Abstract
This paper is based on an article from The Economist published on June 1st, 2013. In this paper, I will analyze the economic policy against the credit markets fluctuations in the US and try to follow the traces of the failures in this policies due to the reactions of the martkets to this policies. The Fed and the Government implement some macro policies to stable the markets to ensure the growth rate in the US while keeping other macroeconomic variables such as unemployment, inflation, stock exchange markets, foreign exchange rates. However, people’s reaction to these macro policies sometimes makes these unfruit ful and the US economy faces new problems. In this paper, I will try to give reasons behind this and support my ideas from academic articles.
Contend
Abstract 1
Contend 2
Graphics List 2
Fluctuations in the Economy and Macroeconomics on Microfoundations 3
Stabilizing Economy 7
A Few Examples of Unsuccessful Macroeconomic Policy Implementations 8
A Few Examples of Successful Macroeconomic Policy Implementations 9
How to Produce Better Economic Policies 9
Why Are We Having Crises? 11
The Result 12
References 13
Graphics List
Graph 1 U.S. Households: Debts vs. Income 4
Graph 2 Demand and Supply for Credits 5
Graph 3 Policy Tools 7
Graph 4 Real GDP Growth 11
Fluctuations in the Economy and Macroeconomics on Microfoundations
The credit markets in the US are always active due to the high demand for credits due to the relatively higher consumption of the Americans. The relatively more developed credit markets in the US has created an opportunity for the people to consume more than their income they receive.
Considering that people’s consumption behaviors are changing in time depending on the sociological changes occurring as a result of the continuous economic growth and an increase in the welfare of people. Economic growth and well developed income distribution in a country guarantees people some certain level of income, relatively higher in the US. Thus consumers creates a confidence for the economy which effects their economic behaviors including consuming, saving, investing etc. These changes in their behaviors’ are not only a change in amount also a structural change. They change their behaviors patterns: they change what they eat, what they invest in, where they spend their time etc. This change is endless thanks to always changing life conditions and economy.
Graph 1 U.S. Households: Debts vs. Income
Individuals have a common culture in the society; however, at micro level they have all different behavior patterns. Every individual responds to change in life and economy differently. Even though we know that every person has different characteristics, people create a common culture which pushes individuals to follow some behaviors patterns.
Changing conditions affect individuals’ behaviors, culture and society and when all the changes in the economy –we should consider economy as the total of people’s economic behaviors- aggregated we can see the macroeconomic changes. So we need to think on the following question: Are people always making right decisions in the economy and is economy always going well without any failures? Unfortunately, answer to this question is “No”. Economies have crisis in some intervals. This crisis can be seen as macroeconomic problems; however, the economic literature lately has proved that individuals’ behaviors are the causes of the economic crisis. If individuals are not making the right decisions then economy starts having some problems. For instance, if most of the people are getting credits with certain conditions while they do not have the capacity to return it, then at macro level we would see that financial institutions are having problems to run their services or if the financial institutions are giving some credits away without checking the risks, then we might see a financial crisis, people trying to get rid of their credits, and many bankruptcy stories in the economy.
Graph 2 Demand and Supply for Credits
As an example of the changing credit customer behavior, see the graph above. If the income is high enough and income distribution is fair in a country, then customers will be less sensitive to the prices. If we apply this situation to the credit markets, we see the graph above. The credit customer’s demand’s slope changes and demand transforms from D1 line to D2 line. Equilibrium goes from E1 to E2 and at the new equilibrium, the interest rate is higher. Let us explain this more clearly. In this country income level is high enough and income distribution is relatively fair. That means people in this country are relatively richer. As we know rich people pay less attention to the prices and in our case to the interest rates. So they become less sensitive to the interest rates. That is why the credit demand line becomes steeper showing that demand is less sensitive to the interest rates. In this case, credit customers have to pay higher interest rates to the banks just because they do not pay attention to the interest rates. Even worse, rich credit customers pay more attention to the amount of credit. That might mean an increase in the demand for the credits (a shift from D2 to D3 occurs), than they have to pay much higher interest rates. So in an economy, customers’ decisions can create higher interest rates or higher price vice versa.
