Macroeconomics Policy and Practice, 2nd Edition Frederic S. Mishkin Solution Manual

Type:

Solution Manual

Resource:

Macroeconomics Policy and Practice

Edition:

2nd Edition

Author(s):

Frederic S. Mishkin

Online Instructor’s Manual By

Frederic S. Mishkin Columbia University

Martin Pereyra University of Missouri For

Macroeconomics: Policy and Practice Second Edition

Frederic S. Mishkin Columbia University

Contents Chapter 1

The Policy and Practice of Macroeconomics ..............................................................

1

Chapter 2

Measuring Macroeconomic Data ................................................................................

13

Chapter 3

Aggregate Production and Productivity ......................................................................

23

Chapter 4

Saving and Investment in Close and Open Economies ...............................................

32

Chapter 5

Money and Inflation ....................................................................................................

44

Chapter 6

The Sources of Growth and the Solow Model ............................................................

57

Chapter 7

Drivers of Growth: Technology, Policy, and Institutions ...........................................

71

Chapter 8

Business Cycles: An Introduction ...............................................................................

81

Chapter 9

The IS Curve ...............................................................................................................

89

Chapter 10

Monetary Policy and Aggregate Demand ...................................................................

97

Chapter 11

Aggregate Supply and the Phillips Curve ...................................................................

109

Chapter 12

The Aggregate Demand and Supply Model ................................................................

120

Chapter 13

Macroeconomic Policy and Aggregate Demand and Supply Analysis .......................

136

Chapter 14

The Financial System and Economic Growth .............................................................

152

Chapter 15

Financial Crises and the Economy ..............................................................................

162

Chapter 16

Fiscal Policy and the Government Budget ..................................................................

174

Chapter 17

Exchange Rates and International Economic Policy ...................................................

190

Chapter 18

Consumption and Saving ............................................................................................

205

Chapter 19

Investment ...................................................................................................................

220

Chapter 20

The Labor Market, Employment, and Unemployment ...............................................

230

Chapter 21

The Role of Expectations in Macroeconomic Policy ..................................................

240

Chapter 22

Modern Business Cycle Theory ..................................................................................

251

Epilogue

Policy and Practice: Where Do Macroeconomists Agree and Disagree? ....................

259

Web Chapter

Financial Crises in Emerging Market Economies .......................................................

261

.

Web Chapter Financial Crises in Emerging Market Economies ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Dynamics of Financial Crises in Emerging Market Economies Stage One: Initiation of Financial Crisis Stage Two: Currency Crisis Stage Three: Full-Fledged Financial Crisis Application: Crisis in South Korea, 1997–1998 Financial Liberalization/Globalization Mismanaged Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean Crisis Stock Market Decline and Failure of Firms Increase Uncertainty Adverse Selection and Moral Hazard Problems Worsen and Aggregate Demand Falls Currency Crisis Ensues Final Stage: Currency Crisis Triggers Full-Fledged Financial Crisis Recovery Commences Application: The Argentine Financial Crisis, 2001–2002 Severe Fiscal Imbalances Adverse Selection and Moral Hazard Problems Worsen Bank Panic Begins Currency Crisis Ensues Currency Crisis Triggers Full-Fledged Financial Crisis Recovery Begins Policy and Practice: Preventing Emerging Market Financial Crises Beef Up Prudential Regulation and Supervision of Banks Encourage Disclosure and Market-Based Discipline Limit Currency Mismatch Sequence Financial Liberalization

Overview and Teaching Tips This Web chapter is for instructors who want to have a more international orientation of their courses. It extends the analysis in Chapter 15 on financial crises to economies that are just entering the world marketplace. The analysis is parallel to that in Chapter 15, with Figure W.1, which is similar to Figure 15.1, outlining the dynamics of financial crises in emerging market economies. Then the chapter takes

.

262

Mishkin • Macroeconomics: Policy and Practice, Second Edition

students through two detailed applications, South Korea in 1997–1998 and Argentina in 2001–2002, to illustrate how useful the analysis in the chapter is.

I have found that my students particularly enjoy the discussion of the crazy government policies that promote financial crises in emerging market countries, and I spend a lot of time on this in the case on South Korea because the perverse policies to help out the chaebols, who had enormous influence on South Korean politics. Similarly, I spend a lot of time in the case on Argentina discussing how severe fiscal imbalances led to policies that encouraged banks to take on government debt, which eventually was to be their downfall.

Once the case discussions are finished, students can use the material at the end of the chapter to debate differing policies to prevent future emerging market financial crises. They also enjoy the global box on the Icelandic financial crisis because it illustrates how advanced economies can find themselves in similar circumstances to emerging market economies and be subjected to the enormous costs of financial crises.

◼

Answers to End-of-Chapter Questions

1. Mismanagement of financial liberalization or financial globalization that leads to excessive risk taking by financial institutions that eventually blows up and leads to a financial crisis. The second cause is severe fiscal imbalances that lead to a sovereign debt crisis that ends up destroying the balance sheets of financial institutions, which then leads to a financial crisis.

2. If financial liberalization and globalization are not done properly, financial institutions have tremendous incentives to take on risk and a lending boom ensues. When the lending boom crashes, it destroys the balance sheets of financial institutions, which hinders their ability to do financial intermediation, which increases moral hazard and adverse selection problems, so financial markets seize up. In addition, the destruction of financial institutions’ balance sheets makes it difficult for a country’s central bank to raise interest rates, and this can lead to a currency crisis, which then precipitates a financial crisis.

3. Severe fiscal imbalances can result in governments encouraging financial institutions to buy the government debt. Then when the government is unable to repay the debt, financial institutions suffer substantial losses. The resulting destruction of their balance sheets hinders the ability of financial institutions to do financial intermediation, which increases moral hazard and adverse selection problems, so financial markets seize up. In addition, the destruction of financial institutions’ balance sheets makes it difficult for a country’s central bank to raise interest rates, and this can lead to a currency crisis, which then precipitates a financial crisis.

4. A rise in interest rates as a result of rising interest rates abroad increases moral hazard and adverse selection problems, while a collapse in the stock market decreases the net worth of firms, which also increases moral hazard and adverse selection problems. Failures of prominent financial firms also increase uncertainty and makes asymmetric information worse, again increasing adverse selection and moral hazard problems. All of these contribute to financial markets seizing up and thus help promote financial crises.

5. Deterioration in bank balance sheets makes it difficult for central banks to raise interest rates to defend the currency because if they do so it will make banks worse off. Once speculators recognize this, they have a one-way bet and will start selling off the currency, which can result in a collapse of the currency and a currency crisis. Severe fiscal balances, besides leading to a deterioration of bank balance sheets if a sovereign debt crisis occurs, can also contribute directly to a currency crisis,

.

Web Chapter

Financial Crises in Emerging Market Economies

263

because once investors in the government debt suspect they will not be paid back, they will sell off the currency, which can trigger a currency crisis.

6. With debt contracts denominated in foreign currency, the debt burden of domestic firms increases when there is an unanticipated decline in the value of the domestic currency. Because assets are typically denominated in domestic currency, there is a resulting deterioration in firms’ balance sheets and a decline in net worth, which then increases adverse selection and moral hazard problems. The increase in asymmetric information problems leads to a decline in investment and economic activity.

7. The financial crises increased financial frictions sharply, which caused the aggregate demand curve to shift sharply to the left. In addition, the currency crisis which led to a collapse in the value of the domestic currency increased the cost of imports, thereby shifting the short-run aggregate supply curve upward. The result was a rise in inflation and a sharp decline in output.

8. They can put in place regulations to increase the amount of bank capital so banks have a greater cushion if they suffer loan losses and also have greater incentives to pursue safer investments because they have more to lose. Prudential supervision can also encourage banks to have better risk management, which will make excessive risk-taking less likely. Emerging market countries can also devote more resources to bank supervisors, so they are able to effectively monitor banks to keep them from taking on too much risk. All of these steps would make banks more able to withstand negative shocks and would reduce risk taking, thereby making the likelihood of a banking and a financial crisis much lower.

9. Emerging market countries can adopt regulations or impose taxes that restrict businesses from borrowing in foreign currencies. Prudential regulation and supervision of banks can limit them from borrowing in foreign currencies. Moving to a flexible exchange rate system reveals the risk of borrowing in foreign currencies, and so less foreign-currency borrowing may then result. Monetary policy that promotes price stability will make it more desirable to borrow in domestic currency, making currency mismatch less likely.

10. Emerging market countries might want to implement financial liberalization and globalization gradually because this would give them time to set up better prudential regulation and supervision to limit risk taking by financial institutions.

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: Crisis in South Korea: 199 –1998 Data Source Federal Reserve Bank of St. Louis database (FRED):

http://research.stlouisfed.org/fred2/series/BPBLTD01KRQ637S?cid=32286. Here you can find data about South Korea’s current account balance (exports minus imports). Change the graph dates (click “Edit Graph”) to 1995 to 1999 and compare it with Figure W.7 in the web chapter. Note that the current account balance improves sharply as the won depreciates, thereby contributing to South Korea recovery from the crisis.

.

264

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Related Article Hahm, Joon Ho and Frederic S. Mishkin, “Causes of the Korean Financial Crisis: Lesson for Policy”: http://www.nber.org/papers/w7483. In this paper, you can find a rigorous analysis of the South Korean crisis of 1997 . Check pages 57 to 64 for data about economic indicators before and after the crisis.

Discussion Question As shown in the textbook and the data sources, South Korea benefited partially from the depreciation of its currency, which resulted in an increase in their net exports in the aftermath of the financial crisis.

Comment on the pros and cons of a sharp depreciation of the local currency.

Answer: A sharp depreciation of the local currency will lower the price of domestic production and thereby increase exports. At the same time it increases the price of imports, resulting in an improvement of the current account balance. However, a couple of caveats apply. One is that if a country relies heavily on imports to supply important raw materials or energy, this could result in a huge increase in production costs for the private or public sector. In addition, if many debtors have their debts denominated in foreign currency, the depreciation of the local currency will significantly increase the burden of their debt. In most financial crisis in emerging countries, the depreciation of the local currency is not a policy choice, but rather a consequence of the crisis, but it is important to consider its effects. For example, many emerging economies have encouraged their banking systems to lend only in their local currencies, precisely to avoid the potential problem described above.

B. For Information About Application: The Argentine Financial Crisis: 2001– 2002 Data Source The Guardian, “Timeline: Argentina’s Economic Crisis”: http://www.theguardian.com/world/2001/dec/20/argentina1. Here you can find a timeline that identifies the most important events leading to the financial crisis described in the textbook.

Related Article Federal Reserve Bank of San Francisco, “Learning from Argentina’s Crisis”: http://www.frbsf.org/economic-research/publications/economic-letter/2002/october/learning-fromargentina-crisis/. This paper analyses the Argentinean financial crisis, including a comparison with the South Korean crisis.

Discussion Questions How would you avoid the problem of provinces controlling a large percentage of public spending but the federal government being in charge of collecting revenue in Argentina? Why do you think this would be an important issue to solve?

Answer: Solving this problem would be very important for Argentina because it is a constant source of trouble for every government. As stated in the textbook, this structure makes it very difficult for the federal government to control the budget, thereby casting constant doubts about the Argentinean government to honor its debt payments. Whenever the Argentinean economy suffers a negative shock, analysts wonder about the government ability to pay back its debt and how it will solve that problem.

Maybe a way out of this problem is to hold provinces more accountable for their public spending and maybe allow provinces to raise part of their revenue. This, however, may debilitate the implicit power exerted by the federal government.

.

Web Chapter

Financial Crises in Emerging Market Economies

265

C. For Information About Policy and Practice: Preventing Emerging Market Financial Crises Data Source Giordano, Claire, “Prudential Regulation and Supervision Instruments and Aims: a General Framework”: http://www.bancaditalia.it/studiricerche/convegni/atti/Financial_Market_Regulation/background_paper/gi ordano.pdf. In this paper, you can find a list of prudential supervision measures recommended by two authors (Mishkin and White); check table 1 on page 3.

Related Article Mishkin, Frederic S., “Prudential Supervision: Why Is It Important and What are the Issues?”: http://www.nber.org/papers/w7926. In this paper, the author of the textbook outlines the most important characteristics and goals of prudential supervision.

Discussion Question As a potential solution to currency mismatch and other problems experienced by emerging markets economies facing financial crises, some authors have proposed the adoption of a foreign currency, like the U.S. dollar, a concept known as “dollarization”. Based on this paper, http://research.stlouisfed.org/publications/review/01/11/29-40Antinolfi.pdf, comment on the impacts that such a policy could have on an emerging market economy.

Answer: Dollarizing an economy has potential benefits, and a few countries (as explained in the paper) have chosen to follow this recommendation and harvested some interesting results (e.g., no currency mismatch, low inflation). However, one needs to consider that abandoning the use of a local currency means abandoning the possibility of conducting independent monetary policy. This is in general a good idea only if the government recognizes that it cannot handle its own monetary policy or that the U.S. monetary policy (that the emerging country will implicitly adopt) is superior to the domestically designed monetary policy. In addition, usually societies are reluctant to abandon their local currencies, which can potentially make things difficult during the transition to a fully dollarized economy.

.

Chapter 1 The Policy and Practice of Macroeconomics ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline The Practice of Macroeconomics The Process: Developing Macroeconomic Models The Purpose: Interpreting Macroeconomic Data Macroeconomic Policy How Can Poor Countries Get Rich?

Is Saving Too Low? Do Government Budget Deficits Matter?

How Costly Is It to Reduce Inflation?

How Can We Make Financial Crises Less Likely?

How Active Should Stabilization Policy Be? Should Macroeconomic Policy Follow Rules?

Are Global Trade Imbalances a Danger?

How We Will Study Macroeconomics Emphasis on Policy and Practice Concluding Remarks

Chapter Overview and Teaching Tips The first chapter of this textbook has several objectives. The first is to convince students that macroeconomics is worth studying. This chapter pursues this goal by showing the student that macroeconomics is an exciting field because it focuses on phenomena that affect everyday life. A second objective of the chapter is to help the student understand what the practice of macroeconomics is all about and what central policy issues are addressed in the study of macroeconomics. Finally, the chapter provides an overview for the entire book, previewing the topics that will be covered in later chapters. The chapter also provides students with a guide as to how they will be studying macroeconomics, by explaining and developing macroeconomic models and then applying these models to understand the policy and practice of macroeconomics.

In teaching this chapter, the most important goal should be to motivate students by getting them excited about what they are about to learn. I have found that there are two ways to do this. First is to talk about the basic macroeconomic data in Figures 1.2 to 1.10 and explain that numerous real world applications in the book will be used to show how macroeconomic analysis can explain this data. Second is to have the students give their initial reactions to the eight basic policy questions posed in the chapter: How can poor countries get rich? Is saving too low? Do government budget deficits matter? How costly is it to reduce inflation? How can we

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

2

make financial crises less likely? How active should stabilization policy be? Should macroeconomic policy follow rules? Are global trade imbalances a danger?

Once they have given their initial views, the instructor can tell the students that they will have much clearer understanding of these issues when they have finished the course and will have mastered analytic frameworks that can help them have informed views about the issues.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Preview 1. Economic growth, labor market conditions (the unemployment rate and growth in the number of jobs), inflation, the value of the U.S. dollar, and changes in economic policy measures such as interest rates and tax rates all will have significant impacts on your future.

The Practice of Macroeconomics 2. Endogenous variables are the variables whose behavior a model seeks to explain. Changes in the values of these variables are explained in terms of changes in exogenous variables, whose values are not explained by the model but instead are determined outside the model and taken as given. For example, an economist might build a model to explain why inflation rates differ over time and across countries based on changes in money supply growth. In this model, the inflation rate is the endogenous variable, and money supply growth is the exogenous variable.

3. First, identify the question of interest and decide which endogenous variables the model will seek to explain. Then decide which exogenous variables will be used to explain the endogenous variables of interest. Third, express the model in equation or graphic form that will relate changes in the endogenous variables to changes in the exogenous ones. Fourth, compare the predictions of the model with data for the endogenous and exogenous variables. Finally, if the model fits (explains) the data well, use it to make predictions and analyze policy. If it doesn’t explain the data well, then revise the model and try again.

4. Real gross domestic product, which measures an economy’s aggregate output, is important because it gives information about both long-term growth and short-run fluctuations of output. The unemployment rate measures how fully labor resources are being used in the economy and how widespread the economic hardship experienced by unemployed workers may be. The inflation rate gives an overall measure of how rapidly prices are rising and signals how serious the costs of inflation may be at any given time.

5. The business cycle is a sequence of recurring but irregular fluctuations in economic activity. A recession is the period of the business cycle during which economic activity is declining. Macroeconomists study business cycles and are particularly concerned with the causes of recessions and depressions.

6. During periods of inflation, the overall level of prices rises. It falls during deflationary periods.

Macroeconomic Policy 7. A nation’s saving rate is the percentage of income that is saved each year. Nations with higher saving rates tend to also have higher investment levels, which promotes their economic growth. A higher saving rate also means that individuals and households will be better prepared to cope with the potentially severe financial problems they may encounter during a recession. Government policies may encourage or discourage saving and the saving rate. All these factors make the saving rate an important macroeconomic concern.

.

Chapter 1

The Policy and Practice of Macroeconomics

3

8. When government has a budget deficit, it is spending more than the tax revenues it collects and, therefore, must borrow money and go deeper into debt. Macroeconomists have concerns about the size of budget deficits, the burden deficits may impose on future generations facing higher taxes to pay off the government’s debt, and the inflation that may result if a government decides to print more money to cover its deficit and debt. The degree of these concerns increases with the size of the budget deficit.

9. Fiscal policy refers to a government changing its taxes or spending or both. Monetary policy is a central bank’s control of interest rates and the amount of money in an economy. These policies are used for such purposes as influencing an economy’s saving rate, reducing or expanding the size of a government’s budget deficit, influencing the inflation rate and unemployment rate in an economy, or limiting business cycle fluctuations and stabilizing economic activity.

10 Stabilization policy is the use of fiscal and monetary policies to stabilize economic activity by reducing business cycle fluctuations. One debate concerns how active stabilization policy should be. It pits nonactivists, macroeconomists who believe that the economy has a self-correcting mechanism that works rapidly to reduce unemployment without the need for stabilization policy, against activists, who think this self-correcting mechanism is too slow and therefore call for the active use of fiscal and monetary policies to reduce unemployment when it is unacceptably high. A second debate arises between macroeconomists who advocate the use of policy rules to specify in advance precisely how policymakers must react to changes in unemployment or inflation and those who would allow policymakers greater latitude to use their discretionary judgment to formulate the policy response they believe is most appropriate in a given situation.

11 Global trade imbalances occur when some countries run large trade deficits and become increasingly indebted to and dependent on large capital inflows from other countries that are running large trade surpluses. These imbalances are not sustainable in the long run. Economists focus on them because a ready supply of funds from abroad can result in too much investment in particular asset markets, and if the flows are reduced suddenly, it can lead to financial crises, which have detrimental effects on economic activity.

Answers to Problems The Practice of Macroeconomics 1. a.

The endogenous variable is the variable explained by your model, in this case, the prevalence of diabetes in children. The exogenous variable is a variable that is determined outside the model and that presumably has an impact on the endogenous variable. In this case, a child’s weight would be the exogenous variable. b. Other exogenous variables should include factors that one way or another might contribute to diabetes: hours of exercise, income level, education, etc. Choosing the proper exogenous variables and testing their effects is an important part of advancing scientific knowledge.

2. A model is as good as its predictive power, in terms of explaining both previous and future changes in the explained variable. If a current model does not “fit the data,” meaning that it cannot replicate current trends in diabetes prevalence, then the researcher has to go back to step 2 and look for other explanatory variables. This process should be repeated until the model can explain current trends and, therefore, can be used to predict future changes.

3. a. According to the graph, Spain’s real GDP growth rate decreased from the first quarter of 2007 until the third quarter of 2009. After that the growth rate rose but reached a peak of only 0.6 percent in the third quarter of 2011 and then turned negative again in 2012. Thus, the overall trend for the Spanish growth rate has been downward.

.

4

Mishkin • Macroeconomics: Policy and Practice, Second Edition

b. According to data, Spain experienced a recession from the first quarter of 2009 until the third quarter of 2010. However, Spain entered another recession in the first quarter of 2012, when its real GDP growth rate again became negative. Although the real GDP growth rate is not the only indicator of a recession, it usually moves together with other indicators such as the unemployment rate or investment.

4. Although unemployment definitely has negative consequences in terms of decreased production of goods and services, that is not the only reason why it is such an important macroeconomic topic.

Most modern societies are structured based on the idea that individuals need a job to provide for themselves and their families. An individual’s inability to find a job will have important psychological (e.g., depression, lack of confidence) and social (e.g., rejection, lower status) consequences. These considerations will play a crucial role in evaluating potential solutions to mitigate these negative effects (e.g., unemployment insurance).

Macroeconomic Policy 5. Budget deficits by themselves are not inherently good or bad. However, as we will study later, they can be the source of inflation if governments pay for a budget deficit by printing money. Very high inflation rates (sometimes in excess of 50 percent per month) have a disastrous effect on any economy.

High inflation rates decrease incentives to invest and distort relative prices, making economic decisions more difficult. High inflation rates for a sustained period eventually translated into stagnating or decreasing real GDP growth rates in Latin American countries, making this experience an example to avoid. Subsequent (and costly) economic reforms put these countries on the right track again, mostly by reducing budget deficits and inflation.

6. a. The immediate effect of the destruction created by a civil war is a decrease in the economy’s ability to produce goods and services. Goods cannot be moved from producer to buyers, and fewer individuals are able or willing to work during a civil war, decreasing the labor force and work opportunities. Countries with a history of frequent civil wars have significantly lower real GDP growth rates than countries with more stable political regimes. b. A civil war kills incentives to invest, which implies postponing present consumption and putting resources away in order to increase future consumption. The chaos and uncertainty created by a civil war increase incentives for present consumption and, therefore, result in lower economic growth. As we will study later, investment is a major driving force for economic growth.

.

Chapter 1

The Policy and Practice of Macroeconomics

5

7. As a financial crisis develops, businesses find it more difficult to get access to external funds and, therefore, cannot meet their obligations. This results in business failures as well as rising unemployment. At the same time, the decrease in asset prices translates into a decrease in consumption expenditures, decreasing demand for most goods and services. Businesses respond by firing workers, which increases unemployment even more. It is now more difficult to create new jobs, as credit is restricted and demand is uncertain, which decreases investment and, therefore, directly affects economic growth. Financial crisis are usually associated with decreases in real GDP. 8. The fact that Americans currently are not saving enough might have very important implications for future generations. One of them is that future generations might face higher taxes than present generations to pay for the debt accumulated to allow higher current consumption by the present generation. Higher future taxes might result in lower standards of living, as future generations will have to set aside a higher percentage of their income to pay for taxes. Another implication of this situation is that future generations should expect to receive less help from their children to support them when they retire. This follows from the fact that their children will probably face higher taxes.

We will later study the different policies that can affect incentives to save for the future.

9. According to the post, the American Recovery and Reinvestment Act was a policy instrument designed to affect the economic environment and lift the American economy from its recession. This constitutes a typical activist policy, in which the government takes action using either fiscal or monetary policies (or both) to spur consumption and investment and create jobs. Not surprisingly, many nonactivist policymakers criticized the current administration for following this path, arguing that such a set of policies will do more harm than good to the economy. The debate about activist and nonactivist policy is fascinating and will be discussed later.

10. There is little doubt that actions taken by the Federal Reserve (some of them in coordination with the U.S. Treasury) in the aftermath of the subprime financial crisis were necessary to restore confidence in the U.S. financial system. A significant part of these actions involved providing liquidity to different participants in the financial system. This fueled fears of higher inflation rates in the future, as persistent increases in the money supply usually result in high inflation rates, as will be discussed later. Inflation, however, remained at low rates during 2008 and 2009, and expected inflation rates did not increase significantly, as detractors of the Federal Reserve’s approach forecasted. The relationship between monetary policy and inflation is far from simple. However, it is crucial to understand the effects of monetary policy on inflation because high inflation can be detrimental for economic growth.

11. a. The American Recovery and Reinvestment Act of 2009 can be considered an example of discretionary macroeconomic policy. It was essentially a set of policies intended to support economic agents affected by the subprime financial crisis and to promote economic recovery. b. One of the fears related to conducting discretionary policy is that agents will come to expect that the government will react to accommodate unusual economic downturns. This becomes a problem when financial intermediaries expect government assistance when there is a financial crisis. It also affects incentives for households that come to expect some type of support during contractions. In this sense, this problem looks very much like raising children: If kids expect to be “bailed out” when they do not behave as asked, then it is quite possible that their incentives to behave properly decrease. From the point of view of financial intermediaries, this would mean that they do not have a huge incentive to appropriately price risks.

◼

Answers to Data Analysis Problems

1. PINCOME is exogenous, and PCEC is endogenous; M1SL and PAYEMS are unrelated; GS10 is exogenous, and PSAVERT is endogenous. Scatterplots are shown below.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

PCEC (billions of dollars)

Personal Income vs Consumption, Quarterly, 1980:1 - 2013:1 12000.0 10000.0 8000.0

6000.0 4000.0 2000.0 0.0 0.0

2000.0 4000.0 6000.0 8000.0 10000.012000.014000.016000.0

PINCOME (billions of dollars)

Total Nonfarm Payroll (PAYEMS) vs. M1 Money Supply (M1SL), monthly 2000:1 to 2013:5 3000.0 PAYEMS (thousands)

6

2500.0 2000.0 1500.0 1000.0 500.0 0.0 128000

130000

132000

134000

136000

M1SL (billions of dollars)

.

138000

140000

Chapter 1

The Policy and Practice of Macroeconomics

Personal Saving Rate (PSAVERT) vs. 10 year US Treasury Rate (GS10), monthly, 1980:1 to 2013:4 14.0

PSAVERT (percent)

12.0 10.0 8.0 6.0 4.0

2.0 0.0 0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

GS10 (percent)

2. Data from 2000 Q1 to 2013 Q1 are shown below, with recessions highlighted. a. The highest inflation rate was 4.2percent in the third quarter of 2008. The lowest was –0.8 percent in the third quarter of 2009. Deflation occurred in the second and third quarter of 2009. b. The highest GDP growth rate was 5.4 percent in the second quarter of 2000. The lowest growth rate was –4.6 percent in the second quarter of 2009. c. In general, the periods of recession tend to have the lowest inflation rates and the lowest GDP growth rates.

Date PCE Inflation Rate GDP Growth Rate 2000-01-01 2.6 4.2 2000-04-01 2.4 5.4 2000-07-01 2.5 4.1 2000-10-01 2.5 2.9 2001-01-01 2.3 2.3 2001-04-01 2.3 1.0 2001-07-01 1.8 0.6 2001-10-01 1.3 0.4 2002-01-01 0.8 1.6 2002-04-01 1.1 1.5 2002-07-01 1.6 2.3 2002-10-01 2.0 1.9 2003-01-01 2.5 1.5 2003-04-01 1.8 1.8 2003-07-01 1.9 3.0 2003-10-01 1.9 3.9 2004-01-01 2.0 4.1 2004-04-01 2.7 3.9 2004-07-01 2.7 3.0 2004-10-01 3.0 2.9 2005-01-01 2.8 3.3 2005-04-01 2.7 3.1 2005-07-01 3.2 3.1 2005-10-01 3.2 2.8

.

7

8

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Date 2006-01-01 2006-04-01 2006-07-01 2006-10-01 2007-01-01 2007-04-01 2007-07-01 2007-10-01 2008-01-01 2008-04-01 2008-07-01 2008-10-01 2009-01-01 2009-04-01 2009-07-01 2009-10-01 2010-01-01 2010-04-01 2010-07-01 2010-10-01 2011-01-01 2011-04-01 2011-07-01 2011-10-01 2012-01-01 2012-04-01 2012-07-01 2012-10-01 2013-01-01

PCE Inflation Rate 3.1 3.2 2.8 1.9 2.4 2.5 2.4 3.5 3.4 3.7 4.2 1.7 0.2 –0.5 –0.8 1.4 2.4 2.1 1.7 1.5 1.8 2.6 2.8 2.5 2.4 1.6 1.5 1.6 1.2

3. a.

GDP Growth Rate 3.0 3.0 2.2 2.4 1.2 1.7 2.5 2.2 1.6 1.0 –0.6 –3.3 –4.2 –4.6 –3.3 –0.1 1.9 2.5 2.8 2.4 1.8 1.9 1.6 2.0 2.4 2.1 2.6 1.7 1.8

Germany experienced the highest unemployment rate in 2005 at 11.2 percent; Japan experienced the lowest unemployment rate in 2007 at 3.6 percent. b. During years of recession shown in the table, the average unemployment rate is 6.6 percent.

When not in recession, the unemployment is lower at 6.2 percent. This is expected because the unemployment rate rises during recessions and falls during expansions. c. There are clear similarities between the unemployment rates of the United States, Canada, United Kingdom, and Japan. They generally move up and down together. The outlier is Germany, which experienced much higher unemployment than the other countries but has had steady declines in their unemployment rate while many others have experienced high unemployment from the last recession.

.

Chapter 1

The Policy and Practice of Macroeconomics

9

Graph and table are shown below, from 2000 to 2012. The bold indicates a year in which the United States was in recession.

Date 2000-01-01 2001-01-01 2002-01-01 2003-01-01 2004-01-01 2005-01-01 2006-01-01 2007-01-01 2008-01-01 2009-01-01 2010-01-01 2011-01-01 2012-01-01

United States 4.0 4.7 5.8 6.0 5.5 5.1 4.6 4.6 5.8 9.3 9.6 8.9 8.1

Canada 6.1 6.5 7.0 6.9 6.4 6.0 5.5 5.2 5.3 7.3 7.1 6.5 6.3

4. a.

United Kingdom 5.5 5.1 5.2 5.0 4.8 4.9 5.5 5.4 5.7 7.6 7.9 8.1 8.0

Japan 4.4 4.5 4.9 4.6 4.2 3.8 3.6 3.6 3.7 4.8 4.7 4.2 3.9

Germany 7.8 7.9 8.6 9.3 10.3 11.2 10.3 8.7 7.6 7.8 7.1 5.9 5.5

The United States has the highest standard of living according to the data; China has the lowest among the five. b. South Korea’s standard of living has steadily improved over time and has closed a significant gap with Japan and the United Kingdom. In 1990, the gap was $17,694 per person compared to Japan and $12,794 per person compared to the United Kingdom; in 2011, the gap shrunk to $4,040 and $5,434 per person, respectively. c. Although China’s standard of living is much lower overall, it has grown rapidly during the last two decades, from around $674 per person in 1990, to almost $4,500 per person in 2011, a 563 percent increase; South Korea has the next highest growth over that period (152 percent),

.

10

Mishkin • Macroeconomics: Policy and Practice, Second Edition

followed by the United Kingdom (44 percent), United States (33 percent), and Japan (16 percent).

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Nominal and Real GDP Data Sources Bureau of Economic Analysis: http://www.bea.gov/ . BEA is an agency of the Department of Commerce.

Along with the Census Bureau and STAT-USA, BEA is part of the department’s Economics and Statistics Administration. BEA produces economic accounts statistics that enable government and business decision makers, researchers, and the American public to follow and understand the performance of the nation’s economy. To do this, BEA collects source data, conducts research and analysis, develops and implements estimation methodologies, and disseminates statistics to the public.

Related Articles Henderson, David R., “GDP Fetishism”: http://www.econlib.org/library/Columns/y2010/HendersonGDP.html#. This article analyzes GDP’s methodology and economists’ reliance on such measure.

Discussion Questions Do you think GDP is a good measure of individuals’ well-being? Why or why not?

Answer: In general, there is some consensus about the fact that GDP is not a perfect measure of individual well-being. Many methodological (i.e., measurement) problems plague this approach to measuring economic activity (or a nation’s income). However, the GDP measure has some advantages, like allowing cross-country comparisons and being highly correlated with other measures of individual welfare.

.

Chapter 1

The Policy and Practice of Macroeconomics

11

B. For Information About Inflation and Unemployment Data Source Bureau of Labor Statistics: http://www.bls.gov/. The Bureau of Labor Statistics is the principal fact-finding agency for the federal government in the broad field of labor economics and statistics. BLS is an independent national statistical agency within the Department of Labor that collects, processes, analyzes, and disseminates essential statistical data to the American public, congress, other federal agencies, state and local governments, business, and labor. BLS also serves as a statistical resource to the Department of Labor.

Related Article Summers, Lawrence H., “Unemployment”: http://www.econlib.org/library/Enc/Unemployment.html. This article discusses how unemployment is measured and how unemployment figures should be interpreted.

Discussion Question Discuss the implications of a decrease in the official unemployment rate for teenagers.

Answer: The official unemployment rate is an average for all participants of the U.S. labor force. Although a decrease in the official unemployment rate might seem like good news for teenagers, one should check the unemployment rate for teenagers. The latter is usually higher than the former, meaning that teenagers suffer from higher unemployment rates than the rest of the population.

C. For Information About the Policy and Practice of Macroeconomics Data Source Information about macroeconomic variables (e.g., GDP, inflation, unemployment, savings rate) can be found at: http://research.stlouisfed.org/fred2/. This is a comprehensive database created and updated by the Federal Reserve Bank of St. Louis.

Related Articls Library of Economics and Liberty search page: http://www.econlib.org/cgi-bin/searchbooks.pl?query=scientific+method&andor=and (check the following authors: Mill, Marshall, and Say).

Discussion Question What is the object of studying the science of economics in general and macroeconomics in particular?

Answer: In general, the science of economics studies how individuals (or societies) allocate scarce resources to multiple ends. This implies identifying the relevant constraints and preferences (including incentives) that guide our decisions. Macroeconomics deals with topics that affect the whole economy (e.g., the role of the government, economic growth, monetary economics, unemployment, and inflation).

Macroeconomics’ methodology is mostly borrowed from microeconomic analysis.

D. For Information About the Dating of Business Cycles Data Source The National Bureau of Economic Research: http://www.nber.org/. Founded in 1920, the National Bureau of Economic Research is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. The NBER is committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.

.

12

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Related Article Krugman, Paul, “The Third Depression”: http://www.nytimes.com/2010/06/28/opinion/28krugman.html.

In this article, Nobel Prize winner Paul Krugman describes the effects of the most recent recession and comments on the policy measures designed to reduce its adverse effects.

Discussion Question Using data from the NBER, the BLS, and the BEA, characterize the 2007–2009 recession in terms of duration, changes in unemployment, inflation, and real GDP. Answer: According to the NBER, the last recession lasted for 18 months: December 2007 until June 2009.

During this period, unemployment increased from 5.0 percent to 9.5 percent, monthly inflation rates remained low (around 0.4 on average) and were negative at some point. Finally, real GDP dropped by 4.1 percent during the 18-month period.

.

Chapter 2 Measuring Macroeconomic Data ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Measuring Economic Activity: National Income Accounting Measuring GDP: The Production Approach Market Value Final Goods and Services Newly Produced Goods and Services Fixed Period of Time Policy and Practice: Can GDP Buy Happiness?

Measuring GDP: The Expenditure Approach Consumption Expenditure Investment Government Purchases Net Exports Changes in the Spending Components of GDP over Time Measuring GDP: The Income Approach Categories of Income Income Measures Real Versus Nominal GDP Nominal Variables Real Variables Chain-Weighted Measures of Real GDP Measuring Inflation GDP Deflator PCE Deflator Consumer Price Index Policy and Practice: Policy and Overstatements of the Cost of Living Inflation Rate Percentage Change Method and the Inflation Rate Measuring Unemployment Macroeconomics in the News: Unemployment and Employment Measuring Interest Rates Types of Interest Rates

.

14

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Macroeconomics in the News: Interest Rates Real Versus Nominal Interest Rates The Important Distinction Between Real and Nominal Interest Rates

Chapter Overview and Teaching Tips This chapter examines how economists define and measure the most important data in macroeconomics.

Some instructors will want to cover this material in detail in class, but others will prefer to just cover the main points and let students read the chapter on their own as background.

There is no way around it: National income accounting is not the most exciting of topics. Yet it is important, as the preview to the chapter indicates. Students need to be exposed to a basic concept like Gross Domestic Product and how it is measured. Similarly, they need to understand what the data on unemployment, the consumer price index (CPI), inflation, and real interest rates means and how measurement of this data is not always completely straightforward.

Although the material in this chapter can be dry, discussing in class the Policy and Practice cases in the chapter, “Can GDP Buy Happiness?” and “Policy and Overstatements of the Cost of Living,” liven up the material. It also helps students recognize that understanding and measuring macroeconomic data is important to getting policy right.

This chapter introduces “Macroeconomics in the News” boxes, which contain news items and data that are reported daily in the press. These boxes help explain what data are reported on regularly, how to find it, and how to read it. They encourage students to start paying more attention to the data that feature so prominently in macroeconomics.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Measuring Economic Activity: National Income Accounting 1. The fundamental identity of national income accounting states that Total Production = Total Expenditure = Total Income. Its significance is that macroeconomists can define and measure gross domestic product in three ways: by totaling either the value added in production or the expenditures to buy goods and services or the incomes earned by households, business firms, and government.

Measuring GDP: The Production Approach 2. GDP is defined as the market value of all final goods and services newly produced in the economy during a fixed period of time. When a market value or price is not available for a good or service, its contribution to the value of total output is either ignored—as in the case of most household services and underground economic activity, imputed—as with the value of the services homeowners enjoy by living in their houses, or considered to be equal to its cost of production—as is the case with the provision of government services, such as national defense and education. The value of intermediate goods and services that go into the production of final goods and services is included in value of the final products and, therefore, is not counted separately because doing so would result in double counting and cause GDP to overstate the amount of economic activity. GDP likewise omits purchases of used goods and imports, again to avoid overstating the value of the current time period’s production of goods and services.

