Synopsis: The fourth in The Economist’s series on seminal economic ideas discusses the relevance and usefulness of the fiscal multiplier.

Click here to read the original article.

Discussion:

Introduction

The idea of the fiscal multiplier was first introduced after World War 1, and has since gained and lost popularity. Now, when economies around the world are debating the usefulness of fiscal stimulus in the face diminishing effectiveness in using monetary stimulus, economists have gone back to the age-old debate: are fiscal multipliers real?

The fiscal multiplier

The mathematics of the fiscal multiplier will be explained under ‘Context’.

The multiplier explains a scenario in which an initial increase (or decrease) in government spending will increase (or decrease) national income by a disproportionate amount.

For example, if the government spends money to build a new school, construction workers, architects, building planners, etc. will be involved in building it. Later, new teachers, janitors and other staff would get hired. The people involved in either building or running the school would then spend some (not all) of the money on other goods and services, such as restaurants. Now, people working at the restaurants have more income, and they can spend some of it on other goods and services, and so on. Thus, the initial action of increased government spending benefits the economy in many ways. The question is to what extent is the accumulated benefits of the successive waves of spending exceed the initial government expenditure.

History of the fiscal multiplier: the 1920s

Many times, the idea is credited to JM Keynes himself, but it was his student, Baron Kahn, who first mentioned it. In the late 1920s the U.K. had slipped into a recession, as World War 1 had caused a depreciation in the pound, while inflation was high. To counteract a low pound, the Bank of England maintained tight monetary control (explained under ‘Context’). This, in turn, created a period of persisting low growth and deflation – the Great Depression.

Many economists had suggested public investment to increase employment in the economy. This idea was unsurprisingly met with resistance from the government, which echoed the U.S. Treasury’s view: public spending would crowd out private spending (to read more about the crowding-out effect, click here), and thus would not help the economy. In fact, it might exacerbate the depression.
​
Baron Kahn argued vehemently against the “Treasury view”, stating that public investment would increase output not only from the primary spending, but also from “beneficial repercussions”.

The Keynesian multiplier and “General Theory”

Unsurprisingly, Kahn’s view was in line with that of his teacher. In his seminal work, “The General Theory of Employment, Interest and Money” (“GT”), Keynes described exactly how the multiplier would boost growth. Because of not only his thorough description of the concept, but also his influence globally, the fiscal multiplier is often referred to as the “Keynesian multiplier”.

GT was, and continues to be, one of the greatest pieces of economic writing. Keynes’ motivation to write the book stemmed from his frustration with the Treaty of Versailles: he lampooned key figures for not considering what he believed were large risks with the agreements set out in the treaty. Keynes, as well, was very unhappy with what was then considered common and accepted economic knowledge, i.e. classical economics (explained under context). Both these factors drove him to write what would be his magnum opus: GT.

It is in GT that Keynes describes the mechanism through which government spending would have secondary effects, which would lead to tertiary effects, and so on. He also states that during a recession, individuals would be more inclined to save than invest; thus, demand for investment would decrease. As a result, an increase in demand for investment from the government should not cause a crowding-out effect.

History of the fiscal multiplier: the 1920s to the 1960s

The success of the theory of fiscal multiplier seemed to be self-evident during the Second World War and for a long time after. The Great Depression prompted economies worldwide, especially the U.S. and the U.K., to adopt Keynesian economics, and the fiscal multiplier. As the governments eventually increased military spending in the course of  World War II, their economies emerged from depression. Reverence of the multiplier increased multifold after, leading Milton Friedman to state, “We’re all Keynesians now”.

History of the fiscal multiplier: the 1970s

It was Friedman himself who began the long line of criticisms of the multiplier. He outlined the relationship between the business cycle and the money supply in an economy, and thus stated that controlling the money supply was all that was needed to control an economy; the multiplier was not necessary at all.

