Tuesday, 30 September 2014

We Need a Global Carbon Tax

A global carbon tax can both mitigate climate change and radically redistribute wealth.

Image by Jim Cooke
Jim Cooke / Gawker
Despite my suspicions of the neoliberal tenor of the organizers and my post-Occupy reservations about marches without explicit political demands, I’m going to the People’s Climate March this morning.
But if we were mobilizing around just one demand today, we could do worse than a global carbon tax, with revenues redistributed directly back to people through a global universal basic income. The policy is both politically infeasible and economically inferior to more complex and radical policy packages. But it is so blunt, and so revealing of the twin issues of inequality and climate change, that it is still a “useful utopia.”
One of the many things I admire about Thomas Piketty’s Capital in the Twenty-First Century is that it examines capital and inequality through an international lens. His proposed solution is thus global in scope — the institutions and political alliances needed to make any progress must to operate at the same level as (or higher than) other global regulatory, diplomatic, and public goods arrangements. Wealth inequality across the global population is a problem just as inequality between current and future generations is a problem, one that must be addressed at a transnational level.
I want to make the connection between some of Piketty’s arguments about climate policy and environmental economics concrete, just as people like Naomi Klein and Christian Parenti have linked climate issues to redistribution and inequality.
We can, in good economics fashion, play with a prima facie solution to a huge global problem. A global economy organized through decentralized markets means that you only have to change one price to change all the prices faced by everyone. Carbon taxes do exactly that, leveraging market interactions to reduce carbon use throughout the economy. With the quasi-failure of cap-and-trade in Europe and its political defeat in the United States, we’re now closer to a carbon tax, where we charge a tax on each ton of carbon extracted. The tax is completely efficient, set equal to the (marginal) social cost of carbon, which we would have to argue about as a society.
Liberals love this kind of technical, social-democratic, fix. A non-intrusive tax would raise the price of carbon, and the economy would adjust, and we can keep going. But I think the magnitudes of the taxes required, together with the sheer size of the carbon economy, mean that even this liberal measure would lead to political conflicts between the haves and the have-nots that would be closer to redistributive politics than gentle timelines of mitigation and adaption.
Economists, of course, constantly debate who wins and who loses from carbon taxes, even if they all agree that increasing the price of carbon by fiat is much better than any other hodgepodge of fixes. The immediate effect of carbon taxes is an increase in carbon prices, and this is largely regressive, falling on households and countries with low incomes.
But three things work against this: over your lifetime, your consumption of carbon will change. As alternative technologies evolve, the ability of companies to pass along the price increase will fall.
Second, the lump-sum rebate everyone would get in the dream scenario would go a long way towards undoing the price increase. It’s been calculated that a global carbon tax, with equal per-capita revenue payments, would on net lower the world Gini by 3 percent and raise the bottom decile’s share of income by 81 percent. And finally, a lot of the capital tied up in carbon processing, like refineries and oil rigs, would also fall in value due to the increased price of inputs. These are hardly the people’s machines — the shift would decrease inequality.
Besides the forward transmission of the tax to consumers, there is also a backwards transmission of carbon taxes to the owners of carbon stocks. The important effect of the tax is what it does to the value of property rights to stores of carbon that haven’t been extracted yet, essentially fossil fuel reserves that are already discovered. This is paper wealth, the promise of revenue from burning fuel that will be extracted and demanded in the future.
What is frightening is that asset markets are currently pricing these things as though they are actually going to get used. What does a carbon tax do to the value of these assets? It depresses it by killing the anticipated future revenues. One Norwegian study estimates that a $10 per ton global carbon tax would lower petroleum wealth for the average oil producer by 33 to 42 percent.
What is the size and distribution of this carbon wealth? Given how much of it sits on the balance sheets of a) first-world multinationals with concentrated ownership and substantial monopoly power and b) democracy-challenged sovereign wealth funds and small countries with lots of fossil fuels, I’m willing to bet it is pretty unequally distributed. So this means a small share of the population is benefiting from flows of income derived from inheriting a stock of dead dinosaurs.
Of course, if the carbon wealth were distributed equally, we would have a very different social trade-off. But that’s not this world. And let us not forget that the primary source of profit here is pure rent: income derived from exclusive control of a scarce resource, not productive investment or labor.
We can calculate the importance of carbon to global wealth thanks toCarbon Tracker, which put together these estimates: There are roughly 2,700 gigatons of carbon in proven reserves, which have a 90 percent chance of being extracted. Climate scientists guess that we have maybe 886 gigatons in the carbon budget from 2000 to 2050 to avoid 2 degree Celsius increases. And oops, we’ve already used 286 gigatons of that since 2000.
So that means we have about 2,100 gigatons of carbon in proven reserves, sitting on balance sheets (already priced into the global capital stock) that we need to not burn in order keep temperatures from rising 2 degrees Celsius before 2100. Overwhelmingly, this is coal, which is just too abundant for our own good.
To get a sense of the magnitudes, Gabriel Zucman estimated almost $6 trillion were sitting in tax havens in 2008. If we taxed all that carbon as a stock, at $3 a ton, it would be the same liability, and almost completely expropriate the fossil fuels sector (which is worth around $5 trillion). These carbon reserves would become “stranded assets” that are worth nothing or even a costly tax liability.
What carbon tax should we implement? The literature calculates an optimal carbon tax between $27 and $4,293 per ton of coal (the wide range reflects uncertainty on damages and different choices of discount rates). This contains the estimates by Nordhaus ($27) and Stern ($250), who argue about the appropriate interest rate to use.
There are over a trillion tons of coal in the ground. At current prices, that is something like 50 trillion dollars. Essentially, controlling climate change involves driving the value of this down, making it unprofitable to extract. World capital is somewhere around $382 trillion. Given that the world’s top one percent owns about $110 trillion of this, even a moderate carbon taxes could drastically alter the global distribution of wealth, without even accounting for the income that is redistributed.
Carbon taxes do two great things at once, knocking down the share of wealth in the economy while helping us avoid the climate disaster that will drive inundated (and possibly armed) Florida archipelago refugees to besiege dike-encrusted fortress Manhattan in thirty years. But levying the carbon taxes required to avert large environmental changes will destroy a chunk of economic obligations enshrined in stock portfolios around the world.
The political economy of climate change looks a whole lot like the political economy of redistribution. And they’ll be plenty who want to resist it.

