The effect of $1 million of wages would result in $5 million ($1,000,000 × 5) of total spending in the economy. For members of Congress who win public works projects and defense contracts for their districts, their vote-buying power is also multiplied by five.
The IS/LM Curve of the Goods and Money Markets. According to Keynes, interest rates are also powerful driving forces in the economy. Higher interest rates tend to retard the investments (I) that drive economic growth. It is unlikely that consumers will buy expensive items, such as cars and houses, if high interest rates make monthly payments unaffordable. The downward-sloping curve explaining this relationship is called the investment and spending curve (IS).
Acknowledging the power of money, Keynes noted that the higher the interest rates, the higher the liquidity preference for money. On December 19, 1980, interest rates reached an all-time high of 21 percent, and people flocked to invest in money market funds. In 1992, when interest rates were hovering at 3 to 5 percent, investors rushed to shed their cash and ventured into the stock market. In 2003, with rates at 1 to 3 percent, and the stock market somewhat risky, investors rushed into real estate, which ended badly in 2007 and 2008. This relationship is illustrated by an upward-sloping curve called the liquidity and money curve (LM). At some theoretical point there is an equilibrium point where the IS and LM curves meet at an equilibrium interest rate and a level of GNP.
THE IS/LM CURVE
THE IS/LM CURVE
The IS/LM curve is not fixed. It can change. If spending increases due to pump priming by the government during a recession, people will spend more in the aggregate. In this case, the entire IS curve will shift upward, resulting in higher interest rates and a higher GNP. If the money supply were also to be increased by the right proportion to accommodate the increase in spending, then interest rates could remain the same. That’s in theory, of course.
There is not a single interest rate for the whole economy, nor can an accurate picture of how consumer spending responds to interest rates be drawn. That’s why this is economics. The IS/LM curve is not precise; it does, however, illustrate a relationship that makes logical sense.
ECONOMIC GROWTH AND THE MONETARIST VIEW
What Is Money? To begin a discussion on the monetarists, you need to know what they are talking about when they speak of what is dearest to their hearts—money. Money is the medium of exchange to buy and sell goods and services. Sounds simple, but is money just cash? No. When economists speak about measuring the money supply, they also include the “money equivalents” such as checking account balances and money market funds.
The money supply is referred to as M1 and M2. M1, the most accessible money, includes only cash, checking account balances, and nonbank traveler’s checks. M2 includes M1’s components plus savings and money market accounts. In 2010, M1 and M2 equaled $2 trillion and $9 trillion respectively. The government closely monitors M1 and M2 money supply to gauge the economy’s demand for money, and hence, its health.
The Quantity Theory Equation of Money. Whereas Keynes addresses the monetary dimension of the economy with the LM curve, monetarists consider money the main driver of GNP. The Quantity Theory Equation explains the monetarists’ position. Changes in money supply cause direct changes in nominal GNP:
M × V = P × Q
Money × Velocity = Price Level × Real GNP
Money Supply = Nominal GNP
Monetary theories consider the money supply as the product of the amount of money and the velocity at which it travels through the economy. Velocity is the speed at which money changes hands. It is obvious that if a dollar remains under the mattress, it has little value to the economy. Its velocity is zero. If that same dollar were to change hands many times—be spent by some and be income to others—the rate of economic growth would be increased. Nonetheless, monetarists oddly believe that the velocity of money is constant.
The assumption of constant velocity is convenient if you look at the Quantity Theory Equation. Holding velocity constant makes the money supply the only determinant of growth in the economy. Keynesians find that proposition ludicrous. At different points in time, based on prevailing fear or euphoria, Keynesians believe there are changes in velocity. In a depression, for instance, people try to save whatever they can because they fear the next paycheck may be their last.
You might conclude from the equation that by setting the printing press on high speed, a government could send an economy into a high-growth gear. That may be true. The nominal GNP could be driven to new heights, but adjusted for inflation, the real GNP might remain the same or fall as a result.
Monetarists are most concerned about changes in price levels or inflation. If money is devalued by price increases, the real value of the economy’s output is diminished. The trick is to have the wise men in Washington increase the money supply just the right amount so that there may be economic growth with litle inflation.
Keynesians like a little inflation. That preference is supported by the research of A. W. Phillips of the London School of Economics, who claimed that higher inflation is accompanied by lower unemployment. The relationship between inflation and employment is shown by a graph called the Phillips curve. Monetarists don’t buy it. They believe that an economy with lower inflation can also have low rates of unemployment. Historical data in the United States show that the Keynesian relationship does hold. It was especially true in the period between 1950 and 1985, but it has not been consistently so over time, such as the period since 1985.
Monetary Policy Tools. I mentioned that the supply of money can be manipulated. A group of seven men appointed by the president sit on the Federal Reserve Board of Governors in Washington. The Fed, as it is called, has three monetary tools at its disposal to regulate the economy.