A more fierce line of criticism stemmed from economists belonging to the “rational expectations” school of thought, led by Robert Lucas. They claimed that the multiplier does not exist. Forward-looking individuals would realize that fiscal expansion today would have to be met with fiscal consolidation in the future to stabilize debt: thus, they would save the money they get from the government for when there is an increase in taxes in the future. Thus, there would be no multiplier effect. This idea is dubbed “Ricardian equivalence” (discussed under ‘Context’).

History of the fiscal multiplier: post-1970s

Governments tried fruitlessly to boost economic growth through government spending. Yet, they found that despite quiescent unemployment, inflation and interest rates rose unsustainably. The economic situation post-70s gave rise to a school of economic thought dubbed the “freshwater” school (these economists were named as such due to their proximity to the Great Lakes in the U.S.). They fought to recreate macroeconomics from individual consumers’ actions, a phenomenon named “microfoundations of macroeconomics”.

Robert Lucas’s and Tom Sargent’s work on the criticisms of Keynesian economics won them the Nobel Prize, and the fiscal multiplier quickly lost popularity and pertinence.

Then came the rise of “New Keynesian” economists, most of whom came from near America’s coasts; thus, they were dubbed “saltwater” economists. Notable saltwater economists include Larry Summers, Stanley Fischer and Greg Mankiw. New Keynesian economists believed that “recessions were market failures that could be fixed through government intervention”. However, they placed more importance on the central banks’ management of inflation, unemployment and interest rates than they did on fiscal policy. Thus, the fiscal multiplier once again faded into the background.

History of the fiscal multiplier: the 1990s to now

Developing countries around the world have been seeing little success in central bank policies, especially quantitative easing. Since the 1990s, inflation has remained close to being non-existent in Japan despite the Bank of Japan’s best efforts. Cutting interest rates to zero has not been as successful as any economy had hoped. This led to the resumption of the conversation about fiscal expansion. After the Global Financial Crisis (GFC), the U.S. had secured an $800bn stimulus package to revive its economy.

Freshwater economists argue that during times of panic, economists have resorted to the comforting idea of fiscal expansion, even when it doesn’t work. Other economists argue that the lack of fiscal stimulus after the GFC has damaged economies worldwide. Only time will tell which side of the argument is correct. The only thing that seems clear to economists now is that the argument about Keynes’ multiplier will never end.

Recent experiences or evidence

Fiscal multiplier has been calculated to be greater than one for many developed economies. This means that fiscal expansion will boost the economy past its primary effects, while austerity (fiscal consolidation) will harm the economy more than the initial amount of contraction.

In the EU: Austerity has been a centerpiece of government policy ever since the GFC. In the UK, former Prime Minister David Cameron mentioned the “age of austerity” in a 2009 speech to the Conservative Party. In March, the ex-Chancellor of the Exchequer George Osborne mentioned further government spending cuts of about £4bn. Austerity measures in the EU are well-summarized by this website. Some economists believe that it is excessive austerity measures across Europe that keep struggling economies from a full recession, and that the UK only escaped the recession after austerity measures were loosened.

In Japan: Prime Minister Shinzo Abe has been discussing his “three arrows” to economic recovery for a long time: monetary expansion, fiscal expansion and structural reforms (such as encouraging women to participate in the labor force). However, fiscal expansion has been constantly negated at least partially by increased taxation of sorts, including consumption tax and sales tax.

In the U.S.: The U.S. government, under President Barack Obama, had secured an $800bn fiscal expansion package after the GFC. This, along with QE, did well to aid the economic recovery from the recession. However, many economists such as Larry Summers argue that the fiscal expansion package was not large enough and a larger one would have pulled the U.S. out of recession much quicker.