Re-thinking Economics Education: How New 'Core' Curriculum Hopes to Better Prepare Students

Miles McKenna's picture

Is it time for more pluralistic approaches to economic problems?Summer is almost over and the fall semester is about to begin for young economics students. But this semester could be the start of something much larger at University College London (UCL) and the University of Massachusetts in Boston.

These two schools are among the first to pilot a fundamentally new approach to the way economics is taught in higher education. Others including the University of Sydney, Sciences Po (Paris), and the University of Chile will follow in early 2015.

This new approach is based on the CORE project of the Institute for New Economic Thinking (INET) at the Oxford Martin School, part of a global call for an overhaul of the economics curriculum commonly taught to undergraduates. True to its name, the CORE project has developed a new, interactive core curriculum—all delivered through an online virtual learning environment, and completely open to the public.
Led by UCL Professor Wendy Carlin, the CORE project draws on the expertise of more than 25 academics from top universities around the world and has been put together with the help of web designers and developers in Bangalore, with consistent input from panels of students, teachers, employers, and experts. Our own World Bank trade economist Jose Daniel Reyes was one such contributor.

The result is a total re-think of the economics syllabus and teaching methods.

An open letter posted online earlier this year by the International Student Initiative for Pluralism in Economics—a collaboration of 65 student associations from 30 countries around the world—and widely disseminated around the globe helped propel the issue into international headlines.

Students were upset that the theories they were being taught in classrooms did not accurately reflect the economic challenges of the real world—especially in light of the 2008 financial crisis. An excerpt of the letter reads:
 “We are dissatisfied with the dramatic narrowing of the curriculum that has taken place over the last couple of decades. This lack of intellectual diversity does not only restrain education and research. It limits our ability to contend with the multidimensional challenges of the 21st century - from financial stability, to food security and climate change. The real world should be brought back into the classroom, as well as debate and a pluralism of theories and methods. Such change will help renew the discipline and ultimately create a space in which solutions to society’s problems can be generated.”
The CORE project and its new pilot curriculum is a first step towards meeting this call.The Trade Post caught up with Professor Carlin to discuss the project and what role the World Bank Group can help play in reshaping approaches to economic problems.

Trade Post: What was it that led you personally to work on this project? Was there a specific moment or experience that motivated you?

Prof. Carlin: The initial push for me was the financial crisis and the need to integrate the financial system into the way macroeconomics is taught. But I quickly found a group of people from all over of the world who were coming at the problem from different angles.