Change the discount rate. Banks borrow money from the Federal Reserve at a discount rate and loan it at higher rates to customers. If the discount rate is lowered, the margin between the banks’ loan rate and their cost from the Fed is higher. In turn, that encourages banks to make more loans to businesses and to consumers for homes, cars, and credit cards. Banks charge their best customers their lowest loan rate, called the prime rate. More loans increase the money supply in the economy and the multiplier effect starts. After September 11, 2001, the Fed lowered the rate to 1 percent to prevent a severe recession under extraordinary circumstances, and that was lowered to zero after the 2008 financial meltdown.
Trade government securities. The Fed actually trades in government securities in the financial markets. It buys and sells the government’s own Treasury bonds. These trading transactions are called open market operations. When the Fed purchases government securities from the public it places more money in the hands of the public who sold them; the money supply increases. This is called quantitative easing (QE). In addition to the unprecedented lowering of rates to nearly zero, the Fed in 2008 through 2010 also bought over $2 trillion of governmental debt in an effort to bring the United States out of recession. When investors buy government securities sold by the Fed, money is drained from their pool of cash; the money supply decreases.
Change the reserve requirement of financial institutions. The Federal Reserve requires that financial institutions, such as banks and brokers, keep a prescribed percentage of the cash deposited by customers on hand. This cash is called a reserve. A reserve requirement is needed for banks to conduct daily transactions and accommodate depositors who wish to withdraw their funds. A reserve provides a measure of security. The rest of the depositors’ money is loaned to customers. When regulators require a higher level of reserves, banks cannot loan as much money; this reduces the money supply in the economy.
With these three tools, the Fed is able to change not only the money supply, but also the cost of money—interest rates. The Fed tries to gradually increase the supply of money as the economy grows. If this operation is performed correctly, inflation and interest rates can stay low and the economy can grow. If the money supply is kept too tig
ht, a deep recession could occur, as it did in the early 1980s. If left to grow unrestrained, inflation can roar out of control, as has happened in many South American countries in the past two decades and may happen in the United States in the future.
Which Side to Choose? If you are a conservative, you will gravitate to the Friedman camp. If you are politically liberal, Keynesian economics might be appealing since it calls for a more activist government. Regardless, the track record of both camps in keeping the economy on a steady course is not impressive. We still have recessions in the United States.
Both monetary and spending theories play significant roles in the workings of economic systems. It is a chicken-and-egg dilemma. Who starts the process? Monetary policy determines the supply of money, which in turn affects spending and GNP. Or does the Keynesian spending “tail” wag the monetarist “dog”? If you figure that one out, please write a book and set all the economists straight.
MORE ECONOMISTS YOU NEED TO KNOW ABOUT
With Friedman and Keynes in your MBA grab bag, you need to know at least a little something about the following five economists. They are frequently mentioned as having shaped modern economics as we know it.
Adam Smith and The Wealth of Nations. Adam Smith is one of the world’s earliest economists, but he is still much talked about. His book The Wealth of Nations (1776) described the “invisible hand” of competition as guiding an economic system based on self-interest. He saw the “wealth of nations” increase by the division of labor. Using the example of a pin factory, Smith described how productivity of a factory was enhanced when the different tasks were assigned to those workers with the appropriate skill. He observed cases in which ten people each performing a separate task turned out forty-eight thousand pins a day in an era when individuals were still turning out but a few pins.
Joseph Schumpeter and “Creative Destruction.” This Harvard economist, long dead and forgotten, was resurrected in the 1980s. Schumpeter has been exhumed because he saw the entrepreneur as the crucial figure in economic life. If you have picked up any business periodical lately, you will not have failed to notice the word entrepreneur or some derivation thereof used with as much frequency as a and the.
Schumpeter considered capitalism “unruly and disconcerting, a system of flux rather than equilibrium.” In Capitalism, Socialism and Democracy (1942) he wrote about capitalism as a process of “creative destruction.” “Entrepreneurs create new industries that displace others in a painful and disquieting way.” During the takeover and leveraged buyout craze of the 1980s, corporate raiders quoted Schumpeter to justify their actions and their profits as healthy activities that cleansed the capitalist system. For MBAs without the nerve to strike out on their own, theorists have created the term intrapreneurs as a consolation prize for those who are locked in corporations but still want to be agents of change.
John Kenneth Galbraith and a Liberal View. Galbraith, a Harvard economist, is known not for his grand theories or technical research, but for his broad policy statements. Although he is not considered a breakthrough thinker, his ability to give rousing lectures and market his books has given him a big name in economics. In 1951, Galbraith made a case for labor unions in American Capitalism: The Concept of Countervailing Power. In The Affluent Society (1958) he called for the economy to deemphasize production in favor of public services. In his 1967 The New Industrial State, Galbraith commented on the gradual move toward socialism in the United States.
Arthur Okun and Okun’s Law. Arthur Okun studied economic growth and unemployment just as A. W. Phillips did. Okun, from Yale, was one of the most influential economists on the President’s Council of Economic Advisers during the Kennedy and Johnson administrations. He found that higher levels of economic growth are accompanied by lower unemployment. His historical studies indicated that for every 2.2 percentage points of real GNP growth, unemployment falls 1 point. That rule of thumb was extensively used to justify the stimulative policies pursued by Washington in the 1960s.