Context

1. What is the fiscal multiplier?

Assume a closed economy (i.e. one where there are no imports and exports). The output, denoted by Y, in the economy comes from three sections, each of which can be modeled as follows:

1. Consumption, denoted by C. Consumption is written as , where:
   • c0 is consumer confidence. The more confident a consumer is in the economy, the more the consumer will consume, i.e. the higher c0 is.
   • (Y – T) is the disposable income. Y is the income a consumer earns, and T is the tax rate. Note that output is the same symbol as income. The intuition behind this is that all the income earned in an economy will finally be spent in the market, i.e. all the income will result in output. Thus, in this model, income = output. (Y – T) is then the disposable income for a consumer, i.e. the income a consumer can spend in the economy after taxes.
   • c1 is the marginal propensity to consume (MPC). This is the share of disposable income that the consumer will actually spend in the economy. Whatever the consumer does not spend, he or she will save. For this reason, MPC is a figure between 0 and 1.​
2. Investment, denoted by I. Investment is written as , where:
   • b0 is business confidence. The more confident a business is in the economy, the more the business will invest in the economy, i.e. the higher b0 is.
   • b1Y is the proportion of output that leads to investment. In other words, a business that needs to make more and more output will invest more and more in machinery and other things. b1 denotes the proportion of increased output that results in increased investment. b1 always between 0 and 1.
   • b2i is the amount by which an increase in interest rate results in a decrease in investment. If interest rates increase in an economy, it gets more expensive for a firm to borrow money to use in investments, such as machinery.
3. Government spending, denoted by . The bar above the G denotes that government spending is exogenous, i.e. not determined by the market, but determined by the government itself.

​
Together, then, total output (or GDP) in an economy is:

​Rearranging for Y on one side:

The fiscal multiplier is 1/(1-c1-b1). Thus, whatever happens to any term within the squared brackets, which we call autonomous spending, e.g. if government spending goes up or if taxes go down, Y will be affected through the fiscal multiplier, which would increase the effects of an increase in government spending or a decrease in taxes.

2. Why would the Bank of England’s maintaining tight monetary control counteract a low pound?

Tight monetary control means less money supply, which would keep both interest rates and currency value high.
​
Reducing the money supply in the domestic economy increases interest rates. This is demonstrated in the diagram below.

In this diagram, demand for money is denoted by D, and the original supply of money is M1. At the intersection of M1 and D, the quantity of money supplied is Q1, and the interest rate is i1. When the central bank reduces the stock of money, from M1 to M2, the quantity of money reduces to Q2, and the interest rate increases to i2, at the new equilibrium.
​
In the international market, reducing the stock of money increases the currency value. This is shown in the diagram below.

The demand for the British pound is denoted by D, and the original supply of the pound is S1. The equilibrium price and quantity of the pound at this equilibrium is P1 and P2 respectively. When the central bank reduces the amount of money supplied in the international markets, i.e. decreasing S1 to S2, at the new equilibrium, the quantity of pounds traded decreases to Q2 while the price increases to P2. Thus, the exchange rate increases.

3. Why was Keynes unhappy with classical economics?

Classical economists believed that the labor market is self-correcting, in that people who were not employed did not want to be employed. In other words, there is no such thing as involuntary unemployment.

Consider a simple supply and demand diagram for the labor market, where S is the supply of labor and D is the demand for labor by employers. At the given market equilibrium, A, 8 million people are hired at a price of $15 an hour. Assume more people want to be hired, i.e. the supply of labor increased from S to S’. The new equilibrium is at point B, where 10 million people are hired. However, all laborers now get paid more, at $13 an hour.

This classical model of the labor market suggests that the economy can freely expand and contract to accommodate more or fewer workers, with no problem at all. This was the basic idea that Keynes disagreed with.

Keynes, instead, believed that individuals were more likely to accept more nominal wages rather than less nominal wages, even if their real wages did not change. In other words, prices of labor in the economy do not adjust as easily as classicists believed. He called this the “sticky wage” theorem.

