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Recession Puzzles (Introductory Macro)

July 12, 2014

1. If all the money and stocks and bonds and so forth disappeared tomorrow there would still be all the machines and factories and jewels and people with their skills and abilities. So why does the money matter?
2. When the economy drops by 25% or whatever there are still all the factories and people. So what is dropping?

3. If everybody decided to work half as hard and get twice as much money for what they’re doing, everybody would be just as rich and would have much more free time to have fun and hang out with friends and stuff. So why don’t we?

Article here

There are 2 approaches to looking at why economies go into recession: supply and demand. Supply theories of recessions focus on real events which impact the ability of people to make stuff. War, famine, natural disasters, Communism, natural resources running out, things like that. When your countries gets bombed, for example, no one really wonders why people aren’t making as many widgets as before.

These questions are aboutdemand theories of business cycles, which deal with money.

Each person wants many things, but because of specialization, only produces a small number of things. Specialization is critically important to a modern economy. However important you think it is, it is much more important than that. If you were to try to build a $12 toaster completely by yourself, <a href="“>it would take a decade of work. However, if you instead work for money and then use that money to buy a toaster, it will cost you only an hour of work. Specialization is such a strong part of a capitalist economy that literally hundreds of thousands of people cooperate in order to produce something as simple as a pencil. Money facilitates this indirect exchange, and thus encourages specialization. As long as you can sell what you make to someone, you can buy anything you want from anyone (as long as you have enough money).

2. While money is useful, and indeed critical to market exchange, it is also an Achilles’ heel. One person’s spending is another person’s income. If I buy some apples from you, it’s my spending and your income. Every spent dollar goes to someone. If people spend less, other people earn less. Those other people in turn spend less and the cycle repeats in a vicious circle. Even though the factory isn’t gone, no one is buying what it is making, and so the factory owner lays off the workers. Those workers, being unemployed, buy less from other factories, who in turn reduce their workforces.

Now, there’s a few ways out of this cycle. One – prices can fall to the point where people can buy more stuff for less money, and production increases back to capacity. Another method is for the central bank to print more money, which causes increased spending. A third is for the government to spend more money, employing the unemployed workers and factors of production directly and putting money into people’s hands. Depending on how the economy is organized, each method could be effective. Which mechanism to rely on is a controversial issue among economists, although I personally favor mostly using central bank money supply adjustments to stabilize spending.

#3: Consumption can never be greater than production. If you eat a loaf of bread, someone has to bake that bread first. If you buy a new car, someone has to mine the raw materials, design it, and assemble it. Thus, half the work results in half the consumption (more or less).

You can get some wiggle room because work is only one “factor of production”, which is the term economists use to describe the stuff which makes more stuff. So, you imagine a farm. It’s got land, fertilizer, farming equipment, etc. With half the work, you would put out less fertilizer, do less weeding, etc., but you wouldn’t get half the crops.

Because of land and capital, halving work would result in maybe 40% less production, and thus 40% less consumption. France is an example of a country like this. The French work significantly less than Americans, have less material wealth, but have similar per-hour productivity.

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