For example, Oscar Landerretche of the University of Chile was put on the spot by the student movement – students were protesting against inequality in the education system and turned up on campus to demand a more relevant economics curriculum. Begum Ozkaynak of Bogazici University in Turkey was leading a review of the curriculum prompted by student dissatisfaction with the arid courses they were taking. Arjun Jayadev of UMass Boston was facing the challenge of designing a curriculum for the first cohort of students arriving in 2015 at the new Azim Premji University in Bangalore. Kevin O’Rourke of Oxford brought to the group the conviction that economic history is crucial to the core courses in economics. And Sam Bowles of the Santa Fe Institute pulled the different strands together arguing that we should and could teach economics as if the last three decades had happened.

In practice this means teaching an empirically grounded course that begins from the big questions students come to our classes with and where from the beginning students learn, for example, that markets for labour and credit are different from the market for shirts.

Trade Post: Part of what you are calling for in CORE is to bring more examples of empirical research and lessons learned in the field into classrooms sooner. What was it about the World Bank’s quinoa research that made you think it was worthy of inclusion?

Prof. Carlin: Margaret Stevens of Oxford was looking for cases to illustrate how and why prices change. As she described it to me as an interesting story with dramatic changes over time, winners and losers, and a strong international dimension. She also found the economic data were presented clearly and unambiguously, so they could be used with confidence. We would be very happy to be alerted to more good stories from Bank empirical work and experience in the field.

Trade Post: How does the CORE curriculum approach the issues of extreme poverty and shared prosperity in development economics, the pillars of our work here at the World Bank Group?

Prof. Carlin: One aim of the project is to bring the central questions of development economics into the core curriculum. We begin the “Introduction to Economics” course with long run historical data and the question of why the capitalist revolution occurred in England in the 18th century and not in China or India. We ask why and when other countries moved on to a path of sustained growth in GDP per capita and why many remain poor.

Inequality among and within countries is a theme from the beginning of the course. In addition to history, dynamics and inequality, we emphasize institutions and the difference they make to the efficiency and fairness of economic outcomes.

Trade Post: How can global institutions like the World Bank better contribute to the study of economics?

Prof. Carlin: The Bank has been a leading force in convincing economists of the priority of inclusive growth and the necessity in many countries of institutional change to assure this.

Resistance to the necessary policy changes are often based on outdated economics. As part of its attempts to ensure shared prosperity, the Bank might want to invest more in ensuring that the next generation of opinion and policy makers has an understanding of economics more consistent with the Bank’s objectives.

8 institutional innovations that could update the economic system

Otto Sharmer suggests eight ways of shifting outdated capitalism into a 21st century economy that creates wellbeing for all
Blogger Ref http://www.p2pfoundation.net/Transfinancial_Economics

City of London and Canary Wharf
21st century capitalism is hitting the wall, can we come up with new innovations respond to 21st century problems? Photograph: Lefteris Pitarakis/AP
We live in an age of profound disruption. Global crises – financial, food, fuel, natural resources, poverty – challenge almost all societies. Yet over the coming decades these disruptions will also create, and are already creating, opportunities for profound personal, societal, and global renewal.
The world’s crises represent three divides: ecological, social, and spiritual. The ecological divide manifests in symptoms such as environmental destruction, and is experienced as a divide between self and nature. The social divide manifests in increasing rates of poverty, inequity, polarisation, and violence and is experienced as a divide between self and self. And the spiritual divide is experienced as a disconnect between self and self — the “current self” and the “emerging future self”.
A disconnect between these two selves manifests as burnout, depression, and suicide. In 2010, more people died from suicide than from murder, war, and natural disasters combined. Another symptom of this disconnect is the decoupling of GDP from the actual well-being of people: we produce more, consume more, and are busier than ever before but our happiness and wellbeing are declining.

What are the driving forces behind these three divides?

The most important driving force lies in our outdated paradigms of economic thought, which continue to represent a blind spot to measuring wellbeing.
The main shortcomings of conventional economic thought can be summarised in two words: externalities and consciousness. Experts are well aware of externalities; but consciousness is rarely discussed, or even noticed.
Consciousness is not a category of economic thought. Still, the history of the economy and of modern economic thought is the product of an evolving human consciousness. The modern economy is based on the division of labour, which comes with the question: how do we coordinate all individual activity to make a coherent whole?