Nominal wages is just the amount of money individuals earn. Real wages are adjusted to inflation. Now, suppose inflation in the economy increased by 2%, i.e. everything cost 2% more. Wages would increase by 2% as well. The individual who receives higher nominal wages is not richer by real terms, but is still happy. However, suppose there is 2% deflation in the economy, i.e. everything costs 2% less. An individual would be much less willing to receive a 2% pay cut, even if he or she remains equally as rich in real terms after the wage cut. Thus, wages are sticky downwards.

4. What are the problems with Richardian equivalence?

​Ricardian equivalence requires that individuals are forward looking: they will save now for a future tax increase. However, few individuals are actually that forward looking, and those who are will not be able to accurately pinpoint when taxes will increase in the future. Thus, if individuals get a boost to their incomes due to higher government expenditure, they are more likely to spend at least a part of the increased income now and worry about tax increases later.

Synopsis: The second in the series about the Minsky Moment and how it changed economics.

Click here to read the original article.

1. Click here to read the introduction post.
2. Click here to read the first post on asymmetric information.

Discussion:
 
Hyman Minsky
 
Hyman Minsky is best known for his work on what causes a financial crisis. His work remained unnoticed throughout his lifetime and for a long while after. This is, in large part, due to the fact that his work was not in conformity with mainstream economics. While the majority of economists believed that markets were efficient (explained under ‘Context’), Minsky argued that inefficiency is what causes financial crises, and called this hypothesis the “financial-instability hypothesis”.
 
The financial-instability hypothesis
 
This describes how “long stretches of prosperity sow the seeds of the next crisis”, according to The Economist.
 
First, Minsky defined investment as giving money in the present in return for getting money back in the future.  For example, an ice cream machine is an investment. An ice cream parlor gives money right now to buy an ice cream machine. Due to the ice creams the machine produces, the firm gets money back in the future.
 
Where does the ice cream parlor get the money to buy the machine? It can get it from two sources: its own funds or others’ funds (e.g. the bank). The balance between the two sources is key to explaining financial instability.
 
Next, Minsky describes three types of investments.
 

1. Hedge financing: All of a firm’s borrowing is repaid with its future cash flow (explained in ‘Key Terms’). In order for this to work, a firm must have little borrowing and lots of profits. This is the most stable type of investment.
2. Speculative financing: Cash flow covers interest payment but firms must roll over their debt to repay the principal (explained in ‘Context’). This is riskier than hedge financing.
3. Ponzi financing: Cash flow covers neither principal nor interest; thus, a firm is forced to rely on the value of the asset to cover its costs (explained in ‘Context’). If the value of the asset falls, either due to contractionary monetary policy or an external shock, the firm will have to default.

 
These three types of financing are illustrated in the diagram below.

​Thus, an economy with mostly hedge financing is the most stable. An economy dominated by Ponzi financing, on the other hand, would mean that all asset values are vulnerable to external shocks of any kind, which, in turn, would hurt the economy. An economy could restrict itself to hedge financing, but will not do so. During times of healthy economic growth, firms are increasingly tempted to invest in riskier projects, and banks are increasingly tempted to finance these projects through riskier means, i.e. speculative and Ponzi financing. This is because they believe that a firm can ultimately pay back its debt, given the good growth.
 
Thus, an economy dominated by hedge financing slowly becomes an economy dominated by Ponzi financing, and a drop in asset values leads to a financial crisis. In other words, economic stability breeds instability.
 
The point at which asset prices start plunging is called a “Minsky moment”, which is a term coined by PIMCO’s former chief economist Paul McCulley. A Minsky moment is now synonymous with a financial crisis. This is illustrated in the diagram below.

Neither The Economist nor Minsky himself provided an explanation for the trough in the business cycle, but an explanation can be extrapolated from the cause of a Minsky moment. The Minsky moment is the point at which asset values collapse through some external shock (e.g. monetary tightening), or, more importantly, banks stop lending due to faltering confidence. Thus, the trough might be when banks once again resume lending when confidence picks up and they believe that the investment projects are safe.
 
