would surely be an increase in prices as so many people chase after limited supply. This is the basic intuition behind the quantity theory of money, which in its simplest form states that if the money supply doubles, then so will the price level.

  One implication of this theory is that changes in the money supply have no effect on the real economy. In practice, the impact of money on the economy may be more complicated than the theory suggests: some argue that increases in the money supply can affect real economic output, particularly in the short run. Nevertheless, the theory is a useful way of thinking about the difference between real economic variables – those referring to actual goods and services – and nominal variables – those expressed in money terms.

  Hyperinflation

  During its hyperinflation crisis in the early 1930s, Germany was forced to print banknotes with values of tens of millions of marks.

  Hyperinflation has been defined as monthly inflation of above 50 per cent. At these levels, inflation can cause wholesale economic collapse. Episodes of hyperinflation are caused by governments printing huge amounts of money in order to meet spending needs. Often this happens when they are in dire financial straits – with a high budget deficit or debt level (see Budget deficit and surplus) and little capacity to raise taxes or borrow. These were the conditions around German hyperinflation in the 1920s.

  Even in normal economic times, the creation of money by governments is one source of revenue – as this creates inflation it can be thought of as an ‘inflation tax’. Under hyperinflation, this process goes so far and so fast that the system of money breaks down. Because money loses value so fast, people spend it immediately, attempting to hold their wealth as goods or as foreign currency. Scenes of people going to the shops with wheelbarrows full of notes are emblematic of the economic disintegration caused by hyperinflation.

  Rational expectations

  In recent decades, economists have become interested in how buyers and sellers form expectations about the future. When making a decision about what kind of mortgage to take out, whether to go to college or where to locate a new factory, some view about the future direction of the economy needs to be taken. If one believes that interest rates are set to rise, then it makes sense to take out a fixed-rate mortgage now.

  How do people form these expectations? They might use rough rules of thumb – for example, using this year’s rate of inflation as a guide to next year’s. The theory of ‘rational expectations’ says that they are much more sophisticated than this: people forecast the movement of economic variables using all available information and a correct model of the economy. If they didn’t do this, they would make less than optimal decisions. The assumption of rational expectations has profound implications for the impact of government policies, but many question whether people are really able to forecast with such precision.

  The life cycle and permanent income

  Income and wealth over a typical lifetime

  If people are rational they ought to decide how much to save and how much to spend not according to their month-by-month income, but by considering financial flows across their entire lifespans. The life cycle hypothesis says that people try to keep their spending fairly constant over time, smoothing their consumption by borrowing and saving. When young, people save some of their income
for when they are old. When they are old they use these savings to finance their consumption.

  A related idea is that of permanent income: anticipated lifetime income that is related to a person’s assets and skills. When an individual experiences a windfall, he realizes that this is a temporary rather than a permanent boost to income and so does not increase his spending, instead saving the extra transitory income. Similarly, people may borrow or use savings when their income falls temporarily. In this theory, the only thing that causes people to increase or decrease their consumption is when their permanent, long-run income changes.

  The Keynesian multiplier

  Mary’s aunt gives her £20 for her birthday, which she spends on new plants for her garden. The plant shop gains £20 and part of this revenue is used to pay the wages of the shop assistant. The shop assistant uses some of his wages to buy a sandwich, and some of the money that the café receives is used to buy tomatoes. As it diffuses through the economy, Mary’s £20 gives rise to many other items of spending, demand for goods and services that go far beyond her initial purchase of plants. This is John Maynard Keynes’s idea of the ‘multiplier’.

  Because individuals and firms generally only spend a proportion of their income, the impact of Mary’s £20 eventually fizzles out. Before it does, though, it may have generated spending in the economy worth, say, £40. Keynes was particularly interested in ways that government spending could harness this multiplier: by spending money itself, the government might be able to trigger a chain of purchasing that would boost the economy by significantly more than its own outlay.

  Automatic stabilizers

  Governments sometimes try to smooth economic cycles by actively adjusting the amount they spend and tax. In addition, the structure of government spending and taxation creates ‘automatic’ stabilizers that moderate economic fluctuations even without active government intervention.

  During a recession, economic activity declines. As incomes fall, the government takes less in tax: income tax, in particular, often falls quite rapidly because higher tax rates are levied at higher income levels, so as earned income falls, the average tax rate declines. As workers are laid off, the government pays out benefits, so spending rises. Tax rates and spending obligations together create an automatic shift towards more spending and less taxation that tends to boost the economy, moderating the recession. Conversely, during a recovery, the government takes more in tax as incomes rise. It also puts less money into the economy as it has to pay less in benefits. Now the automatic stabilizers work in the opposite direction.

  The automatic stabiliizers of fiscal policy

  Real Business Cycle theory

  Although the performance of an economy can vary markedly over a cycle, average performance over the long-term usually follows a trend of fairly steady growth.