Historical responses to coordinating activity

Centralised coordination saw people organising around hierarchies and central planning gave rise to centralised economies – such as socialism and mercantilism – embodying traditional forms of values and awareness.
Decentralised coordination meant organising around markets and competition giving rise to the “second” (private) sector, the free, laissez-faire market economy, embodying ego-system awareness - a concern for the wellbeing of oneself.
Interest group–driven coordination saw organisation around stakeholder dialogues and negotiations which gave rise to the “third” (social) sector and the social market economy, embodying stakeholder awareness – concern for the wellbeing of oneself and one’s immediate stakeholders.
Finally there is coordination around the commons. This organisation around awareness-based collective action focuses on forming co-creative stakeholder relationships. It embodies eco-system awareness – a concern for the wellbeing of all.
The problem with today’s capitalism, to paraphrase Einstein, is that we are “trying to solve problems with the same consciousness that created them”. Yet there is no bigger waste of economic resources today than addressing 21st-century problems such as climate change with thinking and mechanisms that reside in the societal context of earlier centuries.

Rethinking the narrative of the 21st century

When the laissez-faire capitalism of the late 19th and early 20th centuries hit the wall in the form of poverty, inequality, pollution, and financial breakdowns, societies responded with institutional innovations that set the stage for the next evolutionary stage of capitalism (unions, federal reserve banks, legislation to protect labour, farmers, and the environment).
That stage, the 20th-century social market economy or stakeholder capitalism, is now hitting the wall of global externalities, as we move through the early 21st century. And again, as a century ago, we are challenged to come up with a new set of innovations that respond to these issues on a level commensurate with the challenge they pose.
There are eight institutional innovations that, as a set, could update the economic system to operate more intelligently across silos and boundaries by shifting the economic logic from ego-to eco-system awareness:
1. Nature
Instead of treating nature’s gifts as commodities that we buy, use, and throw away, treat the natural world as an eco-system that we need to cultivate.
2. Entrepreneurship
Reinvent our concept of labour and rather than thinking of work as a “job” think about it as passion-led entrepreneurship.
3. Money
Reinvent our concept of money. Instead of extractive, capital should be intentional, serving rather than harming the real economy.
4. Technology
Reinvent how we develop technologies. Empower all people to be makers and creators rather than passive recipients.
5. Leadership
Instead of individual super-egos, we need to build the capacity to co-sense and co-shape the future on the level of the whole system.
6. Consumption
Rather than promoting consumerism and using metrics like GDP, move towards sharing and collaborative consumption, and using measurements of well-being such as Gross National Happiness (GNH) and the Genuine Progress Indicator (GPI).
7. Governance
Reinvent how we coordinate. Move toward complementing the three older mechanisms (hierarchies, markets, and special interest groups) through a fourth mechanism: acting from shared awareness, from seeing the whole.
8. Ownership
Advance the old forms of state and private ownership by creating a third category of ownership rights: commons-based ownership that better protects the interests of future generations.
These eight “acupuncture points”, as a set, could help us to shift the old outdated capitalism into a 21st-century economy that creates wellbeing for all.
Otto Scharmer is a senior lecturer at MIT and founding chair of the Presencing Institute. This article is is adapted from his most recently co-authored book (with K Kaufer), Leading from the Emerging Future: From Ego-system to Eco-system Economies.
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From Wikipedia, the free encyclopedia

With Transfinancial Economics it would be possible to get a far more accurate understanding of Macroeconomics in Real-Time. This is revolutionary, and goes way beyond the limited claims of this Wikipedia article. http://www.p2pfoundation.net/Transfinancial_Economics RS

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Circulation in macroeconomics.
Macroeconomics (from the Greek prefix makro- meaning "large" and economics) is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets. This includes national, regional, and global economies.[1][2] With microeconomics, macroeconomics is one of the two most general fields in economics.
Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indexes to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. In contrast, microeconomics is primarily focused on the actions of individual agents, such as firms and consumers, and how their behavior determines prices and quantities in specific markets.
While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by governments to assist in the development and evaluation of economic policy.

Basic macroeconomic concepts[edit]

Macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research.[3] Macroeconomic theories usually relate the phenomena of output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also important to all economic agents including workers, consumers, and producers.

Output and income[edit]

National output is the total value of everything a country produces in a given time period. Everything that is produced and sold generates income. Therefore, output and income are usually considered equivalent and the two terms are often used interchangeably. Output can be measured as total income, or, it can be viewed from the production side and measured as the total value of final goods and services or the sum of all value added in the economy.[4]
Macroeconomic output is usually measured by Gross Domestic Product (GDP) or one of the other national accounts. Economists interested in long-run increases in output study economic growth. Advances in technology, accumulation of machinery and other capital, and better education and human capital all lead to increased economic output over time. However, output does not always increase consistently. Business cycles can cause short-term drops in output called recessions. Economists look for macroeconomic policies that prevent economies from slipping into recessions and that lead to faster long-term growth.