3. A flow measure is a quantity per period of time and a stock measure is an amount at a given point in time. For example, your car’s speedometer, by telling you how fast you are driving in miles per hour, provides you a flow measure associated with a period of time. Its odometer gives you a stock measure

.

Chapter 2

Measuring Macroeconomic Data

15

of how many miles the car has been driven up to a particular point in time. GDP measures the value of final goods and services produced during a given time period; thus, it is a flow measure that indicates how much economic activity occurred per period of time.

4. Intermediate goods and services are used up completely in the production of final goods and services during a given time period. Because this is so, their value is completely incorporated into the value of those final goods and services and is not counted separately. This is not the case with capital goods and inventories. A capital good is a final good that is produced during a given time period and is then available to use in the production of other goods and services during one or more future time periods.

It is not completely used up during the time period in which it is produced, and therefore, it is not treated the same way an intermediate good is. Inventory investment, the change in business firms’ holdings of raw materials, unfinished goods, and unsold finished goods, represents the current production of both intermediate and final goods and services during a given time period that, like capital goods, will be available to help produce more goods and services in future time periods.

Because both capital goods and investment in inventories represent production in the current time period that can be used to assist in future production of goods and services, they are counted in the current time period’s GDP. Measuring GDP: The Expenditure Approach 5. According to the national income identity, GDP (Y) can be measured by summing consumption expenditure (C), investment expenditure (I), government purchases of goods and services (G), and net exports (NX). Consumption expenditure includes consumer durable goods, nondurable goods, and services. Investment expenditure includes business fixed investment (capital goods), inventory investment, and residential investment. Government purchases include spending on currently produced goods and services by federal, state, and local governments but do not include transfers such as payments for Social Security and unemployment insurance benefits. Net exports equal exports minus imports, so goods and services that domestic households, business firms, and governments purchase that are produced elsewhere are subtracted from GDP and not counted as domestic production.

Measuring GDP: The Income Approach 6. The major income items in national income are employee compensation, proprietors’ income, rental income of persons, corporate profits, and net interest. The total of these income categories does not equal the GDP because depreciation, which is treated as an expense and therefore reduces proprietors’ income and corporate profits, is not income for anyone else. The same is true of indirect business taxes. Furthermore, a country’s national income includes income its residents earn from productive activities in other countries, which do not contribute to the country’s GDP and excludes income nonresidents earn from their productive activities in the country that do contribute to its GDP. Adjusting national income by adding in depreciation, indirect business taxes, and factor income paid to the rest of the world, subtracting factor income received from the rest of the world, and adjusting for the (relatively small) statistical discrepancy that arises from measuring GDP in two different ways—the production approach and the income approach—reconciles the two approaches.

Real Versus Nominal GDP 7. Variables measured in terms of dollars or other monetary units, such as GDP and its various income and expenditure components, can be measured using either current market prices or the prices of a base year. The nominal value of a variable is measured using current market prices and will change when either current market price or quantity changes. Therefore, a change in a variable’s nominal value gives no information about whether or how much market price or quantity has changed. The measure of a real value, however, always uses the prices of a base year. Thus a variable’s real value changes only when quantity changes and is unaffected by changes in current market prices. For that

.

16

Mishkin • Macroeconomics: Policy and Practice, Second Edition

reason, real GDP rises only when the output of final goods and services rises and falls only when output falls and thus is a better measure of changes in economic activity and well-being.

8. The GDP deflator is a measure of the price level obtained by dividing nominal GDP by real GDP for a given time period. The personal consumption expenditure deflator measure of the price level uses just consumption expenditure rather than total GDP, so it is nominal personal consumption expenditure divided by real personal consumption expenditure for a given time period.

Measuring Inflation 9. The consumer price index (CPI) is a widely followed measure of the average prices of the goods and services a typical urban consumer purchases. The Bureau of Labor Statistics (BLS) conducts periodic expenditure surveys to determine the items in a typical urban consumer’s “basket of goods and services” and then collects data to determine the average cost of purchasing those items each month. This cost is compared to the cost of purchasing those same items in a base year whose index value is set to 100. The CPI figure reported each month, then, tells how high prices are relative to the base year. The percentage changes in the CPI from month to month measure the rate of increase in the price level—the inflation rate.

Measuring Unemployment 10. The unemployment rate, calculated monthly by the BLS, measures the fraction of civilians who want to work but do not have jobs. To estimate this fraction, the BLS surveys about 60,000 households each month and classifies people aged 16 and older as either employed (if they worked full time or part time or were temporarily away from their jobs), unemployed (if they did not work but looked for a job within the past four weeks or were laid off and waiting to be recalled), or not in the labor force (full-time students, retirees, people who choose to stay at home, and discouraged workers who would like to work but have not looked for a job within the past four weeks). Together the employed and unemployed make up the (civilian) labor force. The unemployment rate is the number of unemployed people divided by the labor force.

Measuring Interest Rates 11. A nominal interest rate is the interest rate stated on a loan or other financial instrument that is not adjusted for inflation. The nominal interest rate on a loan, for example, indicates how much money the borrower will pay in interest to the lender, but it does not measure that interest payment in real terms. It does not measure how much purchasing power the borrower will pay the lender. The real interest rate provides this measure because it adjusts for inflation. According to the Fisher equation, the real interest rate equals the nominal interest rate minus the expected inflation rate. This is an ex ante real interest rate because it indicates how well a lender expects to do in real terms at the time the loan is made. An ex post real interest rate, for which the actual inflation rate is subtracted from the nominal interest rate, measures how well the lender actually did in real terms after the fact.

Answers to Problems Measuring Economic Activity: National Income Accounting 1. It is not correct to assume that a household’s total income will equal its total expenditure. This might happen as a particular case, but in general, households choose either not to spend all their income (i.e., to save) or to spend more than their total income (i.e., to accumulate debt). This conclusion is the same if we consider a firm (rather than a household) that produces any good or service: Its income does not necessarily equal its expenditure. However, when we consider all economic agents together (i.e., firms, households, and the government), it is true that total income equals total expenditure.

Note that this conclusion does not imply that income must equal expenditure for all firms, households, and the government individually. This result is obtained by observing that each

.

Chapter 2

Measuring Macroeconomic Data

17

transaction has a buyer and a seller. Consequently, the value of that transaction represents income for one party and expenditure for the other, independently of which agent buys or sells the particular good or service.

Measuring GDP: The Production Approach 2. a.

According to the production approach, which measures GDP by adding the value added from each firm, GDP will increase in this case. This is interpreted as good news, as this measure is intended to measure economic activity. b. We cannot say that both countries are better off for sure. We can say that economic activity has increased in both countries, but GDP cannot measure, by definition, many important aspects of human welfare (including our perceptions about the environment). Theoretically, it is possible that the impact of pollution is so negative that it actually decreases the quality of life in these countries. We can say for sure that the inhabitants of Utopia will benefit more from this increase in economic activity than the inhabitants of Pandora, who value their environment twice as much.

Because individual preferences about issues like environmental protection are inherently difficult to measure, these considerations are often left out of the discussion and most policymakers focus only on the GDP measure when evaluating alternative policies. c. In this alternative scenario, inhabitants of Utopia will not benefit as much from the increased economic activity if it undermines one of their fundamental values: a more equal income distribution. As before, it might even be the case that inhabitants of Pandora will suffer a lot from observing a more skewed income distribution, but they will always benefit more from this situation than their counterparts in Utopia.

Measuring GDP: The Expenditure Approach 3. a.

A household purchase of a home built in 2005 will not affect GDP because only currently produced goods and services are considered by the GDP measure. Counting previously produced goods will overestimate GDP, as these goods were already counted the year they were produced. b. A household purchase of a newly built dishwasher will count toward GDP and will be included in consumption expenditure (as durable goods expenditure). c. A farmer’s purchase of a new tractor will be included in GDP as private investment because the farmer is adding to his or her machinery stock. This transaction will be considered fixed investment. d. An individual receipt of any type of transfer from the government (including tax credits) is not included in GDP because this transaction is not meant to pay for any currently produced good or service. e. A U.S. Department of Defense purchase of equipment could be considered government consumption or government investment. In this case, however, the helicopters are manufactured in another country, and therefore, this transaction will not affect GDP.

Measuring GDP: The Income Approach 4. a.

To calculate other income, subtract the figures for employee compensation and corporate profits from national income: Other income = $14,313 − $8,737 − $2,021 = $3,555 billion. b. Net factor income is the difference between gross national product, which measures the value of total income earned by U.S. residents from production that takes place anywhere in the world, and gross domestic product, which measures the income earned by anyone in the world from production that takes place in the United States. Thus, net factor income is $16,772 − $16,535 = $237 billion.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

18

Real Versus Nominal GDP 5. a.

Lucia is right. In order to properly assess whether a country and its residents are better off, one has to consider the evolution of real GDP, not nominal GDP. Real and nominal GDP might describe the same changes in economic activity, but this happens only under particular circumstances. Nominal GDP might increase even if the quantity of goods and services does not change or if it decreases (this last situation requires a significant enough increase in the price level). A decrease in the quantity of goods and services produced in an economy clearly does not make individuals better off. Mario is not considering the effect that price changes will have on nominal GDP and, therefore, might be making a mistake. Under the particular assumption that prices are not changing, then it is safe to use either nominal or real GDP to measure changes in economic activity and income. b. It is possible for Mario and Lucia to be worse off if the increase in prices described by Lucia is greater than the increase in their income. If their wages increased by 2 percent during these two years, and groceries and rent increased by 5 percent, then they would be unable to buy the same quantity of goods and services as two years ago. Usually all prices change at different rates, and situations as the one described happen quite often. It is also important to note that both nominal and real GDP are broad measures of economic activity and income and, therefore, should not be used to describe particular individual’s cases.

Measuring Inflation 6. a.

If transportation services for the typical U.S. household increase by 10 percent, one can calculate the change in CPI caused by this price change, assuming that no other price has changed. The CPI change can be calculated as: 10%  15% = 1.5%. b. According to the previous information, you will probably not spend 15 percent of your monthly wage in transportation. This means that your consumption pattern does not match the consumption pattern of the typical household. This usually results in over- or under-estimation of changes in your true cost of living as measured by changes in the CPI. In this case, even if the CPI is showing an increase in the cost of living, your cost of living has probably not changed by much; definitely less than 1.5 percent. A more interesting case involves the indexation of Social Security payments to the elderly (i.e., retirees). Social security payments are updated to consider changes in the cost of living, as measured by changes in the CPI. However, the elderly spend a higher percentage of their income on medical services (a category that has experienced a significant price increase lately) than the typical household. This results in an underestimation of the true cost of living for the elderly as measured by the CPI. 7. There are at least two problems that the current CPI methodology faces when measuring the change in the cost of living derived from this scenario. One of them involves the introduction of new goods and the corresponding increase in consumer welfare. The consumer basket is a list of many goods and services that is updated every few years (sometimes as long as 10 years) and often misses the introduction of new varieties of goods. The other problem is how to value quality improvements.

Maybe some individuals value this new feature by more than the increase in the new iPhone’s price.

In that case the CPI will overestimate the change in the true cost of living for these individuals. These situations present difficult challenges to the BLS and remind us of the limitations of such measures.

Measuring Unemployment 8. a. Labor force = unemployed + employed = 7 + 88 = 95 b. Labor force participation rate = labor force / adult population = 95 / 140 = 67.9% c. Unemployment rate = unemployed / labor force = 7 / 95 = 7.37%

.

Chapter 2

Measuring Macroeconomic Data

19

9. The 3 million individuals who are unemployed and decide not to look for a job anymore are no longer considered “unemployed.” These individuals are not part of the labor force anymore (they are neither employed nor unemployed). Everything else the same, both the labor force and the labor force participation rate decrease. The new unemployment rate is: (7 − 3)/(88 + 7 − 3) = 4/92 = 4.35%.

This simple exercise shows the limitations of measures of unemployment because many people become discouraged during exceptionally long recessions. Policymakers might observe a decreasing unemployment rate and interpret that as a good sign, but the decrease might be created by people leaving the labor force. The BLS constructs other measures of unemployment for policymakers and the public in general to have a better description of labor market conditions in the United States.

Measuring Interest Rates 10. a. Ex ante real interest rate = nominal interest rate – expected inflation rate = 8%. b. Ex post real interest rate = nominal interest rate – actual inflation rate = less than 8%. An increase in actual inflation hurts the lender in real terms because it receives fixed nominal payments (loan installments) during a time in which prices are increasing at a rate higher than expected. c. As a borrower, you benefit from higher inflation rates, as the purchasing power of your fixed payments decreases over time. The ex post real interest rate calculation indicates precisely that: because of higher than expected inflation rates, the true cost of borrowing has decreased.

◼

Answers to Data Analysis Problems

1. a.

For 2013:Q1, GDP = $15,984.1 billion and GNP = $16,231.1 billion; net factor income = GDP – GNP = –$247 billion. b. Because net factor income is negative, the amount paid to U.S. residents by foreigners is less than the amount paid by U.S. residents to foreigners, and hence, foreign production by U.S. firms is larger than U.S. production by foreign firms.

2. a. 2013:Q1 = 116.45; 2012:Q1 = 114.6. b. Inflation rate = 100 × (116.45 – 114.6)/114.6 = 1.62%. c. Nominal GDP growth = 3.27%; real GDP growth = 1.62%. They are related in that the growth rate in real GDP plus inflation rate equals (approximately) the growth rate in nominal GDP. 3. For June 2013, UNRATE = 7.6%, CIVPART = 63.5% and CLF16OV = 155,835,000. The number of people not in the labor force = CLF16OV/CIVPART – CLF16OV = 89,574,449. The number of unemployed = UNRATE x CLF16OV = 11,843,460. Number of employed = CLF16OV - UNRATE x CLF16OV = 143,991,540. The adult population is given as CLF16OV/CIVPART = 245,409,449, thus the employment ratio equals 143,991,540/245,409,449 = 58.7% 4. a.

Market participants expected the inflation rate on average to be higher than the nominal interest rate over that same period, thus the real interest rate, as represented by the difference between the treasury and TIIS yields, was negative. b. The difference between the pairs represents expected inflation over the relevant bond horizon.

Calculations for July 9, 2013, are shown below.

Difference (Inflation 9-Jul-13 Nominal TIIS Expectations) 5 Year 1.50 -0.36 1.86 7 Year 2.08 0.14 1.94 10 Year 2.65 0.59 2.06

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

20

20 Year 30 Year c.

3.36 3.64

1.18 1.40

2.18 2.24

The difference, which roughly represents inflation expectations is fairly constant over the various horizons, but grows slightly as you move further out. In this case, market participants expect average inflation to be somewhat lower in the near term but average a bit more than 2 percent at 10, 20, and 30 years out.

◼ Data Sources, Related Articles, and Discussion Questions A. For information About Policy and Practice: Can GDP Buy Happiness?

Data Source The United Nations’ HDI ranking: http://hdr.undp.org/en/statistics/. You can use this resource to compare the situation of a “Low Human Development” country and a “Very High Human Development” country (click on the name of a country to obtain the information).

Related Article OECD Newsroom, “OECD welcomes experts’ call on need for new measures of social progress”: http://www.oecd.org/document/11/0,3343,en_21571361_44315115_43684683_1_1_1_1,00.html. This press release outlines the procedures followed by the OECD commission in charge of reviewing and improving current national statistics.

Discussion Questions 1. Propose alternative factors to be included in a more comprehensive measure of human satisfaction.

How would you suggest these factors should be measured?

2. Suppose national statistics measure other aspects of human life, like gender inequality or access to freedom of religion. Do you think these statistics can be used to compare countries’ achievements in these areas? Why or why not?

Answer 1: Alternative factors might include the quality of the environment, gender disparity, domestic violence, racism, and many other aspects of human life that affect our well-being. Potentially, some of these factors can be measured using relatively objective statistics. As an example, political scientists study by which means some countries make sure that a given percentage of their legislators are women. In general, though, most of these measures are controversial because the degree of gender disparity in a society cannot be fully described by the percentage of female participants in a legislative body.

Answer 2: Even if a national statistic could accurately incorporate (i.e., correctly measure) other aspects of human life, different cultures usually have different perceptions about most of these aspects. As a consequence, cross-countries comparisons of these statistics could be meaningless. One could argue that all cultures place the same value on access to basic needs such as healthcare, housing, and education. But the case is not that strong when one considers topics like income distribution, the environment, freedom of religion, gender disparity, etc. You can check this by realizing how different people have different opinions about what is more important in life. Then imagine a whole country or a given culture! This is one of the reasons as to why the GDP measure is still used to compare countries; it is far from perfect, but it is quite difficult to improve it.

.

Chapter 2

Measuring Macroeconomic Data

21

B. For information About Policy and Practice: Policy and Overstatements of the Cost of Living Data Source The Bureau of Labor Statistics: http://www.bls.gov/bls/inflation.htm. Here you can find the most updated information about inflation in the U.S. economy.

Related Article Greenspan, Alan, “Bias in the Consumer Price Index”: http://www.federalreserve.gov/boarddocs/testimony/1997/19970304.htm. In this speech, then Federal Reserve Chairman Alan Greenspan commented on the CPI bias and its implications for economic policy.

Discussion Question Do you think that the “chained CPI” is a perfect measure of the cost of living? Why or why not?

You can read more about changes introduced in the CPI methodology at the BLS site: http://www.bls.gov/cpi/cpisupqa.htm.

Answer: Although the “chained CPI” represents an improvement over the standard CPI, it is not a perfect measure of the cost of living. The “chained CPI” methodology tries to incorporate the fact that individuals substitute away from more expensive goods when possible. Even if one could argue that this effect is entirely captured by the “chained CPI” methodology, other aspects of measuring the cost of living are still left out (e.g., changes in quality).

C. For Information About Unemployment Data Source The Bureau of Labor Statistics, “International Labor Comparisons”: http://www.bls.gov/fls/intl_unemployment_rates_monthly.htm. This report compares unemployment rates and other employment indicators across countries for the 2008–2010 period. This information can be used to put in perspective the effect of the recent international financial crisis in different countries.

Related Article Bluestone, Barry, et al., “After the Recovery: Help Needed”: http://www.encore.org/files/research/JobsBluestonePaper3-5-10.pdf. This article discusses the implications of future demographic trends and their effect on the U.S. job market. Employment data and the current and future availability of jobs is a recurrent topic in macroeconomics. This article makes an interesting point, noting that it might be possible for the United States to suffer a shortage of workers in the future.

Discussion Question According to the BLS, the female (20 years and older) labor force participation rate increased from around 32 percent in the early 1950s to around 60 percent in 2010. Provide alternative explanations for this phenomenon.

Answer: The female labor force participation rate has been increasing since the early 1950s in the United States. Many cultural and technological aspects determined this transition: Some claim that WWII helped, in no small part, to introduce women into the labor market. Some sources assert that the extensive use of electronic appliances in households freed women’s time and allowed women to participate in the labor market. Finally, some sources claim that changes in cultural attitudes toward women’s role in the society determined this transition. For a graphic representation of this measure, go to: http://www.bls.gov/webapps/legacy/cpsatab1.htm, then click on the “women, 20 yrs and over, participation rate” box and then “retrieve data.” You will receive data for the last 10 years, but you can change it, and ask the Website for a graphical representation, clicking the “include graphs” box.

.

Chapter 3 Aggregate Production and Productivity ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Determinants of Aggregate Production Factors of Production Production Function Cobb-Douglas Production Function Application: Why Are Some Countries Rich and Others Poor?

Cobb-Douglas Production Function Characteristics Changes in the Production Function: Supply Shocks Determination of Factor Prices Demand for Capital and Labor Supply of Capital and Labor Factor Market Equilibrium Distribution of National Income Application: Explaining Real Wage Growth Application: Oil Shocks, Real Wages, and the Stock Market Concluding Remarks

Chapter Overview and Teaching Tips This chapter develops one of the basic building blocks for all the macroeconomic analysis throughout this book, the aggregate production function. Not only is the aggregate production function used in the study of economic growth, where it plays a central role, it also is a key element of business cycle analysis because it determines the level of potential output given the factor inputs.

The chapter starts by discussing the fundamental factors of production and develops the Cobb-Douglas production function. It then develops key concepts like the marginal product of capital and labor and shows how the production function shifts. Armed with these concepts, the chapter then conducts a supplyand-demand analysis to show how factor prices, like wages and the rental price of capital, are determined, which also shows how the share of national income going to capital and labor is determined.

One important feature of this chapter is that it lays out a supply and demand analysis that is at a similar level to that found in principles of economics textbooks. The derivation of the demand curves is quite detailed and the concept of equilibrium is carefully developed. The step-by-step treatment in this chapter is worthwhile because supply-and-demand analysis is a basic tool used not only in microeconomics, but also in the study of macroeconomics in this book.

.

24

Mishkin • Macroeconomics: Policy and Practice, Second Edition

This chapter has several applications to both stimulate students’ interest and to convince them that the analysis helps explain the real world. The first application, “Why Are Some Countries Rich and Others Poor?” shows how the aggregate production function can help us to understand the sources of huge income differences between countries. Why some countries are so poor and some so rich is an inherently interesting question that students love to think about, and so covering this application in class helps students see that studying the aggregate production function is worthwhile. The second, “Explaining Real Wage Growth,” shows how important productivity changes are to workers’ well-being. The final one, “Oil Shocks, Real Wages, and the Stock Market,” shows how the supply-and-demand model of factor inputs can be used to explain fluctuations in the data. The link between oil prices and the stock market is often discussed in the media and students find it particularly interesting to get an explanation of why there is a link between what they see happening at the fuel pump at their local gas station and what happens in the stock market. Also, students more interested in finance get excited about anything that helps explain fluctuations in the stock market.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Determinants of Aggregate Production 1. The aggregate production function represents the relationship between the quantities of inputs that go into the production process and the output that is produced with those inputs. In the production function Y = F(K,L), output (Y) is an endogenous variable whose value is explained by the production function while the capital (K) and labor (L) inputs used in production are the exogenous variables that determine or explain the level of output produced.

2. Total factor productivity measures the productivity of all inputs. It is the average output produced by one unit of capital together with one unit of labor. Labor productivity measures the average output produced by one unit of labor. Labor productivity increases if increases in capital lead to the production of more output with the same amount of labor, even though total factor productivity does not change in this case. Labor productivity is more easily measured, but total factor productivity is a better indicator of how productive capital and labor are together.

3. The Cobb-Douglas production function is Y = AK0.3L0.7, where Y = output, A = total factor productivity, K = capital, L = labor, and the exponents are the shares of national income received by capital (0.3 or 30 percent) and labor (0.7 or 70 percent). Total factor productivity cannot be measured directly but can be estimated as A = Y/(K 0.3L 0.7).

4. The Cobb-Douglas production function exhibits constant returns to scale and diminishing marginal products for each input. Constant returns to scale means that if all inputs increase by an identical proportion, output rises by that same proportion. For example, if the amounts of capital and labor used in production are doubled, output also doubles. Diminishing marginal product implies that if additional units of one input (capital, say) are added one after another to the production process, while the other input (labor) is held constant, then the additional increments of output that can be produced (the marginal product) become smaller and smaller. In other words, as more capital is used in production, the marginal product of capital diminishes, and the same holds true for labor if the amount of labor increases, while capital remains unchanged.

5. Supply shocks are events that either increase or decrease the amount of output that can be produced with given amounts of capital and labor. In other words, they cause output to change even though capital and labor have remained the same because they change the productivity of the inputs (the A parameter in the Cobb-Douglas production function). They can arise from changes in technology,

.

Chapter 3

Aggregate Production and Productivity

25

weather, natural catastrophes, resource availability, or even government policies. With a positive supply shock, more output can be produced with a given amount of inputs; a negative supply shock reduces the amount of output produced with those same inputs.

Determination of Factor Prices 6. Factor prices are the prices firms pay for each unit of labor and capital they hire. They pay the wage rate for each unit of labor they hire and the rental price of capital for each unit of capital they hire.

The explanation of how these factor prices are determined assumes that all firms operate under conditions of perfect competition. They are price takers and cannot control the prices at which they sell their output or buy the inputs they use in production. With no control over prices, they choose the quantity of output to produce and the quantities of inputs to employ to maximize their profits. The explanation also assumes the economy is in long-run equilibrium, meaning that the quantity of factors supplied is equal to the quantity of factors demanded.

7. The profit function is  = P  F(K,L) − RK − WL.  denotes economic profits, which are revenues earned from production minus the costs of production. Revenues are P  F(K,L), where P is the average price level and F(K,L) is the quantity of output; costs are RK for capital, the rental price of capital times the amount of capital hired, and WL for labor, the wage rate times the amount of labor hired.

8. Firms will hire additional units of capital and labor inputs as long as the additional revenue they can earn by doing so—the marginal product of capital or labor times the average price level—is greater than the cost (rental price of capital or wage rate of labor) of hiring an additional unit of input. As long as this condition holds, firms’ profits increase as they use more capital and labor. Because of diminishing marginal product, however, the additional revenue earned by hiring additional units of input diminishes. Therefore, firms will hire additional amounts of each input until the marginal product of each input equals its real factor price.

9. A factor demand curve for capital or labor shows how much of the factor firms will demand at various real factor prices—the real rental price of capital or the real wage rate of labor—when all other variables (including amounts of the other factor) are held constant. The negative slopes of the demand curves for capital and labor result from the production function’s characteristic of diminishing marginal products and firms’ profit-maximizing decisions to additional units of an input until its marginal product equals its real factor price. When the real factor price of an input decreases, firms will hire additional units of that input until its marginal product declines to the level of its now lower real factor price. Conversely, if an input’s real factor price increases, then firms hire less of that input so that its marginal product will rise to equal the now higher real factor price. Thus, the quantity of a factor demanded will vary inversely with its real factor price and the demand curve for the factor is the same as its marginal product curve. The supply curves for capital and labor are vertical because the quantities of each factor available are assumed to be fixed.

10. Equilibrium occurs in a factor market when the quantity of the factor demanded by firms equals the quantity of the factor its owners offer for sale. The factor price at which this condition is met is the equilibrium price of the factor. When there is an excess demand, firms want to hire more of the factor than owners of the factor offer for sale. This occurs when the factor’s price is below the equilibrium price. Firms’ competition for the factor drives up its price, which eliminates the excess demand. If the price of the factor is above the equilibrium price, the quantity of a factor demanded is less than the quantity offered for sale and there is an excess supply of the factor. In this case, factor owners compete against one another and drive the factor price down. So excess demand and excess supply in a factor market cause the factor’s price to move toward its equilibrium value.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

26

Distribution of National Income 11. Based on the Cobb-Douglas production function and assuming that labor and capital inputs are hired in perfectly competitive factor markets, national income is divided between labor and capital with the payments to each input determined by the input’s marginal product. Support for the Cobb-Douglas production function comes from evidence that the shares of national income going to labor and capital remain constant over time, as it predicts, regardless of the level of national income.

Answers to Problems Determinants of Aggregate Production 1. Replacing K and L by 2K and 2L respectively yields: F (2K ,2L) = A(2(2K ) + 3(2L )) → F (2K ,2L ) = A(4K + 6L ) → F (2K ,2L) = 2  A(2K + 3L) = 2  F (K , L ).

The equation above shows that this production function, although not a Cobb-Douglas, also exhibits constant returns to scale.

dY dAK 0.4 L1.0 = = AK 0.4 L(1.0 −1.0) = AK 0.4 . dL dL b. According to the answer to part (a), this production function does not exhibit diminishing marginal product of labor. Increases in L will increase MPL. One might think that this is not a desirable characteristic of a production function. However, under some circumstances it is correct to assume that increases in the labor input will not decrease the marginal contribution of labor to total output (MPL). Educational improvements will increase labor’s productivity, and the law of diminishing marginal product will be offset by the fact that more highly educated workers can become more productive.

2. a.

MPL =

3. a.

Mexico total factor productivity: 0.065 =

1.0 .

0.18  1050.7

0.13 =

1.7 .

0.74  450.7

Spain total factor productivity:

0.3

0.3

Y 1,000,000 = = $9,524.

L 105 Y 1,700,000 y= = = $37,777.

Spain’s per capita income: L 45 c. Spain’s per capita income is around four times Mexico’s per capita income. This difference is explained by the fact that total factor productivity is higher in Spain than in Mexico (twice as large). Spain has also a higher capital per worker ratio than Mexico: y=

b. Mexico’s per capita income:

K K 0.74 0.18  →  .

L Spain L Mexico 45 105 With respect to factors of production, although Spain has more capital, Mexico has more labor, so it is not correct to explain differences in per capita income based on different levels of factors of production.

.

Chapter 3

4. a.

Aggregate Production and Productivity

27

The unusually high crop yield is interpreted as a positive supply shock. This increases output for any given combination of capital and labor, shifting the production function upward.

b. The marginal product of capital increases as a result of the positive supply shock. Graphically, this can be observed by a steeper slope at every capital level.

Determination of Factor Prices 5. a.

This firm is not maximizing its profit because it is hiring too many employees and using less equipment (capital) than it should. At this current real wage, the marginal product of labor (worker’s contribution to total output) is lower than its cost (the real wage). Also, at this current real rental rate, the marginal product of capital is higher than its cost. Currently, the profit-maximization condition is not met for either factor of production. b. This firm should change the amount of each factor of production it is currently employing. It should therefore lay off some workers until the marginal product of labor rises to $12 and should use more capital (equipment) until its marginal product falls to $20.

52 = 14. As one can see from the formula 800.3 for the marginal product of labor, MPL decreases as L increases. b. To determine the equilibrium real wage, demand must equal supply in the labor market. Demand is represented by the marginal product of labor, while supply is considered to be fixed at 100 million 52 = 13. The equilibrium real wage is $13 when workers. Equilibrium implies: L = 100 → 1000.3 labor supply is 100 million.

7. a. The intersection of supply and demand in the capital market indicates that the real rental rate of capital is: 6. a.

When L = 80 the marginal product of labor is MPL =

K = 10 →

.

60 = 12.

100.7

28

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Graphically:

b. The new real rental rate of capital is given by: K = 10 →

70 = 14.

100.7

Distribution of National Income 8. A Cobb-Douglas production function uses the labor income and capital income shares of total income as the exponents on labor and capital respectively. In this case, the labor income share is 0.75, and the capital income share is 0.25. This economy could be represented by the following production function: Y = F ( K , L ) = AK 0.25 L0.75 .

9. Your boss is not correct because an important characteristic of a Cobb-Douglass production function is that both the labor and capital income shares of total income are constant. Therefore, the CobbDouglas production function is a good representation only for countries whose labor and capital income shares remain relatively constant over time.

10. Chile’s real labor and real capital income are given by the parameters of the Cobb-Douglas production function and national income: Real labor income: 0.6  170 = $102 billion.

Real capital income: 0.4  170 = $68 billion.

.

Chapter 3

◼

Aggregate Production and Productivity

29

Answers to Data Analysis Problems

1. a.

From 1980 to 2012, nominal wage growth has averaged 4.3 percent, and CPI inflation has averaged 3.6 percent per year. Thus, inflation has eroded away a substantial part of the purchasing power of the nominal increase in wages. b. Real wage growth can be inferred from the difference between nominal wage growth and the CPI inflation rate, which is 0.7 percent average per year over that time. c. Average labor productivity growth is 1.8 percent per year from 1980 to 2012; this is consistent with the result that labor productivity growth and real wage growth are positively correlated.

These numbers are also remarkably similar to the period from 1973–1995 as shown in Table 3.2.

2. a.

From 2000:Q1 through 2013:Q1, output per person has grown by 28.4 percent; from January 2000 to March 2013, the labor force participation rate fell from 67.3 percent to 63.3 percent, a decline of 4 percentage points. b. The decline in the labor force participation rate means that for GDP per capita to grow, it will have to be driven by higher labor productivity; in other words, given the demographic factors pushing the labor force participation rate down since its peak around 2000, sustained growth in GDP per capita will have to come from higher labor productivity growth to offset the declining labor force participation rate.

3. a.

Generally, labor productivity rises during expansions and declines or does not grow much during recessions, particularly near the beginning and middle of recessions. Generally, real compensation per hour rises during expansions and declines or grows slowly during recessions. b. If output per worker and the MPL are closely linked, then declines in output per worker (MPL) that happen during recessions should reduce labor demand, and hence the equilibrium real wage, and vice versa. The labor productivity and real compensation measures seem to support this basic labor market result: when OPHNFB declines, COMPRNFB generally declines, and vice versa.

The graph of the two data series are shown below.

.

30

Mishkin • Macroeconomics: Policy and Practice, Second Edition

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: Why Are Some Countries Rich and Others Poor?

Data Source 1. Penn World Tables: http://pwt.econ.upenn.edu/php_site/pwt_index.php. This is a comprehensive database that allows cross country comparisons. You can chose from various versions of this table by scrolling down.

2. World Bank Classification (Atlas method): http://data.worldbank.org/indicator/NY.GNP.PCAP.CD/countries/latest?display=default. This alternative method is used by the World Bank to compare countries according to the Atlas method.

For more information about the Atlas method: http://data.worldbank.org/about/dataoverview/methodologies. The World Bank uses this method to classify countries into four categories.

Related Article 1. Lucas, Robert E. Jr., “On the Mechanics of Economic Development”: http://www.fordham.edu/economics/mcleod/LucasMechanicsEconomicGrowth.pdf. This is one of the most important papers about economic development.

2. Romer, Paul M., “Economic Growth”: http://www.econlib.org/library/Enc/EconomicGrowth.html.

This article discusses various economic growth determinants.

Discussion Question The “total factor productivity” term is usually conceived to be a “black box”: it could represent different technologies, production processes, or even the efficiency of the financial system. Propose different ways to fill that “black box”: factors that can increase a country’s income per worker (everything else given).

Answer: Even though there are no simple answers to this question, economists all over the world keep measuring the effect of several factors to test whether they are related to “total factor productivity.” By nature, though, this line of research is usually controversial, as one might argue that “ideas” or the quality of education can impact total factor productivity. The controversy arises because many of these factors are difficult to measure to begin with.

B. For Information About Application: Explaining Real Wage Growth Data Source The Bureau of Labor Statistics: http://data.bls.gov/PDQ/outside.jsp?survey=pr. To reproduce (and expand) Table 3.2: Select “nonfarm business” for sector, then “real hourly compensation” (real wages) and “Labor productivity (output per hour)” for measures, and finally “percentage change from same quarter a year ago” for duration. When done, click “get data.”

Related Article Greenspan, Alan, “The Revolution in Information Technology”: http://www.federalreserve.gov/boarddocs/speeches/2000/20000306.htm. In this speech, Greenspan points out the implications of the revolution in information technology for the U.S. economy.

Discussion Questions Why do you think that increases in total factor productivity are important for a country as a whole? What about for an individual in particular?

.

Chapter 3

Aggregate Production and Productivity

31

Answer: According to the previous “Application,” increases in total factor productivity will result in increases in income per capita, thereby increasing the standards of living of the whole society. If real wage growth is closely linked to productivity measures, then the case is even stronger to look for factors that can increase “total factor productivity.” Some of these new technologies sometimes affect only one industry (at least at the beginning), like the assembly line implemented by Henry Ford at the beginning of the twentieth century. Real wages for many workers in the automobile industry increased, and ultimately, other industries that copied the same production process also saw an increase in real wages.

C. For Information About Application: Oil Shocks, Real Wages, and the Stock Market Data Sources Federal Reserve Bank of Saint Louis database: http://research.stlouisfed.org/fred2/series/SP500?cid=32232. This link provides information about the S&P 500 Index. Note the decline in stock prices during 1973–1975, 1979–1980, and 2007–2008.

Related Article Hamilton, James D., “Causes and Consequences of the Oil Shock of 2007–2008”: http://www.nber.org/papers/w15002.pdf. This paper compares the causes and consequences of the 2007– 2008 supply shock with previous similar events (e.g., in 1973). Figure 1 (page 50) is a plot of oil prices since 1945.

Discussion Question Fluctuations in the price of oil impact stock prices; real wages and can potentially create a recession. Can you think of a way for countries to avoid such dependence on the price of oil?

Answer: There is no easy answer to this question. Many political leaders have pointed out the need for alternative energy sources (i.e., not oil) precisely because of this problem. If a country does not need to buy oil in the world market, then increases in its price will not affect production (and thereby real wages or stock prices), minimizing the effect of such a price spike. The search for alternative (and renewable) sources of energy is under way also for other reasons: to take better care of our environment. Although many people agree that oil dependence is not a wise policy, apparently the costs of switching to another energy source are still quite high.

.

Chapter 4 Saving and Investment in Closed and Open Economies ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Relationship Between Savings and Wealth Private Saving Government Saving National Saving Policy and Practice: Government Policies to Stimulate Saving Uses of Saving The Link Between Saving and Wealth Macroeconomics in the News: Balance of Payments Accounts Application: How the United States Became the Largest Net Debtor in the World Saving, Investment, and Goods Market Equilibrium in a Closed Economy Saving and Investment Equation Saving Investment Goods Market Equilibrium Response to Changes in Saving and Investment in a Closed Economy Changes in Saving: Autonomous Consumption Changes in Saving: Effects of Fiscal Policy Policy and Practice: Crowding Out and the Debate Over the 2009 Fiscal Stimulus Package Changes in Autonomous Investment Saving, Investment, and Goods Market Equilibrium in an Open Economy Perfect Capital Mobility and the Open Economy Goods Market Equilibrium in an Open Economy Saving, Investment, and the Trade Balance in a Small Open Economy Goods Market Equilibrium in a Small Open Economy Connection Between the World Economy and Small Open Economy Response to Changes in Saving and Investment in a Small Open Economy Changes in Domestic Saving Application: The Twin Deficits Changes in Investment Large Versus Small Open Economies Chapter 4 Web Appendix: Saving and Investment in Large Open Economies

.

