Set 2 Economics Continued

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7 Determinants of Productivity, Income, and Wealth:

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1. natural talent and ability,2. Acquired Skills,3. Effort,4. Compensating Differentials,5. Inherited Wealth6. Accumulated Savings7. Seemingly Unrelated Market Conditions

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Lorenz Curve –

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a graph (developed by economist Max Lorenz) which illustratesincome inequality within a society by plotting the relation between cumulativefraction of the population (with people ordered from lowest income to highest) andcorresponding cumulative fraction of total income earned.

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Gini-Coefficient

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a quantitative measure of income inequality based upon theLorenz Curve, defined as the ratio of “the area between 45-degree line and the LorenzCurve” to “the entire area below 45-degree line.”

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4 Arguments in Favor of Coercive Redistribution:

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1. Utilitarian Justice, 2. Rawlsian Justice (Social Contract Theory), 3. Labor Theory of Value, 4. Overcoming the Free Rider Problem

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1. Utilitarian Justice

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total social welfare can be increased by transferringincome/wealth from the rich to the poor, so long as people have a diminishingmarginal utility for moneyarguments first put forth by Jeremy Bentham (1748-1835) and John StuartMill (1806-1873)

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2. Rawlsian Justice (Social Contract Theory)

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the socially best incomedistribution is the one which maximizes the well-being of the worst-off memberof society developed by the philosopher John Rawls in A Theory of Justice (1971)

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3. Labor Theory of Value

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an assessment of the production process whichattributes all economic surplus generated from production to labor Based upon the ideas of Karl Marx (1818-1883)

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4. Overcoming the Free Rider Problem

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– if society prefers a more equaldistribution of income/wealth, relying upon private charity to reduce inequalitywill result in too little redistribution (due to the “free rider problem” – recall theprevious discussion of market provision of pure public goods)

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An Argument Against Coercive Redistribution

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Libertarian Justice – the argument that the fairest distribution of income andconsumption is the one realized when the government establishes and enforces alegal code which respects all voluntary economic interactions between individualsin society

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Average Tax Rate (ATR)

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–the amount of total taxes paid divided by income

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Progressive Tax

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tax structure for which ATR increases as the level of income isincreased.

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Proportional Tax

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tax structure for which ATR remains constant as the level ofincome is increased. “flat tax” with no deductions whatsoever (e.g., income taxes inBulgaria (10%), Hungary (16%), Iraq (15%), Jamaica (25%), Romania (16%),Russia (13%), Ukraine (15%))

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Regressive Tax

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tax structure for which ATR decreases as the level of income isincreased. U.S. Social Security Payroll Tax – first $118,500 taxed at amarginal rate of 6.2%, while additional earnings are not taxed at all

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Marginal Tax Rate (MTR)

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the percentage of the next dollar earned that must bepaid in taxes.

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Stroup Coefficient

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a measure of the degree of progressivity of a tax, defined as theratio of the area between the Lorenz Curve and the Tax Concentration Curve to theentire area below the Lorenz Curve.

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Pechman-Okner Coefficient

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a measure of the redistributive capacity of a tax,defined as the percentage decrease in the value of the Gini Coefficient brought aboutby imposing the tax.

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Observations on Poverty

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poverty is a relative concept => what it means to be living in poverty in the U.S. isdrastically different than what it means to be living in poverty in Togo By the standard of $1.90 per day, virtually nobody in the U.S. is living in poverty =>examples of current poverty thresholds in U.S. (2015): $12,331 for a single person under age 65 $24,036 for a family of four with two adults and two children

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stabilization function

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attempts by government to minimize fluctuations in overallmacroeconomic activity.

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business cycle

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the periodic but irregular fluctuation in overall macroeconomicactivity which occurs over time, measured by changes in Real GDP (and othermeasures of macroeconomic activity)

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recession

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a period of time during which an economy is contracting, commonlydefined as six or more consecutive months of declining real GDP

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trough

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the point in time at which an economy stops contracting at the end of arecession (i.e., economic activity reaches a minimum)

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expansion

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a period of time during which an economy is growing or recovering (i.e.,economic activity is increasing, often reflected by a positive GDP growth rate)

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peak

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– the point in time at which an economy stops growing at the end of anexpansion (i.e., economic activity reaches a maximum)

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Fiscal Policy

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Government policies related to spending and revenue generation.