Arthur Laffer and the Supply-Side Economists of the 1980s. Arthur Laffer is one of the best-known supply-side economists to emerge in the 1980s. Supply-siders believe in the incentive effects of reduced taxation. Tax incentives and federal spending reductions are critical in promoting growth by causing increases in savings and investment. When individuals and businesses keep more of their earnings, they can save and invest in projects, which in turn makes the economy more productive. This increase in productivity increases the level of “supply” and produces more wealth and economic growth.
While at the University of Southern California, Laffer developed what has come to be known as the Laffer curve to explain the incentive effects of tax rates. No, it’s not a joke. The Laffer curve motivated the Reagan administration and the Congress to cut taxes in 1981. His theory suggests that tax revenues are correlated to the tax rate. His curve shows that total tax revenues increase as tax rates increase, but past a certain point, increases in rates decrease total tax revenues. Higher rates encourage tax cheating. Higher tax rates discourage people from working more. If rates are too high, reducing the tax rate will encourage people to work by making it more profitable to do so. That in turn will increase gross tax receipts although the marginal tax on each dollar of income is smaller. The problem with the theory is that it is too abstract. There is, theoretically, an optimal tax rate, but nobody knows exactly what it is.
THE LAFFER CURVE
Other “radical” supply-side economists from the Reagan era who might creep into your economic conversations include George Gilder (Wealth and Poverty, 1981) and Jude Wanniski (The Way the World Works, 1978).
Gary Becker and Behavioral Economics. Gary Becker was one of the first economists to apply economic theory to topics belonging to sociology. He argued that many types of behavior can be seen as rational and utility maximizing. Racial discrimination, crime, family organization, and drug addiction were topics of his most famous studies. Fellow University of Chicago professor Steven Levitt popularized the field in the book Freakonomics.
INTERNATIONAL MACROECONOMICS
Taking an even broader view, macroeconomics in the international arena is a favorite of business schools. With the globalization of the world’s economy, international economics has become a popular part of the MBA curriculum. The admissions departments of the top schools make special efforts to have just the “right” mix of foreign students in each entering class to add that international flavor to the classroom.
THE COMPARATIVE ADVANTAGE OF NATIONS
In 1817, David Ricardo outlined the principles of comparative advantage in his work Principles of Policy, Economy and Taxation. A comparative advantage of a nation is its ability to produce a product at a lower cost than its trading partners. Nations theoretically should maximize the production of goods that they produce most efficiently because of availability of land, labor, or good weather. Even if a country is able to produce a product at an absolute lower cost relative to another nation, that nation should maximize the output of products that it produces more efficiently than other nations. Ricardo proposed that Portugal export wine to England and import wool from England even though both products are produced at absolutely lower costs in Portugal. The rationale is that Portugal is more efficient at producing wine than wool and it has a limited productive capacity. Therefore its capacity is best utilized for wine, and thus wool should be imported from England.
In the U.S.-Japanese trading relationship, the United States should maximize its ability to produce food at a lower cost. America has plenty of good farmland, machinery, fertilizer, technical expertise, and labor. U.S. farm productivity is three times Japan’s. Japan, on the other hand, is good at producing electronics and automobiles. Theoretically, if these were the only two countries in the world, the United States should slash all electronics production and shift its emphasis to food production. The Japanese, conversely, should stop their inefficient food production. In reality, however, there are other national age
nda and special interests at work that prompt nations to erect trade barriers. These prevent the efficiencies of comparative advantage from working. Trade barriers such as taxes on imports, import quotas, or other trading rules are governmental attempts to protect domestic industries and jobs. MBA schools consistently preach that tariffs and trade barriers are “bad,” and free trade is preferred for long-term economic growth.
BALANCE OF PAYMENTS
Just as companies keep track of their transactions with financial statements, entire nations keep track of their international transactions via balance of payments (BOP) accounting. The BOP registers the changes in a country’s financial claims and obligations with all other countries. It is similar to an accountant’s cash flow statement. Balance of payments accounting shows changes in foreign exchange for a period of time. Foreign exchange is the balance of liquid assets such as cash and gold reserves that can be used to make international payments.
SOURCES OF FOREIGN EXCHANGE: Merchandise Exports
USES OF FOREIGN EXCHANGE: Merchandise Imports
SOURCES OF FOREIGN EXCHANGE: Travel Expenses of Foreigners Here
USES OF FOREIGN EXCHANGE: Travel of Citizens Abroad
SOURCES OF FOREIGN EXCHANGE: Transportation Receipts of Domestic Carriers from Foreigners
USES OF FOREIGN EXCHANGE: Transportation Expenses by Residents Paid to Foreigners
SOURCES OF FOREIGN EXCHANGE: Fees and Royalties Received
The Ten-Day MBA 4th Ed. Page 27