Chapter 4

Saving and Investment in Closed and Open Economies

33

Chapter Overview and Teaching Tips This chapter discusses the relationship of saving and investment and its impact on the economy. A key point to make to students is that the analysis here is a long-run context in which wages and prices are flexible and so the economy is at full employment. A unique feature of this chapter relative to many other textbooks is that it covers both closed and open economies in one chapter. I believe this is important because the impact of saving and investment on the economy needs to be thought of not only in a domestic context, but in the international one as well. Students are interested not only in how increased saving might lead to more investment but also how it affects current account deficits and borrowing from abroad.

The chapter starts by clarifying the relationship of saving and wealth and what the concept of saving actually means. Students need to understand that high saving is one way of accumulating wealth and is one of the reasons there is so much focus on increasing saving. Also higher saving, holding everything else constant, leads to lower current account deficits and less foreign borrowing. These concepts can be made more concrete by discussing in class the Policy and Practice case on government policies to stimulate saving and the application on how the United States has become the biggest net debtor in the world.

The chapter next develops a model to explain the link between saving, investment, and interest rates by looking at what happens when the goods market is in equilibrium. It starts with a closed economy in which net exports are zero because this framework in which equilibrium occurs when S = I is the simplest. Also, because the United States is a relatively closed economy, the analysis answers many questions that students want answered about economies like that in the United States. It is worth spending time to get students to understand the concept of equilibrium here and why equilibrating S and I in Figure 4.5 determines the real interest rate. A deep understanding of this equilibrium concept is essential to the rest of the material in this chapter.

Armed with an understanding of the saving–investment diagram, the next step is to show what happens to the equilibrium when the saving curve shifts, either because of changes in autonomous consumption or government fiscal policy. This naturally leads to the policy discussion in the Policy and Practice case, “Crowding Out and the Debate Over the 2009 Fiscal Stimulus Package.” Discussing this debate is an excellent way of getting students to see the relevance of the saving–investment analysis. The instructor can then take the students through the exercise of seeing what happens when the investment curve shifts because autonomous investment changes, due, say, to a rise in business optimism.

Some professors who prefer to focus on domestic issues only may want to skip the open economy analysis in the rest of the chapter, and this can be done without loss of continuity with the rest of the book. However, international issues have become of greater interest to students, so most instructors will want to teach the open economy material. The key point to emphasize is that the open economy model just modifies the saving–investment diagram to show that the equilibrium condition changes from S = I to S − I = NX. Then the analysis is similar to the earlier analysis in the closed economy framework, which examines what happens when the saving or investment curves shift. Discussing the application on the twin deficits is a nice way to show students that the open-economy model they have learned can help explain real world phenomenon.

The body of the chapter conducts the open-economy framework only for a small open economy. This is because the discussion of the large open economy is a lot more complicated and so is left to an online appendix on the Companion Website, www.pearsonhighered.com/mishkin, which can be taught to students who are particularly interested in international issues. Teaching the online appendix has the advantage that students are able to understand more deeply what is referred to as the “global saving glut” by going through the application with this title. Nonetheless, the online appendix is easily skipped because the intuition for the large open economy is pretty straightforward from the closed-economy and small-openeconomy frameworks, and this is what is discussed in the body of the chapter.

.

34

Mishkin • Macroeconomics: Policy and Practice, Second Edition

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Relationship Between Saving and Wealth 1. The two components of national saving (S) are private saving (SP) and government saving (SG). Private saving is disposable income (YD, which is GDP or national income Y minus taxes T) minus consumption expenditure (C). Government saving is taxes minus government purchases (G). Thus, national saving S = SP + SG = Y − T − C + T − G = Y − C − G. If national saving (a flow) is positive, national wealth (a stock) increases because the saving is used to finance either domestic investment in capital goods or the purchase of foreign assets. Negative national saving involves borrowing from abroad or selling foreign assets to finance domestic investment.

Saving, Investment, and Goods Market Equilibrium in a Closed Economy 2. Desired national saving is positively related to income, the real interest rate, and taxes and inversely related to consumption and government purchases. Desired investment is positively related to the additional profits the investment is expected to generate and inversely related to the real interest rate.

In a closed economy, goods market equilibrium requires the amounts of desired saving and investment to be equal. This balance between desired saving and investment comes about through changes in the real interest rate. If desired saving is greater than desired investment, potential investors do not wish to borrow as much as savers are willing to lend, and the goods market will not be in equilibrium. This causes the real interest rate to fall. As it does so, the desired amount of saving decreases, and the desired amount of investment increases. The two move into balance when the real interest rate has fallen to a low enough level. If desired investment is greater than desired saving, potential investors wish to borrow more than savers wish to lend and the real interest rate rises until a balance between saving and investment is achieved.

Response to Changes in Saving and Investment in a Closed Economy 3. Desired saving increases if autonomous consumption or government purchases decline or if taxes increase. An increase in desired saving shifts the saving curve to the right and causes the equilibrium real interest rate to fall. Desired investment, in turn, increases as the real interest rate drops.

4. Crowding out refers to the decrease in investment spending that results because government spending increases. This occurs because an increase in government spending reduces desired saving and causes the real interest rate to increase, which results in a decline in desired investment spending. Thus an increase in government spending crowds out—leads to a decrease in—investment spending.

Saving, Investment, and Goods Market Equilibrium in an Open Economy 5. A closed economy has no interactions with other economies. Therefore, its net exports and net capital outflow both equal zero. An open economy does engage in international trade and is open to outflows and inflows of capital across its borders. In a closed economy, goods market equilibrium requires that desired saving equal desired investment (S = I). An open economy can be in equilibrium even when desired amounts of saving and investment are not equal, provided that the difference between them equals net exports (NX = S − I equals net capital inflow if S  I and NX  0, or outflow if S  I and NX  0).

6. The world real interest rate is the rate that equates desired world saving and desired world investment and thus achieves goods market equilibrium for the world as a whole. If an individual country’s equilibrium real interest rate (r) is not the same as the world real interest rate (rw), perfect capital mobility will move the domestic rate to the level of the world rate. If the domestic real interest rate were above the world rate, domestic borrowers would borrow only from abroad at the lower world rate, and if it were below the world rate, domestic savers would lend only to foreigners at the higher

.

Chapter 4

Saving and Investment in Closed and Open Economies

35

world rate. Because all lending and borrowing would occur at the world real interest rate, the domestic real interest rate cannot deviate from the world rate.

Saving, Investment, and the Trade Balance in a Small Open Economy 7. Both types of economies are open to trade and capital flows, but the “small” economy is so small relative to the world economy that it has no effect on the world real interest rate. A “large” open economy is large enough that changes in its desired amounts of saving and investment do affect the world real interest rate.

8. The small open economy will have a trade surplus if the world real interest rate is above rE, the real interest rate at which the small open economy’s desired amounts of saving and investment would be the same. (rE would be the equilibrium real interest rate if the economy were closed.) At the higher world real interest rate, the economy’s desired saving exceeds its desired investment; it has positive net exports—a trade surplus—and excess saving that can be lent to foreigners (net capital outflow).

However, if the world real interest rate is below rE, then the economy will have negative net exports and a trade deficit. Because its desired saving falls short of its desired investment, it will borrow from the rest of the world at the world real interest rate and, thus, will experience net capital inflow.

9. Unlike a closed economy where an increase in desired saving would lower the domestic real interest rate and increase investment, an increase in domestic saving in a small open economy has no effect on the world real interest rate or on domestic investment. Instead, it leads to a larger trade balance (a higher trade surplus or a lower trade deficit) and an increase in net capital outflows.

Response to Changes in Saving and Investment in a Small Open Economy 10. An increase in domestic saving shifts the saving curve to the right; as a result, the trade balance and net capital outflow both increase. An increase in domestic investment shifts the investment curve to the right, causing both the trade balance and net capital outflow to decrease.

Large Versus Small Open Economies 11. A large open economy has characteristics of both closed and small open economies. It responds like a small open economy in the way that given changes in domestic saving and investment affect the trade balance and net capital flows. It responds the way a closed economy does regarding the effect those same changes in domestic saving and investment have on the domestic real interest rate and actual levels of saving and investment.

Answers to Problems Relationship Between Saving and Wealth Japan’s national saving rate is 25 percent. Therefore Japan’s national saving is 0.25  $5 trillion = $1.25 trillion. b. Japan’s national saving equals private plus government saving. Therefore, Japan’s government saving is $450 billion.

1. a.

Saving, Investment, and Goods Market Equilibrium in a Closed Economy 2. a.

If you buy a newly built home, you will add to the economy’s residential investment, therefore adding to the investment spending component of GDP. If you buy a U.S. savings bond, you will be transferring funds to the U.S. government, but that action will not add to the economy’s capital stock (the U.S. government might use these funds to build roads, which would be considered government investment, but that is another transaction). b. A decrease in the real interest rate will make your option to buy a house more appealing. A decrease in the real interest rate not only means smaller mortgage payments but also lower opportunity

.

36

Mishkin • Macroeconomics: Policy and Practice, Second Edition

cost (in terms of lost interest income from holding a savings bond) when you choose to buy a house. A decrease in the real interest rate promotes additions to the capital stock, or investment.

Response to Changes in Saving and Investment in a Closed Economy 3. If workers realize that they will not have a safety net when they retire, they might start saving more now. This is the case in many other countries in which a social security system either does not exist or is not reliable (payments are really low and do not allow for a decent living). Sometimes people choose to save more during their early years or to rely on their offspring for later support. Assuming people choose to decrease autonomous consumption, the new saving curve should shift to the right, as individuals will save more at any given real interest rate. As a result, saving and investment increase, as the equilibrium real interest rate decreases.

4.

An economic recession (in this case, caused by a financial crisis) usually decreases business optimism about the future. There is generally a lot of uncertainty about consumers’ ability to buy the same amount of goods and services, and therefore, some firms might be forced out of business. As a consequence, firms hesitate to increase their capital stock in such an environment. Businesses decide to decrease desired investment at every given real interest rate, as shown by the shift to the left on the investment curve. Investment and saving decrease, as well as the equilibrium real interest rate.

.

Chapter 4

Saving and Investment in Closed and Open Economies

37

5.

Everything else the same, a decrease in the government deficit means that national saving will increase as a result of an increase in government saving. When national saving increases for each real interest rate, the saving curve shifts to the right (as shown in the graph). The level of investment and saving increase, and the equilibrium real interest rate decreases.

Saving, Investment, and Goods Market Equilibrium in an Open Economy 6. a.

Considering Japan an open economy means that Japan’s investment equals its national saving minus its net exports. If saving is $1.25 trillion (25 percent of $5 trillion) and net exports equal $50 billion, then Japan’s investment is $1.20 trillion. b. If Japan’s net exports equal $50 billion and its imports are valued at $650 billion, then Japan’s exports equal $700 billion.

7.

a.

When the world real interest rate is 7 percent, desired saving exceeds desired investment by $400 billion. Net exports are, therefore, $400 billion, which is equal to capital outflow. b. When the world real interest rate is 3 percent, desired investment exceeds desired saving by $600 billion. Net exports are, therefore, negative $600 billion, which is equal to capital outflow.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

38

Response to Changes in Saving and Investment in a Small Open Economy 8.

a.

If this country is running a trade surplus, this means that the world real interest rate is such that desired saving exceeds desired investment. The world real interest rate is noted as rw, which is higher than the interest rate that would prevail in a closed economy. b. A decrease in autonomous investment will increase net exports, as noted in the graph. The difference between desired saving and desired investment increases when the investment curve shifts to I2.

9. a.

A decrease in autonomous investment decreases desired investment at each real interest rate and, therefore, shifts the investment curve to the left. In a closed economy, this results in a decrease in the equilibrium real interest rate and investment and saving levels. The economy’s wealth will eventually decrease, as the economy’s addition to its capital stock decreases. b. In a small open economy, a decrease in autonomous investment increases net exports, and the economy buys more foreign assets (capital outflow increases). This economy is investing less in itself, but it is increasing its holdings of foreign assets, so there is no change in its wealth.

Large Versus Small Open Economies 10. a.

For a large open economy, an increase in government surplus increases desired saving at every real interest rate. The saving curve shifts to the right, increasing net exports. The domestic real interest rate decreases because the large open economy can affect the world real interest rate. b. In a small open economy, an increase in government surplus increases desired saving at every real interest rate. The saving curve shifts to the right, increasing net exports. The world real interest rate, however, does not change, as this economy is considered to be “small” with respect to the world economy.

◼

Answers to Data Analysis Problems

1. a.

GPSAVE was 2,138.9 billion in 2008:Q1, and 2,752.2 billion in 2013:Q1. GSAVE was 2,010.1 billion in 2008:Q1 and 2,232.3 billion in 2013:Q1. Thus, gross private saving increased by 613.3 billion, while total gross saving only increased by 222.2 billion. b. Gross government savings in 2008:Q1 = 2,010.1 – 2,138.9 billion = –128.8 billion. In 2013:Q1, the gap widens to 2,232.3 – 2,752.2 billion = –519.9 billion.

.

Chapter 4

c.

Saving and Investment in Closed and Open Economies

39

In both 2008 and 2013 the government ran budget deficits because gross government saving is negative in both cases.

2. a.

For 2013:Q1, net exports = 559.018 – 682.676 billion = –123.658 billion. This represents a trade deficit since net exports are negative. b. Using these data, net exports have not been positive since 1976:Q1. Since then, the United States has continually had net capital inflows into the country.

3. a.

From 2005:Q1 to 2013:Q1 government saving decreased from –19.9 billion to –519.9 billion, a decrease of 500 billion. This is due to persistently large budget deficits that grew rapidly during and after the Great Recession of 2008–09 but have moderated in recent years. b. The decline in government saving of 500 billion, holding all other factors constant, should shift the savings curve to the left, resulting in higher equilibrium real interest rates in the United States. c. The real interest rate (DFII10) has decreased from the beginning of 2005 to the end of the first quarter of 2013, declining from 1.70 percent to –0.64 percent, a decrease of 2.34 percentage points. This is inconsistent with the answer to (b) above; it could be due to many factors, such as a larger increase in investment demand resulting in lower real interest rates or a decline in world real interest rates despite the reduction in saving in the United States.

◼

Answers to Review Questions and Problems in Web Appendix, “Saving and Investment in Large Open Economies”

1. Goods market equilibrium requires that world saving equal desired world investment, which means that a trade surplus (or deficit) in the domestic economy must equal the trade deficit (or surplus) in the rest of the world, so that net capital outflows from one economy match net capital inflows to the other economy. This is brought about by adjustments in the world real interest rate. If the trade surplus in the domestic economy is greater than the trade deficit in the rest of the world, the world real interest rate will fall until the two magnitudes match. If the domestic economy’s trade surplus is smaller than the rest of the world’s trade deficit, the world real interest rate will rise until equilibrium is attained.

2. A decrease in domestic investment raises the domestic economy’s trade surplus and capital outflows and raises the trade deficit and capital inflows in the rest of the world. The world real interest rate decreases, and investment in the rest of the world rises.

3. A fall in domestic saving decreases the domestic economy’s trade surplus and its net capital outflow to the rest of the world. The trade deficit and capital inflows to the rest of the world decline, and the world real interest rate rises, which causes investment to decline in both the domestic economy and the rest of the world.

4. When the interest rate is 7 percent, net exports are $90 billion, which equals the amount of funds that domestic residents want to lend to the rest of the world. When the interest rate is 5 percent and 3 percent, net exports equal $60 billion and $30 billion, respectively. The equilibrium world interest rate is 5 percent, when the excess funds in the domestic economy equal the demand for foreign lending by the rest of the world. At a world interest rate of 5 percent, desired world saving equals desired world investment.

5. A decrease in government expenditures in the domestic economy results in an increase in domestic saving, shifting the saving curve to the right. At a world interest rate of 4 percent, the trade deficit shrinks (in absolute value). The domestic economy does not need the amount of funds that the rest of the

.

40

Mishkin • Macroeconomics: Policy and Practice, Second Edition

world is ready to lend at a world interest rate of 4 percent. As a result, the world interest rate decreases to a lower level, say 3 percent. At the new, lower world interest rate, domestic investment increases.

6. A decrease in autonomous domestic investment shifts the investment curve to the left and increases the trade surplus at every given world interest rate. This will increase the amount of funds that U.S. residents want to lend to the rest of the world. As a result, the world interest rate decreases from r1w to r2w .

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Policy and Practice: Government Policies to Stimulate Saving Data Source Federal Reserve Bank of St. Louis database: http://research.stlouisfed.org/fred2/categories/112. Here you can find the latest data on saving and investment indicators in the United States (by clicking on a series name, you can get a graphic representation immediately).

.

Chapter 4

Saving and Investment in Closed and Open Economies

41

Related Article Ehrbar, Al, “Consumption Tax”: http://www.econlib.org/library/Enc/ConsumptionTax.html. This article discusses the implications of capital income taxation. It refers to the 2003 tax bill that reduced the top tax rate on dividends and capital gains.

Discussion Question Suppose you are a policymaker and your goal is to increase national savings. Everything else the same, do you think that a budget deficit reduction is the best way to achieve your goal? Explain.

Answer: Everything else the same, a decrease in the government budget deficit increases national saving.

This can potentially benefit the whole country if these savings are used to fund infrastructure improvements, education plans, and other means to increase productivity in the future. However, a reduction of the budget deficit can arise precisely because of a cut in spending in these areas. A government can decrease its deficit by investing less in education or telecommunications infrastructure, which will most probably result in lower economic growth in the future. A reduction in the government deficit (and the resulting increase in national savings) has to be properly evaluated to determine if it is a good thing or not.

B. For Information About Application: How the United States Became the Largest Net Debtor in the World Data Source Bureau of Economic Analysis, “U.S. Net International Investment Position”: http://www.bea.gov/newsreleases/international/intinv/intinvnewsrelease.htm. Here you can find the latest news release about the U.S. net international investment position (you can find the latest data on the navigation bar on the right side).

Related Article Caplan, Bryan, “Trade Deficit? What Trade Deficit?”: http://econlog.econlib.org/archives/2006/08/do_we_even_have.html. This article points out the interesting fact that despite the decrease in net foreign assets held by Americans, the net income flow generated by these assets is still positive.

Discussion Question A negative trade balance indicates a net capital inflow (i.e., a negative net capital outflow), meaning that foreigners are buying more U.S. assets than foreign assets bought by Americans. Describe the positive and negative effects of such a situation.

Answer: Although usually considered a “bad” thing, a negative trade balance does not necessarily imply that. The negative effect of a persistent trade balance is that the country might become a net debtor, as in the case of the United States. However, when foreigners decide to buy U.S. assets (e.g., stocks, bonds), they are potentially funding investment projects in and improvements to the U.S. economy. These projects might result in a better economic environment in the United States and help to repay the debt accumulated over the years.

C. For Information About Policy and Practice: Crowding Out and the Debate Over the 2009 Fiscal Stimulus Package Data Source The White House: http://www.whitehouse.gov/recovery/. Here you can find information (data, videos, etc.) about the effect of the Economic Reinvestment Cct of 2009 on the U.S. economy.

.

42

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Related Articles: Edwards, Chris, “10 Reasons to Oppose a Stimulus Package for the States”: http://www.cato.org/pubs/tbb/tbb_1208-51.pdf. This article criticizes part of the bailout package proposed by the Obama administration late in 2008 (it passed in early 2009). Note argument number 4, the most relevant for this discussion.

Discussion Question How can one find evidence of crowding out due to an increase in the budget deficit (created by a stimulus package)?

Answer: One way of finding evidence in favor of the crowding-out hypothesis is to find evidence of increases in the interest rate linked to a worsening budget deficit. Even if this type of evidence would not be conclusive, it would support such a hypothesis. In the case of the U.S. economy, short-term interest rates remained at low levels even after a significant part of the stimulus package was spent.

D. For Information About Application: The Twin Deficits Data Source Bureau of Economic Analysis: http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=1&isuri=1. Here you can find information about the U.S. trade balance (section 1 or 4) and the budget deficit (section 3).

Related Article Bartolini, Leonardo and Lahiri, Amartya, “Twin Deficits, Twenty Years Later”: http://www.newyorkfed.org/research/current_issues/ci12-7/ci12-7.html. This article discusses the relevance of a hypothesis that meant to explain the decline in the trade balance during the 1980s in the United States.

Discussion Question What would be the effect on the trade balance of an autonomous increase in private saving?

Answer: An autonomous increase in private saving will improve the trade balance. If individuals (i.e., not the government) decide to increase their savings rate, national savings will increase, closing the trade balance. There are many hypotheses as to why individuals have different savings rates across countries.

One of them is that individuals in a few countries save a lot in expectation of future low social security transfers (where they are available).

E. For Information About Application: The Global Saving Glut Data Source OECD Stats: http://stats.oecd.org/index.aspx. This link provides access to information about China from the OECD’s Website. Click on “General Statistics” (left panel), then on “Country statistical profiles” and select “China.” On the statistical profile, you can observe the size of China’s positive trade balance (net exports) relative to other countries.

Related Article Bernanke, Ben, “The Global Saving Glut and the U.S. Current Account Deficit”: http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/. This is the speech in which Bernanke coined the term “global saving glut.”

.

Chapter 4

Saving and Investment in Closed and Open Economies

43

Discussion Question One of the consequences of an abundance of savings in some regions of the world is that it might create imbalances in other parts of the world. Do you think it is possible to solve these imbalances by restricting the behavior of individuals or countries that save a lot or not enough?

Answer: Although such a measure might seem tempting (due to its apparent simplicity), it is actually quite controversial. No international organization can “force” countries or individuals to affect their saving behavior. Even if a country agrees to reduce or increase its savings rate, it would be quite difficult to do so, as individuals are the ultimate decision makers. It seems more plausible that country leaders might have to coordinate their efforts to manage these imbalances created by different cultures (and often different economic systems) across the world. This is often the topic of G-7 or G-20 meetings.

.

Chapter 5 Money and Inflation ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline What Is Money?

Meaning of Money Functions of Money The Federal Reserve System and the Control of the Money Supply Federal Reserve Banks Board of Governors of the Federal Reserve System Federal Open Market Committee (FOMC) Control of the Money Supply Measuring Money The Federal Reserve’s Monetary Aggregates The Fed’s Use of M1 Versus M2 in Practice Macroeconomics in the News: The Monetary Aggregates Quantity Theory of Money Velocity of Money and the Equation of Exchange From the Equation of Exchange to the Quantity Theory of Money The Classical Dichotomy Quantity Theory and the Price Level Quantity Theory and Inflation Application: Testing the Quantity Theory of Money Hyperinflation Policy and Practice: The Zimbabwean Hyperinflation Inflation and Interest Rates Application: Testing the Fisher Effect The Cost of Inflation Costs of Anticipated Inflation Costs of Unanticipated Inflation Chapter 5 Appendix: The Money Supply Process The Fed’s Balance Sheet Liabilities Assets

.

Chapter 5

Money and Inflation

45

Control of the Monetary Base Federal Reserve Open Market Operations Shifts From Deposits Into Currency Discount Loans Overview of the Fed’s Ability to Control the Monetary Base Multiple Deposit Creation: A Simple Model Deposit Creation: The Single Bank Deposit Creation: The Banking System Critique of the Simple Model Factors that Determine the Money Supply Changes in the Nonborrowed Monetary Base Changes in Borrowed Reserves from the Fed Changes in the Required Reserve Ratio Changes in Currency Holdings Changes in Excess Reserves Overview of the Money Supply Process Application: Quantitative Easing and the Money Supply, 2007–2013 The Money Multiplier Deriving the Money Multiplier Intuition Behind the Money Multiplier Money Supply Response to Changes in the Factors

Chapter Overview and Teaching Tips Chapter 5 examines Milton Friedman’s famous adage that “inflation is always and everywhere a monetary phenomenon.” It shows that in the long run, inflation is determined by the growth rate of the quantity of money.

To understand the link between money and inflation, the student must understand how money is defined and measured. The first half of Chapter 5 discusses the definition of money: how the economist’s definition differs from that of common speech, the functions of money, and measures of the money supply, such as M1 and M2.

The first half of the chapter also contains a brief discussion of the central bank in the United States, the Federal Reserve System, and how it controls the quantity of money, also referred to as the money supply.

For instructors who want to cover how the Federal Reserve determines the money supply in more detail, the chapter has an appendix on the money supply process. This appendix outlines how the Fed controls the monetary base and what other factors affect the supply of money. The framework in the appendix is made to come alive for students with an application on how quantitative easing during the period from 2007– 2013, which quadrupled the size of the Federal Reserve’s balance sheet and increased the monetary base by more than 250 percent, led only to a moderate increase in the money supply. Students are particularly interested in this application because so many commentators, especially politicians, argue that the Fed has pursued ultra expansionary, inflationary, monetary policy during this period and yet inflation remained low. This application helps explain why high inflation didn’t occur ; it shows why the huge expansion of the Fed’s balance sheet did not translate into high growth rates of the money supply. An online appendix has an additional application on how the Great Depression bank panics caused a precipitous fall in the money supply from 1930 to 1933. This episode is one of the most important in the monetary history of the United States, and discussion of the Great Depression, particularly after our near-brush with a depression

.

46

Mishkin • Macroeconomics: Policy and Practice, Second Edition

during the recent financial crisis, always engages student interest. The second half of the chapter develops the quantity theory of money. The key equation to get students to understand is the equation of exchange in Equation 2, which is then transformed into the quantity theory, Equation 4. The quantity theory embedded in Equation 6 is then tested in the application, “Testing the Quantity Theory of Money,” which shows that the theory helps explain long-run inflation. The Policy and Practice case on the Zimbabwean hyperinflation is fun to discuss in class because Robert Mugabe is famous for destroying his country, and hyperinflation is one manifestation of his disastrous policies.

The chapter ends by discussing the cost of inflation. This motivates why macroeconomic policy is so focused on controlling inflation.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions What Is Money?

1. Money is anything that is accepted generally in payment for goods and services or in repayment of debts. As a medium of exchange, money is used to pay for goods and services. This function of money, which replaces barter exchanges of goods and services, reduces transaction costs by eliminating the need for a double coincidence of wants and promotes greater specialization and efficiency. As a unit of account, money is the unit typically used to measure and discuss the values of goods and services.

This reduces the need to express a good’s exchange value in relation to all other goods and services; instead, it is easily expressed in monetary units. Money’s final function is to serve as a store of value.

People who hold money are using it as an asset to store their purchasing power for future use. As a store of value, money’s advantage over other assets is that it is the most liquid.

The Federal Reserve System and the Control of the Money Supply 2. The Federal Reserve uses open market operations, its purchases and sales of government bonds, to control the money supply. To increase the money supply, the Fed will buy government bonds. When the Fed pays for the government bonds it buys, the public’s currency holdings increase, and banks will have more resources with which to make loans, so checkable deposits will rise also. Because both currency and checkable deposits are part of the money supply, an open market purchase by the Fed causes the money supply to rise.

Measuring Money 3. The M1 monetary aggregate, the Fed’s narrowest measure of the money supply, consists of the most liquid assets that function as mediums of exchange: currency held by the nonbank public, nonbank traveler’s checks, demand deposits, and other checkable deposits. M2 is a broader monetary aggregate that includes M1 plus these less-liquid assets: small denomination time deposits, savings deposits, retail money market mutual fund shares, and money market deposit accounts.

Quantity Theory of Money 4. The key classical assumption is that wages and prices are completely flexible.

5. The equation of exchange is derived from the definition of velocity as the average number of times per year that a dollar is spent to buy the total output produced in the economy. Total spending is P  Y, and the quantity of money available to spend is M, so velocity V = (P  Y)/M. This definition of velocity is converted into the equation of exchange by multiplying both sides by M to get M  V = P  Y, which states that the quantity of money multiplied by the number of times this money is spent in a given year must equal the average price level times real GDP. Because multiplying real GDP by the price level gives nominal GDP, the equation of exchange says that total spending to buy goods and services equals nominal GDP.

.

Chapter 5

Money and Inflation

47

6. The classical dichotomy, the quantity theory of money, and the neutrality of money are classical long-run views about how changes in the money supply affect the economy. Because classical economists assume that wages and prices are flexible, supply and demand for output and factor services are equal in the long run. Based on this, the classical dichotomy holds that the aggregate production function and the fixed quantities of factors available are the only determinants of the economy’s output of goods and services in the long run, so aggregate output is not affected by changes in the average price level. This dichotomy means that only nominal variables change with the price level and that real variables do not. With the amount of output fixed in the long run and the velocity of money also considered to be constant over long periods of time, the quantity theory of money posits that changes in the money supply can affect only the price level. Because changes in the money supply affect prices and nothing else, and because changes in prices affect neither factor supplies nor the amount of output that can be produced, changes in the money supply do not affect real variables; thus, money is neutral because it has no real economic effects.

7. Based on the relationship that the percentage change in a product of two variables is approximately equal to the sum of the percentage change in each variable, the equation of exchange, M  V = P  Y can be converted to % M + %V = %P + %Y. Knowing that the percentage change is the same as the growth rate of a variable and recognizing that inflation is the growth rate (percentage change) of the price level, the equation tells us that inflation equals the growth rate of money plus the growth rate of velocity minus the growth rate of output. Assuming velocity is constant yields the theory that inflation equals the growth rate of money minus the growth rate of output. This relationship emphasizes the key role of a central bank to limit money supply growth in order to control inflation.

Hyperinflation 8. Hyperinflation is generally defined as inflation in excess of 1,000 percent per year. The main cause of hyperinflation has been fiscal imbalances in which governments that wish to increase their spending without increasing taxes resort to printing excessive amounts of money that produces a high rate of money supply growth.

Inflation and Interest Rates 9. According to the Fisher effect, an increase in expected inflation causes a one-to-one change in nominal interest rates, which means that changes in the growth of the money supply and, therefore, in inflation have no long-run impact on real interest rates.

The Cost of Inflation 10. Anticipated inflation has several costs. Individuals and businesses incur “shoe-leather” costs to minimize their cash holdings in order to take advantage of higher nominal interest rates when inflation increases. Businesses incur menu costs to inform their customers of price changes. Inflation also imposes costs on taxpayers, who are taxed on their nominal incomes and capital gains rather than on the real values of these items and, therefore, must pay higher taxes even though their real incomes and gains have not increased. Even when inflation is anticipated, not all prices change at the same time so that temporary changes in relative prices of goods and services can cause resources to be misallocated and make the economy less efficient. Finally, inflation can increase the difficulty consumers have in calculating relative prices and distort their spending decisions. Unanticipated inflation increases uncertainty throughout the economy and makes relative prices more variable.

Inflation becomes more variable and more difficult to predict, especially when inflation is higher.

These results of unanticipated inflation can lead households to make incorrect spending, saving, and labor supply decisions and business firms to make incorrect investment and hiring decisions, thus reducing the economy’s ability to allocate resources appropriately and efficiently.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

48

Answers to Problems What is Money?

1. a.

Most probably people used some type of bank note or a check to pay for a house in order to avoid all the problems associated with wandering around in a wagon filled with silver and gold. Not to mention its weight, one has to consider also the risk of being robbed. Gold and silver pieces were considered (along with many different types of money) to be “commodity money.” In short, commodity money is a particular good (a “commodity”) that can perform the three functions of money. Commodity money has value in itself (even today gold has many uses), while paper money is intrinsically worthless. b. Most types of commodity money had characteristics that limited their use: They were too heavy (e.g., gold coins) or perishable (e.g., tobacco). These limitations resulted in significant transaction costs associated with the use of commodity money, making the payments system less efficient.

Modern societies created different means of payments that reduced transaction costs (think about how much time it costs you to pay for your groceries using your debit card). A corollary of this reasoning is that as technology improves, so will our payments system and maybe some day checks or even debit cards will be a thing of the past!

2. The degree of liquidity of an asset is measured by considering how much time and effort (i.e., transaction costs) are needed to convert that asset into currency. Currency is by definition the most liquid type of money. Different types of money have different degrees of liquidity. A check, which represents a balance on a checking account, is a quite liquid type of money. After all, all that is needed to pay for a good or service using a check is the two minutes it takes to include the date and amount and sign the check. However, the above example shows that some merchants refuse to accept checks as a means of payment. (They cannot refuse to accept dollars, as dollars are legal tender in the United States.)

This can result in significant transaction costs in trying to find a bank or an ATM. It is even possible that the transaction never takes place. This example illustrates the point that even inside the same monetary aggregate, different types of money do not have the same degree of liquidity.

3. a.

This situation illustrates the medium-of-exchange function of money. We often do not think why we accept money in exchange for hours spent working, as we are so accustomed to using money.

The medium-of-exchange function of money refers to its ability to facilitate trades (hours worked per money and then money per groceries) in a society. b. In this case we observe money performing its unit-of-account function. If modern societies did not use money as a unit of account, then the price of apples would have to be quoted in terms of all the other items at the market. This quickly becomes an impossible task. Suppose that a pound of apples sells for 0.80 pounds of oranges, half a gallon of milk, one third of a pound of meat, 2 razor blades, 1.5 pound of potatoes, etc.! c. Maria is contemplating the store-of-value function of money. As a medium of exchange and unit of account, measures of money known as M1 or M2 have no important rivals. With respect to the store-of-value function, however, there are many assets that can preserve value better than a checking account. Maria’s choice to preserve the purchasing power of her income by accruing her savings account balance is fine for a small period of time. For a period of 20 years, however, you might choose to buy a U.S. Treasury bond that matures in 20 years (as many grandparents have done as a way to pay for their grandchildren’s educations).

Measuring Money 4. a.

To estimate annualized rates, multiply the three months percentage growth rate by 4 and the six months percentage growth rate by 2. The table on the next page shows the results:

.

Chapter 5

Money and Inflation

49

Annualized Growth Rate Period

M1

M2

3 months

9.17%

6.68%

6 months

10.74%

5.84%

1 year

12.03%

7.38%

b. As noted in Chapter 5, growth rates of M1 and M2 can be quite different. An important feature is that M1 can be substantially more volatile than M2, as observed since 1992 (see Figure 1 in the text chapter).

5. Your actions will reduce your checking account balance and increase your holdings of money market mutual fund shares. Considering this transaction only, M1 will decrease as one if its components decreased. M2 will remain constant, as M2 is composed of all items that add up to M1 plus some other types of money that are not so liquid to be considered part of M1. One of these categories is money market mutual fund shares. The decrease in your checking account balance is offset by the increase in money market mutual fund shares, and therefore, M2 remains constant.

Quantity Theory of Money 6. a.

According to the quantity theory of money, the money supply times the velocity of money equals aggregate spending. Aggregate spending therefore equals 200 million stone beads. b. The velocity of money is defined as the ratio of aggregate spending to the money supply. If a smaller quantity of money can support the same aggregate spending level, then the ratio increases.

This example illustrates how the introduction of new financial products can affect the velocity of money. One of the reasons as to why the inhabitants of Pandora might want to hold fewer beads at any given time may be that they can exchange a few beads for bonds and earn a return by holding these bonds. Financial developments affect the velocity of money and the willingness to hold money.

7.

Data for these countries and time period supports the quantity theory of money. Countries with relatively higher money growth rates also experienced higher inflation rates during the period

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

50

considered. Most Latin American countries experienced very high inflation rates during the decade from 1981 to 1990, mostly due to high budget deficits. Some of these countries even experienced episodes of hyperinflation. Mostly because of the disastrous effects of inflation on these economies, many countries decided to contain the growth rate of money in order to keep inflation controlled. In retrospective, Argentina’s inflation rate in 1990 was around 1,350 percent, while it was only about 10.88 percent between 2002 and 2012.

The Cost of Inflation 8. Online banking and ATMs reduce the impact of shoe-leather costs on the economy. Online banking allows depositors to move their balances in their noninterest-bearing checking accounts to savings accounts more easily. ATMs allow depositors to carry only a debit card to make payments for most of their monthly purchases and, therefore, decrease the time spent in getting access to their balances. In addition, many employers pay their employees through direct deposit, which greatly reduces transaction costs associated with cashing checks. These technological improvements do not mean that shoe-leather costs do not exist, but their effect is reduced. Finally, keep in mind that not all countries have banking systems that offer these services.

9. Technological improvements as the ones described above resulted in menu costs being less important.

As noted in the text, menu costs do not impose a significant problem when inflation is moderately low.

Technological advances allow firms to change prices quite quickly and to transmit this information in a relatively costless manner to their customers (i.e., via a Website). Incorporating code bars to identify products has also helped retailers to reduce the impact of menu costs on their operating expenses (e.g., the cost of the extra time required to change prices in a supermarket).

10. a.

To calculate the after-tax real capital gain, one has to subtract taxes paid from the real capital gain.

If the tax rate is applied to nominal capital gains, then taxes will equal $500  0.35 = $175. The after-tax real capital gain is therefore $300 − $175 = $125. b. In this case, the tax rate is applied to the real capital gain and, therefore, equals $300  0.35 = $105.

The after-tax real capital gain is now $300 − $105 = $195. This example illustrates the effect of applying taxes to nominal rather than real capital gains: Real after-tax gains decrease. Although this is a quite simple example, tax laws are often much more complicated and changing the tax code to allow for the multiple effects of inflation is a quite time-demanding task.

◼

Answers to Data Analysis Problems

1. a.

From 2000:Q1 to 2013:Q1, average growth in real GDP is about 1.8 percent, average growth in velocity has been –1.6 percent, and the M1 money stock has grown about 6.1 percent per year. b. Based on part (a), the average inflation rate should be about %ΔM + %ΔV – %ΔY = 6.1 – 1.6 – 1.8 = 2.7%. c. Average inflation per year for the period using GDPDEF is 2.2 percent, which is roughly the same as calculated above, consistent with the quantity theory of money.

