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Comparative Political Economy. Western Industrialized Democracies. I. The Classical View of Macroeconomics. Long-run growth determined by population (labor supply), technology, and wealth (supply of capital)

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comparative political economy

Comparative Political Economy

Western Industrialized Democracies

i the classical view of macroeconomics
I. The Classical View of Macroeconomics
  • Long-run growth determined by population (labor supply), technology, and wealth (supply of capital)
  • Market self-corrects for deviations from long-run growth rate (no politics, hence no political economy)
  • Key Assumptions: Flexible Wages, Flexible Prices
  • Implications:
    • No one loses a job when demand is low (wages fall, or they get another job with lower wages)
    • No unsold inventories (suppliers simply lower prices as needed)
e problem ever larger economic shocks










– 4


– 8






E. Problem: Ever-larger economic shocks
ii keynesian macroeconomics a simplified explanation
II. Keynesian Macroeconomics: A Simplified Explanation

Keynes: “In the long run we are all dead.”  Focus on managing short-run fluctuations

  • Key Variables
    • Dependent variables:
      • Output: Real Gross Domestic Product (GDP)
      • Inflation: Rate of increase in prices
      • Unemployment: People looking for work but unable to find it
2 independent variables
2. Independent Variables
  • Consumption Function (70% of US GDP)
    • Primarily determined by disposable income: Income – Net Taxes
    • Net Taxes = Taxes - Transfers
consumption and disposable income
Consumption and Disposable Income



C = c0+ C1YD

Consumption, c

Slope = c1

Disposable Income,YD

b economic growth in the short run supply and demand
B. Economic growth in the short run: Supply and Demand
  • Aggregate Demand
    • Definition: How much stuff everyone in society buys at a given price level
    • Demand = Consumption + Investment + Government Spending + Exports – Imports
aggregate demand curve

PRICE LEVEL (average price)

REAL OUTPUT (quantity per year)

Aggregate demand curve

Higher prices

Lower prices

Aggregate demand

Less output demanded

More output demanded

2 aggregate supply
2. Aggregate Supply
  • Definition: How much stuff firms choose to produce and sell at each price level
  • Supply curve determined by income (ability to produce at a given price level)
aggregate supply curve

PRICE LEVEL (average price)

REAL OUTPUT (quantity per year)

Aggregate Supply Curve

Higher prices

Aggregate supply

More output supplied

3 equilibrium where supply meets demand
3. Equilibrium: Where supply meets demand
  • Best single predictor of economic output.
b equilibrium effects of increases in aggregate demand on output





b. Equilibrium effects of increases in aggregate demand on output

Price level









National output

c what shifts aggregate demand
c. What shifts aggregate demand?
  • Remember the equation: Demand = Consumption + Investment + Government Spending + Exports – Imports
  • So changes in any one of these independent variables can shift aggregate demand at a given price level (policy levers  political economy)
4 disequilibrium
4. Disequilibrium
  • Definition: Actual price level is higher or lower than equilibrium point
  • Equilibrium may be unstable: Example of Great Depression
macro disequilibrium oversupply and low demand


PRICE LEVEL (average price)

REAL OUTPUT (quantity per year)

Macro Disequilibrium: Oversupply and Low Demand

Aggregate supply



Aggregate demand



c equilibrium may be undesired excessive unemployment

PRICE LEVEL (average price)

REAL OUTPUT (quantity per year)

