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Macroeconomics in One Lesson
by Fred E. Foldvary, Senior Editor, June 29, 2009There have been comments in the media saying that the Great Recession of 2008-9 shows that economic theory has failed, and that we need a theory that shows how an economy can have continuing prosperity, efficiency, equity, and sustainability. I hereby present such a theory, macroeconomics in one lesson, in its most essential and basic elements.
The three input categories or factors of production are land, labor, and capital goods. Land includes all natural resources. Labor is human exertion that produces wealth, including all goods and services with value. Capital goods are produced and not yet consumed. The wealth is distributed to land rent, wages, and capital yields. The total amount of wealth produced during a year within an economy is called its gross domestic product or national income.
Time preference is the tendency of most people most of the time to prefer goods in the present day to goods that one waits for to get in the future. The discounting of future goods creates the natural rate of interest. People pay interest to shift purchases from the future to the present.
Income that is not used for consumption is by definition saved. A successful economic investment is an increase in the stock of capital goods or in human capital (education, training, skills). Spending is either for investment or consumption. The natural rate of interest adjusts to equalize savings and borrowing, and thus also savings and investment, as investment comes from savings. The interest rate thereby ensures that all income is allocated between consumption and investment.
Economic growth is caused by investment and innovation. More and better capital goods and human capital make the economy more productive, which increases per-capita output. Entrepreneurs drive economic growth, bringing investments and better technology to markets. Knowledge about production is decentralized, changing, and in peoples’ minds, and so not available to a central planner. With free-market dynamics, entrepreneurs discover what goods are most preferred, and prices efficiently allocate goods to where they are most wanted, and so central planning and interventions are inherently wasteful.
A pure free market is an economy in which all activity is voluntary for everyone. Voluntary action includes all acts that do not coercively harm others. A governmental intervention forcibly changes the peaceful and honest acts that people would otherwise do.
Money is a medium of exchange and the final means of payment. The speed of the circulation or turnover of money is its velocity. Commodity money is convertible into a fixed amount of an element such as gold, and fiat money exists by law. Free banking means a financial system in which changes in the money supply as well as the rate of interest are set by a pure free market. A central bank is a governmental institution that intervenes to control the money supply and to change the rate of interest away from the natural rate.
The price level is an index of the average price of goods. An index for the whole economy is the GDP deflator, and the consumer price index and producer price index are what the terms imply. The price level is set to one for a base year.
Price inflation is an on-going increase in the price level. Monetary inflation is an increase in the money supply times velocity that is greater than the increase in wealth. The equation of exchange, MV=PT, explains the effects of inflation. M is money, V is velocity, P is the price level, and T is the totality of transactions measured in money. When MV/T rises, P rises. Price inflation is usually caused by monetary inflation.
Aggregate supply means all the wealth produced, and aggregate demand means all the goods purchased. They are graphed with the price level on the vertical axis and GDP on the horizontal (see graph). With a lower price level, the same amount of money buys more wealth, so the aggregate demand curve slopes down. When prices are flexible and set by markets, the aggregate supply curve is vertical, since changes in the money supply and price level do not affect output, which is determined by the amount of factors and their productivity.
If prices are not flexible, such as wages being “sticky,” not falling with falling demand, then an increase in the money supply can change real prices, such as the real wage, the money wage relative to the price level. A lower real wage increases employment and output, so in that case, in the short run, before prices adjust, an increase in money can increase output, and AS slopes up.
Capital goods have a time structure like a stack of pancakes, the lower levels being capital goods with a high turn over, like inventory, and the higher levels being long-lasting investments, chiefly in real estate. Low interest rates induce more investment in the higher-order capital goods. In a pure free market, more savings reduces the natural rate of interest, increasing borrowing for investment in higher order capital goods, offsetting the reduced consumption.
But when a monetary authority expands the money supply, pushing the interest rate below its natural rate, this induces unsustainable investment in the higher-order capital goods. Much of the lending goes to real estate construction and speculation in land values. Land speculation feeds on itself, as buyers expect other to buy at higher prices. Interest rates rise back up, and high land prices as well as higher interest rates choke the expansion, and the economy falls into recession.
Government subsidizes land values with tax advantages and with its spending. Infrastructure and civic services increase rent and land value. If taxes are on labor, goods, and enterprise, this transfers wealth from workers to the subsidized landowners. Land speculation also pushes production to less productive margins, further lowering wages and increasing the rent in the more productive areas. The wage level is set at the least productive areas (the margin of production), and land rents are set by the difference in their product and the output of marginal land.
Punitive taxes impose an excess burden or deadweight loss by raising prices above the cost of production, reducing consumption and production. Punitive taxes and restrictions create unemployment by imposing barriers between labor and resources. These interventions -- punitive taxes, restrictions, land-value subsidies -- push down wages and create poverty.
Pollution and other negative externalities are caused by a lack of property rights and by subsidies to the actors. Pollution taxes and congestion charges can eliminate the excessive pollution and the crowding. In some cases, lawsuits and negotiations can also remedy the externalities.
Land is fixed in supply, so taxing its value has no deadweight loss. A tax on land value also avoids the subsidy of public goods to landowners. A levy on land rent also avoids excessive sprawl. We can have a prosperous, efficient, equitable, stable, and sustainable economy with two basic policies. First, use land rent or land value for public revenue, along with user fees and pollution levies. Second, let the money supply and interest rates be set by the market rather than by the central planning of a monetary authority.
The pure free market will provide all with enough wealth to finance their consumption, including medical services and retirement, eliminating any need for a welfare state. With the proper initial distribution of wealth, there is no need for redistribution.
-- Fred Foldvary
Copyright 2008 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
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