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What a central bank does to control the money supply, and thereby manage demand. Monetary policy involves open-market operations, reserve requirements and changing the short-term rate of interest (the discount rate). It is one of the two main tools of macroeconomic policy, the side-kick of fiscal policy, and is easier said than done well. (See monetarism. )
Industry:Economy
Changes in the money supply have no effect on real economic variables such as output, real interest rates and unemployment. If the central bank doubles the money supply, the price level will double too. Twice as many dollars means half as much bang for the buck. This theory, a core belief of classical economics, was first put forward in the 18th century by David Hume. He set out the classical dichotomy that economic variables come in two varieties, nominal and real, and that the things that influence nominal variables do not necessarily affect the real economy. Today few economists think that pure monetary neutrality exists in the real world, at least in the short run. Inflation does affect the real economy because, for instance, there may be sticky prices or money illusion.
Industry:Economy
Control the money supply, and the rest of the economy will take care of itself. A school of economic thought that developed in opposition to post-1945 Keynesian policies of demand management, echoing earlier debates between mercantilism and classical economics. Monetarism is based on the belief that inflation has its roots in the government printing too much money. It is closely associated with Milton Friedman, who argued, based on the quantity theory of money, that government should keep the money supply fairly steady, expanding it slightly each year mainly to allow for the natural growth of the economy. If it did this, market forces would efficiently solve the problems of inflation, unemployment and recession. Monetarism had its heyday in the early 1980s, when economists, governments and investors pounced eagerly on every new money-supply statistic, particularly in the United States and the UK. Many central banks had set formal targets for money-supply growth, so every wiggle in the data was scrutinized for clues to the next move in the rate of interest. Since then, the notion that faster money-supply growth automatically causes higher inflation has fallen out of favor. The money supply is useful as a policy target only if the relationship between money and nominal GDP, and hence inflation, is stable and predictable. The way the money supply affects prices and output depends on how fast it circulates through the economy. The trouble is that its velocity of circulation can suddenly change. During the 1980s, the link between different measures of the money supply and inflation proved to be less clear than monetarist theories had suggested, and most central banks stopped setting binding monetary targets. Instead, many have adopted explicit inflation targets.
Industry:Economy
One of the most important and influential economic theories about finance and investment. Modern portfolio theory is based upon the simple idea that diversification can produce the same total returns for less risk. Combining many financial assets in a portfolio is less risky than putting all your investment eggs in one basket. The theory has four basic premises. * Investors are risk averse. * securities are traded in efficient markets. * Risk should be analyzed in terms of an investor’s overall portfolio, rather than by looking at individual assets. * For every level of risk, there is an optimal portfolio of assets that will have the highest expected returns. All of this seems comparatively straightforward now, except perhaps the bit about efficient markets. But it was shocking when it was put forward in the early 1950s by Harry Markowitz, who later won the Nobel Prize for it. According to Mr. Markowitz, when he explained his theory to the high priests of the Chicago school, “Milton Friedman argued that portfolio theory was not economics”. It is now. (See arbitrage pricing theory, capital asset pricing model and black-scholes. )
Industry:Economy
When economists make a number of simplified assumptions about how the economy, or some part of it, behaves, and then see what this implies in various different scenarios. Milton Friedman argued that economic models should not be judged on the basis of the validity of their assumptions, but on the accuracy of their predictions. An expert billiards player, he said, may not know the laws of physics, but acts as if he knows such laws. So his behavior could be predicted accurately with a model that assumes he knows the laws of physics. Likewise, the behavior of people making economic decisions may be accurately predicted by a model that assumes their goal is, say, profit Maximization, even if they are not actually conscious of this being their goal. The more complex the thing being modeled, the harder it is to get right. Economic forecasting has a poor overall track record. The more micro¬economic the thing being modeled, the more likely it is that a model can be designed that will deliver accurate predictions.