Main article: Unemployment
A chart using US data showing the relationship between economic growth and unemployment expressed by Okun's law. The relationship demonstrates cyclical unemployment. Economic growth leads to a lower unemployment rate.
The amount of unemployment in an economy is measured by the unemployment rate, the percentage of workers without jobs in the labor force. The labor force only includes workers actively looking for jobs. People who are retired, pursuing education, or discouraged from seeking work by a lack of job prospects are excluded from the labor force.
Unemployment can be generally broken down into several types that are related to different causes.
  • Classical unemployment occurs when wages are too high for employers to be willing to hire more workers.
  • Consistent with classical unemployment, frictional unemployment occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment.[5]
  • Structural unemployment covers a variety of possible causes of unemployment including a mismatch between workers' skills and the skills required for open jobs.[6] Large amounts of structural unemployment can occur when an economy is transitioning industries and workers find their previous set of skills are no longer in demand. Structural unemployment is similar to frictional unemployment since both reflect the problem of matching workers with job vacancies, but structural unemployment covers the time needed to acquire new skills not just the short term search process.[7]
  • While some types of unemployment may occur regardless of the condition of the economy, cyclical unemployment occurs when growth stagnates. Okun's law represents the empirical relationship between unemployment and economic growth.[8] The original version of Okun's law states that a 3% increase in output would lead to a 1% decrease in unemployment.[9]

Inflation and deflation[edit]

The ten-year moving averages of changes in price level and growth in money supply (using the measure of M2, the supply of hard currency and money held in most types of bank accounts) in the US from 1875 to 2011. Over the long run, the two series show a close relationship.
A general price increase across the entire economy is called inflation. When prices decrease, there is deflation. Economists measure these changes in prices with price indexes. Inflation can occur when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to deflation.
Central bankers, who control a country's money supply, try to avoid changes in price level by using monetary policy. Raising interest rates or reducing the supply of money in an economy will reduce inflation. Inflation can lead to increased uncertainty and other negative consequences. Deflation can lower economic output. Central bankers try to stabilize prices to protect economies from the negative consequences of price changes.
Changes in price level may be result of several factors. The quantity theory of money holds that changes in price level are directly related to changes in the money supply. Most economists believe that this relationship explains long-run changes in the price level.[10] Short-run fluctuations may also be related to monetary factors, but changes in aggregate demand and aggregate supply can also influence price level. For example, a decrease in demand because of a recession can lead to lower price levels and deflation. A negative supply shock, like an oil crisis, lowers aggregate supply and can cause inflation.

Macroeconomic models[edit]

Aggregate demand–aggregate supply[edit]

The AD-AS model has become the standard textbook model for explaining the macroeconomy.[11] This model shows the price level and level of real output given the equilibrium in aggregate demand and aggregate supply. The aggregate demand curve's downward slope means that more output is demanded at lower price levels.[12] The downward slope is the result of three effects: the Pigou or real balance effect, which states that as real prices fall, real wealth increases, so consumers demand more goods; the Keynes or interest rate effect, which states that as prices fall the demand for money declines causing interest rates to decline and borrowing for investment and consumption to increase; and the net export effect, which states that as prices rise, domestic goods become comparatively more expensive to foreign consumers and thus exports decline.[12]
In the conventional Keynesian use of the AS-AD model, the aggregate supply curve is horizontal at low levels of output and becomes inelastic near the point of potential output, which corresponds with full employment.[11] Since the economy cannot produce beyond more than potential output, any AD expansion will lead to higher price levels instead of higher output.
A traditional AS–AD diagram showing an shift in AD and the AS curve becoming inelastic beyond potential output.
The AD–AS diagram can model a variety of macroeconomic phenomena including inflation. When demand for goods exceeds supply there is an inflationary gap where demand-pull inflation occurs and the AD curve shifts upward to a higher price level. When the economy faces higher costs, cost-push inflation occurs and the AS curve shifts upward to higher price levels.[13] The AS–AD diagram is also widely used as pedagogical tool to model the effects of various macroeconomic policies.[14]