If we assume this to be the reason for a trough, then we can assume that even without any external shocks (such as government intervention or a war), the business cycle would occur.
 
Minsky today
 
At the time, Minsky’s work was disregarded. People believed that markets are efficient and stable. Now, behavioral economics has adopted the idea that markets are not efficient.
 
Minsky and the nature of economics
 
The financial-instability hypothesis explains a very specific situation in which a stable economy leads to an unstable economy due to increasingly risky investments and financing. This goes against the grain of economic theory, which aims to explain a general concept. Take, for example, the theory of demand, which states that for any normal good, the increase in the price results in a decrease in demand. Thus, the theory of demand explains a multitude of economic situations – the financial-instability hypothesis does not.
 
For this reason, mainstream economics ignored Minksy’s hypothesis. After his death, and after the financial crisis, his work gained popularity and relevance.
 
The implications of the hypothesis
 
The world is still shaken up by the Global Financial Crisis (GFC) and its aftermath. Investment is much less risky now than it was pre-GFC. But if we were to look at the future of the global economy using Minsky’s hypothesis, the conclusion is clear: economic actors will forget, or perhaps ignore, the warnings of the GFC in favor of riskier and riskier financing.
 
Looking further
 
Looking past The Economist article, there are some things worth mentioning.
 
The application of the Minsky moment can be seen in the financial world. Firms have to make two types of decisions: which investment projects are worth pursuing, and how to finance them (i.e., through their own funds or borrowed funds). As the economy picks up steam, firms start undertaking riskier projects and they also start financing them with more of borrowed funds. This eventually leads to a Minsky moment of instability.
 
The other interesting point about Minsky’s work is what generates business cycles, and why they are self-adjusting. Mainstream thinking follows Keynesian economics: peaks and troughs are determined by whether an economy is above or below full employment. Minsky provides an alternative explanation to why the business cycle is self-adjusting.

Key Terms:
 
Cash flow: The amount of money generated by a business.
 
Context:

1. What does “markets are efficient” mean?

This refers to a hypothesis called the efficient market hypothesis.
 
The efficient market hypothesis states that all the available information in a market is already reflected in the price. One of the implications is that it is impossible to “beat the market”.
 
For example, assume the price of Disney shares is $10 per share. Disney then releases the news that a new movie is coming out, and everyone reacts immediately by buying Disney shares in the hope that when the movie comes out, the value of the share will appreciate. The share now costs $11. When the movie actually comes around, the market would have already reacted to the news and the price of the share will stay at $11.
 
An individual might try to beat the market by investing in a share given new information, but ultimately, according to the efficient market hypothesis, he or she will not be able to.

2. What does it mean to roll over debt to repay principal?

A firm rolls over its debt by borrowing principal from another bank.
 
Suppose an ice cream firm borrows $100 to buy an ice cream machine from Bank 1. The interest rate at Bank 1 is 10% a year. Thus, after a year, the ice cream firm must pay $110 to Bank 1.
 
At the end of year 1, the ice cream firm has made $30. Thus, it still needs to get $80 from somewhere to pay back Bank 1. The firm goes to Bank 2 and borrows $80 at 10% a year. It can now pay back Bank 1.
 
At the end of year 2, the firm owes Bank 2 $88. If the firm has made $30 again during year 2, it must borrow again to repay the principal from Bank 2.
 
This is how a firm rolls over debt. In theory, as long as the profits exceed the interest rate, a firm will ultimately be able to pay back all its debt.

3. How would an asset cover a firm’s costs?
​
Selling off an asset would get a firm money, which it can then use to pay back the bank. If the value of the asset falls, then it may not be able to cover the principal or the interest rate it owes the bank.

Synopsis: How economics has shaped the evolution of politics.

Click here to read the original article. 