c. Equilibrium may be Undesired: Excessive Unemployment

Aggregate demand

Aggregate supply





Equilibrium output

Full employment



c keynesian policy recommendations
C. Keynesian Policy Recommendations
  • Focus on “demand side” by manipulating independent variables such as government spending and taxes
  • If people demand a product, producers will supply it  get money into people’s hands and production will rise
  • Spending increases more effective than tax cuts: All of spending is consumption but some of tax cuts will be saved by taxpayers instead of being used for consumption
iii alternatives to keynesian macroeconomics
III. Alternatives to Keynesian Macroeconomics
  • Problem: Emergence of stagflation in 1970s
    • Cause: External force shifted supply curve (firms less willing to supply at a given price)
    • Leading suspect: Oil price shocks increased costs of production so much that even large increases in price didn’t stimulate more production (simultaneous inflation and unemployment  recession)
    • Effect – Negated the “Philips Curve”
3 why not increase government spending
3. Why not increase government spending?
  • Increased spending increased inflation even further (usually not a problem, since inflation is low during recessions)
  • Very large deficits limited governments’ ability to spend (in US: Vietnam expenses and increased social spending)
b demand side alternative monetarism
B. Demand-side alternative: Monetarism
  • Interest rates and money supply affect people’s willingness to buy at a given price
  • Shift demand curve by manipulating interest rates or money supply (Interest rates actually easier to manipulate! “We don’t know what money is anymore.”)
  • Increase interest rates (reduce money supply) to cut inflation at expense of increasing unemployment (induce a recession to prevent stagflation). Key is to alter expectations of future inflation.
  • Cut interest rates to lower unemployment at expense of increasing inflation (economic stimulus)
5 example the us monetary system
5. Example: The US Monetary System
  • The Federal Reserve Board: Created in 1913 to act as a central bank (mixes public appointees with private banks)
b functions of the federal reserve
b. Functions of the Federal Reserve
  • Conduct Monetary Policy
    • Formal mandate: Low inflation and Low Unemployment
    • Actual policy emphasizes low inflation over full employment or economic growth
  • Serve as a lender of last resort to commercial banks within the District
  • Issue Currency – “In God we Trust”
  • Provide Banking Services to the U.S. Government
  • Supervise and regulate financial institutions
c the frb toolkit
c. The FRB Toolkit
  • Buying/selling government securities
    • Stimulation: Fed purchases U.S. Government Securities in the bond market (U.S. Treasury Notes) – Raises bond prices; reduces interest rates
      • Cash flows from the Fed to sellers of bonds; sellers deposit cash in their banks, thereby increasing the nation’s deposits and the excess reserves of the banking industry
    • Restraint: Fed sells U.S. Government Securities in the bond market (U.S. Treasury Notes) – Lowers bond prices; increases interest rates
      • Cash flows from the banks to buyers of bonds and ultimately to the Fed, thereby reducing the deposit accounts and restricting the ability of commercial banks to loan money
ii alter the fed funds or discount rates
ii. Alter the Fed Funds or Discount Rates
  • Fed Funds Rate: the interest rate commercial banks must charge one another to lend or borrow on an overnight basis for reserve management purposes
  • Discount Rate: the interest rate commercial banks must pay the Fed to borrow directly from the Fed for reserve management purposes
iii the reserve rate the fed s ultimate weapon
iii. The reserve rate: The Fed’s ultimate weapon
  • Amount of cash banks have to keep on hand to cover withdrawals
  • Use of this tool would be perceived as a reaction to extraordinary events
    • Fed will be very cautious and publicize its intentions well in advance
    • Last time required reserves changed – 1980 – resulted in a credit crunch that plunged the economy into the worst recession since the Great Depression
6 the role of banks in monetary policy
6. The role of Banks in Monetary Policy

a. Banks Create Money: Banks can be viewed as counterfeit operations authorized by the government, and are an essential tool in affecting monetary policy

  • Banks lend money that they don’t have -- so they are essentially minting their own currency!
  • Reserve requirements set by the government determine the extent to which banks can counterfeit
b banks depend on confidence
b. Banks depend on confidence
  • Customers could bankrupt a bank simply by asking for all of their reserves back, which they can do at any time.
  • Customers don’t ask for their money back when “counterfeiting” is profitable and they earn a part of the returns (interest)
  • Customers will tolerate the behavior only as long as they believe that the bank is reputable in this activity
c money creation through fractional reserves
c. Money creation through fractional reserves
  • The money creation process: Making one loan creates the opportunity to make another loan, a process which continues in perpetuity.
    • Step 1: Bank issues a promissory note for which there is no “direct” reserve. (ie. the bank makes a loan and gives the borrower a receipt against that banks reserves)
    • Step 2: This receipt (loan) is traded for a good or service (promissory note is passed on to a new holder)
    • Step 3: The promissory note is deposited back into a bank by the new holder, creating a new deposit (bank liability).
    • Step 4: The promissory note is available once again to be loaned.
money creation example

A bank receives $100 Million in deposits, keeps $20 million in reserve.

