5. The economic cost of unemployment as measured by the GNP gap, consists of the goods & services which society foregoes when its resources are involuntarily idle. Okun's law suggests that every one person increase in unemployment above the natural rate gives rise to a 2.5%
GNP gap.
Classical & Keynesian theories of employment
1. Classical employment theory envisonet laissez faire capitalism as being capable of providing virtually continous full employment. This analysis was based on Say's Law and the assumption of price-wage flexibility.
2. The classical economists argued that because supply creates its own demand, general overproduction was improbable. This conclusion was held to be valid even when saving occurred, cause the money market or most specifically, the interest rate, would automatically synchronize the saving plans of households and the investment plans of businesses.
3. Classical employment theory also held that even if temporary declines in total spending where to occur, these declines would be compensated for by downward price wage adjustments in such a way that real output, employment, and real income wouldn't decline.
4. Keyneisian employment theory rejects the notion that the interest rate would equate saving and investment by pointing out that savers & investors are substantially different groups who make their saving & investment decisions for different reasons - reasons which, for savers, are largely unrelated to the interest rate. Further more, because of changes in
a) The publics holdings of money balances;
b) Loans made by banks and other financial institutions, the supply of funds may exceed op fall short of current saving to the end that saving & investment will not be equal.
5. Keyneisian economists discredit price-wage flexibility on both practical and theoretical grounds. They argue that
a) Union and business monopolists, minimum-wage legislation, and a host of related factors have virtually eliminated the possibility of substantial price-wage reductions;
b) Price-wage cuts will lower total income and therefore the demand for labor.
6. The Classical & Keyneisian views can be illustrated through the AD-AS model. Classical economists envision
a) A vertical AS curve which establishes the level of output;
b) A stable AD curve which establishes the price level ;
Keyneisians see
a) A horizontal AS curve at less-than-full-employment levels of output;
b) Inherently unstable AD curve.
7. The basic tools of Key employment theory are the Consumption (C), Saving (S) and Investment (I) schedules, which show the various amounts that households intend to consume and save and that businesses plan to invest at the various possible income-output levels given a particular price level.
8. The locations of the consumption and Saving schedules are determined by such factors as:
a) The amount of wealth owned by households;
b) The price level;
c) Expectations of future income, future prices and product availability;
d) The relative size of consumer indebtedness;
e) Taxation;
The consumption and saving schedules are relatively stable.
9. The average propensities to consume and save show the proportion of fraction of any level of total income that is consumed and saved. The marginal propensities to consume and save show the proportion of fraction of any change in total income that is consumed or saved.
10. The immediate determinants of investment are:
a) The expected rate of net profit;
b) The real rate of interest
The economy's investment-demand curve can be determined by cumulating investment projects and arraying them in descending order according to their expected net profitability and applying the rule that investment will be profitable up to the point at which the real interest rate equals the expected rate of net profit. The investment-demand curve reveals and inverse relationship between the interest rate and the level of aggregate investment.
11. Shifts in the investment-demand curve can occur as the result of chances in
a) The acquisition, maintenance and operating costs of capital goods;
b) Business taxes;
c) Technology;
d) The stocks of capital goods on hand;
e) Expectations.
12. We make the simplifying assumption that the level of investment determined by the current interest rate and the investment-demand curve doesn't vary with the level of aggregate income.
13. The durability of capital goods, the irregular occurrence of major innovations profit volatility, and the variability of expectations all contribute to the instability of investment spending.
Equilibrium National output in Keynesian model
1. For a closed no-government economy the equilibrium level of NNP is that at which the aggregate expenditures and national output are equal or graphically where the C + In line intersects the 45-degree line. At any NNP greater than the equilibrium NNP, national output will exceed aggregate spending resulting in unintended investment in inventories, depressed profits and eventual declines in output employment and income. At any below equilibrium NNP the aggregate expenditures will exceed the national output, thereby resulting in unintended disinvestment in inventories, substantial profits and eventual increases in NNP.