The IS–LM model represents the equilibrium in interest rates and output given by the equilibrium in the goods and money markets.[15] The goods market is represented by the equilibrium in investment and saving (IS), and the money market is represented by the equilibrium between the money supply and liquidity preference.[16] The IS curve consists of the points where investment, given the interest rate, is equal to savings, given output.[17]
The IS curve is downward sloping because output and the interest rate have an inverse relationship in the goods market: As output increases more money is saved, which means interest rates must be lower to spur enough investment to match savings.[17] The LM curve is upward sloping because interest rates and output have a positive relationship in the money market. As output increases, the demand for money increases, and interest rates increase.[18]
In this example of an IS/LM chart, the IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y).
The IS/LM model is often used to demonstrate the effects of monetary and fiscal policy.[15] Textbooks frequently use the IS/LM model, but it does not feature the complexities of most modern macroeconomic models.[15] Nevertheless, these models still feature similar relationships to those in IS/LM.[15]

Growth models[edit]

The neoclassical growth model of Robert Solow has become a common textbook model for explaining economic growth in the long-run. The model begins with a production function where national output is the product of two inputs: capital and labor. The Solow model assumes that labor and capital are used at constant rates without the fluctuations in unemployment and capital utilization commonly seen in business cycles.[19]
An increase in output, economic growth, can only occur because of an increase in the capital stock, a larger population, or technological advancements that lead to higher productivity (Total factor productivity). An increase in the savings rate leads to a temporary increase as the economy creates more capital, which adds to output. However, eventually the depreciation rate will limit the expansion of capital: Savings will be used up replacing depreciated capital, and no savings will remain to pay for an additional expansion in capital. Solow's model suggests that economic growth in terms of output per capita depends solely on technological advances that enhance productivity.[20]
In the 1980s and 1990s endogenous growth theory arose to challenge neoclassical growth theory. This group of models explains economic growth through other factors, like increasing returns to scale for capital and learning-by-doing, that are endogenously determined instead of the exogenous technological improvement used to explain growth in Solow's model.[21]

Macroeconomic policy[edit]

Typical intervention strategies under different conditions
Macroeconomic policy is usually implemented through two sets of tools: fiscal and monetary policy. Both forms of policy are used to stabilize the economy, which usually means boosting the economy to the level of GDP consistent with full employment.[22]

Monetary policy[edit]

Further information: Monetary policy
Central banks implement monetary policy by controlling the money supply through several mechanisms. Typically, central banks take action by issuing money to buy bonds (or other assets), which boosts the supply of money and lowers interest rates, or, in the case of contractionary monetary policy, banks sell bonds and takes money out of circulation. Usually policy is not implemented by directly targeting the supply of money.
Banks continuously shift the money supply to maintain a fixed interest rate target. Some banks allow the interest rate to fluctuate and focus on targeting inflation rates instead. Central banks generally try to achieve high output without letting loose monetary policy create large amounts of inflation.
Conventional monetary policy can be ineffective in situations such as a liquidity trap. When interest rates and inflation are near zero, the central bank cannot loosen monetary policy through conventional means. Central banks can use unconventional monetary policy such as quantitative easing to help increase output. Instead of buying government bonds, central banks implement quantitative easing by buying other assets such as corporate bonds, stocks, and other securities.
This allows lowers interest rates for broader class of assets beyond government bonds. In another example of unconventional monetary policy, the United States Federal Reserve recently made an attempt at such as policy with Operation Twist. Unable to lower current interest rates, the Federal Reserve lowered long-term interest rates by buying long-term bonds and selling short-term bonds to create a flat yield curve.

Fiscal policy[edit]

Further information: Fiscal policy
Fiscal policy is the use of government's revenue and expenditure as instruments to influence the economy. Examples of such tools are expenditure, taxes, debt.
For example, if the economy is producing less than potential output, government spending can be used to employ idle resources and boost output. Government spending does not have to make up for the entire output gap. There is a multiplier effect that boosts the impact of government spending. For example, when the government pays for a bridge, the project not only adds the value of the bridge to output, it also allows the bridge workers to increase their consumption and investment, which also help close the output gap.
The effects of fiscal policy can be limited by crowding out. When government takes on spending projects, it limits the amount of resources available for the private sector to use. Crowding out occurs when government spending simply replaces private sector output instead of adding additional output to the economy. Crowding out also occurs when government spending raises interest rates which limits investment. Defenders of fiscal stimulus argue that crowding out is not a concern when the economy is depressed, plenty of resources are left idle, and interest rates are low.
Fiscal policy can be implemented through automatic stabilizers. Automatic stabilizers do not suffer from the policy lags of discretionary fiscal policy. Automatic stabilizers use conventional fiscal mechanisms but take effect as soon as the economy takes a downturn: spending on unemployment benefits automatically increases when unemployment rises and, in a progressive income tax system, the effective tax rate automatically falls when incomes decline.