  • But the $80M in loans returns to the banking system somewhere else -- the second generation bank
Money Creation Example

The third generation bank receives $64 million of new loan deposits, allowing another $51.2 million in loans

7 is monetary policy effective
7. Is Monetary Policy Effective?
  • Easy to curb inflation (excess money) -- at cost of lower growth / recession and increased unemployment
  • Harder to stimulate growth
    • Example: Fed can lower interest rates, increase the banks’ deposits BUT
    • It cannot force a broke person (business) to borrow
    • Good risks in prosperous times become poor risks in recessionary times
    • Central banks’ ability to stimulate often compared to problem of trying to push a string – no matter how much effort you give it, it just doesn’t move much
c supply side economics
C. Supply-side economics
  • Adverse shift in supply curve means BOTH higher prices (inflation) AND lower output (recession and unemployment)
  • Demand-side shifts cannot simultaneously boost production and lower inflation
  • Solution: Shift supply curve by altering ability and willingness of firms to produce at a given price point
  • Policy levers: Corporate tax cuts, deregulation, increased labor supply (immigration), lower tariffs on raw materials, education and training (increases in per-worker productivity) etc.
e conclusions
E. Conclusions
  • Economics has become political: Few classical economists around anymore, and they don’t get to stay in office!
  • Political choices (fiscal policy, monetary policy, trade policy, immigration policy, etc) affect economic outcomes
  • Political Business Cycle: Desire to stimulate economy before election at expense of slowdown/recession after election
4 summary the macro political economy


Internal market



External shocks



Policy levers



4. Summary: The Macro Political Economy





v characteristics of monetary policy
V. Characteristics of Monetary Policy
  • The Choices
    • Central Bank dependence vs independence
the time inconsistency problem
The Time Inconsistency Problem
  • Policymakers have incentives to promise low inflation (economic stability, prevent more inflation)
  • Policymakers have incentives to renege on promises of low inflation to increase growth/employment (political business cycle)
  • Problem: Private actors know these incentives and therefore anticipate high inflation by raising wages and prices, so short-term stimulus fails to do anything except further increase inflation
  • Solution: Central bank independence makes low-inflation promises credible, prevents political manipulation
i characteristics of monetary policy
I. Characteristics of Monetary Policy
  • The Choices
    • Central Bank dependence vs independence
    • Exchange rate regimes: fixed vs. floating
exchange rates fixed vs floating
Exchange Rates: Fixed vs. Floating
  • Floating: Government has more autonomy because has no duty to pay specific amount for own currency (not backed with gold or other reserves)
  • Fixed: Government promises to exchange specific amount of gold/reserves for currency. Government cannot release too much money or speculators may try to cash in and “break the bank”
i characteristics of monetary policy1
I. Characteristics of Monetary Policy
  • The Choices
    • Central Bank dependence vs independence
    • Exchange rate regimes: fixed vs. floating
    • Wage-setting institutions: centralized vs decentralized
wage coordination problem
Wage Coordination Problem
  • Even where workers wish to avoid wage-price spiral, incentives to free-ride on other workers’ restraint
  • So each union assumes that other settlements will be inflationary and compensates by raising its own demands
  • Coordinated bargaining reduces ability to free-ride by imposing same agreement on all workers: allows incomes policy
4 comparison economic institutions in five industrialized democracies
4. Comparison: Economic Institutions in Five Industrialized Democracies