On the other hand, the relation between micro behaviors and macro level changes are not one sided. The changes in the economy at macro level might impact individual’s behaviors. For example, if there is a government which overspends for the public services and cannot cover them by the taxes, then it might create disbelief for the government, and the worse for the economy, which may affect individuals’ economic behaviors and other behaviors.
The economy is two sided –macro and micro- and if something changes in one it affects the other and we can see that an interaction occurs in the economy. While thinking economy, one should check individuals’ behaviors, companies’ decisions as well as policy decisions by the Government, the Fed, other countries governments and other policy makers at national and international levels.
Finally we can see that the fluctuation in the economy is not something that can be stopped until we stop fluctuations in our lives, in our societies and in our countries and fluctuations in economy means some unexpected surprises with negative (means economic crisis) or positive effects that we may have to face. However, even we know individual life, social life, culture, and economy are some phenomenon which cannot be stabilized or standardized for a long time -change is the most important reality on the earth-, we still need to guarantee a somehow stable life so we can develop and do better things.
Stabilizing Economy
The body which needs to interfere the economy is the Government. Because we need one institution which has power enough to rule the country and that is the Government selected by the people and who can use public power – which is more powerful than any individual and company alone. The government uses its power through some institutions such as Ministry of Finance, the Fed etc. and some policies. The policies which are used to lead or control economy are classified into two: 1) monetary policies and 2) fiscal policies. The Fed is responsible for the monetary policies whereas the Ministry of Finance and some other public institutions are responsible for the fiscal policies. Monetary policies aim at managing the money supply in the economy. By changing the amount of the money supply, the Fed can change interest rates, the amount of credits supplied and other monetary values directly. Also monetary policies can affect the real values such as real wages, real GDP, etc. as well as people’s expectations by giving them some information about the future implementations. Fiscal policies are about to change the tax and government spending regime. By increasing or decreasing the tax burden on people and companies, the Government can create a fast growing economy or slowdown the economy.
Graph 3 Policy Tools
We know that the Government and the Fed should be able to create a stable economy for the citizens and the companies so we, as citizens, can make the right economic decisions. Unfortunately, stabilizing economy is not an easy job. There are two levels you need to control: 1) at micro level and 2) at macro level. At macroeconomic level, the Government and the Fed can change things very easily by making one decision such as increasing/decreasing money supply, increasing/decreasing tax rates on a certain product groups or on all the products, however, no one can say for sure that macroeconomics changes will diffuse into people’s behaviors or into social life. To be able to say that a macroeconomics policy is successful, we should be able to see that it has diffused into people’s behaviors, social life and culture so that way people and companies decision making process are to be affected by the macroeconomic policy. If that is applied to any macroeconomic policy case, then we will observe that the individuals and the society will develop responses to cancel the effects of the macroeconomic policy in the economy. Consequently, implementing macroeconomic policies is relatively easy, however changing behavioral patterns at microeconomic level is truly though.
A Few Examples of Unsuccessful Macroeconomic Policy Implementations
In 1929, the Fed informed the banks about the speculations and instructed banks to curtail lending, however, after a slight decrease, the amount of total loans still exhibit a rise. The banks did not follow the Fed’s instruction fully.
Starting from 1935, the Fed has begun implementing Required Reserve policy where banks have to deposit some reserves into the Fed. From 1948 to 1980, due to the high required reserves ratio, the amount of the loans was low. But in 1960s and 1970s, the banks could find some extra funds to satisfy the Fed’s high required reserve demand and they were to be able supply more loans.
In 1941, the Trading with the Enemy Act of 1917 invoked by Franklin Roosevelt was aiming restricting consumer installment loans and this policy had a negative impact on credit growth.
In 1950, the Fed’s control extended to home loans. The Fed tried to decrease the number of new houses to be constructed and implemented a tightening policy on the economy. Home constructions went down a bit, however, it was less than expected by the Fed.
A Few Examples of Successful Macroeconomic Policy Implementations
In 1969, Congress gave the rights to the Fed to be authority on the financial markets which allowed the Fed to control the financial markets to get rid of high interest rates and high inflation in the prices. In 1980, the Fed implemented a policy including higher required reserve ratios on the credit cards, personal loans, and money market funds which has been effective and caused a decrease in the amount of loans.