Economists usually favor monetary over fiscal policy because it has two major advantages. First, monetary policy is generally implemented by independent central banks instead of the political institutions that control fiscal policy. Independent central banks are less likely to make decisions based on political motives.[22] Second, monetary policy suffers shorter inside lags and outside lags than fiscal policy. Central banks can quickly make and implement decisions while discretionary fiscal policy may take time to pass and even longer to carry out.[22]



Macroeconomics descended from the once divided fields of business cycle theory and monetary theory.[23] The quantity theory of money was particularly influential prior to World War II. It took many forms including the version based on the work of Irving Fisher:
M\cdot V = P\cdot Q
In the typical view of the quantity theory, money velocity (V) and the quantity of goods produced (Q) would be constant, so any increase in money supply (M) would lead to a direct increase in price level (P). The quantity theory of money was a central part of the classical theory of the economy that prevailed in the early twentieth century.

Austrian School[edit]

Ludwig Von Mises work Theory of Money and Credit published in 1912 was one of the first books from the Austrian School to deal with macroeconomic topics.

Keynes and his followers[edit]

Macroeconomics, at least in its modern form,[24] began with the publication of John Maynard Keynes's General Theory of Employment, Interest and Money.[23][25] When the Great Depression struck, classical economists had difficulty explaining how goods could go unsold and workers could be left unemployed. In classical theory, prices and wages would drop until the market cleared, and all goods and labor were sold. Keynes offered a new theory of economics that explained why markets might not clear, which would evolve (later in the 20th century) into a group of macroeconomic schools of thought known as Keynesian economics – also called Keynesianism or Keynesian theory.
In Keynes's theory, the quantity theory broke down because people and businesses tend to hold on to their cash in tough economic times, a phenomenon he described in terms of liquidity preferences. Keynes also explained how the multiplier effect would magnify a small decrease in consumption or investment and cause declines throughout the economy. Keynes also noted the role uncertainty and animal spirits can play in the economy.[24]
The generation following Keynes combined the macroeconomics of the General Theory with neoclassical microeconomics to create the neoclassical synthesis. By the 1950s, most economists had accepted the synthesis view of the macro economy.[24] Economists like Paul Samuelson, Franco Modigliani, James Tobin, and Robert Solow developed formal Keynesian models, and contributed formal theories of consumption, investment, and money demand that fleshed out the Keynesian framework.[26]


Milton Friedman updated the quantity theory of money to include a role for money demand. He argued that the role of money in the economy was sufficient to explain the Great Depression and aggregate demand oriented explanations were not necessary. Friedman argued that monetary policy was more effective than fiscal policy; however, Friedman doubted the government has ability to "fine-tune" the economy with monetary policy. He generally favored a policy of steady growth in money supply instead of frequent intervention.[27]
Friedman also challenged the Phillips curve relationship between inflation and unemployment. Friedman and Edmund Phelps (who was not a monetarist) proposed an "augmented" version of the Phillips curve that excluded the possibility of a stable, long-run tradeoff between inflation and unemployment. When the oil shocks of the 1970s created a high unemployment and high inflation, Friedman and Phelps were vindicated. Monetarism was particularly influential in the early 1980s. Monetarism fell out of favor when central banks found it difficult to target money supply instead of interest rates as monetarists recommended. Monetarism also became politically unpopular when the central banks created recessions in order to slow inflation.

New classicals[edit]

New classical macroeconomics further challenged the Keynesian school. A central development in new classical thought came when Robert Lucas introduced rational expectations to macroeconomics. Prior to Lucas, economists had generally used adaptive expectations where agents were assumed to look at the recent past to make expectations about the future. Under rational expectations, agents are assumed to be more sophisticated. A consumer will not simply assume a 2% inflation rate because that has been the average the past few years; she will look at current monetary policy and economic conditions to make an informed forecast. When new classical economists introduced rational expectations into their models, they showed that monetary policy could only have a limited impact.
Lucas also made an influential critique of Keynesian empirical models. He argued that forecasting models based on empirical relationships would keep producing the same predictions even as the underlying model generating the data changed. He advocated models based on fundamental economic theory that would, in principle, be structurally accurate as economies changed. Following Lucas's critique, new classical economists, led by Edward C. Prescott and Finn E. Kydland created real business cycle (RBC) models of the macroeconomy.[28]
RBC models were created by combining fundamental equations from neo-classical microeconomics. In order to generate macroeconomic fluctuations, RBC models explained recessions and unemployment with changes in technology instead changes in the markets for goods or money. Critics of RBC models argue that money clearly plays an important role in the economy, and the idea that technological regress can explain recent recessions is also implausible.[29] However, technological shocks are only the more prominent of a myriad of possible shocks to the system that can be modeled. Despite questions about the theory behind RBC models, they have clearly been influential in economic methodology.

