Thinking like a Macro-Economist

Question 1: The Circular Flow diagram is model of how the economy works. Explain how the model would change if the following events occurred;

The circular Flow diagram is chart showing different components of the economy and the interrelation between them. The components of the economy are households, businesses, government and international markets. The households provide labor, capital, land and raw materials to the businesses (Colander, 2008). Households are also the major markets for the good manufactured by the businesses and foreign markets. In return, households receive salary and wages for labor provided and goods and services from the businesses and foreign markets. Households provide labor to the government in terms of employment, while the government impose taxes to the households for which it provide services such as security, protecting private property, providing legal system, and providing infrastructure (Varian, 2009). Government provide enabling environment to do business by providing important services to the businesses and international markets (Colander, 2008). The businesses pay taxes to the government to enable it provide those services. The government also buys goods and services from businesses and international markets.

Households increase savings

Households save what they have not consumed from their disposable income. The effect of increased savings by the households will be felt across the economy. Increased savings by the households will increase the funds households can provide as capital to the businesses.

Reduction in consumptions translates to reduced purchases of goods and services from businesses and international markets (Colander, 2008). The businesses will be forced to cut production and lay off workers due to reduced intake of goods and services by the households. The profits from the businesses will reduce thereby reducing the taxes the government collects from the businesses. The government will find difficulties in providing services to the households and businesses due to decreased revenue from taxes.
Drastic spending cuts are implemented by the government.

Government buys goods and services from the businesses, the effect of drastic spending cuts by the government will reduce the amount of goods and services businesses provide to the government. The businesses will be forced to cut down their production capacities, and lay off workers due to redundancy. The taxes the government obtains from businesses will also reduce, thus creating a negative impact on the services provided by the government (Colander, 2008).

Question 2: The online textbook identifies three types of economic systems, which one closely resembles the US economy. Explain and support your answer.

In macroeconomics, laissez-faire, mixed, and command economies are recognized as the main economic models.

Laisez-faire economy: the French word Laisez-faire has been applied in macroeconomics to mean “…Let others do…” (Varian, 2009). The main characteristics of leissez-faire economy are: first demand and supply determine the prices of commodities and services as well as the prices of factors of production. Second Leissez-faire economy is purely capitalistic system (Varian, 2009). Thirdly, the government role in leissez-faire economy is limited to only providing essential services such as protecting private property, providing legal system, providing infrastructure, and making sure essential public goods are available (Colander, 2008).

Command economy: Command economy is a system where the government controls all the aspects of the economic system. The government has the critical role of determining the prices of goods and services and of factors of production. Command economy is practiced in the communist governments, where all economic decisions are made by the government.

Mixed economy: A mixed economy combines the two types of economic models, that is, leissez-fair and command economies. In a mixed economy the forces of supply and demand in the marketed are allowed to determine the prices of goods and services and factors of production. However, the government retains some control on the economy through various ways.

The US economy

The US economy closely resembles the mixed economy system whereby the markets forces of supply and demand are allowed to determine the prices with considerable level of government interventions. First, the government through the central bank controls the monetary system, thus all the functions of the commercial banks are under government regulations (Colander, 2008). Secondly, the government through various regulations determines how the businesses are conducted; these regulations include antitrust laws, worker safety, anti pollution and anti discrimination laws (Colander, 2008). Thirdly, the government provides social programs such as, unemployment compensation, social security, farmer support program, and minimum wage laws. In recent time, due to economic recession of 2007- 2008, the government has bailed out private businesses and introduced the stimulus packages to revamp the economy. This has increased the level of government presence in the economy.

Question 3: Discuss the policies that Keynes and Hayek advocated regarding how the federal government should manage the economy. What are the major differences between each school of thought?

Keynesian economic policies

Keynesian economic policies deal with the effects of total spending in the economy on inflation and output (Keynes, 2006). Keynesian policies advocate for government intervention to economic systems in short run basis. Keynes argued that during depressions or recessions the government should run on deficit budget through increase in spending and lowering taxes. Keynes (2006) also encouraged the government to print money, to pay for the extra expenditure. The effects of these interventions by the government are to create demand and raise people’s earnings (Colander, 2008).

Keynes also argued that during expansion, the government should intervene to prevent inflation by reducing government expenditure, raising taxes and decreasing the money supply in the economy.

Hayek economic policies

Hayek was one of the classical economic theorists preceding Keynes. These theorists were more inclined to the lassez-faire type of economic model in which the governments had minimum role in the control of the national economy (Cohen, 2003). Hayek believed that the economy had self regulatory mechanisms and that in the long run, the various components of the economy eventually adjusts themselves. Decrease in business profits was offset by companies lowering their wages (Colander, 2008). Decreased demand during recessions was addressed through lowering of prices to the level where consumers could afford (Cohen, 2003). Banks are likely to lower their interests if both business organizations and individuals are not willing to borrow.

Difference between the Keynesian economic policies and Hayek’s are in various aspects. First, Keynes believes in government intervention to solve economic problems such as recession, while Hayek opposes the need for government interventions (Keynes, 2006). Hayek believes that the economic systems have their own mechanisms of solving economic problems themselves (Cohen, 2003). Secondly, Keynes advocate for a short run approach to solve economic problems, while Hayek advocates for a long run approach which allows the economic system to adjust itself and provide solutions to the economic problems in a country.

Question 4: Based on your answer to question #3, which of the two economists would you agree with more? Explain.

From the above argument the economic model that I find agreeable is the Keynesian economic model. The economic problems should be addressed as quickly as possible to save jobs and business collapse. During the time of recession, the government should create demand and help in raising people’s earning, this stabilizes the economy. Keynesian economic model allow the government to intervene in situation where the inflation poses a threat to the economy.

References

Cohen, A. J. (2003). The Hayek/Knight Capital Controversy: the Irrelevance of Roundaboutness, or Purging Processes in Time? History of Political Economy 35(3), 469–490

Colander, D. (2008). Microeconomics. New York: McGraw-Hill Paperback

Keynes, J. M. (2006). The General Theory of Employment, Interest, and Money eds. London: Macmillan

Varian, H. R. (2009). Intermediate Microeconomics: A Modern Approach. New York, NY: W. W. Norton & Company