2. a.

From 2005:Q1 to 2013:Q1, the inflation rate has declined from 3.3 percent to 1.6 percent (decrease of 1.7 percentage points), while the interest rate has declined from 3.06 percent to 0.15 percent (decrease of 2.91 percentage points). Interest rates have fallen a bit more than one-forone in this case, so the Fisher effect does not seem to hold. b. From 1980:Q1 to 2013:Q1, the inflation rate has declined from 9.0 percent to 1.6 percent (decrease of 7.4 percentage points), while the interest rate has declined from 13.93 percent to 0.15 percent (decrease of 13.78 percentage points). Interest rates have fallen a bit more than onefor-one in this case, so the Fisher effect does not seem to hold.

.

Chapter 5

c.

◼

Money and Inflation

51

The scatterplot and regression line are shown below. Overall, the data show very strong support for the Fisher equation, below. The slope of the regression coefficient is 0.987; meaning on average, for every one percentage point increase in the inflation rate, the nominal interest rate will rise by 0.987 percentage points, demonstrating a very close correspondence to the Fisher Effect.

Answers to Review Questions and Problems in Web Appendix, “The Money Supply Process”

1. The monetary base is the sum of currency in circulation and bank reserves, which consist of banks’ vault cash and the deposits they hold at the Federal Reserve. The Fed influences the size of the monetary base through open market operations—Fed purchases or sales of U.S. Treasury securities—and through discount loans to banks. The monetary base rises when the Fed buys Treasury securities or makes loans to banks; when the Fed sells some of its holdings of Treasury securities or banks repay loans from the Fed, the monetary base declines.

2. When the Fed purchases the Treasury securities from Bank of America (BA), the bank’s reserves rise by the dollar amount of the Fed purchase. Because the Fed’s purchase does not increase BA’s deposits, all of BA’s new reserves are excess reserves that it can safely lend (without lowering its reserves below the required level). When BA lends its excess reserves, it creates new deposits on which the borrowers write checks to buy goods and services. When these checks are deposited into other banks, the excess reserves will leave BA and go to the banks receiving the new deposits. If the required reserve ratio is 10 percent, these banks’ required reserves rise by 10 percent of the amount of their new deposits, but the remaining 90 percent of their new reserves are excess reserves that they, like BA before them, can safely lend out. As with the loans that BA made, these new loans will also be spent and the excess reserves will go to the banks that receive new deposits as a result. As this process of lending excess reserves, spending the money that is lent, and depositing the funds into

.

52

Mishkin • Macroeconomics: Policy and Practice, Second Edition

other banks continues, the total deposits that are created by the banking system through lending becomes a multiple of the original dollar amount of the Fed’s Treasury security purchases. With a required reserve ratio of 10 percent, the multiple deposit creation will be 10 times the dollar amount of securities purchased, because the simple deposit multiplier is the reciprocal of the required reserve ratio (10 = 1/0.10). The simple model assumes that all the money created through bank lending is deposited in banks so that none of it is added to household or business cash holdings, and that banks will lend all of their excess reserves. If either assumption is violated, the total amount of deposits created through bank lending will be less (and perhaps much less) than the simple model predicts.

3. The Federal Reserve controls the nonborrowed monetary base, the portion of the monetary base that it creates thorough open market operations. An increase in the nonborrowed monetary base increases the monetary base, so more multiple deposit creation can take place and the money supply rises. The Fed and banks influence borrowed reserves. (The Fed can discourage or encourage bank borrowing by increasing or decreasing the discount rate, but banks decide whether and how much to borrow from the Fed at any given discount rate.) When borrowed reserves increase, so does the monetary base.

Hence, more multiple deposit creation can take place, and the money supply rises. The Fed controls the required reserve ratio. An increase in the required reserve ratio decreases the money multiplier because, for a given level of the monetary base, banks have fewer excess reserves to lend and less multiple deposit creation can take place, so the money supply falls. Depositors control currency holdings.

When they hold more currency relative to checkable deposits, the money multiplier falls because bank deposits fall, bank reserves fall, and less multiple deposit creation occurs for a given level of the monetary base. As a result, the money supply falls. Depositors and banks influence excess reserves, because banks’ desire to hold excess reserves depends in part on the level of depositor withdrawals.

When banks hold more excess reserves relative to checkable deposits the money multiplier again falls because bank lending falls and multiple deposit creation is less, so the money supply falls for a given level of the monetary base. (The Great Depression provides a powerful example of how the money supply responds to increases in currency holdings and excess reserves.)

4.

Federal Reserve System Assets

Liabilities

Government Securities

$ 450

Currency

$750

Discount Loans

$1,150

Reserves

$850

Fed’s total monetary liabilities = currency in circulation + reserves of the banking system = $1,600 billion.

5.

Federal Reserve System Assets Government Securities

Liabilities −$200

Reserves

−$200

Banking System Assets

Liabilities

Government Securities

+ $200

Discount Loans

− $200

Because there is no change in currency in circulation, the Fed’s monetary liabilities decrease by the full amount of the open market sale = −$200 million.

.

Chapter 5

Money and Inflation

53

6. In a country prone to banking crises in which depositors may end up losing their deposits, even a rumor about a banking crisis encourages depositors to shift their deposits into currency. Depositors resort to this action to avoid losing their checkable deposits in the event that a crisis actually happens. Usually depositors either shift their deposits into currency, decreasing reserves of the banking system (but not affecting the monetary base, as currency in circulation increases), or they deposit their savings in other countries with a more trustworthy banking system. When rumors about a possible bank crisis spread throughout Argentina in December 2001, checkable deposits at Argentine banks sharply decreased; part of these deposits fled to Uruguay, while another portion was deposited in the United States.

7. The closing of the TAF program would be equivalent to the repayment of discount loans by financial intermediaries. If the TAF closes, financial intermediaries will have to pay back their discount loans, which were usually extended for a 28-day period. Once the TAF closes, most discount loans will be quickly paid back and reserves of the banking system will decrease, decreasing the monetary base.

Note that even if the Fed closes the TAF, it will keep its regular discount window open so that financial intermediaries can still borrow from the Fed. 8. a.

In this case, the bank decides not to make loans; therefore, there is no increase in checkable deposits. The monetary base has increased, as the bank is holding more reserves as a result of the open market operation, but because it is not using these reserves to create loans, checkable deposits do not change, and the money supply remains unchanged. b. In this case, checkable deposits increase by the full amount of the bank’s excess reserves = $100 million, as the bank is using all of its excess reserves to create a loan. Because checkable deposits are a component of the money supply, the money supply increases by $100 million. c. With many banks operating side by side, the multiple deposit creation process takes place, and checkable deposits increase by more than the original increase in reserves. Assuming banks make loans for the full amount of their excess reserves, the increase in the money supply can be estimated at $1,000 million = $100 million  10. The multiplier, 10, is the reciprocal of the required reserve ratio.

9. If banks decide to borrow from the Fed, discount loans will increase, and the borrowed monetary base will increase one to one with the expansion of discount loans. This is what happened when the Fed decided to facilitate the access to funds for financial intermediaries so that credit could keep flowing in the U.S. economy during the most recent financial crisis. Banks, however, did not find it profitable to lend these funds, and lending was restricted (asymmetric information problems were quite severe, in addition to uncertainty about the future of the economy). When banks decided to keep most of their discount loans in the form of excess reserves at the Fed, the money supply did not increase by much, whereas the monetary base increased by a lot (at some point during 2009 the monetary base exceeded the money supply, as measured by M1). To be precise, if all discount loans are kept in the form of excess reserves, the money supply should not change.

10.

Currency deposit ratio

0.5

0.7

0.5

Excess reserves ratio

0.01

0.01

0.9

Required reserves ratio Money multiplier

0.08 2.54

0.08 2.15

0.08 1.01

The M1 money multiplier decreases when the currency deposit ration increases because depositors’ decisions to keep their money in the form of currency decrease banks’ ability to create money (i.e., the multiple deposit creation process is negatively affected). When banks decide to keep a lot of excess reserves (an increase in the excess reserves ratio), their ability to make loans also decreases.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

54

As a result, fewer loans are made, and the money supply decreases (keeping the monetary base constant). Note that an excess reserves ratio of 90 percent (or more) is difficult to observe, but this actually happened in the United States banking system during the second quarter of 2009.

11. The loss of confidence in the banking system led to surge in holdings of currency and a decline in the holdings of deposits. The resulting rise in the currency-deposit ratio, c, reduced the overall level of multiple deposit expansion, leading to a decline in the money multiplier and the money supply. To protect themselves from the large deposit outflows, banks increased their holdings of excess reserves, leading to a surge in the excess-reserves-to-deposits ratio, e. The increase in the excess reserve ratio resulted in a further decrease in the money multiplier. Hence even though the monetary based increased during this period, the sharp decrease in the money multiplier resulted in a sharp fall in the money multiplier

Answers to Appendix Data Analysis Problems 1. a. c = CURRNS/TCDSL = 1,124.9/1,395.6 = 0.806 as of June 2013. b. Excess Reserves is calculated as RESBALNS – RESBALREQ = 2,010.604 – 63.667 billion = 1,946.937 billion as of June 2013. Thus, e = [RESBALNS – RESBALREQ]/TCDSL = 1,946.937/1,395.6 = 1.395. c. Given the data above, m = 1.806/[0.806 + 1.395 + 0.11] = 0.78.

2. a.

The money multiplier for June 2013 is 2,522.3/3,222.3 = 0.78; for June 2008, the multiplier is 1,401.2/863.88 = 1.62. b. The $100 million open market purchase of securities will increase the monetary base by $100 million and would hypothetically increase the M1 money supply by 0.78 ×$100 million = $78 million in June 2013, and the same open market operation would result in 1.62 × $100 million = $162 million increase in M1 in June 2008.

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: Testing the Quantity Theory of Money Data Sources Federal Reserve Bank of St. Louis: http://research.stlouisfed.org/fred2/categories/9 (for inflation) and http://research.stlouisfed.org/fred2/categories/25 (for monetary aggregates).

Related Article The Concise Encyclopedia of Economics, “Milton Friedman”: http://www.econlib.org/library/Enc/bios/Friedman.html. This article is a short biography about the economist that resurrected the quantity theory of money in the twentieth century.

Discussion Question What would be the problem of applying the insights of the quantity theory of money to explain short-run changes in the inflation and money growth rates?

Answer: The quantity theory of money provides a good explanation to long-run movements in the price level. In the short run, however, changes in the money growth rate cannot explain changes in inflation.

Asserting that a recent increase in the M1 or M2 monetary aggregate would result in an increase in the price level in the near future would be a mistake.

.

Chapter 5

Money and Inflation

55

B. For Information About Policy and Practice: The Zimbabwean Hyperinflation Data Sources World Bank Data and Statistics: http://data.worldbank.org/country/zimbabwe. Here you can find summary statistics about Zimbabwe. You can get more data by following the “DATABANK” link.

Related Article Martinez, Ibsen, “Can ‘New’ Currency Abate Venezuelan Inflation?”: http://www.econlib.org/library/Columns/y2007/Martinezinflation.html. This article has a brief reference to the (often failed) government attempts to fight inflation by introducing “new” currency in many countries (including Zimbabwe).

Discussion Question By which mechanisms can a hyperinflation affect the performance of the economy (e.g., effects on the unemployment rate, and GDP growth rate)?

Answer: Hyperinflation is a very disruptive event. Not only does it affect the rate at which prices increase, but it affects the behavior of individuals. Some of these effects include a decrease in incentives to invest, which decreases current and future economic growth. In addition, individuals spend a large proportion of their time devising and implementing strategies to fight inflation (as opposed to being at work). Finally, during these episodes, different sectors of the society compete (sometimes aggressively) for the economy’s resources. As prices do not work as a rationing device anymore, other allocation mechanisms arise during hyperinflations.

C. For Information About Application: Testing the Fisher Effect Data Source Federal Reserve Data: http://www.federalreserve.gov/releases/h15/update/. Here you can find information about inflation expectations. The expected inflation rate (for each maturity) can be calculated by subtracting the interest rate on the TIPS (inflation indexed) bonds from the interest rate on the (same maturity) Treasury bonds.

Related Article Mishkin, Frederic S., “The Real Interest Rate: An Empirical Investigation”: http://www.nber.org/papers/w0622. This paper outlines the methodology used to estimate expected inflation to get the data used in the textbook graph.

Discussion Question Suppose that according to a survey about inflation expectations, inflation is expected to rise in the near future. Would this mean that nominal interest rates will increase as well? Explain your answer.

Answer: The evidence about the link between inflation expectations and nominal interest rates indicates that a positive relationship exists in the long run. This evidence is not reliable in the short run, meaning that one cannot assert that nominal interest rates will increase in the short run due to the current increase in inflation expectations. This relationship is clearer in the long run.

D. For Information About Application: Quantitative Easing and the Money Supply, 2007–2013 Data Sources Federal Reserve Bank of St. Louis: http://research.stlouisfed.org/fred2/categories/25. Here you can find data about the M1 money multiplier (second series). Note the evolution of the M1 money multiplier since 2007,

.

56

Mishkin • Macroeconomics: Policy and Practice, Second Edition

and check how this explains the relatively smaller increase in M1 in relation to the increase in the monetary base.

Related Article O’Driscoll Jr., Gerald P. “Where’s the Inflation? Coming to your neighborhood”: http://www.cato.org/publications/commentary/wheres-inflation-coming-neighborhood. This article explains why quantitative easing did not result in inflation but warns that the exceptional increase in the monetary base might create inflation in the future.

Discussion Questions Suppose that after the increase in the monetary base engineered by the Federal Reserve (quantitative easing) someone argues that this will unambiguously result in an increase in the money supply and, therefore, will create inflation. Would you agree with this idea? Why or why not?

Answer: The surge in the monetary base results in an increase in the money supply only if the money multiplier remains constant. However, this was not the case during the 2007–2013 period in the United States. To claim that the money supply will increase at the same rate that as the monetary base means that the money supply process is not understood. It is interesting to note that some people used this claim during the 2008–2013 period to criticize the Federal Reserve’s actions on this matter.

E. For Information About Web Appendix Application: The Great Depression Bank Panics and the Money Supply, 1930–1933 Data Source Federal Reserve Bank of St. Louis: http://research.stlouisfed.org/fred2/series/MULT?cid=25. Here you can find the latest data on the M1 money multiplier. Note the decrease in the M1 multiplier during the 2007–2009 crisis, due mostly to the increase in the excess reserves ratio.

Related Article Smiley, Gene, “Great Depression”: http://www.econlib.org/library/Enc/GreatDepression.html. This article puts the 1931–1933 banking crisis in the context of the Great Depression.

Discussion Question During the 2007–2009 crisis in the United States, the currency deposit ratio did not increase significantly (as opposed to the 1931–1933 banking crisis), even though quite a few banks failed during the 2007–2009 crisis. Why do you think that the currency deposit ratio did not change by much in the most recent crisis?

Answer: The answer to this question is related to the behavior of depositors and their desire to keep their savings in the banking system. It also has to do with the fact that the FDIC has insured all deposits since 1933. Prior to the creation of the FDIC, individuals were reluctant to keep their deposits in the banking system, but this fear was not present in the most recent crisis. As a result, the currency deposit ratio did not change by much in 2007–2009.

.

Chapter 6 The Sources of Growth and the Solow Model ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Economic Growth Around the World The Solow Growth Model Building Blocks of the Solow Growth Model Dynamics of the Solow Growth Model Convergence in the Solow Model Application: Evidence on Convergence, 1960–2012 Saving Rate Changes in the Solow Model Population Growth in the Solow Model Population Growth and the Steady State Changes in Population Growth Population Growth and Real GDP Per Capita Policy and Practice: China’s One-Child Policy and Other Policies to Limit Population Growth Productivity Growth in the Solow Model Technology Growth and the Steady State Summing Up the Solow Model Solow Model: The Results Solow Model: Limitations Sources of Economic Growth: Growth Accounting Growth Accounting Equation Growth Accounting in Practice Application: U.S. Growth Rates in the Postwar Period Cross-Country Differences in Growth Accounting Rates Chapter 6 Appendix: The Algebra of the Solow Growth Model Chapter 6 Web Appendix: The Golden Rule Level of the Capitol-Labor Ratio

Chapter Overview and Teaching Tips Part Three of the book introduces students to the fascinating study of economic growth. I like to start teaching this material by contrasting the situation in South Korea in 1960 with other poor countries at the time, and then fast forward to today, when South Korea is so rich, while many countries that it was comparable to in 1960 are still so poor. Another contrast that can be used is the condition of South versus North Korea in 1960 when their income per capita was comparable and today, when they are not. These comparisons make clear

.

58

Mishkin • Macroeconomics: Policy and Practice, Second Edition

how important it is to understand what drives economic growth. Putting Lucas’s quote, “The consequences for human welfare involved in questions like these [about economic growth] are simply staggering” on the blackboard is a good way to motivate the material.

The chapter starts with a tour of economic growth around the world. This section provides students with facts about economic growth and motivates the questions that they will want answered in this part of the book: How can we explain why most countries experience economic growth over time? Why do some countries display convergence, while others do not? Why do some countries have growth miracles, while others have growth disasters?

The Solow growth model developed in the chapter is very standard in most macroeconomic textbooks.

One innovation here is the bathtub model of the steady state, which provides a lot of intuition about how the Solow growth model works. One key implication of the Solow model is convergence of economic growth, and the application on the evidence on convergence illustrates when the Solow model helps explain convergence and when it does not. A particularly graphic example of when the Solow model helps explain convergence is in the box, “War, Destruction, and Growth Miracles,” which shows that economic devastation often does not have long-run effects on per capita income because of convergence.

The rest of the chapter puts the Solow growth model through its paces, explaining the effect of changes in the saving rate, population growth, and productivity growth on economic growth. The chapter ends by providing a recap of the Solow model, which not only helps solidify the student’s understanding, but demonstrates the model’s limitations, which helps motivate the remaining chapters in Part Three of the book.

Having students debate the Policy and Practice case, “China’s One-Child Policy and Other Policies to Limit Population Growth,” in class gets students to recognize that policies to increase growth may not always be beneficial because they may have disturbing moral consequences.

The chapter ends with growth accounting and develops the growth accounting Equation 11, which is derived from the aggregate production function in Chapter 3. Although accounting is usually a dry topic, this is not the case for growth accounting. Talking about the sources of economic growth is inherently fascinating, and growth accounting helps lay out the key issues that we have to think about to understand economic growth. Applications, such as the one in the chapter on U.S. growth rates since World War II, drive home that the growth accounting equation is a useful tool for understanding variations in economic growth. This can be driven home even further by discussing international comparisons along the lines in the chapter. The most important conclusion to get across to students from growth accounting is that productivity growth is a more important source of variations in economic growth across countries than is factor accumulation, and this naturally leads to the study of the role of technology and institutions in economic growth in Chapter 7.

The chapter has an appendix on the algebra of the Solow growth model that is worth presenting to more mathematically inclined students, who will see that the results of the Solow growth model can be derived very quickly algebraically, with some quantitative predictions that are quite useful. This chapter also has an online appendix found on the Companion Website at www.pearsonhighered.com/mishkin. It discusses the golden rule level of the capital–labor ratio and indicates that increasingly higher saving rates, which always raise income per capita, do not necessarily lead to higher economic welfare because at some point a higher saving rate leads to a decline in consumption. This analysis is somewhat more complex than in the chapter and is thus relegated to an online appendix, but the basic intuition for this point can be made without going through the full analysis.

.

Chapter 6

◼

The Sources of Growth and the Solow Model

59

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions The Solow Growth Model 1. According to the per-worker production function, derived from the aggregate production function, output per worker yt depends on two things: total factor productivity A and the amount of capital per worker, the capital–labor ratio kt. The Solow growth model considers total factor productivity to be an exogenous variable and provides no explanation for changes in its value.

2. The per-worker production function slopes upward because an increase in capital per worker increases output per worker. However, as capital per worker rises, the additional output per worker that can be produced with each unit addition to the capital–labor ratio declines because the per-worker production function, like the aggregate production function on which it is based, exhibits diminishing marginal product of capital. Thus the per-worker production function becomes flatter as the capital– labor ratio increases.

3. The amount of investment per worker is based on the equality of saving and investment in the long run. The Solow model assumes workers save a given proportion s of their output per worker yt so syt is available to finance investment per worker it. To avoid capital dilution and a decline in the capital– labor ratio, a fraction of this investment must be used to replace old capital that has worn out (depreciated). This fraction is the depreciation rate  . Capital accumulation—increases in capital per worker—occur only if the amount of investment is greater than  kt. The change in capital per worker, then, equals investment per worker minus depreciation per worker.

4. Given the per-worker production function and fixed productivity and population, the steady-state level of capital per worker depends on the proportion of income per worker that is saved and the depreciation rate. The steady state is achieved when the level of capital per worker does not change.

For this to occur, the amount of investment per worker must equal depreciation per worker. If the capital–labor ratio is above the steady-state level, investment is less than the amount of new capital needed to replace that which wears out. With more capital wearing out than is being replaced, capital per worker declines toward the steady-state level. If the capital–labor ratio is below the steady-state level, investment more than adequate to replace the capital that wears out and capital per worker rises toward the steady-state level. Thus the capital–labor ratio moves to the steady-state level regardless of its initial value.

Saving Rate Changes in the Solow Model 5. If the saving rate increases, a larger portion of the present output per worker will be invested in new capital. Capital accumulation and capital per worker will rise, and capital per worker will continue growing until a new steady state is reached. As capital per worker rises, output per worker and investment per worker also grow. In the new steady state, the higher level of investment is needed to replace the greater amount of depreciation that results from the higher level of capital per worker.

Once the new steady state is reached, however, there are no further increases in the levels of capital or output per worker. An increase in the saving rate, then, causes temporary growth in capital and output per worker that raises them to higher levels, but in the long run steady state the growth rates of those variables return to zero.

Population Growth in the Solow Model 6. Population growth results in capital dilution, as a given amount of capital must be used by a larger number of workers. The decline in capital per worker reduces output per worker. (This occurs despite growth in total output that results from having additional workers as population grows.) To achieve a steady state, the amount of investment per worker now must cover two sources of capital dilution,

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

60

depreciation and increases in the number of workers, both of which will reduce the capital–labor ratio if investment is not sufficient. In the steady state, saving per worker equals depreciation per worker ( kt) plus the amount of capital needed to keep capital per worker constant in the face of population growth (nkt.) Compared with a situation in which population is fixed, population growth reduces the steady-state levels of capital and output per worker, ceteris paribus.

7. The exogenous variables include total factor productivity, the saving rate, the depreciation rate, and the population growth rate. The endogenous variables are consumption per worker, investment per worker, capital per worker, and output per worker.

Productivity Growth in the Solow Model 8. An increase in total factor productivity works in two ways to increase output per worker. First, output per worker rises because the available capital and labor inputs are more productive and total output increases for given levels of capital and labor. Graphically, the per-worker production function rotates upward so that at the initial capital–labor ratio output per worker is higher. Second, with higher output per worker there is also more investment per worker, so the amount of capital per worker increases to a higher steady-state level, and output per worker rises along with it.

Summing Up the Solow Model 9. The Solow model provides these insights into economic growth: (1) if different economies have the same aggregate production function they will converge to similar levels of output per worker and per capita income; (2) a higher saving rate increases the levels of capital and output per worker but does not affect their long-run growth rates; (3) a higher rate of population growth reduces the level of output per person; and (4) increases in productivity directly increase output per person and also increase it indirectly by causing the capital–labor ratio to rise. The Solow model’s chief deficiency is that it does not explain sustained increases in output per worker and per capita income. This is so because productivity growth, which in the Solow model is the only source of continuous growth, is determined by factors outside the model.

Sources of Economic Growth: Growth Accounting 10. According to the growth accounting equation, which is derived from the aggregate production function, the three sources of economic growth are productivity growth, capital growth, and labor growth. The contribution to economic growth from productivity is A/A. The contributions to growth from increases in capital and labor are 0.3K/K and 0.7L/L.

Answers to Problems The Solow Growth Model 1. a.

The steady-state condition is given by s2kt0.5 =  kt → 0.2  2kt0.5 = 0.04  kt . Solving for kt yields:

0.4kt0.5 = 0.04  kt →

0.4 = kt → kt = 10 .

0.04

b. Consumption is given by ct = (1 − st ) yt = (1 − st ) 2kt0.5 → ct = 0.8  2  10 = 16.

.

Chapter 6

2. a.

The Sources of Growth and the Solow Model

61

Then new capital–labor ratio will be lower than the original one because this earthquake decreased Chile’s capital stock (including ports, roads, schools, etc.). The new capital–labor ratio is noted in the graph in red.

b. In the aftermath of the earthquake, Chile’s capital–labor ratio will be at a lower level than at its steady state. At this point, investment is higher than depreciation, and Chile will be adding to its capital stock for some time, until the capital–labor ratio reaches its steady state again. According to the model, Chile (or its most affected areas) should grow at a slightly higher rate than prior to the earthquake for some time, until it reaches its steady state again.

Saving Rate Changes in the Solow Model 3. a.

According to the Solow model, an increase in the saving rate will increase the capital–labor ratio in the United States. There will be a transition during which the U.S. economy will move toward a new steady state. At the new steady state, U.S. residents will enjoy a higher capital–labor ratio level and, therefore, a higher output-per-worker ratio. These ratios, however, will not increase any further. The effect of a higher saving rate, according to the Solow model, is to increase the steady state level of output per worker. After this transition period is over, output per worker does not increase any further. b. In light of the previous answer, one might ask: Why not keep increasing the saving rate forever?

The answer is that increasing the saving rate means decreasing current consumption, a quite important trade-off. This reasoning demonstrates that there is a limit to this path to encourage economic growth.

Population Growth in the Solow Model 4. If low standards of living are the reason individuals decide to have many children, then encouraging couples to have fewer children will not have a significant effect on economic growth. Although the concept of capital dilution is very important, there are many arguments in favor of the hypothesis that low standards of living encourage individuals to have more children. Some population control policies were not very successful (e.g., distribution of contraceptives). As people saw no change in their wellbeing, even if they had contraceptive methods at hand, they still decided to have many children.

Some other population control methods were more coercive (e.g., fines, sterilization, etc.) and, therefore, resulted in lower fertility rates. These often did not translate to an increase in the standard of living of these societies. Most societies that saw a decrease in their fertility rates also experienced an increase in their standards of living either prior to or during the decrease in fertility rates.

5. There are many consequences that arise from a coercive population control method as the one implemented by China. First, the drop in fertility rates has been so big that the Chinese labor force

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

62

might be smaller in the future than what it is today. Second, it means that young workers in the future will have to work extra hard to support their parents. This is a phenomenon shared by many aging populations, even when there is not population control, but clearly the one-child policy makes this worse. Finally, and most importantly, Chinese families that are allowed to have only one child usually prefer to have a baby boy. This has resulted in ratios of baby boys to baby girls of around 120 to 100, when the usual ratio is around 103 to 105 baby boys per 100 baby girls. An interesting corollary is that in the future there will be more Chinese young boys trying to marry fewer Chinese girls than in previous years.

6. a.

According to the Solow model, immigration will result in an increase in the aggregate output level. An increase in the labor input increases the economy’s ability to produce goods and services. This can be seen by increasing “L” in the original production function and holding the capital factor and productivity constant. As a result, “Y” will increase. b. Even if aggregate output increases at a higher rate due to immigration, the steady-state capital– labor ratio will decline. Everything else the same (including the savings rate and the productivity factor), the Solow model predicts that higher population growth dilutes the capital stock per worker and therefore results in lower output per worker.

Productivity Growth in the Solow Model 7. a.

Investment increases as productivity increases during the period. This results in an upward shift of the investment curve (holding the saving rate constant). At the same time, the immigration wave means higher population growth during that period, making the depreciation and capital dilution curve rotate counterclockwise.

.

Chapter 6

The Sources of Growth and the Solow Model

63

b. The result of these two opposing effects on the steady state capital–labor ratio depends on their relative magnitudes. If capital per worker was higher in 1910 than it was in 1900, then it is plausible to assume that the increased in productivity offset the increase in population growth, as shown in the graph.

Summing Up the Solow Model 8.

a.

Immigrants’ higher saving rate means that the new saving rate of the whole country will be higher, shifting the investment curve upward. Also, a higher fertility rate means higher population growth, represented by a counterclockwise rotation in the depreciation and capital dilution curve. b. Without having an estimate of the magnitude of these effects, we cannot determine if the new steady state level of the capital–labor ratio will be higher or lower than its previous level. The graph shows the case in which the population growth effect is larger than the increase in the saving rate, and therefore, the economy reaches a lower steady state level of the capital–labor ratio.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

64

Sources of Economic Growth: Growth Accounting 9. a.

India’s output growth can be calculated as: 1 2 gY = 4% +  3% +  3% = 7%.

3 3

b. The contribution of productivity growth to total output growth is 74  57%. Almost 60 percent of India’s growth came from productivity growth in this case.

10. a.

The difference in output growth rates can be explained by differences in productivity growth rates. This is the factor that cannot be measured directly, as opposed to changes in the capital and labor input stocks. b. Productivity growth rates can be calculated as the difference between output growth rates and the combined growth rates of the capital and labor input stock. Productivity growth in country 1 is a mere 0.5 percent, and it is 2.5 percent for country 2, which explains its higher output growth rate.

◼

Answers to Data Analysis Problems

1. a. See table below. b. See table below. The low population growth countries of Japan, United States, and Canada have an average population growth rate of 1.3 percent, and average GDP per capita of $48,119 for the sample period. The high population growth countries of Egypt, Mexico, and the Philippines have an average population growth rate of 4.2 percent, and average GDP per capita of $5,066 for the sample period. This is to be expected based on the Solow model. Among these 10 countries, Brazil and Mexico seem to be outliers to the pattern. Both have population growth in the 3 percent range; however, they have much higher GDP per capita than the other countries with approximately similar population growth.

Country

Average Population Growth Rate (1960–2011)

GDP Per Capita (2011)

Japan

0.73%

$45,902.67

United States

1.39%

$48,111.97

Canada

1.78%

$50,343.69

China

1.95%

$5,444.79

Indonesia

3.15%

$3,494.60

Brazil

3.27%

$12,593.89

India

3.41%

$1,508.54

Egypt

3.77%

$2,780.95

Mexico Philippines

3.82% 5.09%

$10,047.13 $2,369.70

.

Chapter 6

c.

The Sources of Growth and the Solow Model

65

See scatterplot below. Clearly, among these countries there is a strong relationship between high population growth leading to low GDP per capita as predicted by the Solow model.

2. a. Calculations not shown here. b. See table below. c. See table below. In every decade except the 2000s, total factor productivity (A) contributes significantly more to growth in output per worker than does capital accumulation, represented by 0.3gk. This can be seen more clearly in the averages across each decade: real output per worker has grown slightly more than 1 percent on average per year, and more than 80 percent of the growth (0.84/1.03) derives from improvements in total factor productivity, while only around 20 percent of that growth derives from growth in capital per worker.

Decade

gk

gA

0.3gk

gy = 0.3gk + gA

1960–1969

0.77

2.07

0.23

2.30

1970–1979

0.39

0.41

0.12

0.53

1980–1989

0.73

0.87

0.22

1.09

1990–1999

0.97

1.05

0.29

1.34

2000–2009

0.70

-0.17

0.21

0.04

2010–2012

0.29

0.81

0.09

0.90

Average

0.64

0.84

0.19

1.03

3. a.

From 1960 to 1980, the average net saving rate is 9.6 percent, and for 1980 to 2011, the average net saving rate is 4.0 percent. b. The Solow model predicts that, holding all other factors constant, a decrease in the saving rate will reduce the steady-state level of capital per worker and, hence, reduce output per worker and output per capita.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

66

c.

The net saving rate went down from 9.6 percent to 4.0 percent, while real GDP per capita increased significantly from $29,041 in 1980 to $48,282 per person in 2011. This is inconsistent with the Solow model prediction from part (b); however, the predicted decline in real GDP per capita from the declining saving rate is likely offset by slower population growth and significant increases in total factor productivity during that time in the United States.

◼ Answers to Review Questions and Problems in Appendix, “The Algebra of the Solow Growth Model” 1. According to the per worker production function, the steady-state value of the capital–labor ratio is given by: 1.43

 sA  k =   + n 

1.43

 0.3  2  =   0.07 

1.43

 0.6  =   0.07 

= 8.571.43 = 21.6.

The steady-state value of per-worker output is: y* = 2(k * )0.3 = 5.02 k y

Steady-state capital–labor ratio Steady-state output

21.6 5.02

2. According to the per-worker production function, the steady-state value of the capital–labor ratio is now: 1.43

 sA  k* =    + n

1.43

 0.5  2  =   0.07 

1.43

 1  =   0.07 

= 14.28571.43 = 44.82.

The steady-state value of per-worker output is: y* = 2(k * )0.3 = 6.26.  The higher saving rate shifts the investment curve up, intersecting the depreciation plus capital dilution curve at a new (higher) steady state value of the capital–labor ratio. Intuitively, the increase in savings allows this economy to reach a higher capital-per-worker steady state by adding more capital to the existing capital stock until the economy reaches its steady state again. Once the new steady state is reached, the addition to the capital stock is just enough to replace worn out capital and match new workers with the same capital stock as the previous generation. The new capital–labor ratio and output per worker steady states are denoted in red in the graph:

.

Chapter 6

The Sources of Growth and the Solow Model

67

3. According to the per-worker production function, the steady-state value of the capital–labor ratio is given by: 1.43

 sA  k =   +n *

1.43

 0.3  2  =   0.1 

1.43

 0.6  =   0.1 

= 61.43 = 12.96.

The steady-state value of per-worker output is: y* = 2(k  )0.3 = 4.31. The higher population growth rate rotates the depreciation plus capital dilution curve counterclockwise and determines a lower level of the steady-state values of the capital–labor ratio and output per worker. (The new values are denoted in red in the graph; the values from Problem 1 are in blue.)

.

68

Mishkin • Macroeconomics: Policy and Practice, Second Edition

4. An increase in productivity (the technology factor) results in a rotation upward of both the output and investment curves. At the original capital–labor ratio, output per worker rises as the output curve rises. Output per worker will also rise because the intersection point of the new investment curve and the depreciation plus capital dilution curve occurs to the right of the original steady state value of the capital–labor ratio, so that output per worker will be higher because the capital–labor ratio is higher.

Thus the original increase in output that results from an increase in technology is amplified. See graph:

◼ Answers to Review Questions and Problems in Web Appendix, “The Golden Rule Level of the Capital–Labor Ratio” 1. The Golden Rule capital–labor ratio is special because it is the value of the capital–labor ratio that maximizes consumption per worker; at the Golden Rule capital–labor ratio the marginal product of capital equals the depreciation rate. Whether or not the economy achieves the Golden Rule capital– labor ratio and maximizes consumption per worker depends on the saving rate. If the saving rate is too low, the capital–labor ratio will be below the Golden Rule value. The marginal product of capital exceeds the depreciation rate, and the economy passes up the opportunity to add units of capital that would increase consumption per worker because they would increase output per worker by more than the increase in investment per worker. If the saving rate is too high, the capital–labor ratio will be greater than the Golden Rule value. The marginal product of capital will be less than the depreciation rate, and consumption per worker will be lower than at the Golden Rule capital–labor ratio because the added units of capital add less to output per worker than they do to investment per worker, which lowers consumption per worker.

2. A saving rate that is lower than the Golden Rule saving rate results in a capital–labor ratio that is smaller than the Golden Rule ratio. This implies that consumption is not maximized. The choice of a lower saving rate means that current and future generations will not enjoy as much consumption as possible. One could interpret this as the current generation preventing future generations from achieving higher consumption levels.

.

Chapter 6

The Sources of Growth and the Solow Model

69

3. An increase in the population growth rate will result in a decrease in the Golden Rule level of the capital–labor ratio (refer to Equation 5 and remember that the marginal product of capital increases as the capital–labor ratio decreases). Intuitively, if the capital–labor ratio does not change, then the marginal product of capital will be less than the sum of the depreciation and population growth rates.

This means that the addition to output derived from increasing the capital–labor ratio is less than the increase in investment, thereby decreasing consumption. The increase in the population growth rate has the same effect on both the steady state capital–labor ratio and the golden rule capital–labor ratio.

4. A decrease in the depreciation rate means that fewer units of capital are needed to replace the wearing out of the current capital stock and maintain the Golden Rule capital–labor ratio. Using Equation 5, this means that the lefthand side of the equilibrium condition has decreased. This results in an increase in the Golden Rule capital–labor ratio, so that the marginal product of capital is set now at the new (lower) level consistent with the lower depreciation rate. The decrease in the depreciation rate has the same effect on both the steady state capital–labor ratio and the Golden Rule capital–labor ratio.

5. The Golden Rule capital–labor ratio is determined at $6,000 per worker, when the equilibrium condition in Equation 5 is met: marginal product of capital = depreciation rate + population growth rate.

6. An increase in the technological factor increases the marginal productivity of capital, thereby resulting in an increase in the Golden Rule capital–labor ratio. Graphically, the increase in A (technology) shifts up the production function Akt0.3 and the saving function sAkt0.3 . Everything else the same, including the depreciation and population growth rates, the Golden Rule capital–labor ratio increases.

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: Evidence on Convergence, 1960–2012 Data Source Penn World Tables: http://pwt.econ.upenn.edu/php_site/pwt_index.php. Here you can find information about different countries’ growth rates.