Fiscal Policy
1. Government responsibility for achieving and maintaining full employment is set forth in the Employment Act of 1946. The Council Economic Advisers (CEA) was established to advise the President on policies appropriate to fulfilling the goals of the act. The Humphrey-Hawkins Act of 1978 contains specific inflation and unemployment rate objectives.
2. Increases in government spending expand, and decreases contract, the equilibrium NNP. Conversely, increases in taxes reduce, and decreases expand the equilibrium NNP. Appropriate fiscal policy therefore calls for increases in government spending and decreases in taxes - that is, for a budget deficit - to correct for unemployment. Decreases in government spending and increases in taxes - that is, a budget surplus - are appropriate fiscal policy for correcting demand-pull inflation.
3. The balanced-budget multiplier indicates that equal increases in government spending and taxation will increase the equilibrium NNP by the amount of the increase in government expenditures and taxes.
4. Built-in stability refers to the fact that net tax (NT) revenues vary directly with the level of NNP. Therefore, during a rescission the public budget automatically tends toward a stabilizing deficit; Conversely, during expansion the budget automatically tends toward an anti-inflationary surplus. Built-in stability ameliorates, but doesn't correct, undesired changes in the NNP.
5. The full-employment budget indicates what the Federal budgetary surplus or deficit would be if the economy operated at full employment throughout the year. The full-employment budget is a more meaginful indicator of the government's fiscal posture than is its actual budgetary surplus or deficit.
6. The enactment and application of appropriate fiscal policy and subject to certain problems and question. Some of the most important are these
a) Can the enactment and application of fiscal policy be better timed so as to maximize its effectiveness in heading off economic fluctuations?
b) Can the economy rely upon Congress to enact appropriate fiscal policy?
c) An expansionary fiscal policy maybe weakened if it crowds out some private investment spending;
d) Some of the effect of an expansionary fiscal policy maybe dissipated in inflation;
e) Fiscal policy maybe rendered ineffective or inappropriate by unforeseen events occurring within the world economy. Also fiscal policy may precipitate changes in exchange rates which weaken its effects;
f) Supply-side economists contend that Keynesian fiscal policy fails to consider the effects of tax changes upon AS.
Monetary Policy
1. Like fiscal policy, the goal of monetary policy is to assist the economy in achieving a full-employment, noninflationary level of total output.
2. For a consideration of monetary policy the most important assets of the Federal Reserve Banks are securities and loans to commercial banks. The basic liabilities are the reserves of member banks, Treasury deposits & Federal Reserve Notes.
3. The three major instruments of monetary policy are
a) open-market operations;
b) changing the reserve ratio;
c) changing the discount rate;
4. Minor selective controls involve the margin requirement, consumer credit & moral suasion.
5. Keynesians envision monetary policy as operating through a complex cause-effect chain
a) policy decisions effect commercial bank reserves;
b) changes in reserves effect the supply of money;
c) changes in the supply of money alter the interest rate;
d) Changes in the interest rate affect investment, the equilibrium NNP and the price level;
6. The advantages of monetary policy include its flexibility and political acceptability. Further, monetarists feel that the supply of money is the single most important determinant of the level of national output.
7. Monetary policy is subject to a number of limitations and the problems
a) They excess reserves which an easy money policy provides may not be used by banks to expend the supply of money;
b) Policy-instigated changes in the supply of money maybe pertially offset by changes in the velocity of money;
c) The impact of monetary policy will be lessened if the money-demand curve is flat ant the investment-demand is steep. The investment-demand curve may also shift so as to negate monetary policy.
8. The monetary authorities face a policy dilemma in that they can stabilize interest rates or the money supply but not both. In the post-World War II period monetary policy has shifted from stabilizing interest rates to controlling the money supply and more recently to a more pragmatic position.
9. The impact of an easy money policy upon domestic NNP strangthed by an accompanying increase in net exports precipitated by a lower domestic interest rate. Likewise, a tight money policy is strengthed by a decline in net exports. In some circumstances there maybe a trade off between the use of monetary policy to affect the value of the dollar and thus to current at rage imbalance and the use of monetary policy to achieve domestic stability.