Module 3: Economic policy

Niklas Hanes, Sudarsha Lakmini Kodithuwakku, Kumuduni Rashikala

March 20-April 25

This lecture: Introduction and Unit 13.

Module 3. Economic policy
Literature
The Economy 1.0 (chapter 13, 14, 15, 17)

Examination
Module 3: hall exam

Teaching
Classroom lectures (Niklas)
Exercises (Sudarsha and Kumuduni)
OUTLINE TODAYS’ LECTURE (UNIT 13)
A. Introduction
B. The business cycle
C. Measuring the aggregate economy
D. Economic fluctuations and consumption
E. Economic fluctuations and investment
F. Inflation
A. Introduction
What determines GDP – different time
perspectives in macroeconomics

The long run – economic growth (Module 1)

The medium run – the labour market (Module 2)

The short run - business cycles (Module 3)

What determines GDP? Think this way ..
• Why did GDP fall so sharply around the world in 2020?

• A virus that caused the demand for goods and services to drop dramatically

• Macroeconomics and cyclical (multiplier) effects: less demand ⟹ less

production and income ⟹ less demand ⟹ less production …..

• In the short run, the economy is often driven by demand, and economic
policy during recessions is usually aimed at stimulating demand ⟹ reverse
the negative trend
Shocks on the supply side
• Economic crises can arise on the supply side, for example sharply rising
energy prices that not only affect households but also companies and costs
of production.

• Higher energy costs ⟹ higher production costs ⟹ price increases ⟹

reduced purchasing power and demand

• ↓ Real wages ⟹ Wage setters demand higher wages ⟹ higher production

costs ⟹ price increases ⟹ risk of wage and price spiral
In a few years' time, what could increase
Sweden's GDP?
• One example is the large immigration in recent years. If a larger proportion of
the immigrants enter the labour market, more people will work, and the
economy (GDP) will grow.

• The labour market determines the equilibrium output in the medium run
(a couple of years). Capital stock and technology assumed to be fixed.

• Policies that affect labour supply and employment thus affect GDP in the
medium run (Module 2)
Why are we about 5 times richer today
compared to the 1950s (GDP per capita)?
• It is not due to higher demand or the labour market being in equilibrium.

• In the long term, the increase in GDP is due, among other things, to that we
have had a technological development, large investments in education have
increased our human capital, we have increased our capital intensity in
production (Module 3).

• Policies that drive growth can, for example, focus on research and
development, reforms for education and health, infrastructure, etc.
Module 3: The economy does not develop in a "smooth" path

• Economic fluctuations – the business cycle – a problem for firms and households
• Unemployment
• Inflation

• Economic crisis – we will focus on the financial sector and the 2008 crisis

(Unit 17: housing bubbles, the financial crisis in 2008, and the role of the banking sector)

• Mitigate shocks to the economy with the help of stabilization policy

⇒ Fiscal policy
⇒ Monetary policy
Monetary policy
• The Central bank is responsible for monetary policy - price stability is the main
task.

• Central bank conventional monetary policy – changes short term interest rates.

• Unconventional monetary policy – for example quantitative easing and

negative interest rates
Fiscal policy
• The government budget sets the framework for fiscal policy - the government's
income (taxes) and expenditure.

• How large and which expenses should the state prioritize?

• How will the expenses be financed?

• When to change spending and taxes (stabilization policy)

In a recession ….

Fiscal policy: increase public spending or cut taxes will increase demand
and production

Monetary policy: lowering the interest rate stimulates investment and

consumption – higher demand and production

In a Boom ….

Cut public spending, increase taxes or higher interest rates, will slow down
demand
B. The business cycle
 The business cycle
Business cycle = Alternating periods of positive and negative growth rates.

Recession = period when output is declining or below its potential level

Potential production (GDP) – when the labour market is in equilibrium

The business cycle affects labour market outcomes – recession implies a

negative unemployment gap
 Okun’s Law
Okun’s Law = a strong and stable
relationship between
unemployment and GDP growth.

Changes in the rate of GDP

growth are negatively correlated
with the unemployment rate.

Output falls → Unemployment rises

→ Well-being falls
Later in Chapter 15, we will
see that the labour market
medium run equilibrium is
the only equilibrium with
stable inflation.