Related Article Grier, Kevin, “Empirics of Economic Growth”: http://www.econlib.org/library/Enc/EmpiricsofEconomicGrowth.html. This article refers to the “absolute” and “conditional” convergence concepts.

Discussion Question What are some potential reasons different countries might be represented by different production functions (so that according to the Solow model they would not converge to the same steady state)?

Answer: Even if some countries have similar per capita stocks or human capital (i.e., education), they might be represented by different production functions. This is due mostly to different ways in which economic activity is organized across countries. A fundamental ingredient is “institutions,” meaning formal (e.g., judicial system) or informal (e.g., corruption prevalence and/or enforcement) arrangements that determine how efficiently inputs can be used in a society. This concept (and others) is captured by total factor productivity, so that different countries can potentially be represented by different production functions.

.

70

Mishkin • Macroeconomics: Policy and Practice, Second Edition

B. For Information About Policy and Practice: China’s One-Child Policy and Other Policies to Limit Population Growth Data Source OECD Statistics, China’s statistical profile: http://stats.oecd.org/index.aspx?queryid=32517. Check China’s current fertility rate (around 1.59) and China’s fertility rate in 1970 (around 5.5).

Related Article Nie, Weiliang, “China’s One-Child Policy: Success or Failure?” http://www.bbc.co.uk/news/world-asiapacific-11404623. This article evaluates the consequences of the one-child policy in China.

Discussion Questions Do you agree with the one-child policy? Why or why not?

Answer: The principle of the one-child policy is highly controversial. Not only does it impose a restriction on the behavior of individuals, but it also creates some short- and long-term problems. Even if virtually any form of government enacts policies that affect our behavior, most of them are in the form of taxes or with the ultimate goal of protecting our human rights. This policy, however, does not allow individuals to make one of their lives’ most important decisions: how many children to have. In addition, due to the fact that most households prefer to have one boy, girls are not given the proper care or attention. This behavior has been reported many times in China. The long-term effect has been that entire generations of Chinese males are find it increasingly difficult to marry, which could potentially decrease the already low fertility rate even further.

C. For Information About Application: U.S. Growth Rates in the Postwar Period Data Source Bureau of Economic Analysis, NIPA Tables: http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=1&isuri=1. Here you can find information about nominal and real GDP for the United States.

Related Article Bosworth, Barry P. and Jack E. Triplett, “What’s New About the New Economy? IT, Economic Growth and Productivity”: http://www.brookings.edu/research/papers/2000/10/20healthcare-bosworth . This article discusses the “new economy” concept and measures its effects on the U.S. economy.

Discussion Question Suppose that during the next 10 years the growth rate of both labor and capital input remains constant in the U.S. economy. What would happen to the U.S. GDP growth rate?

Answer: If the growth rate of both the labor and capital inputs remain constant, GDP growth will be entirely determined by productivity growth. This scenario might be possible in the future if one thinks that a depressed savings rate will not allow for a significant increase in capital inputs. With respect to the labor input, future fertility and immigration rates will play important roles in determining the evolution of this input.

.

Chapter 7 Drivers of Growth: Technology, Policy, and Institutions ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Technology as a Production Input Technology Versus Conventional Production Inputs Technology and Excludability Policies to Promote Productivity Building Infrastructure Increasing Human Capital Policy and Practice: Government Measures to Increase Human Capital Encouraging Research and Development Institutions and Property Rights The Legal System and Property Rights Obstacles to Effective Property Rights Policy and Practice: The World Bank’s Doing Business Policy and Practice: Does Foreign Aid Work?

Endogenous Growth Theory Allocation of Labor Production Function Production of Technology Sustained Growth in the Romer Model Factors That Affect Endogenous Growth Effects of an Increase in the Fraction of the Population Engaged in R&D,  Effect of Changes in the Productiveness of R&D,  Response to an Increase in the Total Population N Application: Does Population Growth Improve Living Standards?

The Romer Model and Saving

Chapter Overview and Teaching Tips The previous chapter’s discussion of growth accounting and the Solow model indicates that understanding what drives technology and productivity growth is crucial to understanding why some countries are rich and others poor. In contrast to most macroeconomic textbooks, which give only a cursory treatment of what drives technology and productivity growth, this chapter provides a deep discussion of this topic.

.

72

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Because some instructors prefer to spend more time on business cycle analysis, they may not have time to cover this chapter and can skip it without loss of continuity with subsequent chapters. However, this topic is inherently fascinating and has generated an explosion of research in recent years.

The first thing to get across to students, which is discussed at the beginning of the chapter, is that technology is inherently different from other inputs to production and is somewhat magical. It has the big plus of being nonrivalrous and so can be used over and over again without being used up. Technology does, however, have a big minus: It is often nonexcludable, and so there may not be sufficient incentives to invest in producing it. Getting students to understand the key concepts of nonrivalry and nonexcludability is crucial because they are so important in thinking about policies to stimulate technology production and economic growth.

The chapter is structured with the sections on policies to promote productivity and on institutions and property rights coming before the development of endogenous growth theory. I have done this because endogenous growth theory is harder for students to master than the policy issues, and teaching this theory is not necessary for discussion of these policy issues. However, if an instructor wants to teach endogenous growth theory, I would recommend that he or she teach it before the sections on policies to promote productivity because understanding this theory leads to a deeper understanding of the policy issues.

Students enjoy talking about policies to promote productivity growth, and discussion of the Interstate Highway System as an example of a highly successful physical infrastructure to promote productivity is very relevant to them because almost many students use it frequently. Another nice example is to discuss how China has a far superior road and port infrastructure than does India, and this can help explain why China’s growth has been superior to India’s. Human capital is another concept that is key for students to understand, and because they currently are engaged in building their human capital by being in school, it is a natural one for them to understand. Discussing the Policy and Practice case on government measures to increase human capital in class also will drive home this important concept. Also, because government support of universities is a key government policy to encourage research and development, it is easy to discuss examples like this that are close to home.

Student understanding of the role of good institutions and property rights to promoting economic growth is enhanced by practical policy examples discussed in the Policy and Practice cases in this section. The example of the World Bank’s Doing Business publication illustrates how a focus on institutional development has become important in development institutions like the World Bank. Getting students to debate whether foreign aid helps or harms countries as is discussed in the Policy and Practice case, “Does Foreign Aid Work?” is a good way to get them to recognize that obvious solutions to poverty of giving poor countries money may not work because it can hinder the development of good institutions.

The last part of the chapter develops endogenous growth theory with the so-called Romer model. I build this model as a direct extension of the Solow model, which I have not seen done in any other macroeconomics textbooks. This has two advantages. First, all the intuition the students developed with the Solow model can be carried over to the Romer model. Second, the model developed in this chapter gets all the rich dynamics from both changes in the capital–labor ratio as well as from the endogenous growth of productivity. One of the key concepts to get across to students in endogenous growth theory is the balanced growth path. You can help students get the intuition behind it by indicating that it is similar to the steady state in the Solow growth model, but where technology is growing at a steady rate, so capital, labor and output also grow at a steady rate. One of the interesting implications of the endogenous growth model is that population growth can raise per capita income, while it does the opposite in the Solow growth model. The application in the chapter, “Does Population Growth Improve Living Standards?” can be used in class to add a further dimension to the debate over whether measures to limit population growth are a good idea.

.

Chapter 7

◼

Drivers of Growth: Technology, Policy, and Institutions

73

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Technology as a Production Input 1. As physical objects, labor and capital inputs are rival and excludable: They can only be used in one productive activity at a time, so that using them to produce one thing precludes their use to produce something else, and they cannot be used by producers who have not obtained permission to do so.

Technology (ideas) differs completely in these important characteristics. Ideas can be used in more than one productive activity at the same time and are more likely to be nonexcludable, so that other people can use them without permission or payment for their use. In these respects, technology has the characteristics of public goods.

Policies to Promote Productivity 2. Government can promote productivity growth by designing policies that lead to more spending on infrastructure, human capital, and research and development. These policies might take the form of increased government spending in these areas or instead provide greater incentives for private individuals and investors to undertake the increased expenditures.

3. Because of the nonexcludable nature of technology, many of the benefits of new technology will be external. This means that private businesses that invest in R&D will not get the full benefits of the new technology they create and, therefore, may not expect to earn enough profits to justify the R&D investment necessary to develop the new technology.

4. A patent gives an inventor exclusive rights over the use of his or her invention for a specific period of time. The inventor may use the new technology or sell or license it for others to use. When governments grant patents, this enables inventors to earn higher profits from their inventive activities—e.g., R&D—and thus helps overcome the disincentives that otherwise spring from the nonexcludability of technology. This should benefit society by increasing R&D spending, technological progress, and the growth rate of per capita output.

Institutions and Property Rights 5. Property rights protect property owners from government and others who might want to extort their wealth. Property rights promote economic growth by providing incentives to save and invest and allocate capital to its most productive uses.

6. Property rights are no better than the legal system that defines, interprets, and enforces them. To promote strong property rights, a society needs an effective legal system that enforces contracts, has adequate resources (courts and judges) to hear and decide cases within a reasonable time, and provides access to lawyers, so aggrieved parties can have their day in court.

Endogenous Growth Theory 7. The Solow growth model treats changes in technology and productivity exogenously, which renders it incapable of explaining sustained economic growth and differences across countries in terms of per capital income levels and growth. The Romer model provides endogenous explanations for technological advances and, thus, for sustained economic growth.

8. In the Solow model, diminishing returns to capital move the economy to a steady state at which capital and output per worker are constant. However, sustained per capita growth is possible in the Romer model because the nonrivalrous nature of technology means that additions of technology that result from R&D are not subject to diminishing returns.

© 2015 Pearson Education, Inc

Mishkin • Macroeconomics: Policy and Practice, Second Edition

74

Factors That Affect Endogenous Growth 9. The three determinants of an economy’s growth rate in the Romer model are the productiveness of labor used in research and development (R&D), the fraction of the population that is engaged in R&D, and the total population. Each determinant affects the growth rate positively.

10. The growth rate of per capita output at first falls, but ultimately it rises. This is so because an increase in the fraction of the population engaged in R&D means a decrease in the fraction of workers available to use in the production of goods and services. This initially causes per capita output to fall and also causes a slowing in the growth rate of per capita output as the capital–labor ratio for workers employed in the production of goods and services first rises and then returns to its steady-state level. However, because the growth rate of technology will increase as more workers engage in R&D, the growth rate of per capita income will rise permanently above its initial value.

11. The growth rate of per capita output increases and then drops but remains higher than before. Initially, the increase in total population causes the capital–labor ratio for workers employed in the production of goods and services to decrease. Because the capital–labor ratio falls below its steady-state value, it will begin to rise. This will increase the growth rate of per capita output temporarily above its longrun rate. However, because there will be more labor engaged in producing new technology, the growth rate of per capita output will fall toward a long-run rate that is permanently higher than before.

12. An increase in the saving rate causes per capita output temporarily to grow faster as it allows for more investment per worker and a higher steady state capital–labor ratio, which raises per capita output to a new higher level. However, an increase in saving does not cause the per capita output growth rate to be permanently higher because the increase in saving does not affect any of the variables in the technology production function.

Answers to Problems Technology as a Production Input 1. a.

A robot is a rival input, as it cannot be used in another activity when used to weld cars in a factory.

The idea of an assembly line is a nonrival good, as many people can use that idea at the same time.

A robot is an excludable input, as it is a piece of property and its owner can prevent others from using it. The idea of an assembly line has a very low degree of excludability, as it is quite difficult to prevent other entrepreneurs to use it. b. Both recipes are nonrival goods, as they are ideas. The recipe to make pancakes has a very low degree of excludability, but the recipe to manufacture a soda drink probably has a higher degree of excludability. The latter is probably protected by a patent.

Policies to Promote Productivity 2. The rationale for this policy is to increase technology and to make each U.S. worker more productive.

Easier and faster Internet access can reduce businesses’ costs, for example, by allowing faster inventory updates. It can also create opportunities for new businesses as the Internet has already done for many entrepreneurs.

3. a.

The One Laptop per Child program will most surely increase workers’ productivity when today’s children join the labor force in the future. In the Romer model’s terminology, we can interpret this program as an increase in the chi (  ) parameter.

b. An increase in the chi (  ) parameter increases the growth rate of technology, as the same stock of workers devoted to the production of technology become more productive. This also increases the balanced growth path of output per capita.

.

Chapter 7

Drivers of Growth: Technology, Policy, and Institutions

75

4. According to Romer’s model, government spending on infrastructure can increase productivity in many ways. Government spending on education and health usually has high returns. Improving health conditions in poor countries’ crowded cities usually decreases the prevalence of transmittable diseases like cholera. This reduces the costs associated with treating patients at the same time it increases returns to education (e.g., children do not miss as many school days as before). This results in a healthier and, therefore, more productive labor force, increasing the balanced growth part of output per capita.

5. According to Romer’s model, we should expect that countries that have better designed and enforced property rights are the ones with better standards of living. Properly enforcing property rights increases individuals’ and firms’ ability to recover their investment needed to advance technology. After the period from which the innovation is made excludable by patents laws (or the enforcement of some other property right), technology spills over and benefits the whole society, even the world. Countries in which individuals and firms have the incentives to engage in R&D will benefit the most from this innovation process. As predicted by Romer’s model, the IPRI ranking and per capita income growth are strongly correlated.

Institutions and Property Rights 6.

According to the graph, there is a close association between corruption and per capita income. As the CPI value increases, indicating that corruption is less prevalent, GNI per capita also increases. As expected, relatively richer countries exhibit higher values of the CPI. This constitutes evidence in favor of the hypothesis that corruption and economic growth are negatively related.

7. Unfortunately, there is no clear answer for this question. There are valid arguments for both positions.

The prevalence of corruption in a society makes the enforcement of property rights very difficult, as government officials are often bribed in exchange for preferential treatments or concessions. Also, in a society in which most people are corrupt, it often pays off to behave as a corrupt individual, making this problem even worse. It is also true, however, that badly designed institutions can promote corruption. This is the case when bureaucracies create positions (usually government officials) that create the opportunity for individuals to exert some power. If you have to pay many license fees to obtain a permit to conduct your businesses, it is probable that the higher the number of licenses you

© 2015 Pearson Education, Inc

Mishkin • Macroeconomics: Policy and Practice, Second Edition

76

have to obtain at different government offices, the more bribes you will be asked to pay. This is an example of a vicious circle from which it is very difficult to escape. Poor countries often exhibit a combination of poorly designed and enforced property rights and of corruption.

8. Although the answer to this question is based on personal opinion, both Sachs and Easterly make good points. Sachs argues that increasing foreign aid can effectively break down the poverty cycle and allow individuals to escape their poverty traps. This can happen by financing projects that improve healthcare in poor countries, like mosquito nets designed to reduce the prevalence of malaria. According to Sachs, only then will individuals be able to stand on their own feet and create the economic conditions for economic growth. Easterly’s view is basically that giving more money to poor countries will not solve the problem (a concept he has well documented in his research) and that it can actually help keep kleptocrats in power for a longer time, thereby impoverishing the country even more. Easterly argues that the conditions for economic growth must grow from the bottom to the top, as opposed to the top-to-bottom approach used by international donor agencies. According to Easterly, the best way to help poor countries is to reward those who implement reforms that promote economic growth (e.g., properly enforce property rights, eliminate price controls) by funding more projects that work in terms of raising the standards of living of individuals.

Endogenous Growth Theory 9. a.

The change in technology is At =  At LA = 0.0005  20  25 = 0.25%.

b. The growth rate of technology is c.

At =  N = 0.0005  0.25  100 = 1.25% = g A .

At

The per-person output growth rate is gA  1.43 = 1.7875%

Factors That Affect Endogenous Growth 10. The Industrial Revolution was a period in which technological growth increased at a fast rate. The invention of the steam machine in the late eighteenth century and its many applications allowed labor and capital to be increasingly productive. Advances in most sciences, like chemistry, physics, and medicine, resulted in many ideas that added to the technology stock of the world economy. According to this, the world’s output per worker growth rate increased during the Industrial Revolution. Note that this was not a homogeneous process, and many regions were left out of the Industrial Revolution and did not immediately benefit from this wave of inventions and increase in technology.

11. The Cultural Revolution years in China can be interpreted as a decline in the fraction of total population devoted to the production of technology (i.e., research and development). The Romer model predicts a decrease in the growth rate of the technology factor. Not surprisingly, and consistent with the predictions of the Romer model, the growth rate of output per worker decreased in China during that period.

12. There are many potential “stories” that rationalize the idea that a higher population will increase incentives to spur technological change. One of them is that a higher population puts more pressure on available resources, like arable land. For the same land area, the country (or region) with the highest population will face more pressure to increase crop yields than the country (or region) with fewer people. This will increase the incentives for individuals to look for solutions to the problem of low crop yields. Note that if successful in increasing crop yields, this country will be able to sustain an even higher population and will probably face another similar challenge in the future (e.g., sources of energy). The same principle applies to the production of manufactured goods or even services.

13. The statement is false. Both Solow’s and Romer’s models conclude that changes in the saving rate do not affect the long run (i.e., sustained) growth rate of per capita output. In the case of Solow’s model,

.

Chapter 7

Drivers of Growth: Technology, Policy, and Institutions

77

that growth rate (in the absence of exogenous technological growth) is zero. Changes in the saving rate only affect the level of per capita output. In Romer’s model, the sustained growth rate is determined by the growth rate in technology, but it is also independent of the saving rate.

◼

Answers to Data Analysis Problems

1. a.-c.No answer shown.

d. See table below. Total factor productivity in Turkey fell sharply over this period of time, while total factor productivity increased in South Korea. The Solow model predicts that this will lead to declines in real GDP per capita in Turkey and increase real GDP per capita in South Korea, which is exactly what the data demonstrate. e. See table below.

Country

gA

gk

0.3gk

gy

Turkey (2000–2011)

-4.54

3.89

1.17

-3.37

South Korea (2000–2011)

2.62

2.19

0.66

3.28

2. a.

See table below. Clearly, the countries that have overall higher economic freedom scores have much higher average growth rates of per capita real GDP than those with lower scores. Brazil, Russia, and Argentina have very large negative real GDP per capita growth, suggesting that their very poor institutions have a large impact on standard of living overall. b. See table below. The countries that have the biggest movement in the Heritage index generally appear to also have the biggest movements in real GDP per capita growth. Russia and Argentina appear to be exceptions to what would be expected; in the case of Russia, its Heritage score was relatively constant during both periods; however, it experienced a significant turnaround in growth in standard of living associated with a sharp rise in demand for its oil production.

Argentina had a sharp decline in their Heritage score compared to the earlier period, but still managed to have significantly positive growth in the standard of living in the second half of the sample period because of increased foreign demand for the commodities it produces. c. The results from part (a) and (b) generally support the importance of institutions, transparency, and rule of law in determining total factor productivity for a country and, hence, sustained growth in the standard of living. Countries that have weak institutions, lack transparency, and have poor rule of law suffer from low or negative TFP growth, which hurts real GDP per capita (and vice versa).

Top Three

1980–2011 Average Real GDP PC growth

Singapore

4.39%

Switzerland

3.77%

United States

1.58%

Top Three Average

3.25%

Bottom Three Brazil

–34.36%

Russia

–14.97%

Argentina

–24.42%

Bottom Three Average

–24.58%

© 2015 Pearson Education, Inc

Mishkin • Macroeconomics: Policy and Practice, Second Edition

78

1995–2004 Average Real GDP PC Growth

2005–2011 Average Real GDP PC Growth

Growth Rate Change

2000–2013 Heritage Change

Singapore

3.28%

3.24%

–0.04%

0.3

United States

2.18%

0.31%

–1.87%

–0.4

–17.75%

8.71%

26.46%

–0.7

Georgia

–1.56%

8.88%

10.44%

17.9

Mexico

–6.47%

1.24%

7.71%

7.7

Argentina

–4.33%

5.92%

10.25%

–23.3

Three Static

Russia Three Movers

3. a. b. c. d.

e.

αt = [ At + 1/At – 1]/LFt, where LFt is the (indexed) labor force. Yearly data calculations not shown.

Yearly data calculations not shown.

Yearly data calculations not shown.

See table below. Based on this constructed measure of data from 1980 through 2011, α averaged about 0.8 percent in the 1980–1999 period and much lower at 0.19 percent in the post-2000 period. Based on these results, endogenous growth theory would suggest that with a lower proportion of the workforce dedicated to R&D as in the post-2000 period, this would lead to a permanently lower growth rate of real GDP per worker.

The growth in real GDP per worker in the 1980–2000 period averages a bit more than 2 percent per year, while the post-2000 period is much lower, at 0.84 percent per year on average. Given the results from part (d) above, and the predictions of the endogenous growth model, this is entirely consistent with the model: less of the workforce devoted to R&D will lead to a slower growth path in real GDP per person. α 0.80 % 0.19 %

Average 1980 to 1999 Average 2000 to 2011

gy, per year 2.08 % 0.84 %

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Policy and Practice: Government Measures to Increase Human Capital Data Source UNESCO database: http://stats.uis.unesco.org/unesco/ReportFolders/ReportFolders.aspx. Here you can find extensive information about different education measurements, like enrollment rates for countries that are members of the United Nations. You can also get a chart by selecting the table first and then the “see as a chart” icon.

Related Article White House, “President Obama to Announce Major Expansion of ‘Educate to Innovate’ Campaign to Improve Science, Technology, Engineering and Math (STEM) Education,” September 16, 2010: http://www.whitehouse.gov/the-press-office/2010/09/16/president-obama-announce-major-expansioneducate-innovate-campaign-impro. This press release indicates the U.S. effort to improve its education quality.

.

Chapter 7

Drivers of Growth: Technology, Policy, and Institutions

79

Discussion Question During the second half of the twentieth century, many poor countries invested heavily in education and dramatically increasing their enrollment rates. Despite this effort, most of them remain poor. How is this possible?

Answer: Investing in education does not guarantee an improvement in human capital or an increase in labor productivity. Many poor countries learned this lesson the hard way. Huge investments in education during the second half of the twentieth century in many developing countries resulted in an increase in enrollment rates. However, after some time the newly enrolled children realized they had no or very few job opportunities in which to put to work their acquired skills. This quickly undermined the efforts put forward by their governments. Education is a necessary condition to increase productivity and create growth but is not sufficient. Other aspects, like the availability of good paying jobs, are very important for this equation.

From an empirical point of view, there are many interesting subtleties to consider; for example, enrollment rates only measure enrolled students but do not measure the quality of education. In addition, corruption often plagued governments’ efforts to increase investment in education.

B. For Information About Policy and Practice: The World Bank’s Doing Business Data Source World Bank: http://www.doingbusiness.org/rankings. Here you can find the Doing Business report.

Related Article Espinosa, Alberto, “Colombia: Private Help for a Public Problem”: http://www.doingbusiness.org/reforms/case-studies/2009/building-permit-process-reform-in-colombia.

This article refers to one of many attempts by Colombia to improve its Doing Business ranking.

Discussion Questions What would be the consequences for both a domestic entrepreneur and a foreign investor of a country improving its Doing Business ranking? How would this benefit that country?

Answer: Improving the channels by which one can set a legal business (i.e., improving its Doing Business ranking position) has many important implications for both domestic and foreign investors. First, the setting of a legal business is an upfront cost an entrepreneur has to face. Decreasing that cost makes it more likely projects will be undertaken. Second, when it is costly (in terms of time and money) to set up a legal business, many individuals opt for the alternative. This drives away customers from legally set up businesses, which not only have to pay for licenses but also compete for customers with illegal businesses.

Also, high costs of setting up a legal business are usually associated with high corruption levels, as corruption becomes the alternative to obtain some licenses needed to operate. This drives away foreign investors, who usually do not have the knowledge or willingness necessary to engage in such practices. To conclude, an improvement in the Doing Business ranking should promote investment and, therefore, economic growth in an economy.

C. For Information About Policy and Practice: Does Foreign Aid Work?

Data Source USAID (the U.S. agency in charge of U.S. foreign aid): http://www.usaid.gov/results-and-data/budgetspending/where-does-money-go. This link provides a snapshot of where USAID’s money goes.

© 2015 Pearson Education, Inc

80

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Related Article Alesina, Alberto and David Dollar, “Who Gives Foreign Aid to Whom and Why?”: http://www.nber.org/papers/w6612. This paper is a comprehensive study of foreign aid flows.

Discussion Question Consider the above paper: “Who Gives Foreign Aid to Whom and Why?” What would be the result in terms of economic growth of foreign aid flows destined to support a poor country’s government in exchange for political favors?

Answer: Even if used properly, foreign aid flows do not guarantee an increase in economic growth.

However, some types of foreign aid, especially those that aim to secure political favors, have a lower probability of affecting the recipient economy. A few developed countries used this mechanism to gain developing countries’ governments support (i.e., votes) in some scenarios (e.g., the United Nations assembly). Of course this was never proved, but empirical data (see paper) shows that there is some truth behind this hypothesis (there is a positive correlation with “voting together” and “foreign aid flows”).

Such a reason to give foreign aid decreases the probability that these funds will be used to spur economic growth.

D. For Information About Application: Does Population Growth Improve Living Standards?

Data Source Maddison, Angus, “Statistics on World Population, GDP and Per Capita GDP, 1-2008 AD”: http://www.ggdc.net/maddison/maddison-project/data.htm Here you can find extensive data about world population and GDP (including data to reproduce text figure Figure 7.5).

Related Article World Bank, “World Development Indicators”: http://data.worldbank.org/data-catalog/worlddevelopment-indicators/wdi-2012 . Click on the “People” link to get a comprehensive study about the relationship between world population and living standards in the near future.

Discussion Question According to Michael Kremer’s conclusions about the link between population growth and technological change, what do you think would be the consequence of a stagnating world population on the rate of technological change?

Answer: A stagnating world population would decrease the rate of technological advance, according to the idea that individuals are more prone to innovate as they face challenges imposed by greater needs. This is the reasoning behind Kremer’s conclusion: More populated societies faced increasing challenges to produce food, improve transportation means, and so on. This resulted in more rapid technological changes. Also, one can assume that the existence of more individuals increases the chance that at least one of them will discover a new production process or otherwise advance our technological knowledge. A decrease in the world population growth rate would result in fewer challenges and, therefore, in a lower rate of technological change, according to this idea. Most demographic studies conclude that by around the year 2050 the world population will stagnate at around 9 to 10 billion people; what will happen to the rate of technological change remains to be seen.

.

Chapter 8 Business Cycles: An Introduction ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Business Cycle Basics Business Cycle Illustration An Alternative View of the Business Cycle Co-Movement and Timing of Economic Variables Macroeconomic Variables and the Business Cycle Real GDP and Its Components Macroeconomics in the News: Leading Economic Indicators Unemployment Inflation Financial Variables International Business Cycles A Brief History of U.S. Business Cycles Pre–World War I The Interwar Period and the Great Depression Post–World War II The “Great Moderation” The Great Recession of 2007–2009 Time Horizons in Macroeconomics Keynesian and Classical Views on Economic Fluctuations The Short Run Versus the Long Run Price Stickiness Perfect Competition Versus Monopolistic Competition Sources of Price Stickiness Empirical Evidence on Price Stickiness Road Map for Our Study of Business Cycles

Chapter Overview and Teaching Tips This chapter provides an introduction to Part Four of the book by first discussing the basic features of business cycles and how key macroeconomic variables—real GDP and its components, unemployment, inflation, interest rates, stock prices, and term and credit spreads—vary over the business cycle. Discussing the cyclical movements of these variables with Figures 8.2 to 8.9 lets students know what data the aggregate demand-

.

82

Mishkin • Macroeconomics: Policy and Practice, Second Edition

aggregate supply (AD/AS) model developed in the coming chapters is intended to explain. Taking students through a brief history of U.S. business cycle episodes, what I like to describe as the “greatest hits of U.S. business cycle history,” is a way of getting them excited about the study of business cycles.

The chapter ends by discussing two key issues in business cycle analysis. First is the distinction between the short and the long run, and how long it takes to get to the long run, which separates Keynesian versus classical views of economic fluctuations. It then goes on to discuss price stickiness, an essential feature of short-run business cycle models. Because the degree of price stickiness is also important in differentiating Keynesian and classic views of business cycle analysis, it is worth discussing what the empirical evidence tells us about the degree of price stickiness in the economy.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Business Cycle Basics 1. Business cycles are fluctuations in aggregate economic activity that follow a sequence of expansion, peak, contraction, and trough. The period between a peak and a trough is a business cycle contraction (commonly referred to as a recession), and the period between a trough and a peak is a business cycle expansion (or boom). Peaks and troughs are referred to as the turning points in the business cycle.

Although each business cycle follows this peak-recession-trough-expansion sequence, the lengths of expansions and recessions vary from one cycle to another.

Macroeconomic Variables and the Business Cycle 2. The distinction is based on the direction of change in a variable’s value relative to changes in the overall level of aggregate economic activity. Procyclical variables move in the same direction as aggregate economic activity, so they rise during business cycle expansions and fall during recessions.

Countercyclical variables move in the opposite direction from aggregate economic activity, falling during expansions and rising during recessions.

3. The distinction is based on the timing of directional changes in a variable’s value relative to business cycle peaks and troughs. A variable whose value starts to rise before a business cycle trough and to fall before a business cycle peak is a leading variable: Changes in its value lead (occur before) the turning points in the business cycle. The value of a lagging variable peaks after a business cycle peak occurs and likewise reaches a trough after the business cycle does. Variables whose values peak and trough at the same time as business cycle turning points are coincident variables.

4. Real consumer spending: procyclical, coincident; real investment spending: procyclical, coincident; unemployment: countercyclical, timing is uncertain; inflation: procyclical, lagging; S&P 500 Index: procyclical, leading; spread between long- and short-term interest rates on U.S. government bonds: procyclical, leading; spread between interest rates on corporate bonds and government bonds: procyclical, coincidental.

A Brief History of U.S. Business Cycles 5. The “Great Inflation” was the period from the mid-1960s to the early 1980s when annual inflation rates rose from an average of less than 2 percent to more than 15 percent and exhibited extremely high variability before settling down to a narrower range of 4–5 percent. During this time span, the inflation rate rose during both expansionary and recessionary periods of the business cycle. The “Great Moderation” occurred during the 1990s when the volatility of real GDP and inflation narrowed considerably.

.

Chapter 8

Business Cycles: An Introduction

83

Time Horizons in Macroeconomics 6. Flexible prices and wages rise and fall in response to demand and supply shocks and move to new long-run equilibrium values following these shocks. Sticky prices may rise and fall some but do not move to new long-run equilibrium values when these shocks occur.

7. In the long run, prices and wages are completely flexible and fully adjust to their long-run equilibrium values. In the short run, prices and wages are sticky and do not fully adjust to long-run equilibrium. Macroeconomists make the distinction between the two time horizons because only in the long run, when all price and wage adjustments have taken place, will the classical dichotomy hold. In the short run, before all price and wage adjustments occur, monetary neutrality does not hold, and thus, changes in the money supply affect the values of real variables as well as nominal ones in the short run.

8. Classical macroeconomists hold that prices and wages are flexible so that the economy adjusts quickly to long-run equilibrium following demand and supply shocks. (In other words, the short run is a very short period of time.) They advise that government policymakers, therefore, should focus more on promoting the economy’s long-run economic growth than on reacting to its short-run ups and downs. Keynesians hold opposing views. They think that because of sticky prices and wages the economy adjusts slowly to long-run equilibrium (the short run is a very long period of time) and, therefore, believe government can and should play an important role in countering economic fluctuations.

Price Stickiness 9. Classical macroeconomists treat economic actors as price takers who buy or sell standardized products at prices determined in perfectly competitive markets. Given this market structure, prices and wages adjust rapidly to changes in demand and supply conditions. Keynesians think it is more realistic to assume that firms have some market power and that they are able to set prices even if there is competition in markets. This means that if firms find it advantageous to do so, they can keep their prices fixed even when market demand and supply conditions are changing, which will slow the speed of price and wage adjustment.

10. Menu costs refer to the costs a firm incurs when it changes its prices. These costs may include printing new catalogs, price lists, or menus, informing salespeople of new prices, advertising to inform customers of the new prices, and re-marking the prices of goods on shelves and in inventories.

Also, a firm may be concerned that price changes will anger its customers. Because of menu costs, changing prices is not costless, and a firm will only change its prices if it believes the benefits of adopting new prices will exceed the costs of changing them. Given the menu costs it faces, a firm likely will change prices less frequently than it would if it ignored these costs. Thus, menu costs slow the pace of price adjustments following changes in market demand and supply conditions.

Answers to Problems Business Cycle Basics 1. a.

There are two expansions according to this graph: (1) from January 1912 to January 1913, which lasted 12 months, and (2) from December 1914 to August 1918, which lasted 44 months, or 3 years and 8 months. b. There are two contractions according to this graph: (1) from January 1913 to December 1914, which lasted 23 months, and (2) from August 1918 to March 1919, which lasted 7 months.

2. This statement is not entirely correct. A contraction is a decrease in aggregate economic activity, measured by changes in many economic indicators. The NBER Business Cycle Dating Committee uses many sources of information to determine when the economy is experiencing a contraction or

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

84

expansion. Changes in real GDP receive a lot of media attention, but that does not mean it is the only indicator used to determine expansions or contractions. As many indicators of economic activity move together, it might be the case that an economy is experiencing a contraction when its real GDP decreases for a couple of periods, but this would only be true if the other indicators tell the same story about the economy.

3. a.

Although home prices declined slightly before aggregate economic activity declined, home prices decreased during the current contraction, suggesting this could be a cyclical variable. As of May 2009, home prices stabilized and even started to increase, while broad economic conditions did not improve by much, which might suggest that this could be an a cyclical variable. b. Because home prices reached a peak in April 2006, we can assert that home prices are a leading indicator of the business cycle. Note that this is only one example and that more evidence is needed to properly state the timing of an indicator.

4. a.

Considering only changes in real GDP, the economy reached its peak in February and reached its trough in April. b. The inflation rate seems to be a lagging variable. The economy reached its peak in February, but the inflation rate kept increasing for a few more periods. Inflation began its decrease after the economy reached its trough in April. The stock price index seems to be a leading (by one month) indicator of the business cycle. It peaked one month before real GDP, and it reached its trough one month before (March) real GDP (April).

5. a.

Real GDP and stock prices index:

.

Chapter 8

Business Cycles: An Introduction

85

b. Unemployment and inflation rates:

c.

Considering real GDP and the unemployment rate, it is not clear that the economy reached its trough in April because the unemployment rate kept increasing after that period. Using other indicators, the trough would probably be determined at some date between April and May (when unemployment peaks). d. By considering these four indicators, it is clear that no single indicator can be used to determine the business cycle. The problem is that even if the timing of some variables can be assessed, this relationship can change over time. A leading variable might predict a peak in the next month, or the next quarter, depending on the ever changing economic environment.

Macroeconomic Variables and the Business Cycle 6. Real GDP is procyclical and coincident. Consumer and investment spending also appear to be procyclical and coincident. Unemployment is countercyclical and its timing is uncertain. Inflation is procyclical and lagging. Stock prices are procyclical and leading. Interest rates are procyclical and their timing is uncertain. The spread between interest rates on long- and short-term government bonds is procyclical and leading. The spread between interest rates on corporate and government bonds is procyclical and coincident.

A Brief History of U.S. Business Cycles 7. The longest expansion took place between March 1991 and March 2001 and lasted 120 months. The shortest expansion took place between March 1919 and January 1920 and lasted 10 months only. The longest contraction took place between October 1873 and March 1879 and lasted 65 months. The shortest contraction took place between August 1918 and March 1919 and lasted 7 months only.

Table 1 data shows that U.S. business cycles are quite difficult to predict, as their lengths vary substantially. It is not correct to say that there is a contraction coming because we are living through an expansion that lasted 20 months and the last five recessions came after 20 months of expansion.

Business cycles are unpredictable by nature, and so is their persistence. They might last for more or fewer months than their previous episodes would lead one to believe.

Time Horizons in Macroeconomics 8. This statement is not correct. Keynes stated that we should primarily focus on short-run fluctuations because it takes a long time for the economy to reach its long-run equilibrium. Waiting for such a long time would be useless, Keynes argued, because there are policy tools that can be used to reduce the pervasiveness of business cycle contractions. Instead of waiting for prices to adjust, which takes a long time, Keynes argued for an approach that would make use of policy tools to stimulate the

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

86

economy. Keynes was also worried about the long-run consequences of policy actions, however, and it is not correct to interpret his famous statement as irresponsible.

Price Stickiness 9. a.

Dairy products are considered to be quite standardized. The market for dairy products is, therefore, a pretty competitive market, in which buyers and sellers are price takers. b. The production of motor vehicles in the United States is dominated by a few big manufacturers.

Although competition is fierce in this market, it cannot be considered a perfectly competitive market. Car manufacturers, through advertising, encourage consumers to develop a preference for their brand (e.g., associate a Corvette with a given lifestyle), which enables them to have some control over prices. This market is better described as a monopolistically competitive market.

10. If an economy is composed of only competitive markets, then prices would be more flexible than in an economy in which firms have some market power. In this particular case, the classical assumption of flexible prices holds and would, therefore, be a better representation of that economy.

11. There are a few aspects of wage determination that contribute to their relative stickiness, in particular in the downward direction. Wages are usually set for a year or maybe more. Employers and employees decide on a given wage and benefits for some time, and this contributes to wage rigidity. On the other hand, wages are mostly determined in competitive markets and, therefore, respond to supply and demand conditions in the labor market. During contractions, when the demand for labor decreases, wages usually decrease as well. Because wages are such an important price in the economy, there is an ongoing debate about their relative rigidity or flexibility.

◼

Answers to Data Analysis Problems

1. a.