New Keynesian response[edit]

New Keynesian economists responded to the new classical school by adopting rational expectations and focusing on developing micro-founded models that are immune to the Lucas critique. Stanley Fischer and John B. Taylor produced early work in this area by showing that monetary policy could be effective even in models with rational expectations when contracts locked-in wages for workers. Other new Keynesian economists expanded on this work and demonstrated other cases where inflexible prices and wages led to monetary and fiscal policy having real effects.
Like classical models, new classical models had assumed that prices would be able to adjust perfectly and monetary policy would only lead to price changes. New Keynesian models investigated sources of sticky prices and wages due to imperfect competition,[30] which would not adjust, allowing monetary policy to impact quantities instead of prices.
By the late 1990s economists had reached a rough consensus. The rigidities of new Keynesian theory were combined with rational expectations and the RBC methodology to produce dynamic stochastic general equilibrium (DSGE) models. The fusion of elements from different schools of thought has been dubbed the new neoclassical synthesis. These models are now used by many central banks and are a core part of contemporary macroeconomics.[31]
New Keynesian economics: which developed partly in response to new classical economics, strives to provide microeconomic foundations to Keynesian economics by showing how imperfect markets can justify demand management.

See also[edit]


  1. Jump up ^ Blaug, Mark (1985), Economic theory in retrospect, Cambridge, UK: Cambridge University Press, ISBN 0-521-31644-8 
  2. Jump up ^ Sullivan, Arthur; Steven M. Sheffrin (2003), Economics: Principles in action, Upper Saddle River, New Jersey 07458: Pearson Prentice Hall, p. 57, ISBN 0-13-063085-3 
  3. Jump up ^ Blanchard (2011), 32.
  4. Jump up ^ Blanchard (2011), 22.
  5. Jump up ^ Dwivedi, 443.
  6. Jump up ^ Freeman (2008). http://www.dictionaryofeconomics.com/article?id=pde2008_S000311.
  7. Jump up ^ Dwivedi, 444–445.
  8. Jump up ^ Dwivedi, 445–446.
  9. Jump up ^ Neely, Christopher J. "Okun's Law: Output and Unemployment. Economic Synopses. Number 4. 2010. http://research.stlouisfed.org/publications/es/10/ES1004.pdf.
  10. Jump up ^ Mankiw 2014, p. 634.
  11. ^ Jump up to: a b Healey 2002, p. 12.
  12. ^ Jump up to: a b Healey 2002, p. 13.
  13. Jump up ^ Healey 2002, p. 14.
  14. Jump up ^ Colander 1995, p. 173.
  15. ^ Jump up to: a b c d Durlauf & Hester 2008.
  16. Jump up ^ Peston 2002, p. 386-387.
  17. ^ Jump up to: a b Peston 2002, p. 387.
  18. Jump up ^ Peston 2002, p. 387-388.
  19. Jump up ^ Solow 2002, p. 518-519.
  20. Jump up ^ Solow 2002, p. 519.
  21. Jump up ^ Blaug 2002, p. 202-203.
  22. ^ Jump up to: a b c Mayer, 495.
  23. ^ Jump up to: a b Dimand (2008).
  24. ^ Jump up to: a b c Blanchard (2011), 580.
  25. Jump up ^ Snowdon, Brian; Wane, Howard R. (2005). Modern Macroeconomics - Its origins, development and current state. Edward Elgar. ISBN 1 84542 208 2. 
  26. Jump up ^ Blanchard (2011), 581.
  27. Jump up ^ Blanchard (2011), 582–583.
  28. Jump up ^ Blanchard (2011), 587.
  29. Jump up ^ Blanchard (2011), 587.
  30. Jump up ^ The role of imperfect competition in new Keynesian economics, Chapter 4 of Surfing Economics by Huw Dixon
  31. Jump up ^ Blanchard (2011), 590.


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