ECON 104 Final

Within the context of functional finance, what is the justification for the government running deficits during recessions, such as the one we experienced over 2007-09?

At the end of 2007, the 10 largest banks in the United States were all deemed to be in perfectly good shape. By 2008, we knew that wasn't true, the economy was tanking and the banks were falling apart. In order to save the economy, functional finance was put in place. Functional finance is a stimulus policy that rapidly increased government spending by borrowing the money to stimulate the economy. Considering national income identity (Y ≡ C + I + G + (X -M)), if the economy is moving into a recession, consumption (C) and private investment (I) both drop. Consumers spend less because there is a fall in confidence. They rather save then spend to feel secure. Private investments fall because businesses are afraid to invest. This lowers GDP meaning the government must find a way to counteract the recession. There are two possible ways to "break downward the vicious cycle". The government can either increase government spending (G) or try to increase net exports (X-M). The government has full control on their spending but not full control on net exports. Therefore, increasing government spending is the most efficient way to increase national GPD and fight the recession.

Cyclical vs. structural deficits

Cyclical vs. structural deficits Cyclical: Gov. borrowing money to counteract recession. Structural: Gov. borrowing money not to counteract recession but to improve the structure of the economy.

Deficits vs. accumulated debt

Deficit: are flows, how much the government borrows over a given time Debts: are stocks, how much you add up every year by the increments of the deficits. Debt is about 70% of GDP.

The main justification for cyclical deficits comes from the "functional finance" approach. The overall approach here is not to think of government deficits as necessarily either good or bad, but to ask the question: What function are the deficits serving? Are the deficits being put to good use?

Functional finance was a revolutionary concept in the 1940's. It's the primary tool for the government to maintain/achieve full employment in able to get out a recession.

Has the rise of China as an export powerhouse been detrimental in any way to working people in the U.S.? If so, how; and if not, why not?

If China's products are cheaper people will buy it over American made products, which are more expensive. This creates fewer jobs in the US and scares workers. Global trade in general but specifically with China has expanded the reserve army of labor. Workers are unable to barging their wages because their employers can just go to cheaper sources. This happens even at low unemployment.

Be sure to understand the role of exchange rate issues with respect to China and the US, and more generally. How does having a "cheap" currency help a country export? How could China continue to help keep its currency value low?

If currency rises that means it would be more expensive to buy goods, which in turn decreases demand. China wants to keep their demand high for exports and they do so by manipulate their currency. China's goal is to have one US dollar be equivalent to a lot of Yuan's. To buy Chinese product, America first has to buy Yuan's, which in turn drives up the demand and then the value of a Yuan. When the value of the Yuan goes up so does the price of the goods, decreasing demand. To counteract this, China drives up the value of the dollar. China buys bonds with US dollars, forcing up the value of the dollar.

What is your assessment as to how well these various efforts worked to get the economy out of the crisis?

Improved but not well enough because it took too long. Monetary and fiscal were not as bad as great depression. Lender of last resort let one bank collapse but saved others.

Consider the decade of the 1970s. What could explain the relationship between unemployment and inflation that we observe then, relative to the relationship we observe for the 1950s and 1960s?

In the 70s, both inflation and unemployment were high because of serge in oil prices. The surge in oil prices caused the price of goods and services to also increase causing inflation. To cut costs companies laid off/fried employees increasing unemployment. In the 50s and 60s, unemployment was low and inflation was high.

Consider the 1990s: Then Federal Reserve Chair Alan Greenspan hypothesized that the U.S. workers had become "traumatized." If Greenspan's observation is accurate, why might that influence the inflation/unemployment trade-off, both in the 1990s and more generally?

In the 90s, both inflation and unemployment were low. There were more technological advancements, which made people feel replaceable. Globalization also became a problem, it was easier for companies to up and move to another country. This meant that workers felt replaceable and become "traumatized workers". Even at low unemployment, these workers had no job security making them unable to barging up their wages. Without workers bargaining up their wages, inflation also stayed low.