In a boom, unemployment
is lower than equilibrium
unemployment, which
creates inflationary
pressure.
 C. Measuring the
aggregate economy
 Measuring the aggregate economy

3 equivalent ways to measure GDP:

1. Total spending on domestic products

2. Total domestic production (measured as value added)

3. Total domestic income

 Exports, imports, and government
How do we account for international transactions?

Foreign production is domestic consumption (imports); or domestic

production is foreign consumption (exports)

→ We include exports and exclude imports, so that GDP includes value

added, income from, or consumption of, domestic production.

How do we incorporate the government?

→ Treat it as another producer – public services are “bought” via taxes

→ Assume that cost of production captures the value added
 Components of GDP
• Consumption (C) = Expenditure on consumer goods and services
• Investment (I) = Expenditure on newly produced capital goods (incl.
equipment, buildings, and inventories = unsold output)
• Government spending (G) = Government expenditure on goods and
services (excluding transfers to avoid double-counting)
• Net exports (trade balance) = Exports (X) minus imports (M)

GDP = C + I + G + X – M
D. Economic fluctuations
and consumption
 Shocks
Shock = an unexpected event. Strikes the household, the firms or the entire
economy (positive / negative shocks) which causes GDP to fluctuate.

People use two strategies to deal with shocks that are specific to their
household:

1. Self-insurance – saving and borrowing. Other households are not

involved.
2. Co-insurance – support from social network or government.

This reflects that households prefer to smooth their consumption, and that
they are (to a degree) altruistic.
 Economy-wide shocks
Co-insurance is less effective if the bad shock hits everyone at the
same time.

But when these shocks hit, co-insurance is even more necessary

(government needs to take action).

In farming economies of the past that were based in volatile climates,

people practised co-insurance based on trust, reciprocity, and
altruism.
 Smoothing Consumption
Households make lifetime consumption plans based on
expectations about the future, and react to shocks:

• Readjust long-run
consumption (red line) if
shocks are permanent

• Do not change long-run

consumption if shocks are
temporary
 Consumption smoothing and the aggregate
economy
Consumption smoothing is a basic source of stabilisation in an
economy.

Limitations to consumption smoothing mean it cannot always

stabilise the economy (e.g. highly indebted governments); it may
amplify the initial shock.

• credit constraints, weakness of will, limited co-insurance

This helps us understand the business cycle and how to manage it.
 Limitations to smoothing: credit constraints
Credit constraints – limits on amount borrowed/ability to borrow.
The households unable to adjust to a temporary income shock
have lower welfare.
Limitations to smoothing: weakness of will

Weakness of will – inability to

commit to beneficial future plans.

A household is able to smooth

consumption but doesn’t, and
may regret it later.
 E. Economic
fluctuations and
investment
 Volatile Investment
Firms don’t have preferences for smoothing like households.

They adjust investment plans to both temporary and permanent

shocks, to maximise their profits.

High demand → high capacity utilisation, → investment → even

higher demand

Investment decisions depend on firms’ expectations about

future demand
 Business confidence

Business confidence coordinates firms to invest at the same

time.
 Investment and the aggregate economy
The benefits of coordinating investment makes cycles self-
reinforcing.

Firms respond positively to the growth of demand in the

economy.

This is why investment is more volatile than GDP.

F. Inflation
 Inflation, GDP, and Unemployment
Inflation = an increase in the general
price level in the economy
Inflation tends to be lower during
recessions (high unemployment)
 Measuring inflation
The Consumer Price Index (CPI) measures the general level of prices
that consumers have to pay for goods and services, including
consumption taxes

• Based on a representative bundle of consumer goods – “cost of

living”
• Common measure of inflation = change in CPI

GDP deflator = A measure of the level of prices for domestically

produced output (ratio of nominal to real GDP)
• We will devote all of Chapter 15 to inflation and monetary policy and
leave it at that for now.
 In the next unit
• The multiplier process: How limits on
households’ ability to save, borrow, and share
risks affect GDP

• Fiscal policy: How government spending can

help stabilize the economy

• Limitations of fiscal policy: The consequences

of being part of the world economy