* Increased from Low in last 20 years

iv economic learning by leaders 1973 2000
IV. Economic Learning by Leaders, 1973-2000
  • Cross-national differences are not static: Countries seem to “learn” and change in response to crises
  • Three types of change:
    • Alter the usual variables (incrementalism)
    • Try a different variable (innovation)
    • Rethink how all settings work together and alter many at once (paradigm shift)
a japan
A. Japan
  • Initial system: Large, interlocking alliances with government sponsorship (keiretsu)
    • Dangers of inflation: High growth rates combined with fear of social instability from unemployment
    • National labor talks produce 30% wage increases
  • 1973 Oil Shock: Policy inconsistency
    • Japan received 82% of oil from Middle East
    • Initial price shock causes inflation fears
    • Workers demand raises to compensate
    • Increased wages lower profits  lower investment and recession (worst one in any industrialized nation in % terms)
    • Attempts to tighten money to fight inflation deepen recession
    • Crisis ends when price shock stabilizes, prices allowed to rise, full employment resumes
3 1979 oil shock consistency
3. 1979 Oil Shock: Consistency
  • Response: Immediate tightening of money supply  only mild reduction in profits/investment
  • Fine-tuning prevented wage-price spiral
4 the 1980s export led growth
4. The 1980s: Export-led growth
  • Huge trade surplus bolsters demand throughout 1980s
  • However, non-export sectors begin to encounter problems (low productivity increases, unable to lay off workers)
  • Banks tied to failing enterprises prop them up with profits from successful ones (no problem as long as exports continue to surge)
  • Profits from exports lead to “easy money” for banks  speculation in stocks and real estate
  • 1986-1990: The Bubble: Stocks and real estate bid up by bankers and investors  choicest parcels bid up to $93,000 per square foot
5 early 1990s the bubble bursts1
5. Early 1990s: The Bubble Bursts
  • Late 1989: Central Bank raises interest rates in effort to deflate bubble --> reduces investment in stock market, popping a bubble in stocks  Crash
5 early 1990s the bubble bursts2
5. Early 1990s: The Bubble Bursts
  • Late 1989: Central Bank raises interest rates in effort to deflate bubble --> reduces investment in stock market, popping a bubble in stocks  Crash
  • Failing domestic enterprises lead banks to slow investment, call in some loans  discover many loans are unrepayable
  • Result is credit crunch as businesses and banks (tied together) try to reduce own debt load instead of expanding production
6 the lost decade a failure of governance
6. The “Lost Decade:” A Failure of Governance?
  • 1988 law reduces workweek from 44 to 40 hours by 1992 ( lower per-worker productivity)
  • Government maintains tight money supply, leading to deflation (money sucked out of economy leads to expectations of lower prices, leading to saving instead of consumption, leading to price cuts, etc)
  • Government tries to loosen money supply by cutting interest rates, but even ZERO interest fails to spark investment (business cartels are trying to reduce debt load and banks are skittish about lending)
  • By 2004, prime "A" property in Tokyo's financial districts had slumped to less than 1 percent of its peak
b united kingdom
B. United Kingdom
  • Initial system: Internal and external goals
    • Internal: Commitment to full employment, to be achieved by wage restraint (politically unstable combination)  general tool of “incomes policy.” Inflation “fought” by measures to increase production (= lower unit prices, in theory, but failed).
    • External: Maintain value of the pound to sustain Commonwealth stability/trade (removed certain monetary options like devaluing currency or inflation)
2 the 1973 crisis political instability and paradigm shift
2. The 1973 Crisis: Political Instability and “Paradigm Shift:
  • Conservatives lose power
  • The “Social Contract:” Informal agreement between Labour and labor
    • Labour converts to monetarism! Exchanges promise of no price rises for “voluntary” wage restraint. Allows pound to fall.
    • Bargain fails: subsidies and sales tax cuts to hold down prices lead to huge deficits  inflation through government spending; monetary instruments fail to control money supply until mid-1980s; government consistently overestimates future productivity growth
    • Wage-price spiral follows, along with recession
3 the 1979 crisis thatcherism
3. The 1979 Crisis: Thatcherism
  • “Winter of Discontent” – Labor turns on Labour
  • 1979: Thatcher elected on promises to cut spending, cut taxes, curb inflation, deregulate (supply-side stimulation and monetarist deflation). Unable to effectively control money supply (lack of adequate measures – remember the Fed’s solution…)
  • Government soon abandons attempts to cut spending/taxes  both rise
  • 1980: North Sea oil begins to increase revenues BUT leads to overpricing of British goods (Dutch disease – exchange rate distortions) and decline in domestic manufacturing
4 the 1980s monetarism abandoned
4. The 1980s: Monetarism abandoned
  • Problem: Monetary control without proper exchange rate controls killed inflation but also much of the UK manufacturing base
  • Government gradually seeks integration with European monetary policy to control both inflation and exchange rates
  • Integration fails: Europe unable to stabilize pound (we’ll see why when we get to Germany…)