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Monetary Policy

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Government policies which determine a nation’s Money Supply. “The General Theory of Employment, Interest and Money” (1936) by John MaynardKeynes – a book, written against the backdrop of the Great Depression, which was inmany ways an assault on “traditional macroeconomic thought” (previous argumentwas for direct control of the macroeconomy)

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corollary:

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government should cut back spending and run a surplus during anexpansion (this has often been overlooked) [a budget surplus occurs whengovernment revenues exceed spending]

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solution ( low output equilibrium)

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replace missing private spending with government spending (i.e.,offset the low value of C with a higher value of G ) => deficit spending asan economic stimulus during downturns [a budget deficit occurs whengovernment spending exceeds revenues]

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Expansionary Fiscal Policy

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– increases in government spending or decreases intaxes with the aim of stimulating overall economic activity

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Contractionary Fiscal Policy

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decreases in government spending or increases intaxes with the aim of dampening overall economic activity

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Crowding Out

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decreases in private spending that occur following increases ingovernment spending

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money supply

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the amount of money in circulation in an economy (denoted M )

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velocity of money

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the number of times that a typical dollar is used in markettransactions in a single year (denoted V )

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overall price level

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the “average” of all the prices of goods/services traded (denotedP )

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aggregate level of output

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a measure of the real quantity of goods/servicesproduced (denoted Q)

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Equation of Exchange

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an identity which relates the money supply, velocity ofmoney, overall price level, and aggregate level of output to each other: MV = PQ “A Monetary History of the United States, 1867-1960” (1963) written by Friedmanand Anna Schwartz – provided strong evidence to support a claim that the moneysupply has a direct impact on short run levels of income, employment, and inflation

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loanable funds market

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the collection of all markets in which lenders andborrowers interact (e.g., mortgage markets, auto loan markets, consumer creditmarkets, business loan markets)

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expansionary monetary policy

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an increase in the money supply which provides ashort term stimulus to the macro-economy, resulting in higher levels of output,employment, and incomes

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contractionary monetary policy

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a decrease in the money supply which dampensoverall economic activity, resulting in lower levels of output, employment, andincomes in the short term (but greater stability in the long term)

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central bank

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entity which has the ability to alter the money supply of an economy Primary task is to control the nation’s money supply. U.S.: Federal Reserve (created in 1913) U.K.: Bank of England (created in 1694) Federal Reserve is an independent central bank, in that its actions are not directlydictated by the legislative or executive branch

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fractional reserve banking system

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a system in which at any point in time acommercial bank is only required to retain a portion of the money it has accepted asdeposits

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Three policy tools of the Fed to alter the money supply:

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1. open market operations,2. setting of reserve requirements,3. setting of discount rate

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open market operations

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– buying and selling of U.S. Treasury debt securities toand from the publico buying bonds puts more money in circulation (increases money supply);selling bonds takes money out of circulation (decreases money supply)

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setting of reserve requirements

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minimum restrictions on the amount of moneythat a bank must keep on hand at any point in time, in the form of either cash in itsvault or deposits with the central banko lowering the reserve requirement increases the money supply; raising thereserve requirement decreases the money supply

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setting of discount rate

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setting the interest rate that the Fed charges banks onshort-term loans ,lowering the discount rate increases the money supply; raising thediscount rate decreases the money supply

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Timing Difficulties of Stabilization (both Fiscal Policy and Monetary Policy):

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1. Information and Recognition Lags,2. Decision Lag,3. Implementation Lag

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1. Information and Recognition Lags

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the time that policymakers must wait inorder to collect and process economic data and confirm that a stabilization policyis needed

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Decision Lag

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the time that it takes a policymaker to decide upon the specificstabilization policies to enact- it may take Congress several months to pass a “stimulus bill”

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3. Implementation Lag

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the time that it takes for the enacted policy to have animpact on macroeconomic outcomes- it often takes about 12 to 18 months for an enacted policy to have an actualimpact on the economy