  Most economists blame booms and busts on imperfections in markets. The Keynesian explanation is that during downturns, wages are slow to adjust: the economy gets stuck below its potential output with persistent unemployment. But some economists have offered an explanation without invoking such frictions. The Real Business Cycle theory assumes that all markets function perfectly – prices adjust quickly to bring supply in line with demand – and firms and individuals are rational. As a result, the economy always runs at the long-run level of output permitted by available means of production. Cycles then arise because this long-run level changes. Suppose a new technology boosts productivity: output and employment rise in a boom caused by a ‘real’ feature of the economy. The theory, while ingenious, can be criticized: technology is a long-run phenomenon, so can it really explain economic cycles that ebb and flow every couple of years? Finally, while technological progress might drive booms, recessions certainly don’t seem to be accompanied by technological reversals.

  Money neutrality

  People sometimes think of economics as the study of money and finance. In fact, its more fundamental aim is to analyse the production and allocation of ‘real’ goods: computers, pineapples, evening courses, heart operations and so on. Some economists – particularly those allied to the so-called classical school – think of money as little more than a veil over the real workings of the economy.

  This leads to the idea of money neutrality – the notion that money itself has no effect on the real economy. If the money supply was doubled, the impact would be a doubling of prices; nothing would happen to production or the level of employment (see The quantity theory of money). Money neutrality underpins the ‘classical dichotomy’, the separation between the real and the nominal (money) sides of the economy. In contrast, Keynesian theories show how money can affect the real side of the economy. Most economists accept that this can happen in the short run, and that it is really in the long run that money neutrality may hold.

  The political business cycle

  Some economic models tie the business cycle to political factors. In modern democracies, a government only stays in power if it pleases the electorate, so a struggling economy can cost a government the election. Governments, like firms and individuals, are rational and forward-looking: they will do anything that they can to maximize their chances of staying in power. In the run-up to an election, they have a strong incentive to boost the economy.

  A government can do this by increasing spending, perhaps on hospitals, schools or infrastructure projects. It can lower taxes to increase people’s spending power. It may also cut interest rates to encourage investment. These measures stimulate the economy, but can also store up problems for the future, such as inflation and too high a government budget deficit (see Budget deficit and surplus). Once power has been secured, policy may go into reverse – hence, a government’s political aims have the potential to generate economic cycles.

  Demand for labour

  Like the price of toffees, wages are determined by supply and demand. Firms demand labour, but this demand is a bit different to that for toffees because labour is not a final ‘good’ for consumption, it is an input to production. A restaurant employs chefs to produce meals that it sells for profit. The number of chefs employed is linked to the profitability of the meals. Each extra chef makes more meals, adding some amount to the restaurant’s profits – the marginal product of labour.

  But the marginal product falls as the number of chefs rises: when there are many, an extra one doesn’t make as much of a difference as when there are a few. So how many chefs should the restaurant employ? If the wage is £30 and the marginal product £35, then it is still profitable to take on an extra chef. The restaurant maximizes its profits when the marginal product equals the wage rate. If the marginal product rises, the restaurant will demand more chefs: this may happen if meal prices increase or through some technological improvements.

  Efficiency wages

  It is hard for an employer to constantly check up on all her employees and this gives ample opportunities for workers to shirk. Efficiency wage theory is based on the idea that an increase in wages can create incentives for workers not to shirk. As a result, it might be worth the firm paying more because of the increased productivity induced in its workers. The high wage will also increase the number of people seeking employment and so create a pool of unemployed people. The high wage together with the threat of unemployment if they are caught shirking, encourages workers to be diligent.

  Another reason why a high wage might affect the efficiency of workers is that it allows them to eat well, a factor which may be especially important in developing countries. Efficiency wages may also account for the puzzle of why wage rates often don’t fall during recessions – during a downturn, it may be more advantageous for firms to keep wages high and fire some workers, instead of cutting pay for all.

  Wage and price rigidity

  Wage rates often respond sluggishly to changing economic conditions, and in particular can be slow to adjust downward.

  Keynesian economics is based on the idea that wages and prices are ‘sticky’. For example, when demand for la
bour falls, wages rates don’t always adjust downwards. Even more, during recessions price levels fall so real wages actually increase. This reduces demand for labour from firms, causing unemployment. The ‘New Keynesian’ economists have tried to explain these wage and price rigidities. One reason is that changing prices has costs – the printing of new price lists and so on. Another explanation is that prices and wages are adjusted at fixed time intervals and these adjustments are not synchronized across firms. Consider that at the time a firm is reconsidering its prices, market conditions already point to an increase – but because their competitors will not be adjusting their prices until later, the firm holds off from doing this to stay competitive. The result is that price adjustment is sluggish. The message is that even when firms and individuals behave rationally, markets don’t necessarily adjust smoothly, and so recessions and unemployment can emerge.