What is industrial policy? What are the main features of industrial policy that have contributed to the strong economic growth performance of some Asian countries such as, initially, Japan, then South Korea and China?

Industrial policy is the research/development, commercialization, and adaptation of technology. The government's purpose is to serve the public interest to advance the state of technology and adapting technology to make it more marketable. The main feature of industrial policy that has contributed to the strong economic growth performance of some Asian countries are their practice of industrial policy in combination with markets.Their governments actively supported the development of technology so they are be able to produce thing other countries want to buy. The government supported the companies by subsidizing at cheap rates to companies that can prove that they can export. Japan used industrial policy to learn to build better cars that the US would want to purchase which benefited private companies. As soon as a country become successful in trade and industrial policy their currency goes up forcing them to have to intervene to drop the currency to keep their products cheap and demand high.

What would be reasons for the Fed to be raising the Federal Funds rate now? Is there a relationship between their most recent actions, and their understanding of the concept of the "natural rate of unemployment?"

Inflation, start to raise rates to slow down spending. Numbers from Feds that tell us natural unemployment rate is 4.7 % for U-3 so we are at full employment. Any further deductions could lead to inflationary measures. They started to raise it to stop this but we currently have weak GDP growth so the fed this month did not raise rate again because economy is already too slow. If it is too low then it can not work as a tool anymore.

In 2007 - 09, the U.S. and global economy experienced the most severe financial bubble, collapse, and crisis in 70 years. Be clear on the basic dynamics driving a financial bubble. Why can financial bubbles be self-reinforcing? Why do they collapse?

Investors see a new opportunity (tulips, the internet) and financial market gives out loans to these investors. These people only want to invest because they see that prices are going up and believe they will continue to go up and they can sell at a higher profit. But what they don't realize is that the more they borrow and invested the higher the price becomes. Eventually the bubble burst because income from assets is not producing enough to cover the debt from the loans.

It is also a widely held view that immigrants living in the U.S. are absorbing a significant share of the economy's available public services, without paying a proportional share of taxes to support these services. On balance, what does the evidence on this issue find?

It is false to say immigrants living in the U.S. are absorbing a significant share of the economy's available public services, without paying a proportional share of taxes to support these services. Undocumented workers don't not use a significant share of the economy's public services because they are undocumented. These workers are not taking any of their benefits. These undocumented workers are contributing to social security trust funds because they are taxed at jobs. They also pay sales tax on anything that they purchase but do not receive health care benefits.

Rich, poor and middle-income countries: Be clear on some of the major differences between countries in terms of what the average person in each category of country can expect.

Life opportunities are dramatically different depending on where you're born. Avg. income in Haiti is around $700 a year with a life expectancy 55-60. Compared to Sweden where the avg. income is around $55,000 yearly and life expectancy of 80. There are countries in the middle, ex. Iran, avg. income is roughly $7000 with a life expectancy of 70.

The Fed's mandate is to maximize employment in a manner consistent with price stability. The Fed's main policy tools are to: 1) lower or raise the Federal Funds interest rate; and 2) lender of last resort policies. Be clear on what both of these policies are and how they differ.

Lower or raise the Federal Funds interest rate: Banks have more money to lend so they lower interest rates. Rates that banks charge each other goes down. If the Fed is afraid that unemployment is low they will raise interest rates to make it harder for people to borrow before inflation is high. Lender of last resort policies: Bank bailouts, no one wants to lend to them so the Fed saves them from failing.

How did the government try to get out of the crisis using monetary policy, fiscal policy, lender-of-last-resort and financial regulatory policies?

Monetary Policy: Control interest rates...lower them by driving down the federal funds rate to zero. Fiscal policy: Lower taxes, Increase Gov. spending Lender of last resort: U.S. treasury bailed out banks, financial reserve bailed out Wall Street. This prevented institutions from collapsing and deepening rescission and hurting innocent people. Financial regulatory policy: New law, Dodd Frank. Not as strict as past laws. Goal was to limit financial speculation in the long run.