5 the 1990s return to stability
5. The 1990s: Return to stability
  • Anti-inflation policies finally pay off: Government began targeting real interest rates instead of nominal rates or money supply
  • Pound allowed to sink
  • 1997: Central bank independence increased
c france
C. France
  • Before the crises: Dirigisme
    • Government owns energy, infrastructure, defense, communications industries
    • Unions are weak (no exclusivity or closed shops), so workers look to government to set wages and working conditions
2 1973 government tries to cushion shock
2. 1973: Government tries to cushion shock
  • Efforts to increase social spending and stimulate economy lead to high rates of inflation
  • 1976: New P-M focuses on deflation. Allows unemployment to rise in order to hold down inflation. Balanced budgets become norm.
  • No effort to deal with unions by Conservative governments
3 1979 socialism fails
3. 1979: Socialism Fails
  • Voters elect Socialists
  • Socialists nationalize more industries to prevent them from failing and achieve strategic control of economic development
  • Socialists raise wages (also increase benefits, lower hours per week) and make it harder to fire union leaders and other workers (thus increasing unemployment), also stimulate economy through spending, hoping to increase productivity enough to offset inflation (complete failure)
4 the 1980s malaise
4. The 1980s: Malaise
  • Recession avoided in France BUT cost was continued high unemployment and inflation
  • Socialists retreat from economic stimulus, lowering inflation and tying the Franc to the DM -- BUT are blamed for previous failures and lose power in 1986
5 the 1990s still more malaise
5. The 1990s: Still More Malaise
  • The plan: “Competitive disinflation” argued that keeping inflation lower than neighbors (UK and Germany) would make France more competitive and increase unemployment
    • Central Bank independence dramatically increased to fight inflation
  • Problem: Huge gains in competitiveness unacceptable to French trading partners
d west germany
D. (West) Germany
  • Prior to crisis: Strong, independent central bank (with price stabilization mandate) combined with national-level labor-industry wage bargaining. High job security, with government tasked with full employment and unions free to pursue max % of economy as wages.
  • The 1973 Shock: Government implements counter-cyclical Keynesian policies, but has little effect on unemployment (manages to increase deficit/debt, however). Hiring freeze on foreign workers has some effect, causing some migration.
3 the 1979 shock
3. The 1979 Shock
  • Shock is widely perceived as loss of competitiveness (real effect was largely on exchange rates)
  • Business anticipates downturn and cuts investment, people then follow by cutting consumption
  • Policy recommendations from Council of Economic Experts: Don’t stimulate demand-side at all, since this would cause inflation. Instead reduce regulations on investment. (Shared by Bundesbank and FRG)
  • Policy recommendations from Trade Unions: Stimulate demand to provide full employment (shared by SPD)
  • Government coalition (SPD plus FDP) is divided – FDP joins CDU to form conservative government in 1982
4 the 1980s a conservative approach
4. The 1980s: A Conservative Approach?
  • Little deregulation; subsidies not cut; mild reductions in spending growth and taxes
  • Firms do invest more – but they invest in labor-substitution instead of new jobs!
  • Inflation controlled by Bundesbank, unemployment continues through most of decade
5 the 1990s reunification
5. The 1990s: Reunification
  • Immediate problem: East German industry cannot compete  high unemployment
  • West Germany promises to exchange DM for Ostmarks 1:1 (essentially means printing lots of money)
  • Massive wage increases for East German workers (benefit of West German labor contracts)
  • Bundesbank restricts money supply to prevent massive inflation ( recession in 1993 and unemployment throughout decade)
e conclusions national political differences drive economic differences
E. Conclusions: National Political Differences Drive Economic Differences
  • Democratic leaders learn: When economic programs fail, leaders try new ideas  policy inconsistency
  • Greater crises = greater changes in economic management
e conclusions national political differences drive economic differences1
E. Conclusions: National Political Differences Drive Economic Differences
  • Democratic leaders learn: When economic programs fail, leaders try new ideas  policy inconsistency
  • Greater crises = greater changes in economic management
  • “Economic voting” can be sophisticated: French Socialists don’t get credit for tight money and German Conservatives aren’t blamed for high unemployment
e conclusions national political differences drive economic differences2
E. Conclusions: National Political Differences Drive Economic Differences
  • Democratic leaders learn: When economic programs fail, leaders try new ideas  policy inconsistency
  • Greater crises = greater changes in economic management
  • “Economic voting” can be sophisticated: French Socialists don’t get credit for tight money and German Conservatives aren’t blamed for high unemployment
  • Path dependence: Previous choices can constrain current policy options
  • Critical variables include central bank independence, exchange rates, wage-setting institutions, and job protection
  • International trade critical to most non-US economies