The most recent recession, according to the National Bureau of Economic Research (NBER) spanned 2008:Q1 through 2009:Q2. b. See table below, for averages from 2008:Q1 through 2013:Q1. c. All three variables are procyclical because they have negative growth rates during the recession and positive growth rates during the expansion phase.

Recession Average, 2008:Q1 to 2009:Q2 Post-Recession Average, 2009:Q3 to 2013:Q1

Real Consumption Growth Rate –2.3

Real GDP Growth Rate –3.2

Real Investment Growth Rate –26.5

2.1

2.1

9.4

2. a. The most recent recession, according to the NBER spanned January 2008 through June 2009. b. From January 2008 to June 2009, the unemployment rate increased from 5.0 percent to 9.5 percent, an increase of 4.5 percentage points. From July 2009 through June 2013, the unemployment rate fell from 9.5 percent to 7.6 percent, a decline of 1.9 percentage points. The unemployment rate is countercyclical. c. For the period from January 2008 through June 2009, nonfarm payrolls declined from 138,056,000 to 130,578,000, a net loss of 7,478,000 jobs during the recessionary period. In the post-recession period from July 2009 to June 2013, nonfarm payrolls increased from 130,227,000 to 135,902,000, a net gain of 5,675,000 jobs. Nonfarm payroll employment is procyclical, declining during recessions and increasing in expansions. d. Although the lowest part of UNEMPMEAN occurs in September 2007 at 16.3 weeks, the data does not start increasing substantially until July 2008, when it increases from 17.0 weeks, to 17.7

.

Chapter 8

Business Cycles: An Introduction

87

the following month. After that, the average duration of unemployment rises substantially. At its peak, it tops out at 40.7 weeks in December 2011, long after the recession officially ends.

Because of the delayed timing, the average duration of unemployment lags the business cycle and is countercyclical because it rises during recessions and falls during expansions.

3. a. The most recent recession, according to the NBER, spanned January 2008 through June 2009. b. The average of the consumer sentiment index is 63.6 during the recessionary period and 71.6 from July 2009 to January 2013. Consumer sentiment is procyclical, declining during recessions and rising during expansions. c. Industrial production declined from 100.5 in January 2008 to 83.8 in June 2009, a decrease of 16.6 percent during that period. After that, it increased from 84.5 in July 2009 to 99.0 in June 2013, and increase of 17.2 percent during that time. Industrial production is procyclical, declining during recessions and rising during expansions. d. Real retail and food sales declined from $177,022 million in January 2008 to $158,550 million in June 2009, a decrease of 10.4 percent during that period. After that, it increased from $159,209 million in July 2009 to $181,500 million in June 2013, and increase of 14 percent during that time. Real retail and food sales are procyclical, declining during recessions and rising during expansions. e. All three are fairly closely coincident to the business cycle, although this isn’t all that obvious in the 2001 recession for (RRSFS), and more generally (UMCSENT) fluctuates quite a bit, so it is harder to clearly tie major upward or downward movements in consumer sentiment to the exact business cycle dates.

4. a. See table below. b. The highest average real GDP growth occurred during the Great Moderation period at 3.3 percent, while the lowest occurred most recently from 2008:Q1 to 2013:Q1, at just 0.7 percent.

Real GDP had its largest swings during the Great Inflation period, as measured by its standard deviation (which is almost twice as much as during the Great Moderation period). c. The highest average inflation rate, not surprisingly, was during the Great Inflation period at 7 percent, and the lowest occurred most recently from 2008:Q1 to 2013:Q1, at just 1.7 percent.

Inflation fluctuated the most during the Great Inflation period with a standard deviation more than twice as much as occurred during the Great Moderation Period.

Real GDP Growth Standard Average Deviation 2.5 2.94 3.3 1.61 0.7 0.66

Great Inflation Period Great Moderation Period 2008:Q1 to 2013:Q1

Inflation Rate Standard Average Deviation 7.0 1.93 2.6 0.83 1.7 0.63

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Dating and Measurement of Business Cycles Data Source Federal Reserve Bank of St. Louis: http://research.stlouisfed.org/fred2/series/GDPCA?cid=106. Here you can get access to a chart showing the evolution of real GDP. Note how during the shaded periods (i.e., recessions as determined by the NBER) real GDP either stagnated or decreased.

.

88

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Related Article Business Cycle Dating Committee, NBER: http://www.nber.org/cycles/sept2010.html. This article explains how the Business Cycle Dating Committee determined the duration of the last contraction in the U.S. economy.

Discussion Question What are the consequences of a business cycle contraction for a college graduate?

Answer: The determination of a business cycle contraction depends on many indicators, all of them related to current economic activity. An important component in that equation is the current situation of the labor market. Business cycles contractions are associated with increasing unemployment rates, and most of the time the unemployment rate remains at a relatively high level for an extended period (i.e., even after the economy has recovered). This has direct negative consequences for recent college graduates, who enter a depressed labor market and compete with other individuals with more experience and qualifications for fewer job positions.

B. For Information About the Behavior of Macroeconomic Variables During the Business Cycle and International Business Cycles Data Source The Conference Board: http://www.conference-board.org/data/bcicountry.cfm?cid=1. Follow the “press release with graph and summary table” link to download a PDF file showing the latest changes in the index of leading economic indicators (LEI).

Related Article CNN, “Financial Crisis Dominates G-20 Agenda,” Monday, March 30, 2009: http://www.cnn.com/2009/WORLD/europe/03/30/g20.summit.explainer/index.html?iref=allsearch. This press article explains most prominent world leaders’ efforts to deal with the most recent financial crisis. It also shows how business cycles are highly correlated in a deeply interconnected world.

Discussion Question Business cycles now have the ability to propagate quite quickly across countries. What are the implications for policymakers of this relatively new scenario?

Answer: The recent financial crisis that originated in the United States in 2007 reinforced the idea that business cycles fluctuations in one country can have immediate effects on other countries. This new scenario makes policymakers around the world very anxious about current economic conditions in other countries. It also requires a lot of coordination of the type described in the CNN article. World leaders cannot afford to be out of touch and unaware of potential risks that can turn into contractions affecting many countries at the same time. This is indeed a by-product of globalization: the need for increased coordination.

.

Chapter 9 The IS Curve ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Planned Expenditure The Components of Expenditure Consumption Expenditure Planned Investment Spending Net Exports Government Purchases and Taxes Goods Market Equilibrium Solving for Goods Market Equilibrium Deriving the IS Curve Understanding the IS Curve What the IS Curve Tells Us: Intuition What the IS Curve Tells Us: Numerical Example Why the Economy Heads Toward Equilibrium Why the IS Curve Has Its Name and Its Relationship with the Saving-Investment Diagram Factors That Shift the IS Curve Changes in Government Purchases Application: The Vietnam War Buildup, 1964–1969 Changes in Taxes Changes in Autonomous Spending Policy and Practice: The Fiscal Stimulus Package of 2009 Changes in Financial Frictions Summary of Factors That Shift the IS Curve

Chapter Overview and Teaching Tips This chapter introduces the basic concept of aggregate demand and develops one of the key building blocks of the AD/AS model, the IS curve. The framework here is pretty conventional, first outlining the components of planned expenditure—consumption expenditure, planned investment spending, government purchases and net exports. Then the chapter goes into detail about goods market equilibrium, when planned equals actual expenditure, and shows how this equilibrium generates the IS curve, the relationship between the real interest rate and equilibrium output. Spending a fair amount of time in class

©2015 Pearson Education, Inc.

90

Mishkin • Macroeconomics: Policy and Practice, Second Edition

on the concept of goods market equilibrium, and why the economy will gravitate to this equilibrium, is worthwhile because this concept is so important to short-run macroeconomic analysis.

The chapter then goes on to provide a deeper understanding of the IS curve by giving the intuition behind it, using a numerical example to explain it with mathematics and then showing the relationship between the IS curve and the saving-investment diagram students were exposed to in Chapter 4. Then the chapter takes the student through all the factors that shift the IS curve and explains the intuition for how each factor shifts the IS curve. The application of the Vietnam War Buildup from 1964–1969 and its effect on the economy shows that the IS curve analysis is a useful one for explaining interesting historical episodes (and the Vietnam War period is one close to my heart because it had such a big impact on my generation).

Discussion of the Policy and Practice case on the fiscal stimulus package of 2009 also shows students that the analysis in this chapter is useful for understanding more recent events.

One teaching device that I have found helps students develop their intuition is the use of summary tables such as Table 9.1 in class. You can use the blackboard to write a list of changes in variables that shift the IS curve and ask students to fill in the table by saying which way the IS curve shifts in response to each change and explaining what the reasoning is. This exercise gives students good practice in developing their analytic abilities. I use this device continually throughout this part of the book, as is evidenced from similar summary tables in later chapters. I recommend this approach highly.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Planned Expenditure 1. Planned expenditure is the sum of four types of spending to purchase goods and services: consumption, planned investment, government, and net exports (exports minus imports). Keynes emphasized this concept because he believed analyzing the determinants of planned expenditure provided the best approach to explain why output dropped sharply during the Great Depression despite little if any change in the economy’s capacity to produce output.

The Components of Expenditure 2. The consumption function states that consumer spending depends on disposable income, the real interest rate, and other variables such as consumers’ optimism and wealth. The consumption function is written as C = C + mpc  (Y – T) – cr. Y – T represents disposable income, and mpc is the marginal propensity to consume, the fraction of an additional dollar of disposable income that consumers will spend to purchase goods and services; r is the real interest rate, and c measures how sensitive consumers’ spending plans are to a 1 percentage point change in the real interest rate; and C represents autonomous consumption, the portion of total consumer spending that is determined by variables other than disposable income and the real interest rate. Consumer spending is positively related to autonomous consumption and disposable income and inversely related to the real interest rate.

3. Planned investment spending consists of fixed investment, which is expenditures by business firms on equipment and structures and by households on residential housing, and inventory investment, planned changes in a firm’s holdings of raw materials, parts, semi-finished goods, and finished goods.

A firm may also experience unplanned inventory investment that results from unexpected fluctuations in the firm’s sales over a given time period.

4. Firms plan to invest in equipment, structures, and inventories when they expect to earn more from these forms of physical capital than the interest cost of the funds used for their purchase. When the real interest rate is very low, the cost of funds is very low, and many of the firm’s planned

©2015 Pearson Education, Inc.

Chapter 9

The IS Curve

91

investments will exceed it. As the real interest rate rises, fewer and fewer planned investments will exceed the cost of funds; thus, planned investment spending falls as the real interest rate rises and rises as the real interest rate falls. The firm must consider the real interest rate even when it invests funds it already has because when it invests in physical capital it gives up the opportunity to earn the real interest rate by using those funds to buy securities instead.

5. An increase in financial frictions raise the real interest rate for investments, and so there are fewer investment projects that earn more than the real interest rate for investments. As a result, firms will be less likely to undertake investment projects, and so planned investment spending will decrease.

6. Net exports are inversely related to the real interest rate. When the real interest rate increases, ceteris paribus, the expected return on domestic assets rises relative to foreign assets. People’s increased desire to hold domestic assets raises the value of domestic currency relative to foreign currencies.

This makes domestic exports more expensive for foreigners and imported goods cheaper for domestic purchasers. The resulting decrease in exports and increase in imports causes net exports to decline when the real interest rate rises.

Goods Market Equilibrium 7. Equilibrium in the goods market requires that total planned spending on goods and services equals the amount of aggregate output that is actually produced. This condition is represented by the equation Y = C + I + G + NX. When it is satisfied, producers can sell all their output and have no reason to change their production decisions because there is no unplanned inventory investment.

8. If unplanned inventory investment is positive, there is an excess supply of goods because aggregate output exceeds planned expenditures. When this occurs, firms will cut production, and aggregate output will decline. If unplanned inventory investment is negative, there is an excess demand for goods because planned expenditures are greater than aggregate output, firms will increase production, and aggregate output will rise.

Understanding the IS Curve 9. The IS curve shows the different combinations of the real interest rate and aggregate output for which the goods market is in equilibrium with Y = C + I + G + NX. Because consumption, planned investment, and net exports all are inversely related to the real interest rate, planned expenditures rise as the real interest rate falls, and therefore, the level of aggregate output required to satisfy goods market equilibrium will be greater at lower real interest rates and smaller at higher real interest rates.

When the points of goods market equilibrium are plotted on a diagram that measures the real interest rate on the vertical axis and aggregate output on the horizontal axis, the IS curve will slope downward.

Factors That Shift the IS Curve 10. The IS curve shifts when autonomous factors (factors that operate independently of the real interest rate and aggregate output) cause changes in planned expenditures. When an autonomous factor increases planned expenditures at each real interest rate, the IS curve shifts to the right because the level of aggregate output required for goods market equilibrium rises. The IS curve shifts to the left when an autonomous factor decreases planned expenditures at each real interest rate. The autonomous factors are autonomous consumption, autonomous investment, autonomous net exports, taxes, and government purchases. Increases in all these factors except taxes shift the IS curve to the right; tax increases shift it to the left.

©2015 Pearson Education, Inc.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

92

Answers to Problems Planned Expenditure 1. Replacing the given estimates in Equation 1 yields: 16,420 = 12,210 + 1,680 + 2,970 + NX. Solving for NX, we can find NX = –$440 billion. If NX equal – $440 billion and imports equal $2,100 billion, then export = $1,660 billion bcause NX = Exports – Imports.

The Components of Expenditure 2. In order to use Equation 2 to calculate consumption expenditure, we need an estimate of the marginal propensity to consume (mpc). If an increase of $1,000 in disposable income leads to an increase of $750 in consumption expenditure, then mpc = 0.75. Plugging this estimate and the other data into Equation 2 yields: C = 1,625 + 0.75  11,500 = 10,250. Consumption expenditure is, therefore, $10,250 billion.

3. In order to apply Equation 2, we need to calculate disposable income first. According to the data, disposable income equals $11,000 billion in this case ($14,000 – $3,000). Applying Equation 2 yields: C = 1,450 + 0.8  11,000 = 10,250. Consumption expenditure is, therefore, $10,250 billion.

4. a.

Dell’s inventory on December 31, 2013, is the market value of the 20,000 computers at its warehouses. Therefore, Dell’s inventory equals 20,000  $500 = $10,000,000 on December 31, 2013. b. Dell’s inventory spending is the change in the level of its inventory during the course of 2014.

On December 31, 2014, Dell’s inventory equals 25,000  $450 = $11,250,000. Therefore, Dell’s inventory spending in 2014 is $1,250,000 = $11,250,000 – $10,000,000. c. During the early stages of an economic recession, as soon as households’ income starts to fall, firms realize that their sales drop. This drop in sales results in fewer requests from dealers and, therefore, an increase in the number of goods stocked at warehouses (because they probably have already decided about production levels for that period). The consequence is that inventory spending will be positive for some time, but firms will quickly cut production and will try to sell their already manufactured goods before increasing production again.

Factors That Shift the IS Curve 5. a.

A decrease in U.S. imports of Chinese goods will result in an increase in U.S. Net Exports (assuming exports do not change), a component of planned expenditure. Assuming the goods market is in equilibrium, this will increase aggregate output at every interest rate, thereby shifting the IS curve to the right. Intuitively, fewer Chinese goods will be imported, and consumers will buy more U.S. goods.

©2015 Pearson Education, Inc.

Chapter 9

The IS Curve

93

b. See graph:

6. a.

Using the values of the parameters on page 239, a tax cut of $93 billion results in the following expression for the IS curve: Y = [1.1 + 1.2 + 3.0 + 1.3 − 0.6  2.907] 

1 0.4 4.8558 − r = −r 1 − 0.6 1 − 0.6 0.4

Y = 12.1395 − r This results in a shift to the right of the IS curve. To calculate the decrease in autonomous consumption expenditure that leaves aggregate output unchanged for the same interest rate, we need the intercept to be 12 instead of 12.1395. To reduce the intercept by 0.1395, autonomous consumption must decrease by 0.0558 (= 0.1395  0.4), or $55.8 billion, to a new level of $1.0442 trillion. Therefore, the decrease in autonomous consumption expenditure that offset the effect of the tax cut was $55.8 billion.

Y = [1.0442 + 1.2 + 3.0 + 1.3 − 0.6  2.907] 

1 0.4 −  r = 12 − r 1 − 0.6 1 − 0.6

b. See graph:

7. a.

An increase in interest rates will decrease consumption expenditure, decrease planned investment spending, and decrease net exports, as summarized by the terms c, d, and x in Equation 10. This reduction in planned expenditure (assuming the goods market is in equilibrium) will result in a ©2015 Pearson Education, Inc.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

94

decrease in aggregate output. The effect of an increase in interest rates is a movement along the IS curve to the northwest. The IS curve does not shift. b. See graph.

8. a.

A more expensive dollar will result in fewer U.S. exports and more U.S. imports (everything else the same), therefore decreasing Net Exports. Graphically, this shifts the IS curve to the left, decreasing aggregate output at every interest rate. b. Usually the increase in stock prices is interpreted as having a positive effect on autonomous planned investment, as investors become more confident about the future prospects of the economy. Therefore, we should expect autonomous planned investment to increase and the IS curve to shift to the right.

9. This is an example in which it is quite difficult to measure the net effect of these events. Depending on the relative magnitude of the shifts, the IS curve might end up shifting to the left, to the right, or not shifting at all. This problem arises because these events have opposite effects on the IS curve.

◼

Answers to Data Analysis Problems

1. a.

For 2013:Q1, total personal consumption expenditures are $11,350.3 billion, nondurable consumption is $2,603.3 billion, and durables consumption is $1,271.8 billion. Thus, nondurables represent 100 × 2,603.3/11,350.3 = 22.9%, and durables represents 100 × 1,271.8/11,350.3 = 11.2%. b. Because nondurables are almost twice the size of durable consumption, a decline in household spending would most likely impact nondurables more (at least in total change) than durables.

2. a.

For 2013:Q1, personal income minus disposable personal income = $13,601.3 billion – $11,992.2 billion = $1,609.1 billion. This difference represents the amount of taxes households pay. b. For 2012:Q2 to 2013:Q1, personal consumption averaged $11,205.4 billion, and from 2011:Q2 to 2012:Q1 it averaged $10,839.3 billion. Disposable personal income over the same periods averaged $12,004.7 billion and $11,622.4 billion, respectively. Thus, personal consumption increased by $11,205.4 billion – $10,839.3 billion = $366.1 billion. Disposable personal income increased by $12,004.7 billion – $11,622.4 billion = $382.3 billion. The ratio between the two represents the marginal propensity to consume, which is $366.1 billion/$382.3 billion = 0.96.

©2015 Pearson Education, Inc.

Chapter 9

The IS Curve

95

Thus, for every $100 decrease in taxes, consumption would be predicted to increase by $96. Note however, that this estimate of the marginal propensity to consume is quite high and might not reflect the true marginal propensity to consume because other factors affect consumption besides disposable income. Hence, other periods might produce very different values for the marginal propensity to consume.

3. a. From 2012:Q2 to 2013:Q1, the average change in investment was $18.75 (billion). b. From 2012:Q1 to 2012:Q4, the average change in ri was –0.48. c. The ratio of the changes is 18.75/–0.48 = –39.06; the absolute value of this represents the coefficient d on the investment function; that is, for every 1 percentage point increase in ri, real private domestic investment falls by about $39 billion. d. From 2008:Q3 to 2009:Q2, the average change in investment was –$155.83 (billion), and from 2008:Q2 to 2009:Q1, the average change in ri was 0.86. The coefficient on investment, d during that period is the absolute value of –155.83/0.86, or d = 181.2. Thus, for every 1 percentage point increase in ri, real private domestic investment would fall by about $181.2 billion. This is significantly higher than during the current period; the financial frictions component partly helps explain the significant decline in investments during the financial crisis period despite real interest rates being relatively low; however, other factors are clearly at play that pushed the drop in investment (and hence the increase in the coefficient) much higher than it is today that can’t be captured by the financial frictions data series (for instance, prospects for long-term growth). In other words, in order to have the coefficient be comparable to what it is today, the financial frictions measure would have to be much higher to capture the drop in investment seen during the financial crisis.

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: The Vietnam War Buildup, 1964–1969 Data Source Federal Reserve Bank of St. Louis: http://research.stlouisfed.org/fred2/series/GCEC96?cid=107. Click on “Edit Graph” and change the years to see the evolution of defense expenditure between 1960 and 1970.

Related Article Feldstein, Martin, “Rethinking the Role of Fiscal Policy”: http://www.nber.org/feldstein/RethinkingtheRole.pdf. This article puts in perspective the increase in government expenditure during the 1960s (Section 1) and discusses the effectiveness of stimulus packages in general.

Discussion Question During the period described in the application, unemployment and interest rates were at relatively low levels for some time, while output increased. Would this mean that an increase in government spending is the answer to reach low unemployment and economic growth at the same time?

Answer: Note that this is only a part of a more comprehensive analysis conducted over the next chapters.

According to the IS curve analysis, an increase in government expenditure will result in higher output at every interest rate level, shifting the IS cure to the right. This, however, does not guarantee that low unemployment and low interest rates will persist. A continuous increase in government spending will set up the conditions for other events that will prevent the economy from staying in an equilibrium with low unemployment and interest rates.

©2015 Pearson Education, Inc.

96

Mishkin • Macroeconomics: Policy and Practice, Second Edition

B. For Information About Policy and Practice: The Fiscal Stimulus Package of 2009 Data Source Federal Reserve Bank of St. Louis: http://research.stlouisfed.org/fred2/series/FDEFX?cid=107 Click on “Edit Graph” and change the years to see the evolution of government expenditures between 2002 and the last available date.

Related Article Shambaugh, Jay (Council of Economic Advisors), “Fiscal Stimulus Making an Impact Around the World”: http://www.whitehouse.gov/blog/2010/02/19/fiscal-stimulus-making-impact-around-world. This article provides evidence in favor of the hypothesis that the 2009 fiscal stimulus package has had a positive effect on the U.S. economy.

Discussion Question The Obama administration (as the previous Bush administration did) stated that the stimulus package would increase employment and successfully pull the economy out of the recession. However, unemployment remained high for some time even after the second stimulus package was approved.

Discuss whether this implies that stimulus packages are completely useless to affect aggregate output.

Answer: This is a quite controversial topic. Adherents to stimulus packages argue that, in the absence of such programs, unemployment would have been much higher, with the corresponding negative consequences for the economy. Deterrents of stimulus packages argue that there is no reason to use them.

Stimulus packages cannot successfully pull the economy out of a recession, and they distort incentives for market participants (i.e., everyone comes to expect such a program in the next crisis). It is difficult to settle this question because it is very difficult (if not impossible) to assess the state of the economy had the stimulus package not been approved.

©2015 Pearson Education, Inc.

Chapter 10 Monetary Policy and Aggregate Demand ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline The Federal Reserve and Monetary Policy The Monetary Policy Curve The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope Shifts in the MP Curve Movements Along the MP Curve Versus Shifts in the Curve Policy and Practice: Movements Along the MP Curve: The Rise in the Federal Funds Rate Target, 2004–2006 Policy and Practice: Shifts in the MP Curve: Autonomous Monetary Easing at the Onset of the 2007– 2009 Financial Crisis The Aggregate Demand Curve Deriving the Aggregate Demand Curve Graphically Factors That Shift the Aggregate Demand Curve The Money Market and Interest Rates Liquidity Preference and the Demand for Money Demand Curve for Money Supply Curve for Money Equilibrium in the Money Market Changes in the Equilibrium Interest Rate Chapter 10 Appendix: The Demand for Money Keynesian Theories of Money Demand Transactions Motive Precautionary Motive Speculative Motive Putting the Three Motives Together Portfolio Theories of Money Demand Portfolio Theory Portfolio Theory and Keynesian Liquidity Preference Other Factors That Affect the Demand for Money Summary

.

98

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Empirical Evidence on the Demand for Money Interest Rates and Money Demand Stability of Money Demand

Chapter Overview and Teaching Tips Chapter 10 develops two other building blocks of the AD/AS framework: the monetary policy curve and the aggregate demand curve. It explains why monetary policy makers raise interest rates when inflation rises so that there is a positive relationship between real interest rates and inflation, which is called the monetary policy (MP) curve. It also explains that shifts in monetary policy involve autonomous easing or tightening of monetary policy, which involve changes in the real interest rate for a given level of inflation.

Because students might have some trouble understanding the difference between movements along the MP curve and shifts in the curve, it is worth covering in class the two Policy and Practice cases, “Movements Along the MP Curve: The Rise in the Federal Funds Rate Target, 2004-2006,” and “Shifts in the MP Curve: Autonomous Monetary Easing at the Onset of the 2007–2009 Financial Crisis.” These cases are nice illustrations to hammer home the difference between autonomous shifts in the MP curve versus movements along the curves.

The chapter then goes on to use the MP curve with the IS curve from the previous chapter to derive the aggregate (AD) curve, a key element in the AD/AS framework. The AD curve has the usual downward slope, but in contrast to the more traditional AD curve in other textbooks, it displays a negative relationship between inflation (instead of the price level) and aggregate demand. The AD curve is derived both graphically and with a numerical example to hone students’ intuition, and students are shown that the factors that shift the IS curve are the same ones that shift the AD curve in exactly the same direction.

The last part of the chapter can be skipped without loss of continuity, but it provides more detail on how central banks like the Federal Reserve set interest rates. It brings in the LM analysis that is often found in other macro textbooks by showing how the interaction between the supply and demand for money determines the equilibrium nominal interest rate. Then, because prices are sticky, the changes in nominal interest rates translate to changes in real interest rates. For instructors who want to examine how interest rates are determined in even more detail, there is an appendix on the demand for money. This appendix first describes the different theories of the demand for money. It then discusses the current state of empirical evidence on the demand for money, and it focuses on two basic questions: (1) How sensitive is the demand for money to changes in interest rates? and (2) Is the demand for money function stable over time?

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions The Federal Reserve and Monetary Policy 1. The real interest rate is the nominal interest rate minus the expected inflation rate. Because it adjusts for inflation, the real interest rate indicates the reward for lending and the cost of borrowing money in purchasing power rather than dollar terms. Because prices are sticky in the short run, changes in the money supply have little if any short-run effect on prices and therefore on actual and expected inflation. Hence, when a change in the Fed’s monetary policy causes the nominal interest rate to change, the real interest also changes in the same direction. In the long run, however, when prices are flexible, actual and expected inflation do change in response to changes in monetary policy, leaving the real interest rate unaffected.

.

Chapter 10

Monetary Policy and Aggregate Demand

99

The Monetary Policy Curve 2. The monetary policy curve represents the relationship between the inflation rate and the real interest rate. It slopes upward because monetary policy makers who wish to keep actual inflation and expected inflation stable will follow the Taylor principle and respond aggressively to a given increase in the inflation rate by raising nominal interest rates by an even greater amount so that the real interest rate also rises.

3. An autonomous monetary policy tightening occurs when the Fed decides to raise the real interest rate at any given inflation rate. This shifts the MP curve upward. An autonomous monetary policy easing, a decision to lower the real interest rate at any given inflation rate, shifts the MP curve downward.

The Aggregate Demand Curve 4. The aggregate demand curve shows combinations of the inflation rate and the quantity of aggregate output for which the goods market is in equilibrium with Y = C + I + G + NX. It slopes downward because, as the MP curve indicates, an increase in inflation results in an increase in the real interest rate. As the IS curve indicates, increases in the real interest rate cause consumption, planned investment, and net exports to decline. These spending declines reduce the quantity of aggregate output demanded and, hence, reduce the equilibrium quantity of aggregate output. Thus, the aggregate demand curve slopes downward because a rise in inflation works through the increase in real interest rates to reduce the equilibrium quantity of aggregate output.

5. The aggregate demand curve shifts to the right if autonomous consumption, autonomous investment, autonomous net exports, or government purchases increase or if taxes are decreased. Opposite changes in these factors shift the aggregate demand curve to the left. In general, changes in these factors shift the aggregate demand curve in the same direction they shift the IS curve.

6. When the Fed tightens monetary policy by raising the real interest rate at any given inflation rate, this means that the quantity of aggregate output demanded at any given inflation rate will be lower and so will the equilibrium quantity of aggregate output. This shifts the aggregate demand curve to the left.

Conversely, an autonomous easing of monetary policy lowers the real interest rate at any given inflation rate, increases the equilibrium quantity of aggregate output, and shifts the aggregate demand curve to the right.

The Money Market and Interest Rates 7. The demand for real money balances (M d/P) depends on the nominal interest rate i and real income Y. Real money balances earn little or no interest; the opportunity cost of holding them is the nominal interest rate that could be earned on bonds. The higher this interest rate, the greater the interest earnings that people sacrifice when they hold money rather than investing in bonds. As the nominal interest rate rises, so does the opportunity cost of holding money, and the quantity demanded of real money balances decreases. Thus the demand for money is inversely related to the nominal interest rate. The demand for real money balances is positively related to real income because, as income rises, people make more purchases and, thus, demand more real money balances to pay for these transactions. Furthermore, as income rises, households also tend to have more wealth and want to hold more financial assets, including real money balances.

8. Open market operations are purchases or sales of government securities the Fed undertakes to change the level of bank reserves and the amount of lending that banks do. When the Fed purchases government securities, the sellers of these securities deposit the money they receive into the banking system, increasing banks’ reserves. With more reserves, banks can make additional loans that increase the supply of money. When the Fed sells government securities, the money paid for the

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

100

securities is withdrawn from the banking system. Banks therefore lose deposits and reserves and must reduce their lending, which decreases the supply of money.

9. Equilibrium in the money market occurs through adjustments in the nominal interest rate to bring the demand and supply for real money balances into equality. If the nominal interest rate is above its equilibrium value, the quantity of real money balances supplied is greater than the quantity of real money balances demanded. People will use the excess supply of money to purchase bonds; this will push up bond prices, which causes the nominal interest rate to fall toward the equilibrium value.

When the interest rate is below its equilibrium level, the demand for real money balances is greater than the supply of real money balances. Now people will sell bonds they are holding to satisfy their excess demand for money. This exerts downward pressure on bond prices, causing the interest rate to rise toward the equilibrium value.

10. The equilibrium interest rate increases if real income increases, which shifts the money demand curve to the right; if the Fed reduces the supply of real money balances, which shifts the money supply curve to the left or if the price level increases, which also reduces the supply of real money balances and shifts the money supply curve to the left.

Answers to Problems The Monetary Policy Curve 1. a.

When the inflation rate is 2 percent, the real interest rate is given by: r = 1.5 + 0.75 → 3 = 1.5 + 0.75  2 . For inflation rates of 3 percent and 4 percent, real interest rates are 3.75 percent and 4.5 percent, respectively. b. See graph:

2. a.

According to the new monetary policy curve, the real interest rate is higher at every inflation rate.

This means that there is an autonomous tightening of monetary policy.

.

Chapter 10

Monetary Policy and Aggregate Demand

101

b.

The Aggregate Demand Curve 3. a.

Substituting the expression for the monetary policy curve in the IS curve equation yields: Y = 13 − (1.5 + 0.75 ) = 11.5 − 0.75

b. Replacing the values of the inflation rate in the AD curve expression yields: Y = 11.5 − 0.75 → Y = 11.5 − 0.75  2 → Y = 10 when the inflation rate is 2 percent. A similar procedure indicates that aggregate output equals $9.25 trillion and $8.5 trillion when inflation rates are 3 percent and 4 percent, respectively. c. See graph:

4. An increase in U.S. net exports directly affects the IS curve because planned expenditure increases at every real interest rate. Assuming the goods market is in equilibrium, aggregate output increases, shifting the IS curve to the right. The monetary policy curve does not shift because net exports are not a determinant of the monetary policy curve. The monetary policy curve represents the monetary authorities’ willingness to set a given real interest rate in the short run according to current inflation rates. Given the same monetary policy curve and a new IS curve, the aggregate demand curve shifts to the right. This means that aggregate output increases at every inflation rate.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

102

5. a.

A Fed chairman mostly worried about decreasing unemployment will probably result in a loosening of monetary policy. Graphically, this translates as lower real interest rates at each inflation rate, or a shift downward of the monetary policy curve. b. Lower real interest rates encourage consumption and investment expenditure and result in higher planned expenditure. Assuming the goods market is in equilibrium, the aggregate demand curve shifts to the right, as aggregate output increases at every inflation rate.

The Money Market and Interest Rates Real money balances are given by MP = 12,900 − 150i = 2,150 − 150i . Real money balances are 6 $1,550 billion, $1,700 billion, and $2,000 billion when the interest rate is 4 percent, 3 percent, and 1 percent. b. See graph: d

6. a.

7. If aggregate output decreases, the demand for real money balances decreases at every given interest rate. This results in a shift to the left in the demand curve.

Md Ms 12,900 = → − 150i = 1,700 → i = 3%.

P P 6 Md Ms 13,800 = → − 150i = 1,700 → i = 4%. b. The equilibrium interest rate is given by P P 6

8. a.

The equilibrium interest rate is given by

.

Chapter 10

c.

Monetary Policy and Aggregate Demand

103

See graph:

9. The increase in aggregate output shifts the demand curve to the right, increasing the interest rate, holding everything else constant. If the Federal Reserve decides to increase the money supply, then the level of the new interest rate is indeterminate. Its new equilibrium level will depend on the magnitude of the change of both the supply and demand curves. It is possible that the money supply will increase as a consequence of the Federal Reserve actions to support the U.S. financial system.

However, the Federal Reserve will try to minimize the effect of its policies on the money supply, which will probably result in an increase in the interest rate, as a result of the shift to the right on the demand curve (and a relatively small shift in the supply curve).

◼

Answers to Data Analysis Problems

1. a.

For the period of 2011:Q2 to 2012:Q1, average inflation was 2.34 percent, and the average real interest rate was –0.68 percent. For 2012:Q2 to 2013:Q1, inflation averaged 1.21 percent, and the real interest rate averaged –1.29 percent. b. The change in average inflation was 1.21% – 2.34% = –1.13%. The change in average real interest rate was –1.29% – (–0.68%) = –0.62%. c. The ratio equals –0.62%/–1.13% = 0.55. This is an estimate of the coefficient λ, which represents the slope of the MP curve. Because λ = 0.55 is positive, this means that according to this data, monetary policy over the last couple years has adhered to the Taylor Principle.

2. See graph on the next page. Periods of autonomous monetary policy change are characterized by a decoupling of real rates and inflation rates. From the middle of 2007 to late 2008, inflation increased, while the real interest rate fell, indicating an autonomous easing of policy. The period from late 2008 through mid-2009 was consistent with a move along the MP curve, where policy was reacting to variation in inflation. From mid-2009 through mid-2011, inflation rose steadily, while the real interest rate continued to decline, suggesting autonomous easing of policy. From mid-2011 to the end of 2012, both inflation and the real interest rate fell, again suggesting a movement along the MP curve as policy reacted to changes in inflation.

.

104

Mishkin • Macroeconomics: Policy and Practice, Second Edition

a. See table below. b. See below. c. Yes, for the most part the results are entirely consistent with liquidity preference theory. Over all three time horizons, the real money supply has increased substantially, which has resulted in declines in nominal interest rates over those periods of time. This indicates that the money demand function is downward sloping, consistent with liquidity preference.

Percentage Point Change May 2012 to May 2008 to May 2003 to May 2013 May 2013 May 2013 Fed Funds Rate –0.05 –1.87 –1.15 Three-Month T-Bill Rate –0.05 –1.69 –1.03 Prime Rate 0.00 –1.75 –1.00 Real Money Growth

◼

10.89

70.01

61.43

Answers to Appendix Review Questions and Problems

1. The three motives Keynes discussed were the transactions motive, the precautionary motive, and the speculative motive. The transactions motive refers to people wishing to hold money because it is the medium of exchange they need for their daily transactions. The precautionary motive refers to people holding money so they will be able to take advantage of unexpected opportunities or handle unexpected expenses as they arise. People’s speculative motive for holding money recognizes that money is a store of wealth that people may choose to hold instead of other assets. (In Keynes’s liquidity preference theory, the only alternative asset was bonds.) Keynes believed that the amount of money people would hold for transactions and precautionary purposes would vary positively with their income, while the amount they held for speculative reasons would be inversely related to the nominal interest rate on bonds because that is their opportunity cost of holding money instead of bonds.

2. The four determinants of money demand identified in portfolio theory are wealth, expected return relative to other assets, risk relative to other assets, and liquidity relative to other assets. The demand for money increases when wealth or the risk associated with other assets increases; it decreases when expected return or liquidity of other assets increases or when the risk of inflation increases.

.

Chapter 10

Monetary Policy and Aggregate Demand

105

3. Macroeconomic researchers use data on money supply (which in equilibrium equals money demand), output, and interest rates to estimate the money demand function. Comparing the results of numerous studies covering various time periods shows how consistent the relationships between money demand, output, and interest rates are over time. Based on this approach, the money demand function appeared to be stable until the early 1970s. After that time, the stable relationship between money supply and aggregate spending was weakened by an accelerating pace of financial innovation that made it more difficult to correctly define and measure the money supply. Instability of the money demand function since the early 1970s suggests that the velocity of money is unstable and that the quantity of money is not as tightly linked to aggregate spending as the quantity theory of money holds. This means that controlling money supply growth does not assure policy makers of controlling the future course of economic activity and inflation. As a result, monetary policy makers around the world have downgraded the importance of money supply in setting monetary policy and now think largely in terms of setting interest rates.

4. This technology would result in a decrease in the transactions component of the demand for money and, therefore, in a decrease in the demand for money. This would allow individuals to hold smaller currency and checking account balances (the most narrow definition of money) to carry out their everyday transactions. In essence, improvements in payment technologies reduce the transaction costs associated with turning a not-so-liquid asset into money. If successful, individuals will most probably keep more of their wealth in the form of these not-so-liquid assets (that usually pay some interest) and then carry out their everyday transactions using the payment technology.