Two factors have contributed to making this most recent financial bubble and crash bigger than previous ones: 1) rising inequality in the U.S. economy; and 2) Deregulation of U.S. financial markets. How have these factors contributed to the crisis?

Rising inequality in the U.S. economy: Rich people can borrow money and do more with it. Moves more money to the rich people and gives them more money to speculate in financial markets. Trillions to play with and put it into the financial market. Deregulation of U.S. financial markets: Bill Clinton. Encouraged financial speculation. Effective regulation stabilizes economy historically 1950-1960.

The late Professor Vernon Ruttan asks the question, "Is war necessary for economic growth?" His answer was "Yes." What specifically did he mean by this?

Ruttan did not mean that war is necessary for economical growth but that industrial policy is and it is carried out by the US defense system. Industrial policy consists of policies that promote technological developments. Many people oppose industrial policy but we actually do it threw the military therefore being called military policy. Some technological research is too risky for private sectors to try because private secures need return and it can take years to develop a new technical advancement, so private sectors are not interested. The military is not at any risk of going out of business so they are able to work on new advancements without the fear of failing. Most if not all innovations that were relevant for business development happen threw the U.S. pentagon, such a nuclear energy, computers, information technology.

The debates on the crisis and on solutions for getting out involve both philosophical positions and technical debates on policy tools. How would you distinguish between the philosophical viewpoints? How would you distinguish the technical debates on policy approaches?

Should governments be able to go into debts? Philosophical positions say no. Big gov. are bad and put a limit on human freedom, free market maximizes human freedom. The technical debate is if the Gov. uses functional finance will it generate a favorable outcome? Phil. Position on min. wage the Gov. shouldn't be making businesses follow a certain min. wage.

Two perspectives other than "functional finance" on the governments running fiscal deficits are the doctrine of "sound finance" and the "Ricardian Equivalence" theory. Be clear on what these mean. In both cases, they would argue against the government running deficits. But what are their arguments? In what ways do they differ from the functional finance perspective?

The "sound finance" approach is when deficits should be balanced except in wartime. Advocates of the "sound finance" approach believe that big deficits during recession will cause high inflation, high interest rates, and overwhelming debt burden. They also believe that it is risky to trust Politian's with their money because they are unpredictable. The Ricardian Equivalence theory claims that the government should not be borrowing because deficit will not bring up GDP. Consumers will not spend when they see the government spending and believe that the government will raise taxes in the future to ay off debt. By not spending they will have enough saved to pay the high taxes.

. Be clear on what we are referring to when we talk about "The Fed." Who are the main decision makers at the Fed?

The Fed consists of an office in D.C. and there are 12 regional banks in the US. The main decision makers are the open market committee; it's a 12-person committee with a chair. There are 7 governs appointed by president with 14 year terms and 5 presidents of the 12 regional banks that rotate. The chair has no more voting power than the rest of the committee but they are the face of "The Fed", speaks to the press, etc.

. Using the tools available to them, how might it be more difficult for the Fed to maintain control over inflation and unemployment when financial markets are unregulated?

The Fed lowers interest rates if the economy needs heat and raises interest rates if the economy needs a break. Low interest rates can cause financial speculation and financial bubbles. People borrow money and are more risky with it to make a profit. Some people doing things such as play the stock market but if everyone starts doing playing it causes a bubble to form.

While the fiscal deficit reached an historic high over 2009-12, government interest payments as a share of overall government spending remained historically low. How could this be possible? Why has it happened?

The Federal Reserve Bank tries to keep interest rates low by creating money so there is more money available for borrowers. Interest payments are 1.3% of GDP. The Gov. interest payments are low because they borrowed at very low interests rates. They are able to borrow at such low interest rates because the Federal Reserve drives down the Federal Fund rate close to zero. Gov. bond rates are risk free so they don't deviate from fed funds rates becoming the safest asset anyone could buy driving down interest rates further.

Be clear on where the U.S. stands in the global economy. How big is the U.S. economy as a share of the global economy? How important is the U.S. in terms of population? In terms of addressing climate change?