Industry:Economy
The easier it is for the factors of production to move to where they are most valuable, the more efficient the allocation of the world’s scarce resources is likely to be and the faster GDP will grow. Apart from continental drift, land is immobile. Capital has long been extremely mobile within countries, and, with the rise of globalization, it is now able to move easily around the world. Enterprise is mobile, although to what extent depends on the particular entrepreneur. Some members of the labor market zoom around the world to work; others will not move to the next town. Capital controls are the main obstacle to capital mobility, and these have been mostly removed or reduced since 1980. The sources of labor immobility are more numerous and complex, including immigration controls, transport costs, language barriers and a reluctance to move away from family or friends. Workers are far more mobile within the United States than they are within the European Union or within individual EU countries. Some economists reckon that the willingness of workers to move to where the work is helps to explain the stronger economic performance and lower unemployment of the United States. Can you sometimes have too much mobility? Certainly, some developing countries have suffered from hot money rushing into and then out of their markets. In general, the possibility that a factor of production may suddenly move elsewhere can create serious economic problems. For instance, an employer may think twice about investing in training an employee if it fears that the employee may suddenly take a job with another firm. Similarly, entrepreneurs are unlikely to take the risk of pursuing a new idea if they fear that their capital may disappear at any moment, hence the importance of having access to long-term capital, such as by issuing bonds and equities.
Industry:Economy
A market economy in which both private-sector firms and firms owned by government take part in economic activity. The proportions of public and private enterprise in the mix vary a great deal among countries. Since the 1980s, the public role in most mixed economies declined as nationalization gave way to privatization.
Industry:Economy
The sum of a country’s inflation and unemployment rates. The higher the score, the greater is the economic misery.
Industry:Economy
A minimum rate of pay that firms are legally obliged to pay their workers. Most industrial countries have a minimum wage, although certain sorts of workers are often exempted, such as young people or part-timers. Most economists reckon that a minimum wage, if it is doing what it is meant to do, will lead to higher unemployment than there would be without it. The main justification offered by politicians for having a minimum wage is that the wage that would be decided by buyers and sellers in a free market would be so low that it would be immoral for people to work for it. So the minimum wage should be above the market-clearing wage, in which case fewer workers would be demanded at that wage than would be hired at the market wage. How many fewer will depend on how far the minimum wage is above the market wage?
Some economists have challenged this simple supply and demand model. Several empirical studies have suggested that a minimum wage moderately above the free-market wage would not harm employment much and could (in rare circumstances) potentially raise it. These studies are not widely accepted among economists. Whatever it does for those in work, a minimum wage cannot help the majority of the very poorest people in most countries, who typically have no job in which to earn a minimum wage.
Industry:Economy
Loved and loathed; perhaps the most influential economist of his generation. He won the Nobel Prize for economics in 1976, one of many Chicago school economists to receive that honor. He has been recognized for his achievements in the study of consumption, monetary history and theory, and for demonstrating how complex policies aimed at economic stabilization can be. A fierce advocate of free markets, Mr. Friedman argued for monetarism at a time when Keynesian policies were dominant. Unusually, his work is readily accessible to the layman. He argues that the problems of inflation and short-run unemployment would be solved if the Federal Reserve had to increase the money supply at a constant rate. Like Adam Smith and Friedrich Hayek, who inspired him, Mr. Friedman praises the free market not just for its economic efficiency but also for its moral strength. For him, freedom--economic, political and civil--is an end in itself, not a means to an end. It is what makes life worthwhile. He has said he would prefer to live in a free country, even if it did not provide a higher standard of living, than a country run by an alternative regime. However, the likelihood of a free country being poorer than an unfree one strikes him as implausible; the economic as well as the moral superiority of free markets is, he has declared, "now proven". An adviser to Richard Nixon, he was disappointed when the president went against the spirit of monetarism in 1971 by asking him to urge the chairman of the Fed to increase the money supply more rapidly. The 1980s economic policies of Margaret Thatcher and General Pinochet were inspired--and defended--by Mr. Friedman. However, in 2003, he admitted that one of those policies, the targeting of the money supply, had "not been a success" and that he doubted he would "as of today push it as hard as I once did".
Industry:Economy