Discussion:

This article discusses the history of prevalent economic thought and its effects on politics. Throughout history, politicians have adopted only those economic policies that allow them to stay in power. In this way, a country’s economic issues can be viewed through the “prism of the political structure.”

19th Century:

Political scenario: Wealthy creditors with no real interest in the government were concerned with “maintaining the real value of their money”, as can be seen by the use of the gold standard (explained in Key Terms) and their one allowance of government intervention, through the use of the central bank, to ensure the success of the financial system.

Economic climate: Classical theory dominated economics. Classical theory concerned itself with the self-correcting nature of an economy (explained in Context), and thus reasoned that the government had little place in the free market.

1914 – 1929:

Political scenario: World War I (1914-1918) resulted in the sudden need for ammunition and manpower. The brief respite during the Roaring Twenties was overshadowed by the Great Depression, which began in 1929.

Economic climate: Government intervention, high inflation and debt during World War I destroyed classical theory. Any attempts to rebuild classical theory during the twenties were outweighed by the Great Depression: there was great reluctance by mass democracies to put the strain of the gold standard on the already suffering working class.
​
1930s and 40s:

Political scenario: In the aftermath of the Great Depression, economies did not return to full employment. This was a great cause for concern among politicians, and the worry was carried into World War II.

Economic climate: Popular economist J.M. Keynes focused on government spending to boost demand, and thus, lower unemployment, through the use of fiscal policy (explained under Key Terms). This theory gained traction during World War II, where government intervention increased greatly and unemployment was wrestled down to a manageable level. Welfare states (explained in Key Terms) seemed like a small concession compared to the threat of communism (explained in Context).

1960s and 70s:

Political scenario: The rapid rise of inflation led politicians to believe that the government focus on unemployment was wrong. Middle-class voters, angry at high taxes, were quick to support an economic reform. Reagan and Thatcher adopted new policies quickly, with Europe following later, having been shaken by the scare of Eurosclerosis (explained under Key Terms).

Economic climate: The previously successful Phillips curve (explained under Context) was falling apart. Milton Friedman and his followers thus argued that governments should shift their focus away from controlling unemployment and towards managing inflation through controlling the money supply. Supply-side economics (explained in Key Terms) became popular quickly, as did monetary policy, which led to an active central bank.

1980s and 90s:

Political scenario: The fall of inflation resulted in a reputation boost for central bankers, despite the fact that inflation may have decreased due to China’s entry into the global economy (explained under Context). Reagan's and Thatcher’s reforms were well underway, which led to a rise in the debt-to-GDP ratio.

Economic climate: Reagan's and Thatcher’s reforms meant the recognition of the financial sector as a key player in any economy.

1987:

Political scenario: The riskiness of the system that ensued from the increasing debt-to-GDP ratio encourage central banks to cut interest rates during any period of uncertainty, as was seen on Black Monday.

Economic climate: Economic actors interpreted central banks’ nervous response to a wobbly economy as their “[underwriting of] asset prices”. Buying assets with borrowed money seemed to be the quick and easy way to make fortunes.

1990s:

Political scenario: The end of fixed exchange rates, and along with it, capital controls (explained in Context) made global finance very powerful, as money could easily enter and exit economies and sectors. At the same time, the wealth of the financial sector allowed its key players to fund and win favour of the political elite.

Economic climate: The loss of control over capital flows turned government focus towards dissuading capital flight, while the wealth of the financial sector meant that politics supported economic policy that favoured financial markets.

1980s to 2007:

Political scenario: The threat of communism fell along with the Soviet Union. Center-right politicians who had acquiesced to government regulation during the Great Depression gained political power, while center-left politicians supported more right-wing policies. At the same time, trade-union power fell, partially due to globalization, and partially due to the “relative decline in manufacturing”. Organizing protests became harder when many of its remaining members were dispersed across different jobs in different economies.