The US is about 20% of global GDP, 5% of global population, and 15% share of total greenhouse gases. We are polluting the world about 3 to 4 times more than the rest of the world.

As a share of U.S. GDP, the federal government's fiscal deficit reached its highest level since World War II between 2009-12. What is the explanation for deficits at this level?

The economy was going down, automatically there's less tax revenue, and more government expenditures. (more spent on unemployment, etc.) The government spent money they didn't have due to the stimulus policy and increase GDP.

What is the law of comparative advantage? Following the law of comparative advantage, why would any given country seek to specialize in producing one or two products and importing everything else they need, rather than diversifying?

The law of comparative advantage encourages countries, regions and people to specialize enable to produce goods and services at a lower opportunity cost than other country, region or people. Any given country would seek to specialize in producing one or two products and importuning everything else they needed rather than diversifying to be able to produce more of all goods and then trade them with other countries so everyone has more of everything. In the case of Pakistan and Belgium, Pakistan has comparative advantage in textiles and Belgium has comparative advantage in chocolate. Pakistan can produce 4,000 yards of textiles or 1 ton of chocolate per day, while Belgium can produce 1,000 yards of textiles or 4 tons of chocolate per day. To maximum the production of both textiles and chocolate, Pakistan and Belgium must follow the law of comparative advantage and produce what they are best at to produce more and then trade.

China's successful growth experience since the early 1980s has been closely tied to its achievements as an exporter, with the United States being the largest single purchaser of Chinese-made products. What have been the main factors behind China's success in exports?

The main factors behind China's success in exports is keeping their currency cheap, having cheap labor and producing goods that people want to buy at mass quantity at low costs. China is considered to be a currency manipulator because they have maintained their currency at low level to keep price of exports low in other foreign markets.

We have gone over how the current monetary policy stance at the Fed has been extraordinary in historical terms, because the Fed held the Federal Funds interest rate at close to zero for nearly 7 1/2 years. The Fed is currently slowing raising the Federal Funds rate, but only very modestly. What is the purpose of this policy?

The purpose is to encourage people to borrow more that will allow them to spend more and increase GDP. Unemployment is low. When interest rates low, companies are encouraged to expand so they hire more people and consumers are more willing to borrow to buy homes and cars. The main goal is to help main St. not wall St.

Evidence on inflation/unemployment trade-off: Is it accurate to say that there is always a trade-off between unemployment and inflation? Compare evidence on a decade-by-decade basis. What do the patterns show?

The relationship between unemployment and inflation is unstable. Both low in the 90s. Both high in the 70s.When unemployment is low and inflation is high, workers have more bargaining power which drives up wages also driving up prices of goods and services.

It is a widely held view among some politicians and authors (e.g. Camerota, NY Times) that immigrants in the U.S. labor market hurt job prospects for native U.S. workers. Why might this be the case? On balance, what does the evidence on this issue find?

There is mixed evidence on whether immigrants in the US labor market hurt job prospects for native US workers. Many claim that the increase in labor supply pushes down wages but when studies were conducted there was no evidence of downward pressure. Immigrants increase demand because there is more spending in the economy. This leads to more need in labor which driving up wages.

Noam Chomsky Lecture

Two threats to human survival: Climate change Nuclear weapons Goal: To provoke people to change their ways and do something about it

If we consider the cases of South Korea and China, is it accurate to say that their successful growth experiences have been tied to the idea of comparative advantage? In this context, be able to distinguish between "static" and "dynamic" comparative advantage.

Yes, it accurate to say that their successful growth experiences have been tied to the idea of comparative advantage. South Korea and China "nurtured" what they wanted to me good at, in this case cars. If they had never diversified they would have never become good at producing high demanded cars. By using dynamic comparative advantage they produced things that did not define their economy (static). By taking the dynamic approach these countries became successful at exporting manufacture products. South Korea and China's living standards increased because they ignored the static approach and pursued industrial policy.