5. The lack of the necessary infrastructure needed by some payment technologies (e.g., credit card reading machines, reliable phone lines, reliable electricity supply) or its high cost determines that most of these technologies are not extensively used in developing countries. Because of that, most individuals in developing countries use cash to carry out their everyday transactions. Everything else the same, one would expect the transaction component of the demand for money to be greater in developing countries than in developed or rich countries.

6. If most people hold cash to insure themselves against unfortunate events, then the precautionary component of the demand for money will be higher than in other societies in which individuals do not need to hold money for such a purpose. In societies where insurance markets are more developed, or in which the government has provided a safety net (e.g., unemployment insurance, disaster relief), individuals do not need to insure themselves by holding cash.

7.

Period 1

Period 2

Period 3

Period 4

Period 5

Period 6

Period 7

Y (in billions)

12,000

12,500

12,250

12,500

12,800

13,000

13,200

Interest rate

0.05

0.07

0.03

0.05

0.07

0.04

0.06

Velocity

8.28

8.38

8.16

8.27

8.37

8.20

8.30

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

106

8.

Velocity 8.40 8.35 8.30 8.25 8.20 8.15 8.10 Period 1

Period 2

Period 3

Period 4

Period 5

Period 6

Period 7

According to this data set, the velocity of money seems to be quite volatile (i.e., experiences substantial fluctuations) over these seven periods. This data set supports the Keynesian view that nominal income is not primarily determined by movements in the quantity of money.

9. a.

During a business cycle contraction, income decreases. As income and wealth are closely related, wealth usually decreases as well. The decrease in wealth directly affects the demand for money, as wealth is one of its determinants according to the portfolio theory approach. As a consequence, the demand for money decreases during recessions. b. When brokerage fees decrease, bonds become relatively more liquid because the transaction costs associated with trading bonds are now smaller. The relative decrease in the liquidity of money decreases the demand for money, according to the portfolio theory approach to money demand.

10. High and volatile inflation rates decrease the relative real return of money, decreasing the demand for money. As individuals observe a persistent increase in the price level, they tend to get rid of money and store their wealth in either interest-bearing securities (if their nominal yields exceed expected inflation) or inflation hedges. The issuance of inflation-protected securities gives individuals an extra opportunity to protect against the effects of inflation, further decreasing the demand for money. This happens because now people have the opportunity to hold a safe asset (issued by the government) that offers inflation-protected yields, a much better option than holding money when there is inflation.

11. The portfolio theory approach to money demand predicts that the real return of holding money sharply decreases during hyperinflations. During hyperinflations, the demand for money contracts so much that sometimes other mediums of exchange are used to conduct trades. In some situations, people have even resorted to barter to exchange goods and services. This of course results in a decrease in economic efficiency, as many people spend a significant portion of their time designing and applying strategies to avoid the effects of inflation. In general, depositors shift out of checking accounts balances denominated in the domestic currency if they can, and into bank deposits denominated in a foreign currency that is not experiencing a decrease in its value. (Savings deposits or securities denominated in the domestic currency are not a good alternative in this case, as inflation rates are so high that nominal interest rates would have to be extremely high to compensate for the decrease in purchasing power of any interest payment.)

.

Chapter 10

Monetary Policy and Aggregate Demand

107

12. In the aftermath of a stock market crash, uncertainty about the performance of many firms increases, and stock price volatility increases as well. The increase in stock price volatility increases the relative safety of holding money. Thus, money demand should increase. However, shares of stock are a significant portion of some individuals’ wealth. A stock market crash means that stock prices decrease, negatively affecting the wealth of these individuals. As a consequence, the demand for money would decrease because wealth is one of the determinants of the demand for money. The final effect of a stock market crash on the demand for money cannot be determined that easily. It depends on the magnitude of the aforementioned effects. Note that usually a stock market crash or an increase in asymmetric information problems that decrease the demand for other securities (e.g., corporate bonds) in general increases the demand for safer assets but not money. (U.S. Treasury bonds are a good example of investors’ choice in this case.) In addition, if the stock market crash affects the wealth of only a few individuals, then the effect of the market crash on the demand for money might not be as relevant.

13. For this country, the evidence shows that velocity can be considered a constant, meaning that the relationship between the money supply (as measured by M2) is closely related to aggregate spending (nominal GDP). In this case it would be a good idea to focus the attention of monetary policy on a monetary aggregate, as its growth rate would be a good indicator of the stance of monetary policy. A risk associated with this strategy is that if the relationship between the monetary aggregate and aggregate spending breaks down, monetary policy authorities would be focusing on the wrong instrument to reach their monetary policy objectives.

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Policy and Practice: Movements Along the MP Curve: The Rise in the Federal Funds Rate Target, 2004–2006 Data Source Federal Reserve Bank of St. Louis data base (FRED): http://research.stlouisfed.org/fred2/series/FF?cid=118. Click on “Edit” and change the years to 2003–2007 to observe changes in the effective federal funds rate engineered by the Fed during this period.

Related Article Federal Reserve System, “Press Release”: http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm. This is the FOMC statement (June 2004) that declares the first rise in the federal funds rate target in the 2004–2006 period.

Discussion Question In the second paragraph of the June 30, 2004, FOMC statement, the committee affirmed that it increased the federal funds rate target partly due to the fact that “The evidence accumulated over the intermeeting period indicates that output is continuing to expand at a solid pace and labor market conditions have improved.” Explain why this should be interpreted as a movement along the MP curve and not as a shift in the MP curve.

Answer; In this case, the FOMC quotes changes in economic conditions that are linked to future changes in the inflation rate. Fears that the expansion of economic activity could lead to accelerating inflation lead the FOMC to start a path of continual increases in the federal funds rate target. In order to interpret this policy as a shift of the MP curve, the FOMC should have quoted a reason not related to inflationary pressures in order to increase the federal funds rate target.

.

108

Mishkin • Macroeconomics: Policy and Practice, Second Edition

B. For Information About Policy and Practice: Shifts in the MP Curve: Autonomous Monetary Easing at the Onset of the 2007–2009 Financial Crisis Data Source Federal Reserve Bank of St. Louis data base (FRED): http://research.stlouisfed.org/fred2/series/FF?cid=118. Click on “Edit Graph” and change the years to 2007–2010 to see the decrease in the effective federal funds rate engineered by the Fed during this period.

Related Article Federal Reserve System, “Press Release”: http://www.federalreserve.gov/newsevents/press/monetary/20070918a.htm. Here you can find the Fed’s statement about the first change to the federal funds rate target and discount rate engineered during the 2007–2009 period.

Discussion Question In the second paragraph of the January 22, 2008, FOMC statement, the committee affirmed that it lowered the federal funds rate target “… to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.” Explain how this argument should be interpreted as a shift in the MP curve and not as a movement along the MP curve.

Answer: It is clear from the FOMC’s choice of wording that its intention was to act to counter the effect of an adverse shock to the U.S. economy. This contrast with a natural response (what would be a movement along the MP curve) that would be an increase in the federal funds rate target in light of increasing inflation rates. Furthermore, the FOMC’s reasoning cites factors others than changes in the inflation rate (or directly related to it) as the reason for the lowering of the federal funds rate target.

.

Chapter 11 Aggregate Supply and the Phillips Curve ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline The Phillips Curve Phillips Curve Analysis in the 1960s Policy and Practice: The Phillips Curve Tradeoff and Macroeconomic Policy in the 1960s The Friedman-Phelps Phillips Curve Analysis The Phillips Curve After the 1960s The Modern Phillips Curve The Modern Phillips Curve with Adaptive (Backward-Looking) Expectations The Aggregate Supply Curve Long-Run Aggregate Supply Curve Short-Run Aggregate Supply Curve Shifts in Aggregate Supply Curves Shifts in the Long-Run Aggregate Supply Curve Shifts in the Short-Run Aggregate Supply Curve

Chapter Overview and Teaching Tips The last building block of the AD/AS framework is the aggregate supply curve. This chapter develops the aggregate supply curve from Phillips curve analysis. To give students the intuition behind the Phillips curve, the chapter starts by showing how Phillips curve analysis has evolved through time. The Policy and Practice case, “The Phillips Curve Tradeoff and Macroeconomic Policy in the 1960s,” is a nice example to discuss in class because it can show how incorrect theories can lead to mistakes in macroeconomic policy. An advantage of proceeding with an historical approach to how ideas about the Phillips curve evolved over time is that it naturally lends itself to a step-by-step process of development of the modern, expectationsaugmented Phillips curve, which makes it easier for students to understand it.

Once the modern, expectations-augmented Phillips curve is developed and students understand that it implies that there is no long-run tradeoff between inflation and employment, it is fairly straightforward to develop both the long-run and short-run aggregate supply curve, as is done in the chapter using Okun’s Law. Then shifts in these curves are outlined, enabling students to be prepared for putting the aggregatedemand analysis together with aggregate supply analysis to develop the full-fledged AD/AS analysis for analyzing short-run economic fluctuations in the next chapter.

.

110

◼

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions The Phillips Curve 1. The short-run Phillips curve describes a negative relationship between unemployment and inflation.

This seems to suggest that policy makers can “buy” lower unemployment if they are willing to pay for it with higher inflation and that policies to reduce inflation will be costly because they will increase unemployment.

2. According to the long-run Phillips curve, unemployment moves to a natural rate regardless of the rate of inflation, so there is no long-run tradeoff between inflation and unemployment that policy makers can exploit. This differs from the short-run Phillips curve analysis because in the long run workers and firms care about real rather than nominal wages and incorporate expected inflation into their work and hiring decisions. Because wages and prices are flexible in the long run, nominal wages change in proportion to changes in inflation so that real wages remain unchanged. As a result there is no movement of the unemployment rate away from its natural rate.

3. According to the expectations-augmented Phillips curve, the inflation rate depends on expected inflation and the unemployment gap, which measures tightness in labor markets as the difference between the actual and natural rates of unemployment. The inflation rate is higher with higher expected inflation and a lower unemployment gap. Changes in expected inflation shift the short-run Phillips curve upward (when expected inflation rises) or downward (when expected inflation falls).

Decreases in the unemployment gap (a tighter labor market) cause movements up along a given short-run Phillips curve, and increases in the unemployment gap cause movements down along a given short-run Phillips curve.

4. Adaptive expectations are formed by looking at past values of the variable being forecast. (Because they look at the past, adaptive expectations sometimes are called backward-looking expectations.)

This means that expected inflation is based on past values of the inflation rate. This assumption is justified by the view that inflation expectations are sticky and adjust slowly to past inflation changes and by the fact that some wage and price contracts are backward looking and slow to adjust to changes in expected inflation.

5. In modern Phillips curve analysis, the rate of inflation increases one-for-one with changes in expected inflation and price shocks and moves inversely to the unemployment gap. Price shocks and changes in expected inflation shift the short-run Phillips curve up or down and changes in the unemployment gap cause movements along a given short-run Phillips curve.

The Aggregate Supply Curve 6. The aggregate supply curve shows the relationship between the total quantity of output supplied and the inflation rate. In the long run, the amount of output an economy can produce is determined by its labor, capital, and technology. Because none of these factors are related to the inflation rate, neither is the economy’s potential output in the long run, and its long-run aggregate supply curve is, therefore, a vertical line.

7. Okun’s Law relates the unemployment gap U − Un, where U is the unemployment rate and Un is the natural rate of unemployment, to the output gap Y − YP, where Y is aggregate output and YP is the economy’s potential output. The relationship between the two gaps is negative because when the economy produces less than its potential output, the unemployment rate is greater than the natural rate of unemployment. Combining Okun’s Law and Phillips curve analysis helps to derive the shortrun aggregate supply curve that relates total output supplied to the inflation rate because a negative

.

Chapter 11

Aggregate Supply and the Phillips Curve

111

short-run Phillips curve relationship between unemployment and inflation implies a positive relationship between output and inflation.

8. When output increases relative to potential output, Y − YP increases. At the same time, according to Okun’s Law, the unemployment rate is falling relative to the natural rate of unemployment, which means that U − Un decreases. As the short-run Phillips curve shows, this tightening in the labor market as output rises causes the inflation rate to rise. Therefore the short-run aggregate supply curve, which shows the relationship between output and inflation, slopes upward because when the quantity of output supplied increases, a decline in the unemployment gap causes the inflation rate to also increase.

Shifts in Aggregate Supply Curves 9. Shifts in the long-run aggregate supply curve result from changes in the total quantities of capital and labor in the economy and in the available technology. When any of these increase, the economy’s potential output increases and the long-run aggregate supply curve shifts to the right. Decreases in any of these factors shift the long-run aggregate supply curve to the left.

10. The short-run aggregate supply curve shifts upward when expected inflation increases, when positive price shocks occur, or when there is a positive and persistent output gap that increases expected inflation. Opposite changes in these factors shift the short-run aggregate supply curve downward.

Answers to Problems The Phillips Curve 1.

According to the graph, there seems to be evidence in favor of a negative relationship between inflation and unemployment during the 1960s in Canada.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

112

2.

According to the graph, there seems to be no relationship at all between inflation and unemployment rates in Canada between 1970 and 2012. Higher inflation rates are not in general associated with lower unemployment rates, as the Phillips curve predicts.

3. a.

Substituting the values of expected inflation and the natural rate of unemployment yields the following expression:  = 3 − 0.5(U − 5) . According to this expression, inflation rates are 3.5 percent, 3 percent, and 2.5 percent when unemployment rates are 4 percent, 5 percent, and 6 percent, respectively. b. See graph:

c.

If wages become more rigid, then the slope of the Phillips curve becomes flatter. Algebraically, the  parameter decreases in absolute value to express the rigidity in wages. When prices become less flexible, the same unemployment gap has a smaller effect on inflation rates, which translates into a more horizontal Phillips curve.

.

Chapter 11

Aggregate Supply and the Phillips Curve

113

4. The modern Phillips curve allows for shifts in the Phillips curve that arise from price shocks. In this case, the increase in oil prices is interpreted as a negative price shock that raises prices independently of inflation expectations and labor market conditions. As a result, the Phillips curve shifted upwards, as shown in the graph, from PC1 to PC2. As a result of the price shock, inflation was higher at every unemployment rate.

The Aggregate Supply Curve The percentage point change in unemployment is: % = − 0.75  (%Y). Therefore, a 1 percent decrease in real GDP results in a 0.75 percentage point increase in unemployment. b. The percentage point change in real GDP is: %Y = − 1.33% U. Therefore, a 2 percentage point decrease in unemployment results in a 2.66 percent increase in real GDP.

5. a.

6. a.

First substitute the unemployment gap with Okun’s Law into the Phillips curve to get:  =  e − 0.6  (− 0.75  (Y − Y P )) + . According to the assumptions about inflation expectations, no price shock and the level of potential output, the short-run aggregate supply curve is:  = 3 + 0.45  (Y − 10).

b. Replacing the values for output into the above expression yields inflation rates of 2.1 percent, 3 percent, and 3.9 percent when output is $8, $10, and $12 trillion.

.

114

Mishkin • Macroeconomics: Policy and Practice, Second Edition

7. The new short-run aggregate supply curve is:  = 3 + 0.45  (Y − 10) + .

8. Okun’s Law held for these three countries. In all cases, a decrease in real GDP was matched with an increase in unemployment. However, more rigid labor markets in Germany and France prevented a higher response in unemployment. During 2008–2009, real GDP decreased by 2.5 percent and 5 percent in France and Germany, respectively. This was matched with an unemployment rate increase of 2.5 and 0.5 percentage points in France and Germany, respectively. In the case of the United States, a real GDP fall of 3.5 percent during the same period resulted in an increase of almost 5 percentage points in unemployment. As expected, France’s and Germany’s unemployment rate sensitivities to the real GDP decrease were lower than in the United States. Economists argue that this higher sensitivity of unemployment to real GDP in the United States is due to the ability of firms in the United States to lay off workers more easily than in European countries. Note that in Germany there was almost no change in unemployment, even if real GDP fell by around 5 percent. Although this seems like a nice result, it is also true that because of labor market rigidities, unemployment is usually higher in European countries than in the United States.

Shifts in Aggregate Supply Curves 9. a.

The Internet reduced the amount of time and money spent looking for a job. It also allowed for an increased flow of information between potential employees and employers (e.g., job descriptions, resumes, and other valuable information are usually available online). This resulted in a decrease in the natural rate of unemployment, as unemployed workers are matched with employment opportunities quicker.

.

Chapter 11

Aggregate Supply and the Phillips Curve

115

b. Graphically, the long run aggregate supply curve shifts to the right:

10. If the public assumes that the current Fed officials are not that worried about inflation, expected inflation will increase, shifting the short-run aggregate supply curve upward and to the left. There are periods when Fed officials are in the difficult position of having to choose when to increase interest rates to fight inflation when an economic recovery is just starting. Increasing interest rates too late would fuel expectations about inflation, while increasing interest rates too soon will slow down the recovery. It is quite difficult to make this decision, which is why most of the time the conduct of monetary policy is more an art than a science.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

116

◼

Answers to Data Analysis Problems

1. a.

See figure below. The scatterplot does seem to have a downward slope on inspection of the figure, implying a tradeoff between inflation and unemployment as predicted by the Phillips curve. This is confirmed in part (b) using regression analysis. The most recent unemployment and inflation data for 2013:Q1 are 7.7 percent and 1.2 percent, respectively, and shown as the larger square in the scatterplot. b. The fitted line equation is Inflation = –0.2398UR + 3.6699, with an R² = 0.238. Thus, the negative slope of the fitted line indicates a tradeoff between inflation and unemployment. i. According to the fitted regression, a decrease in unemployment of 1 percentage point would lead to an increase in inflation of 0.23 percentage points. The most current unemployment and inflation figures for 2013:Q1 are 7.7 percent and 1.2 percent, respectively. Thus, this hypothetical change would lead to a 6.7 percent unemployment rate, and a 1.43 percent inflation rate. ii. The estimated Phillips Curve here has a modest amount of predictive power at best. An R2 of 0.24 indicates that this simple Phillips curve can only explain approximately a quarter of the variation between the two variables; the other 75 percent is unexplained in this simple model.

Accounting for movements in inflation expectations, changes in the natural rate, and exogenous price shocks would significantly sharpen the apparent relationship between movements in the unemployment rate and inflation rate.

.

Chapter 11

Aggregate Supply and the Phillips Curve

117

2. a.

Positive output gaps: 2000:Q1 to 2001:Q2; 2005:Q1 to 2007:Q4. Negative output gaps: 2001:Q3 to 2004:Q4; 2008:Q1 to 2013:Q1 b. See table below. c. For the most part, the table does fit the view of an accelerationist Phillips curve. In periods when output is sustained above potential (positive output gaps), the change in inflation is positive over those periods. The recent negative output gaps do not hold as much to form, however. The 2001:Q3 to 2004:Q4 period is an exception, with output declining slightly, while inflation increased through the period. However, the period encompassing the financial crisis from 2008 to the present (2013:Q1) showed significant declines in output below potential, for a significant amount of time. This is entirely consistent with an accelerationist view because inflation fell on net over that time by a relatively large amount. More generally, the larger output gaps, positive or negative, produce a bigger change in inflation over the period, again consistent with an accelerationist Phillips curve.

Average Output Gap

Change in Inflation

Positive Output Gaps 2000:Q1 to 2001:Q2 2005:Q1 to 2007:Q4

2.22 0.46

0.80 0.70

Negative Output Gaps 2001:Q3 to 2004:Q4 2008:Q1 to 2013:Q1

–0.88 –5.56

1.20 –2.20

3. a. See regression output below, for 2000:Q1 to 2013:Q1. b. The results are entirely consistent with a short-run aggregate supply curve: The slope of the curve is positive, with an estimated (γ) coefficient of 0.15 meaning if the output gap rises by 1 percentage point, inflation will rise by 0.15 percentage points. The coefficient on inflation expectations is very close to one, at 0.94; thus, if inflation expectations rise by 1 percentage point, inflation overall will rise by 0.94 percentage points, almost all of the increase in inflation expectations. c. The estimated short-run aggregate supply curve has very good predictive power, with an overall R2 of 0.63. Thus, 63 percent of the variation in inflation can be explained through variation in output gap and inflation expectation movements. It is not surprising that this more sophisticated aggregate supply curve has a better fit to the data than the previous problem because the simple Phillips curve didn’t take account of changes in inflation expectations, or movements in potential output (via the natural rate of unemployment), both of which can shift this relationship and confound the stability between inflation and output (or unemployment). d. In 2013:Q1, the output gap was –5.8 percent; thus, if policy makers were to close this output gap, the short-run aggregate supply curve would predict a 0.15 × (5.8%) = 0.87 percentage point increase in inflation as a result.

Regression Statistics Multiple R 0.79263838 R Square 0.62827561 Adjusted R Square 0.61340663 Standard Error 0.58732954 Observations 53

.

118

Mishkin • Macroeconomics: Policy and Practice, Second Edition

ANOVA df 2 50 52

SS 29.15162874 17.24779922 46.39942796

Coefficients –0.39254458 0.93739884 0.14630438

Regression Residual Total

Intercept Inflation Expectations Output Gap

MS 14.57581 0.344956

F 42.25413

Standard Error 0.414871826 0.132581164

t Stat –0.94618 7.070377

P-value 0.348606 4.66E-09

0.025226888

5.799541

4.48E-07

Significance F 1.80105E-11

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Policy and Practice: The Phillips Curve Tradeoff and Macroeconomic Policy in the 1960s Data Sources Bureau of Labor Statistics: http://www.bls.gov/cps/. For unemployment rate data, click on the “10 years of historical data” icon (the green dinosaur) and select 1959 to 1969 to get data for the period in question. http://data.bls.gov/cgi-bin/surveymost?cu .For inflation data, click on “U.S. All items, 1982-84=100,”,then “retrieve data” and select 1959 to 1969 to get data for the period in question.

Related Article Hoover, Kevin D. “The Phillips Curve”: http://www.econlib.org/library/Enc/PhillipsCurve.html. This article defines the concept of the Phillips curve and reviews later additions to the theory made by other authors.

Discussion Question During the 2000–2010 period, inflation rates in the United States fluctuated around a fairly low average of 2.5 percent annual rate, while the unemployment rate increased sharply at the end of the period (from around 5 percent in the early 2000s to almost 10 percent in 2009). Would this data be consistent with the Philips curve concept?

Answer: According to the Phillips curve, fairly constant inflation rates should have been matched with fairly constant unemployment rates (corresponding to a point in a given Phillips curve). The increase in the unemployment rate at the end of the period should have been matched with a decrease in inflation rates.

This decade adds evidence to the hypothesis that the Phillips curve (in its more basic form) should be reformulated to explain this data. This will happen later in the text.

B. For Information About Okun’s Law Data Sources Bureau of Labor Statistics: http://www.bls.gov/cps/. For unemployment rate data, click on the “10 years of historical data” icon (the green dinosaur) and select 1960 to 2013 to get data used for Figure 11.4.

Federal Reserve Bank of St. Louis data base (FRED): http://research.stlouisfed.org/fred2/graph/?id=GDPC1 . Click on “Edit Graph” and change the years to 1960–2013, and select “Percent Change” in Units to get the data used in Figure 11.4; You can download the dataset by clicking “Download Data in Graph.”

.

Chapter 11

Aggregate Supply and the Phillips Curve

119

Related Article Okun, Arthur M., “Potential GNP: Its Measurement and Significance”: http://cowles.econ.yale.edu/P/cp/p01b/p0190.pdf. Here you can find the paper referenced in the text.

Discussion Question During the second semester of 2009 and the first semester of 2010, the GDP growth rate became positive.

However, percentage changes in the GDP growth rate were not matched by half percentage point decreases in the unemployment rate during that period. Would this suggest that Okun’s Law is no longer valid?

Answer: Even if a percentage point increase in the GDP growth rate was not matched with half a percentage point decrease in the unemployment rate during 2009III–2010II (roman numbers denote quarters), this does not mean that Okun’s Law is no longer holding. One of the problems with severe recessions (like the one experienced during 2007–2009) is that the average duration of unemployment increases. This results in workers losing skills, making it more difficult for firms to find a good match whenever they decide to start hiring again. Other explanations to the slow decrease in unemployment cite the extension to unemployment insurance, as noted in this article: http://online.wsj.com/article/SB10001424052748703959704575454431457720188.html?

KEYWORDS=jobless+recovery.

.

Chapter 12 The Aggregate Demand and Supply Model ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Recap of the Aggregate Demand and Supply Curves The Aggregate Demand Curve Factors That Shift the Aggregate Demand Curve Short- and Long-Run Aggregate Supply Curves Factors that Shift the Long-Run Aggregate Supply Curve Factors that Shift the Short-Run Aggregate Supply Curve Equilibrium in Aggregate Demand and Supply Analysis Short-Run Equilibrium Long-Run Equilibrium Short-Run Equilibrium Over Time Self-Correcting Mechanism Changes in Equilibrium: Aggregate Demand Shocks Application: The Volcker Disinflation, 1980–1986 Application: Negative Demand Shocks, 2001–2004 Changes in Equilibrium: Aggregate Supply (Price) Shocks Temporary Supply Shocks Application: Negative Supply Shocks, 1973–1975 and 1978–1980 Permanent Supply Shocks Application: Positive Supply Shocks, 1995–1999 Conclusions Application: Negative Supply and Demand Shocks and the 2007–2009 Financial Crisis AD/AS Analysis of Foreign Business Cycle Episodes Application: The United Kingdom and the 2007–2009 Financial Crisis Application: China and the 2007–2009 Financial Crisis Chapter 12 Web Appendix: The Taylor Principle and Inflation Stability Chapter 12 Web Appendix: The Effects of Macroeconomic Shocks on Asset Prices Chapter 12 Web Appendix: The Algebra of the Aggregate Demand and Supply Model

.

Chapter 12

The Aggregate Demand and Supply Model

121

Chapter Overview and Teaching Tips Now students are ready for the payoff from their work in understanding all the building blocks in the previous three chapters. The resulting aggregate demand/aggregate supply model differs from that in many other textbooks because it is inherently dynamic and emphasizes the interaction of inflation and economic activity. In contrast to older AD/AS frameworks which have the price level on the vertical axis, the dynamic AD/AS approach in this textbook has inflation on the vertical axis.

There are several advantages to the approach used here. First, students have to learn only one model to understand fluctuations in output and inflation, the AD/AS model here, while older approaches require two models, the ISLM model and then a separate AD/AS model. Learning just one model is almost always easier than learning two. Second, the dynamic AD/AS model used here allows direct analysis of the interaction of inflation and economic activity, a key feature of modern macroeconomic analysis. Third, because the model directly builds in expectations as a central element, it can far more directly deal with current policy discussions about the importance of credibility to the success of macro policies and the benefits of adopting a strong nominal anchor like an inflation target in conducting monetary policy.

Finally, it is general enough to illustrate modern business cycle theories such as the real business cycle model and new Keynesian model.

The chapter starts with a recap of the aggregate demand and supply curve. All this material repeats the analysis in the previous chapters, but I think it is very important to go over this again in class because it puts all the analysis together at one time. Also, recaps like this are a good way of getting students to really understand the material. It is again helpful in class to make use of the teaching device of the summary tables in the text, 12.1 and 12.2, which summarize what factors cause the aggregate demand and supply curves to shift. Listing changes in the variables that shift the AD and AS curves and then asking students to fill in the tables by saying which way the curves will shift and the reasons behind the shift will give them the practice they need to master the model.

The next step is to describe the equilibrium in AD/AS analysis, while getting across the key point that there are two equilibria. The short-run equilibrium occurs at the intersection of the AD curve with the short-run AS curve, while the long-run equilibrium occurs at the intersection of the AD curve and the long-run aggregate supply curve. The chapter then shows them how the economy has a self-correcting mechanism because over time, a sequence of short-run equilibria lead the economy to go to the long-run equilibrium at which output returns to potential and the economy is at full employment.

The rest of the chapter shows how inflation and equilibrium output changes as a result of either aggregate demand shocks or aggregate supply (price) shocks. To drive home the analysis and also show students how useful the AD/AS model is, the chapter goes through a large number of applications. The first two, “The Volcker Disinflation, 1980–1986” and “Negative Demand Shocks, 2001–2004,” demonstrate how the economy responded to demand shocks. The next two, “Negative Supply Shocks, 1973–1975 and 1978–1980” and “Positive Supply Shocks, 1995–1999,” demonstrate how the economy responded to supply shocks. The application “Negative Supply and Demand Shocks and the 2007–2009 Financial Crisis” shows how the economy can be devastated by the double whammy of adverse supply and demand shocks. The chapter ends with two applications involving foreign countries, “The United Kingdom and the 2007–2009 Financial Crisis” and “China and the 2007–2009 Financial Crisis,” to show how useful the AD/AS model is in explaining foreign business cycle episodes, just as it is for U.S. business cycle episodes.

All of these applications are self-contained, so an instructor can pick and choose between the ones he or she would like to teach in class. However, I think there is nothing more fun than to explain important historical episodes, which all of the applications do, and show how powerful economic models can be to explain real world phenomena.

.

122

Mishkin • Macroeconomics: Policy and Practice, Second Edition

The chapter has three online appendices on the companion Website, www.pearsonhighered.com/mishkin.

The first formally demonstrates a point made in Chapter 10 that the Taylor principle is necessary for inflation stability and, thus ,provides the rationale for why a central bank has to raise the real interest rate as inflation rises, giving the MP curve an upward slope. The second, “The Effects of Macroeconomic Shocks on Asset Prices,” is worth teaching to students who are interested in pursuing careers in finance. It shows how the AD/AS model can explain how macroeconomic events that students are seeing reported in the media every day affect both stock prices and interest rates. The third Web appendix, “The Algebra of the Aggregate Demand and Supply Model,” develops all the results described in the chapter mathematically. Although the chapter has numerical examples of how the AD/AS model works provided in boxes, the more general algebraic approach in this appendix is useful for more mathematically inclined students.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Recap of Aggregate Demand and Supply Curves 1. A rise in inflation causes the real interest rate to rise. This reduces planned expenditures and lowers the level of output necessary for goods market equilibrium. The opposite occurs if inflation falls.

Therefore, goods market equilibrium will occur at lower levels of output when the inflation rate rises and at higher levels of output when inflation falls. The downward slope of the aggregate demand curve reflects this. The short-run aggregate supply curve slopes upward to reflect the increase in the inflation rate that occurs when the economy’s aggregate output of goods and services exceeds the potential output level in the short run and the decrease in inflation that occurs when output is below potential output.

2. The following changes shift the aggregate demand curve to the right: monetary policy easing, increase in government purchases, decrease in taxes, autonomous increase in consumption, autonomous increase in investment, a decrease in financial frictions and autonomous increase net exports. The opposite changes in these factors shift the aggregate demand curve to the left.

3. Shifts in the short-run aggregate supply curve result from changes in expected inflation, price shocks, and persistent output gaps. None of these factors shift the long-run aggregate supply curve because price and wage flexibility ensures that in the long run the economy produces at its potential output level. Potential output depends not on actual or expected inflation but rather on the capital, labor, and technology available for producing goods and services.

Equilibrium in Aggregate Demand and Supply Analysis 4. Short-run equilibrium requires that the quantity of aggregate output demanded equals the quantity of output supplied. This occurs where the aggregate demand curve and the short-run aggregate supply curve intersect. Long-run equilibrium requires the economy’s short-run equilibrium to occur at the potential output level so that actual output Y equals potential output Y P. This occurs when the aggregate demand curve and the short-run aggregate supply curve intersect at a point on the long-run aggregate supply curve.

5. When output exceeds potential output, unemployment is below the natural rate, and labor market tightness causes wages to rise more rapidly. As the Phillips curve suggests, this causes firms to raise their prices more rapidly and, thus, increases the inflation rate. As a result, expected inflation will be higher in the following time period, and the short-run aggregate supply curve will shift upward. This adjustment process in which inflation and expected inflation rise and the short-run aggregate supply

.

Chapter 12

The Aggregate Demand and Supply Model

123

curve shifts upward continues over time until output falls to the potential output level, the output gap is lowered to zero, and the economy reaches long-run equilibrium.

Changes in Equilibrium: Aggregate Demand Shocks 6. Demand shocks are exogenous changes that cause the aggregate demand curve to shift. These shocks stem from monetary policy easing or tightening, changes in government purchases and taxes, and autonomous changes in consumption, investment, and net exports. Positive demand shocks shift the aggregate demand curve to the right; negative shocks shift it to the left.

7. A positive demand shock moves the aggregate demand curve to the right and causes both inflation and output to increase. Because this increases output relative to potential output and expands the output gap, the rate of inflation rises. In ensuing time periods, expected inflation rises and the aggregate supply curve shifts to the left until the economy’s self-correcting mechanism has lowered output to potential output. Thus the only long-run effect of the positive demand shock is a rise in inflation.

Changes in Equilibrium: Aggregate Supply (Price) Shocks 8. Supply shocks are another term for the price shocks that cause shifts of the short-run Phillips curve and, therefore, of the short-run aggregate supply curve. Positive supply shocks lower inflation and shift the short-run aggregate supply curve down and to the right; negative supply shocks increase inflation and shift the short-run aggregate supply curve up and to the left. Temporary supply shocks shift only the short-run aggregate supply curve, but permanent supply shocks also shift the long-run aggregate supply curve.

9. The temporary negative supply shock does not affect potential output or the long-run aggregate supply curve but shifts the short-run aggregate supply curve up and to the left. This initially raises the inflation rate and causes short-run equilibrium output to fall below potential output. With actual output falling relative to potential output, the output gap turns negative. This increases unemployment relative to the natural rate of unemployment and increases the unemployment gap, which causes inflation to begin falling. As inflation falls, expected inflation also drops and shifts the short-run aggregate supply curve back down and to the right until long-run equilibrium is attained. Thus the short-run effects of the temporary negative supply shock are to increase inflation and decrease output, and the long-run effects are to leave both inflation and output unchanged.

10. A permanent negative supply shock, unlike a temporary one, reduces potential output and shifts the long-run aggregate supply curve to the left. Inflation begins to rise, and output falls. Although output has fallen, potential output also has fallen, the lower output is above the new potential output, and there is a positive output gap. This, along with increases in expected inflation, shifts the short-run aggregate supply curve up and to the left. This continues until inflation rises enough to eliminate the output gap and reduce output to the new potential output level. Thus a permanent negative supply shock has short-run effects that are identical to those of a temporary negative shock, but its long-run effects are that inflation will be permanently higher and output permanently lower.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

124

Answers to Problems Recap of the Aggregate Demand and Supply Curves 1. a.

In general, these proposals will reduce the tax burden on small businesses and encourage businesses to hire more employees and to increase investment. More employment will result in higher consumption and planned expenditure, as new employees spend their wages. Investment spending should also increase due to the tax incentives. b. Graphically, the aggregate demand curve will shift to the right because the equilibrium level of output will increase at any given inflation rate.

2. The statement is correct. A depreciation of the U.S. dollar makes U.S. exports cheaper for foreign consumers at the same time it makes imports into the U.S. more expensive. As a result, exports increase, imports decrease, and net exports increase. According to aggregate demand and supply analysis, the aggregate demand curve shifts upward and to the right. Note that the depreciation of the U.S. dollar might also affect the short-run aggregate supply curve if U.S. firms import many of their inputs. An increase in the price of inputs will shift the short-run aggregate supply curve up and to the left.

3. a.

According to aggregate demand and supply analysis, a decrease in government spending results in a decrease in aggregate demand at every inflation rate. b. Graphically, the aggregate demand curve shifts downward and to the left.

.

Chapter 12

The Aggregate Demand and Supply Model

125

4. The decrease in oil prices made production possible at lower costs by decreasing the price of energy, transportation, and a number of raw materials. It therefore lessened pressure for firms to raise prices, reducing inflation at every equilibrium level of output. Graphically, the short-run aggregate supply curve shifted downward and to the right. Because neither technology nor factors of production were affected by this price shock, the long-run aggregate supply curve remained unchanged.

Changes in Equilibrium: Aggregate Demand Shocks 5. The decrease in government spending will result in a decrease in aggregate output at every inflation rate and, therefore, will shift the aggregate demand curve downward and to the left in the short run.

The economy will be at a short-run equilibrium with output below its potential and a lower inflation rate. The corresponding decrease in expected inflation and the relatively higher unemployment rate (i.e., a slack labor market) cause a downward and rightward shift of the short-run aggregate supply curve. The self-correcting mechanism has restored the economy to its long-run equilibrium, where output is at its potential and the inflation rate has decreased even further. In conclusion, the short-run effect of this policy is a temporary reduction in output and inflation, whereas inflation decreases further, and output remains unchanged in the long run.

6. The appointment of a Fed chairman who has no interest in fighting inflation will most likely result in an increase in expected inflation. Both firms and workers will expect inflation rates to be higher at any output level. With aggregate demand and supply analysis, we illustrate these expectations by shifting the short-run aggregate supply curve upward and to the left. In the short run, inflation increases, and output decreases. Depending on the ability of the new chairman to fight inflation, inflation expectations might be lowered later, and the economy will then return to its initial long-run equilibrium. If inflation expectations cannot be reduced, then the economy might find itself at the short-run equilibrium characterized by higher inflation and lower output for a long time.

7. The decline in real (i.e., inflation-adjusted) wages reflects the operation of the self-correcting mechanism. Due to the combination of the negative supply shock (increase in oil prices) and the decrease in aggregate demand (from the global financial crisis), output decreased, and unemployment increased. Because the output gap is negative, a slack labor market decreases the bargaining position of workers, who accept employment at lower wages. This shifts the short-run aggregate supply curve down and to the right. The information published in the media is entirely consistent with the predictions of the aggregate demand and supply analysis. The decrease in inflation-adjusted wages should stop when the economy reaches its potential output again.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

126

Changes in Equilibrium: Aggregate Supply (Price) Shocks 8. a.