Economic climate: Right-wing economic policies such as the freedom for free markets to function with minimal intervention were established. The decline in trade-union power and blue-collar worker votes resulted in the larger economic actors having a greater say in shaping economic policy. It is no surprise that today we see the central banks and other large institutions as the most powerful actors in our economies.

During this time, mainstream economic theory became more micro-based as well as mathematical, despite the rise of behavioural economics.

2008 on:

The aftermath of the Great Financial Crisis has taught us that debt and the financial sector should be more central to macroeconomics and macroeconomic policy. Popular policy focus now is on attacking and trying to prevent the effects of globalization, such as the movement of jobs away from developed economies to countries that provide cheap labor. The problem is that globalization has already happened, and its effects are already underway. What will determine the success of globalization is how the Chinese economy will deal with its financial system and whether the Federal Reserve will withdraw its monetary stimulus effectively.

Just as politicians have always reacted to the economic climate, we may find that our future economic state may be a shift away from globalization and towards nationalism.

​Key terms:

1. Gold standard: A system in which the value of currency is fixed in terms of gold, and could be traded in for gold.

2. Fiscal policy: the process of government spending to stimulate demand (fiscal expansion) or government saving to decrease debt (austerity).

3. Welfare state: Where the state plays a pivotal role in protecting and promoting the economy and its citizens.

4. Eurosclerosis: A term coined in the 70s by Herbert Giersch to describe the state of stagnation in Europe that may have resulted from over-regulation by the government.

5. Supply-side economics: also known as “trickle-down economics” and “Reaganomics” – the latter due to Reagan’s active promotion of supply-side economics – argues that production is the most important determinant of economic growth. For this reason, investors and businessmen should face less barriers to production and investment through lower taxes.

Context:

​1. Classical theory: The self-correcting nature of markets was first alluded to by the father of Classical theory, Adam Smith. The idea is that prices adjust themselves and equilibrium is regained in the economy.

Suppose this is the market for a good X. Initially, the supply of X is denoted by S, and the demand denoted by D1. The resulting price P1 and quantity Q1 is shown by the intersection of D1 and S at equilibrium point A.

Now, demand for X increases to D2. At the original price P1, more of X is demanded, resulting in quantity demanded Q3. This is point B. Seeing the increase in demand, suppliers increase the price of X to increase their profits. Now, fewer people can afford the good, but enough people still want more of the good that suppliers feel like they can increase the price. Still fewer people can afford the good, but suppliers can still increase the price. This process, indicated by the red arrows, continues until the economy adjusts to a new equilibrium C, where all the demand is met by supply. Classical economists refer to this as the work of the invisible hand, guiding the economy from one equilibrium to another.

While the theory of the invisible hand is often attributed to Adam Smith, Smith used it as a term to
discuss international trade, and did not mean it to be the process described above. Still, Smith, along with other classical economists like David Ricardo and John Stuart Mill, believed the economy to be self-correcting.

2. Why would the presence of a welfare state result be a small price to pay in the face of the threat of communism? During the Great Depression, it is the democratic countries that suffered, while communist countries seemed to be fairing better. To ensure that communism does not dominate democratic countries, the government had to ameliorate the economic situation by being heavily involved in the economy.

3. To learn more about the Phillips curve and its failure in the U.S. economy, read my article here.

4. Why did China’s entry into the global economy decrease inflation? Not only were cheap goods and services provided by China, but so was cheap labor. For this reason, costs of goods, services and labor fell around the world, resulting in decreased inflation.

5. Why would the end of the fixed exchange rate system lead to the end of capital controls? Under a fixed exchange rate regime, high levels of reserves are needed to keep the exchange rate from fluctuating. For example, Hong Kong needs high levels of reserves for its currency to remain pegged to the U.S. dollar. If, for some reason, Hong Kong becomes less appealing to investors, the demand for the Hong Kong dollar will decrease, and the reserves will deplete. Capital controls are needed to make sure sudden capital influx or capital flight does not deplete the reserves, and thus, the exchange rate.