In mid1980s, the Fed changed the interest rate to influence the demand and the supply of the funds and with this policy the Fed tried to control the home loans. This policy was successful though created some recession in the market. Recently, in 2005 and 2006, the Fed used a similar policy to regulate the home loan markets. At the beginning, it helped increase the home loans.
Finally we can say that there is no guarantee if the policy implementation becomes successful. Policy makers should be able to follow many macroeconomic and microeconomic variables to make the best guesses and the best policies which is truly though job.
How to Produce Better Economic Policies
In the science of economics, the first macro models are written on the assumption of similar individuals in the economy, however, as we know that is not possible in the real world. The following macro models in the economics have started to include the differences between individuals, with firstly with the models including expectations and especially after endogenous growth models. The expectation models in macroeconomics were important for reflecting individuals’ features onto the models. In the endogenous models, people are being classified into a few groups with certain common characteristics and analysis is based on these groups of people. Each group is represented by a representative agent and researcher writes some assumptions on these representative agents and then researcher tries to find out how to shape this representative agent. The formation of the representative agent is important because whole model is based on these agents.
More recently, a new approach in economics is rising: Macro models with micro foundations. This approach claims that better models to understand the reality are possible if only if we can provide micro foundations for macro models. According to this, it is very essential to understand individuals’ behaviors and the rationales behind them to create better macro models and efficient macroeconomic policies. Another fact the assumption about the individuals by the classical economists saying “Individuals are rational” is not accepted by this new approach which means that individuals might decide irrationally and make mistakes in the models.
Micro based macro models approaches develops a model named “Real Business Cycles”. Real Business Cycle (RBC) is a dominant strand of thought in today’s macroeconomics. According to this model the fluctuations in the economy are the results of the real shocks to the economy causing from the structure of the economy. In order to run the economy smoothly, governments should spend their efforts on creating a strong structure in their economies. In another word, strong economies have a stable growth structure so when we graph their growth we can see a steady growth.
Graph 4 Real GDP Growth
As you see in the graph, this approach uses real values of the variables. As we know, nominal values cover the real values with a veil of price. The changes in prices are deceptive and in order to see the reality we should be able to follow the real values detained from price effects.
The real cycle model and micro based macro models give us an idea of how a government can control the economy perfectly. However it is still not that easy. To be able to draw a real cycle model for the economy, we need a large set of data on which economists can make perfect projections. On these projections we can create the best economic policies.
Unfortunately, without depending on how large data we use or how the most efficient models we use to make future projection, there is no way to guess the future perfectly. During the last global financial crisis, we learnt that even the most developed countries with many advantages such as the US, the UK, etc., might face financial and economic crises even tough they have the most developed human capital and very good economists.
We can conclude that any economy on the world cannot live without some crises. The best thing to do for any economy is to figure out how to live with crises.
Why Are We Having Crises?
The crises we face truly disappoint us and we suffer from unemployment, high price, or other unexpected situations. So why are we having some financial and economic crises? Crises shows us that economies are alive and like all the live creatures have some growing pains. Each crisis is a result of a development in an economy. For example, the global financial crisis started in the real estate market in the US is a result of a very well developed financial system supporting the real estate market in the US. What we learned from the crisis?
- While developing financial tools for the mortgage markets, we should make sure that no bubble in the real estate market occur,
- While giving the loans away, the banks should be more picky and receiving credit for a house should not be so easy,
- Credit customers should be able to plan their financial plans very well so they can repay their loans to the banks.
If you read the history of the economic and financial crises, you could easily see that a crisis happened in a country did not repeat itself and the next crisis for this country is a more developed one. We can say basically, as economies are growing and developing, the crises this economy facing is developing itself.
The Result
Controlling the economy at macro level does not guarantee a perfect economy management, because people at micro level do not have a strong tendency to follow the macro policies. The individuals’ goals in the economy are varying and they may not have a common point. When most of the people make some mistakes and if these ones’ effect on the economy is big enough then we have some problems in the economy at macro and micro level.
I would like to make one suggestion at the end. The only policy kind we use these days are macroeconomic policies. To be able to cope with crises we need to improve our policy tools and the most important thing to be able do this is to touch the economy at micro level. Would it be possible? Yes. If you ask me how, my suggestion is to add more classes into schools to create more awareness in our people about economy, economy policies and political economy.
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