The destruction of crops will negatively affect the supply of food, increasing its price. A decrease in U.S. oil refinery capacity reduces the supply of gas and makes transportation and energy more expensive. These events will translate into a negative supply shock, decreasing output and increasing the inflation rate in the short run (as the short-run aggregate supply curve shifts upward and to the left). In the long run, however, the self-correcting mechanism will restore the economy to its initial long-run equilibrium. To conclude, the rise in inflation and the decrease in output are only temporary (assuming policy makers do not shift the aggregate demand upward and to the right). b. See graph:

9. Technological change affects the long-run aggregate supply curve. More fuel efficient cars result in a decrease in the demand for gas at the same time that innovations in energy production make it possible to increase the supply of energy at any price level. Innovations in these fields result in a shift to the right in both the short- and long-run supply curves. In conclusion, inflation decreases, and output increases in the long run.

◼

Answers to Data Analysis Problems

1. a. See summary table below. b. See summary table below. c. No, this is not consistent with what would be expected for tax and spending changes. During both four-quarter periods, a contractionary fiscal policy change took place with both government spending decreasing and taxes increasing. This should reduce output by shifting both the IS and AD curves to the left. However overall, output rose over both those periods. Clearly, there are other factors in the economy that are offsetting the contractionary fiscal policy effects to increase GDP overall in the economy.

2012:Q2 to 2013:Q1 2011:Q2 to 2012:Q1

Government Spending Change, $ Bil. –51.2 –51.7

.

Tax Change, $ Bil. 78.4 89.4

Output Change, $ Bil. 177.2 241.7

Chapter 12

The Aggregate Demand and Supply Model

127

2. a. See summary table below. b. See summary table below. c. Yes, the data from part (b) are consistent with what would be expected to explain part (a).

Household net worth increased over both periods, as did consumer sentiment. This should have increased autonomous consumption; along with the rise in disposable income, together they lead to an increase in consumption over both periods. The effects of the increases in both consumer sentiment and household net worth would lead to a shift to the right in the IS and AD curves, which helps explain the overall increase in real GDP over those two periods.

2012:Q2 to 2013:Q1 2011:Q2 to 2012:Q1 *2012:Q2 to 2012:Q4

Household Net Worth Change, $Bil. 4928.7 1235.7

Sentiment Index Change 3.1* 3.6

Disposable Personal Income Change, $ Bil. 5.7 56.1

Consumption Change, $ Bil. 283.1 322.3

Real GDP Change, $ Bil. 177.2 241.7

3. a. See summary table below. b. See summary table below. c. Yes, the data from part (b) are consistent with what would be expected to explain part (a).

Increases in corporate profits, and improvements (negative change) in economic uncertainty would both lead to an increase in autonomous investment, shifting the IS and AD curves to the right. The declines in real interest rates would further increase investment, and the extent to which they declined as a result of autonomous monetary policy changes means a further shift of the AD curve to the right. Overall, the factors above point to an increase in autonomous investment, along with an increase in investment from lower borrowing costs, which clearly led to higher investment, and higher real GDP.

2012:Q2 to 2013:Q1 2011:Q2 to 2012:Q1

Real Profits Change, $ Bil 57.61 169.18

.

Uncertainty Index Change –10.57 8.03

Real Interest Rate Change –0.32 –0.73

Real Investment Change, $ Bil. 102.7 213.2

Real GDP Change, $ Bil. 177.2 241.7

128

Mishkin • Macroeconomics: Policy and Practice, Second Edition

4. a. See summary table below. b. See summary table below. c. Yes, the data from part (b) do seem to be consistent with what would be expected to explain part (a). The change in net wages above productivity was negative for both periods, meaning that productivity of workers rose faster than wages over those periods, which would put downward pressure on inflation and shift the short-run aggregate supply curve downward. Although the price of oil increased both periods, this increase was relatively negligible. Inflation expectations on net represented slight downward pressure on the short-run aggregate supply curve, declining in the earlier period, then slightly increasing in the more recent four quarters. On the whole, with energy prices relatively stable, productivity gains rising faster than wages, and inflation expectations falling slightly on net, these should result in a shift downward in the short-run aggregate supply curve and result in overall lower inflation. This is exactly what has happened over the previous two periods.

2012:Q2 to 2013:Q1 2011:Q2 to 2012:Q1

Change, Net Wages Above Prod.

–0.24 –1.18

Change, Oil Price $/Barrel 0.87 0.34

Inflation Expectations, Change 0.20 –0.70

Inflation Rate, Change –0.42 –0.20

5. a. See table below. b. Over the period from 2011:Q2 to 2013:Q1, on the whole real GDP increased, and inflation fell by a fair amount. This is consistent with the AS curve shifting down more than the AD curve expands outward, resulting in a net effect of higher output and lower inflation in a new equilibrium. The AS curve shifted downward significantly due to falling wages relative to productivity, a modest decline in inflation expectations, and relatively stable energy prices. The AD curve expanded despite the contractionary nature of fiscal policy; these contractionary effects were offset by increases in autonomous consumption from increases in household net worth and consumer optimism, along with increases in autonomous investment due to reduced uncertainty and significant increases in corporate profits. Autonomous easing of monetary policy leading to lower real interest rates probably also contributed to the increase in investment and expansion of the AD curve.

2012:Q2 to 2013:Q1 2011:Q2 to 2012:Q1

Real GDP Change, $ Bil. 177.20 241.70

Inflation Rate, Change –0.42 –0.20

◼ Answers to Review Questions and Problems in Web Appendix, “The Taylor Principle and Inflation Stability” 1.

Period 1

Period 2

Period 3

Period 4

Period 5

Nominal interest rate

10

10

10

10

10

Inflation rate

3

4

5

6

7

Real inflation rate

7

6

5

4

3

.

Chapter 12

The Aggregate Demand and Supply Model

129

a.

b. According to this monetary policy curve, monetary policy authorities do not increase nominal interest rates more than the inflation rate increases, and as a result real interest rates decrease when inflation increases. The negative slope of the monetary policy curve is associated with a positive slope of the aggregate demand curve and increased instability in inflation rates.

According to this monetary policy curve, an increase in inflation will result in an increase in aggregate output. Once aggregate output is above its potential, inflation keeps increasing as the short-run supply curve continually shifts up and to the left. As a consequence, inflation rates become unstable and very difficult to bring down.

2. a.

If nominal interest rates change by the same amount as inflation, real interest rates remain unchanged (according to the Fisher equation). A plot of inflation rates on the horizontal axis and real interest rates on the vertical axis yields a flat monetary policy curve in this case. b. For some time, policy makers followed the same monetary policy rule and nominal interest rates increased by about the same amount as inflation rates. This resulted in inflation increasing and rapidly getting out of control. As a way to fight inflation, nominal interest rates were later sharply increased (above expected inflation rates) to increase real interest rates. This strategic change paid off, and by the early 1980s, inflation had been lowered and was under control in the United States.

.

130

Mishkin • Macroeconomics: Policy and Practice, Second Edition

◼ Answers to Review Questions and Problems in Web Appendix, “The Effects of Macroeconomic Shocks on Asset Prices” 1.

As seen in the graph, a tightening of monetary policy engineered by the Fed will shift the monetary policy curve up, increasing real interest rates at every inflation rate. An increase in real interest rates results in a decrease in aggregate spending, shifting the aggregate demand curve to the left. The economy moves to a point with lower inflation rate and lower output. As a result, the short-run aggregate supply curve shifts to the right, further decreasing inflation and returning output to its natural rate level. As a consequence, we can state that a tightening of monetary policy will decrease inflation permanently, whereas output and interest rates change only in the short run (aggregate output decreases and the interest rates increases).

.

Chapter 12

The Aggregate Demand and Supply Model

131

2. As seen in the graph, a decrease in net exports decreases aggregate demand and shifts the aggregate demand and IS curves to the left. In the short run, this determines a decrease in the inflation rate and in aggregate output. When the output gap is negative, the short-run aggregate supply curve shifts to the right. This determines that aggregate output returns to its potential and inflation decreases even further. Because the monetary policy curve does not shift, the interest rate decreases permanently to r3.

3. In this context, a rainy season that results in increased electricity production can be considered a temporary positive supply shock (i.e., a decrease in the price of energy). This results in a shift to the right of the short-run aggregate supply curve, increasing output above its potential and decreasing inflation. Because neither the IS curve nor the MP curve shift in this case, real interest rates decrease.

As the economy goes back to its long-run equilibrium (when the short-run aggregate supply curve shifts back to the left), real interest rates, inflation, and aggregate output return to their long-run levels. The temporary positive supply shock has only temporary effects on these variables.

4. This technological advance can be interpreted as a permanent positive supply shock. This is represented graphically by a shift to the right on the long-run aggregate supply curve. As a consequence, the short-run supply curve shifts to the right as well (because the initial output level is now below its potential). In the long run, the economy moves to a point where aggregate output is higher than before and inflation is lower. Because neither the IS nor the MP curves shift in this case, real interest rates are set permanently at a lower level.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

132

5. a.

A monetary policy tightening results in higher interest rates and lower output, decreasing the denominator and increasing the numerator in Equation A2-1. This results in an unambiguous decrease in stock prices. b. A decrease in government spending decreases output in the short run and real interest rates in the long run. The effect on stock prices depends on the size of these effects and cannot be determined without further information. c. A temporary positive supply shock temporarily increases output and decreases interest rates, thereby increasing stock prices. d. A permanent positive supply shock results in a permanent increase in aggregate output and a permanent decrease in real interest rates. These combined effects determine an increase in stock prices that is larger than if the supply shock were only temporary.

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: The Volcker Disinflation, 1980–1986 Data Sources Bureau of Labor Statistics: http://www.bls.gov/cps/. For unemployment rate data, click on the “10 years of historical data” icon (the green dinosaur) and select 1980 to 1986 to get data shown in panel (b) in Figure 12.4). http://data.bls.gov/cgi-bin/surveymost?cu. (for inflation data, click on “U.S. All items, 198284=100,” then “retrieve data” and select 1980 to 1986 to get data shown in panel (b) in Figure 12.4.

Related Article Goodfriend, Marvin and Robert G. King, “The Incredible Volcker Disinflation”: http://www.carnegierochester.rochester.edu/Nov04-pdfs/GK.pdf. This article uses a macroeconomic model to explain the underlying fundamentals of the Volcker disinflation.

Discussion Questions Using Figure 12.4, explain why the unemployment rate decreased from 9.7 percent in 1982 to 7.0 percent in 1986. (Hint: Consider the transition from point 2 to point 3 in the graph.) Can we say that Volcker’s efforts were successful?

Answer: After the economy finds itself in point 2, the output gap is negative, therefore pushing real wages in the downward direction. This decrease results in higher employment and moves the economy toward the longrun equilibrium (point 3), where the economy is producing at potential output again (as in point 1). Chairman Volcker was successful in bringing down inflation, albeit at a high cost. The Fed endured severe criticism during these years for its efforts. It is always difficult to estimate the costs of such a high unemployment rate, but one can always make the argument that the Volcker disinflation created long-term conditions for growth.

B. For Information About Application: Negative Demand Shocks, 2001–2004 Data Source Stock Charts: http://www.stockcharts.com/charts/historical/djia1900.html. Here you can see a chart of the Dow Jones Industrial Average index. Note the drop in March 2000, from its peak at 11,497.1 (one of the events that contributed to the decrease in aggregate demand mentioned in the text). You can get data for unemployment and inflation using the links provided in the previous application and changing the data range to 2000–2004.

.

Chapter 12

The Aggregate Demand and Supply Model

133

Related Article BBC News, “Enron Scandal at a Glance”: http://news.bbc.co.uk/2/hi/business/1780075.stm. In this article, you can get the principal elements of the Enron scandal from a foreign perspective. It also links the effects of the Enron scandal to other countries.

Discussion Question In the aftermath of the September 11 attack, the Federal Reserve announced that it would fulfill its function as lender of last resort to restore confidence in the U.S. financial system. Throughout the year, the Fed closely followed the developments in stock markets and lowered interest rates during 2001. Do you agree with the Fed’s actions during these years?

Answer: The Fed’s actions in the aftermath of the terrorist attacks in 2001 were effective in restoring confidence in the U.S. financial system. However, some economists criticized the Fed’s role in lowering interest rates during 2001, claiming that this was helping Wall Street. The Fed claimed that the economy needed lower interest rates to recover from these negative aggregate demand shocks. In the end, both the Fed’s actions and the self-correcting mechanism (it is difficult to say how much each contributed) pushed the economy back to its long-run equilibrium. In light of the events of 2007–2009, some economists blame the Fed for the low interest rates in the early 2000s, which they claim encouraged the housing boom.

C. For Information About Application: Negative Supply Shocks, 1973–1975 and 1978–1980 Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/CPIENGSL?cid=32424. Here is data about the consumer price index: energy. Setting the data range from 1970 to 1981 allows you to clearly see the increase in this index in late 1973 and 1979.

Related Article OPEC, “Brief History”: http://www.opec.org/opec_web/en/about_us/24.htm. Here you can read OPEC’s own account of the events that unraveled in the 1960s and 1970s and resulted in high oil prices.

Discussion Question Using the aggregate demand and supply model, explain what happened to the unemployment and inflation rate between 1975 and 1978 (the in-between negative shocks period).

Answer: According to the aggregate demand and supply model, after the 1973 negative supply temporary shock was absorbed, unemployment and inflation started to decline. This is because by 1975, the selfcorrecting mechanism was operating and bringing the economy to its long-run equilibrium (i.e., the shortrun aggregate supply curve shifted to the right). As one can see from panel (b) in Figure 12.7, unemployment and inflation dropped from 1975 to 1978. The second negative price shock shifted the short-run aggregate supply curve to the left again, with the same consequences as in 1973.

D. For Information About Application: Positive Supply Shocks, 1995–1999 Data Source Bureau of Labor Statistics: http://data.bls.gov/PDQ/servlet/SurveyOutputServlet?data_tool=latest_ numbers&series_id=PRS85006092. Here you can find data about labor productivity in the nonfarm business sector. You can change the data range to 1990 to 2000 to observe the positive rate of change in this series during the 1995–1999 periods.

.

134

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Related Article Shepard, Stephen, “The New Economy: What It Really Means” (11/17/1997): http://www.businessweek.com/1997/46/b3553084.htm. This contemporary article discusses the implications of the “new economy” concept and its validity.

Discussion Question Based on your knowledge of the production function and drivers of growth discussed in Chapter 7, how can you explain the effects of the “new economy” on the production function?

Answer: The “new economy” entered the production function by increasing total factor productivity (i.e., the “A” term). Improvements in information technology and the Internet set the ground for workers to become more productive. A big part of the criticism to this idea is that improvements in productivity were not that significant. It is difficult to settle this discussion: By nature it is almost impossible to directly observe changes in total factor productivity.

E. For Information About Application: Negative Supply and Demand Shocks and the 2007–2009 Financial Crisis Data Source Bureau of Labor Statistics: http://www.bls.gov/cps/. For unemployment rate data, click on the “10 years of historical data” icon (the green dinosaur) and select 2006 to 2010 to get data shown in panel (b) in Figure 12.10. http://data.bls.gov/cgi-bin/surveymost?cu. For inflation data, click on “U.S. All items, 198284=100,” then “retrieve data” and select 2006 to 2010 to get data shown in panel (b) in Figure 12.10.

Related Article Mouawad, Jad, “Rising Demand for Oil Provokes New Energy Crisis” (11/9/2007): http://www.nytimes.com/2007/11/09/business/worldbusiness/09oil.html. This contemporaneous article shows how worries about increased demand for oil pushed up prices, contributing to the “perfect storm” in 2007.

Discussion Question The Federal Reserve was criticized for supporting the U.S. financial system during the 2007–2009 crisis.

Using the aggregate demand and supply model, explain what would have happened if the Fed refused to help some major participants in the U.S. financial system.

Answer: The financial crisis entered its more virulent stage in 2008, when some high profile firms in the U.S. financial system failed. The Federal Reserve tried to support as many of these firms as possible, successfully contributing to the rescue of AIG and other major market players. If the Federal Reserve in conjunction with the U.S. Treasury would have chosen not to support the U.S. financial system, the impact of the crisis would surely have been bigger: The AD curve would have shifted by much more to the left, therefore increasing unemployment by more than 10 percent.

F. For Information About Application: The United Kingdom and the 2007–2009 Financial Crisis Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/GBRRGDPR?cid=32280 . Here you can see the latest data about GDP growth and a graph showing the decrease in GDP growth during the 2007–2009 financial crisis (click on “Edit Graph” and change the years to 2006–2010).

.

Chapter 12

The Aggregate Demand and Supply Model

135

Related Article Rayner, Gordon, “UK Facing Worst Financial Crisis in ‘Decades’” (11/18/2008): http://www.telegraph.co.uk/finance/markets/2786497/UK-facing-worst-financial-crisis-in-decades.html.

This contemporaneous article shows the extent to which the United Kingdom was hit by the global financial crisis.

Discussion Question During 2008, the British government borrowed heavily and used part of these funds to recapitalize British banks hit by the financial crisis. Using the aggregate demand and supply model, explain the effects of supporting the financial system on unemployment and inflation.

Answer: Actions taken by the British authorities, in conjunction with the Bank of England, had similar effects to those taken by the Federal Reserve and the U.S. Treasury in the United States. Preventing a major failure of the British financial system allowed funds to be channeled from savers to borrowers, and therefore, it prevented a credit crunch. As in the United States, this mitigated the decrease in consumption and investment spending. In addition, interest rates cuts were coordinated between the central banks of the United States and many other countries, the United Kingdom among them. In short, the support to British banks prevented a further shift to the left on the aggregate demand curve and, therefore, prevented a higher unemployment rate and deflation.

G. For Information About Application: China and the 2007–2009 Financial Crisis Data Source International Monetary Fund database: http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/weorept.aspx?sy=2008&ey=2015&scsm=1&ss d=1&sort=country&ds=.&br=1&c=924&s=PCPIEPCH%2CLUR&grp=0&a=&pr1.x=64&pr1.y=14. Here you can access unemployment and inflation data (and IMF estimates) for China.

Related Article Keat, Heng Swee, “The Global Financial Crisis—Impact on Asia and Policy Challenges Ahead”: http://www.frbsf.org/economics/conferences/aepc/2009/09_Heng.pdf. This article summarizes the effects of the global financial crisis in Asian countries.

Discussion Question China was not affected as the United Kingdom was during the 2007–2009 financial crisis; tt was affected only when other countries experienced a recession that resulted in a decrease in Chinese exports. Explain where this difference comes from.

Answer: The Chinese economy (and its financial system in particular) is still heavily controlled by the Chinese government. This strategy has been criticized (especially when considering the long-run effects of such a policy), but it has certainly paid off at some points. The 2007–2009 financial crisis was one of them: The Chinese government, by controlling its banks and capital flows, prevented the contagion effect (credit crunch, decrease in consumer and investment spending) of the financial crisis.

.

Chapter 13 Macroeconomic Policy and Aggregate Demand and Supply Analysis ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline The Objectives of Macroeconomic Policy Stabilizing Economic Activity Stabilizing Inflation: Price Stability Establishing Hierarchical Versus Dual Mandates The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity Monetary Policy and the Equilibrium Real Interest Rate Policy and Practice: The Federal Reserve’s Use of the Equilibrium Real Interest Rate, r* Response to an Aggregate Demand Shock Response to a Permanent Supply Shock Response to a Temporary Supply Shock The Bottom Line: The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity How Actively Should Policy Makers Try to Stabilize Economic Activity?

Lags and Policy Implementation Policy and Practice: The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package The Taylor Rule The Taylor Rule Equation The Taylor Rule Versus the Monetary Policy Curve The Taylor Rule in Practice Policy and Practice: The Fed’s Use of the Taylor Rule Inflation: Always and Everywhere a Monetary Phenomenon Causes of Inflationary Monetary Policy High Employment Targets and Inflation Application: The Great Inflation Monetary Policy at the Zero Lower Bound Deriving the Aggregate Demand Curve with the Zero Lower Bound The Disappearance of the Self-Correcting Mechanism at the Zero Lower Bound Application: Nonconventional Monetary Policy and Quantitative Easing Liquidity Provision Asset Purchases

.

Chapter 13

Macroeconomic Policy and Aggregate Demand and Supply Analysis

137

Quantitative Easing Versus Credit Easing Management of Expectations Policy and Practice: Abenomics and the Shift in Japanese Monetary Policy in 2013

Chapter Overview and Teaching Tips Chapter 13 shifts the perspective by bringing a new set of actors into the AD/AS framework: policy makers. We look at how they react to shocks to the economy in order to stabilize both inflation and economic activity. One unique feature of the dynamic AD/AS framework in this book is that it can address policy questions that other frameworks cannot, such as: When does stabilizing inflation stabilize output (i.e., when does the divine coincidence occur)? How can the concept of the equilibrium real interest rate be used in policy analysis as it is at central banks like the Federal Reserve? Alternative approaches in other textbooks cannot address these important policy issues.

For students to understand what policy makers do, they first need to understand what the objectives of policy makers are, which is the first issue discussed in the chapter. Once they understand that policy makers focus on two objectives, stabilizing economic activity and stabilizing inflation (price stability), the next step is to see how policy makers respond to shocks to aggregate demand or aggregate supply to achieve these objectives. The analysis in the chapter makes clear that stabilizing inflation stabilizes economic activity, so there is no policy tradeoff, only when there are shocks to aggregate demand or permanent shocks to aggregate supply. On the other hand, temporary shocks to aggregate supply do involve a policy tradeoff because in this case stabilizing inflation does not stabilize economic activity.

Another big issue in macroeconomics in whether policymakers should be activist — i.e., respond aggressively to fluctuations in economic activity or, alternatively, not respond and be nonactivist. One way of bringing home to the students the importance of this issue is to discuss in class the Policy and Practice case, “The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package.”

The chapter then goes on to discuss the famous Taylor rule, which says that the monetary authorities should raise real interest rates when there are increases in inflation relative to its target (an increase in the inflation gap) or when there are increases in output relative to potential output (an increase in the output gap). How the Taylor is used in practice is illustrated by the Policy and Practice case, “The Fed’s Use of the Taylor Rule.”

The next section of the chapter discusses one of the most famous adages in macroeconomics, coined by Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.” Although this phrase was discussed in Chapter 5 in a long-run context, it is important to show that it is also valid in the AD/AS framework because the monetary authorities do have the ability to control inflation. If inflation is a monetary phenomenon, there is still an issue as to why monetary policy makers allow it to happen. The AD/AS model shows that overly expansionary monetary policy that leads to high inflation can occur when the policy makers try to achieve high employment targets. The application on the Great Inflation shows students that this is not just a theoretical possibility but actually occurred from the late 1960s to the early 1980s.

The chapter ends with a discussion of monetary policy at the zero lower bound, which is of great interest currently because the Federal Reserve cannot lower the federal funds rate below the zero lower bound and so has to resort to nonconventional monetary policy. The dynamic aggregate demand and supply framework in this text is especially suited to explaining the impact of the zero lower bound and how nonconventional monetary policy works in this situation. The first step is to show students how the zero lower bound results in a backward bending aggregate demand curve, which means that the self-correcting mechanism is no longer operational. Applying this analysis then allows the instructor to show how nonconventional monetary policy and quantitative easing works. To show students how relevant this analysis is, it can be used to show how the historic shift in Japanese monetary policy in 2013, which has been dubbed Abenomics, can help get the Japanese economy out of the funk it has been in for the last fifteen years.

.

138

◼

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions The Objectives of Monetary Policy 1. Stabilizing economic activity and price stability are the two primary objectives of macroeconomic stabilization policy. Stabilizing economic activity requires keeping unemployment at the natural rate of unemployment and thus maintaining a zero unemployment gap. Achieving a zero unemployment gap also produces a zero output gap and implies that there will be no tendency for inflation to rise or fall. The objective of price stability is to minimize the inflation gap by setting and maintaining a target rate for inflation that is low but positive.

2. Policy makers should not strive to achieve zero rates of unemployment and inflation. Even at full employment, unemployment is not zero because of the existence of frictional and structural unemployment. Frictional unemployment is beneficial to the economy as it arises from the search time firms and job seekers spend to find the best available fit between workers and jobs. Structural unemployment occurs because the skills or location of unemployed workers do not match the requirements of available jobs. Attempts to eliminate these types of unemployment and reduce the unemployment rate to zero are not consistent with the objective of price stability. One reason not to aim for a zero target rate for inflation is that pursuing a zero target rate would increase the risk of deflation, a falling price level that can be damaging to the economy.

3. A hierarchical mandate gives top priority to the objective of price stability. Under this mandate, policy makers may pursue the goal of stabilizing economic activity only if it does not compromise their ability to achieve price stability. A dual mandate treats the two objectives as equally important.

The mission assigned to the Federal Reserve gives equal emphasis to stable prices and maximum sustainable employment (which amounts to keeping unemployment at the natural rate), so the dual mandate best describes the policy making environment in the United States.

The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity 4. The equilibrium real interest rate is the real interest rate that keeps the quantity of aggregate output demanded equal to potential output. Thus, it keeps the economy in long-run equilibrium and the output and unemployment gaps equal to zero. The Federal Open Market Committee discusses the equilibrium real interest rate during its meetings. Demand and supply shocks that change this rate lead FOMC members to consider changing the federal funds rate target.

5. Stabilization policy is conducted more frequently using monetary policy rather than fiscal policy because implementing fiscal policy requires making changes in taxes and government spending that take longer to deliberate and enact than monetary policy decisions do.

6. The divine coincidence exists when policies that are appropriate to achieve price stability also stabilize economic activity. When it prevails, policy makers have easier jobs because there is no tradeoff between policy objectives and they do not have to choose between them. They can, in other words, have their cake and eat it, too. The divine coincidence prevails when the economy is beset with aggregate demand shocks or permanent supply shocks but not when it experiences temporary supply shocks. When faced with either of the first two shocks, policy makers can stabilize both inflation and economic activity by enacting policies to shift the economy’s aggregate demand curve and return to long-run equilibrium at potential output. In the case of a temporary supply shock, however, policies that shift the aggregate demand curve to achieve price stability will move the economy further away from potential output and those aimed at stabilizing economic activity at potential output will cause the inflation rate to change.

.

Chapter 13

Macroeconomic Policy and Aggregate Demand and Supply Analysis

139

How Actively Should Policy Makers Try to Stabilize Economic Activity?

7. Activists see the process of price and wage adjustments that move the economy to long-run equilibrium as working very slowly. They argue that instead of waiting for these slow adjustments to move the economy to full employment and potential output, government policy makers instead should implement stabilization policies. Nonactivists hold that prices and wages adjust faster than activists believe and argue that policy making itself is a time-consuming process. Furthermore, policymakers are not sure of the economy’s potential output or natural rate of unemployment and thus do not know where to move the aggregate demand curve, so stabilization policies may do more harm than good.

8. Activists argue that wages are inflexible and, in particular, that they are not likely to fall as would be needed for the self-correcting mechanism to adjust to long-run equilibrium if the economy suffers from low output and high unemployment. Wages and prices may be prevented from changing by existing contractual agreements, for example, between employers and workers. Expected inflation may be slow to adjust, which will delay the upward or downward shifts of the short-run aggregate supply curve that are part of the self-correcting mechanism.

9. The data lag is the time it takes to collect and process the quarterly, monthly, and other data that tell policy makers how well or poorly the economy is performing. The recognition lag is the time policymakers may wait for additional data to come in to be more confident of their interpretations of economic conditions and trends. The legislative lag is the time it takes to decide on a particular policy. This generally is not long for monetary policy makers but can be quite long for fiscal policy makers because legislation must be passed in order to change taxes and government purchases. The implementation lag is the time required for policy makers to adopt a new policy once it has been approved. This lag, like the previous one, is likely to be longer for fiscal policy than it is for monetary policy. The effectiveness lag is the time it takes a policy to affect the economy. The combined length of these five lags can be long and variable, making the outcome of stabilization policy actions uncertain.

The Taylor Rule 10. The Taylor rule advises the Fed to raise the real federal funds rate target when the inflation gap or the output gap rises, and to lower this target rate when those gaps shrink. Inasmuch as it recommends raising the real interest rate in response to an increase in inflation, it relates directly to the upward slope of the monetary policy curve. Its recommendation to change the real interest rate in response to changes in the output gap is a suggestion for implementing autonomous monetary policy easing or tightening to shift the monetary policy curve up or down as is appropriate to move output closer to potential output.

11. There are a number of reasons why this would not be a good idea. There is no guarantee that the Taylor rule coefficients are stable across time and no one, policy makers included, knows the size of inflation and output gaps at any given time. Even if policy makers did have accurate information about the current size of these gaps, relying solely on the Taylor rule would force them to disregard any additional information that might help them predict the size of those gaps in the future. Policy makers need to be able to look at a wider range of information than just the current inflation and output gaps and may need to be able to respond in ways that do not conform to the Taylor rule’s parameters. Strict adherence to the Taylor rule would prohibit autonomous monetary policy easing and tightening.

.

140

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Inflation: Always and Everywhere a Monetary Phenomenon 12. Monetary policy makers can target any inflation rate they want to simply by implementing autonomous monetary policy easing (to target a higher inflation rate) or tightening (to target a lower one). However, although they can exert this control over inflation in the long run, they have no control over real interest rates or potential output in the long run, so the classical dichotomy and monetary neutrality hold just as they do in the classical framework.

Causes of Inflationary Monetary Policy 13. Cost-push and demand-pull inflation result when policy makers in pursuit of high targets for output and employment (and hence low targets for the unemployment rate) implement policies that raise aggregate demand when their targets are not met. The two types of inflation both arise from events that move the economy away from long-run equilibrium, but their initiating causes differ. Cost-push inflation starts with temporary negative supply shocks or wage increases in excess of productivity growth. These shift the short-run aggregate supply curve up and to the left and cause output and employment to fall. Policy makers respond by increasing aggregate demand, which raises output and employment but also increases inflation. Following this accommodating policy, workers now have an incentive to push for further excessive wage increases because they have obtained higher wages but have not suffered in terms of higher unemployment. Continual wage increases, followed by continual increases in aggregate demand, drive the inflation rate higher and higher. Demand-pull inflation begins when policy makers (perhaps unknowingly) set a target for unemployment that is lower than the natural rate level and increase aggregate demand in order to reach an output target above potential output. This increases the inflation rate, which shifts the short-run aggregate supply curve up and to the left and returns the economy to full employment at potential output and the natural rate of unemployment. Because the natural rate of unemployment is higher than the unemployment target, policy makers continue to increase aggregate demand and drive inflation higher and higher. It is not always easy to distinguish the two types of inflation, but generally speaking, cost-push inflation is associated with periods when the unemployment rate is above the natural rate level and demand-pull inflation with periods when the unemployment rate is below the natural rate level.

Monetary Policy at the Zero Lower Bound 14. When the zero lower bound is hit, a lower inflation rate leads to a higher real interest rate because the nominal interest rate is fixed at zero, and this higher real interest rate than causes planned expenditure and therefore aggregate output to decline. The fall in aggregate output as inflation falls, then results in an upward sloping aggregate demand curve.

15. A negative output gap leads to a fall in the short-run aggregate supply curve, which lowers inflation, which then causes aggregate output to fall along the lines outlined in the answer to question 14, which then leads to an even more negative output gap. The result is then a downward spiral where inflation keeps falling, and output does as well, so the self-correcting mechanism is not operational.

16. All unconventional policies work by lowering the interest rate for investments and so stimulate investment spending and shift the aggregate demand curve to the right. Liquidity provision helps to heal impaired financial markets, thereby lowering financial frictions and, hence, the real interest rate for investments. Asset purchases of private securities raise the price of these securities, thereby lowering the credit spread and the real interest rate for investments. Asset purchases of long-term bonds raises the price of these bonds and, therefore, lowers long-term interest rates, which lowers the real interest rate for investments. The management of expectations by committing to keep interest rates low for a long period of time again lowers long-term interest rates, which lowers the real rate for investments.

.

Chapter 13

Macroeconomic Policy and Aggregate Demand and Supply Analysis

141

Answers to Problems The Objectives of Macroeconomic Policy 1. a.

According to Section 8 of the Reserve Bank of New Zealand Act of 1989, the Central Bank of New Zealand has a clear hierarchical mandate to achieve low and stable inflation. The idea behind such a mandate is that stabilizing prices will create the proper conditions for economic growth and low unemployment. b. This mandate is perfectly consistent with a positive inflation rate target. Actually, the last inflation rate target announced by the Central Bank of New Zealand was a target “between 1 and 3 percent on average over the medium term” (Policy Target Agreement, December 18, 2008).

The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity 2. a.

According to aggregate demand and supply analysis, the decrease in government expenditures results in a shift to the left in the aggregate demand curve, as aggregate expenditure decreases at every inflation rate. As a result, the new intersection point with the short-run aggregate supply curve determines a lower inflation rate and output level than before. At this point, output is below potential output and inflation is below its target. b. If the Federal Reserve decides to use its monetary policy tools to stabilize inflation, it will effectively decrease the real interest rate at every inflation rate, thereby shifting the MP curve downward. This action will shift the AD curve to the right and restore the economy to its longrun equilibrium, where the inflation rate is at its target and output is at potential output again. The only long-run effect of this policy is to affect the real interest rate, which is now set at a lower level than the previous long-run equilibrium.

3. According to aggregate supply and demand analysis, a less efficient economy will end up in a new long-run equilibrium at a lower level of output. Depending on the monetary policy response, the inflation rate might be higher than before the implementation of reforms that made the economy less efficient or might remain unchanged. In any event, output is lower in the long run. This is why the argument about the potential effect of the healthcare reform on the efficiency of the U.S. economy is very important. A quick Internet search including “efficiency” and “healthcare” can confirm this.

Proponents of the reform argued that it will make the U.S. economy more efficient by encouraging cost reduction in the healthcare industry. Detractors of the same reform argued it would result in a less efficient economy due to the government intervention in this industry.

4. a.

Changes described by data suggest that policy makers decided to stabilize inflation in the short run, with the corresponding decrease in output, during period 3. b. Labeled arrows in the graph refer to the table time periods.

.

142

Mishkin • Macroeconomics: Policy and Practice, Second Edition

How Actively Should Policy Makers Try to Stabilize Economic Activity?

5. Evidence that shows that the welfare gains from stabilizing output and unemployment are relatively small, which supports the nonactivist case. This is actually a major topic in macroeconomics, which was addressed by the Nobel Prize-winning economist Robert Lucas. Lucas developed a theoretical model meant to represent the U.S. economy after World War II and used to measure how well off the average individual would be if the government followed a stabilization policy agenda. He concluded that there is only a tiny increase in the well-being of the average individual resulting from stabilization policy. On the contrary, long-run monetary and fiscal policies resulted in much bigger welfare gains for the average individual, making them a better option over stabilization policy.

6. In panel (A) the short-run aggregate supply curve has a steeper slope, meaning that wages and prices in general are more flexible (i.e., changes in output result in larger changes in the inflation rate). This situation constitutes a stronger argument in favor of nonactivist policy because changes in the aggregate demand curve will result in smaller changes in output and unemployment when the shortrun aggregate supply curve is depicted as in panel (A). Alternatively, one might think that further efforts in terms of monetary or fiscal policy are needed to affect output if prices and wages are less flexible (as depicted by the somewhat less steep short-run aggregate supply curve in panel B).

The Taylor Rule 7. a.

The decline in potential output shifts the LRAS curve to the left. The lower potential output increases the output gap, prompting an autonomous tightening of policy and a shift of the MP curve to MP2. In the short-run, the economy ends up at point B. As a result of the self-correcting mechanism, the AS curve shifts up, resulting in higher inflation and raising the real interest rate along MP2. Eventually the economy reaches the new long-run equilibrium at point C, at a permanently higher level of inflation, higher real interest rate, and lower potential output.

.

Chapter 13

Macroeconomic Policy and Aggregate Demand and Supply Analysis

143

b. A decline in the target inflation rate increases the inflation gap, prompting an increase in the real interest rate and shift upwards in the MP curve to MP2. As a result of the autonomous tightening policy, aggregate demand decreases to AD2, and the economy is in recession at point B in the short run. The self-correcting mechanism will result in a decline in the AS curve to AS3 until the economy reaches the new long-run equilibrium at point C. In the long-run, the economy will have permanently lower inflation with the real interest rate and output unchanged.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

144

Causes of Inflationary Monetary Policy 8. a.

b. According to the graph, Canada’s unemployment rate was below the estimated natural rate of unemployment for the first part of the period, and then it was above the natural rate. This suggests that Canada’s relatively high inflation rates during this period were the result of demand-pull inflation between 1972 and 1975–1976. As expected, the unemployment rate decreased, but expectations about future high inflation rates quickly became embedded in the economy. As a result, inflation stayed high even when the unemployment rate exceeded its natural rate in the second part of the period. During this second period, inflation could be described as cost-push inflation, as workers asked for higher nominal wages.

9. The Taylor rule suggests that the policy rate target should be increased when the output gap is positive. This rule is perfectly consistent with avoiding demand-pull inflation. The natural rate of unemployment is the unemployment rate at which output is at its potential level. A positive output gap means that the economy is producing more output, a situation in which unemployment is below its natural rate. Therefore, increasing interest rates at every inflation rate (shifting the MP curve up) results in a shift to the left in the aggregate demand curve, thereby increasing unemployment until it reaches its natural rate again. The only problem associated with the Taylor rule is that policy makers could misestimate potential output and might decide to leave the policy target unchanged at a low level for too long, effectively increasing output but creating the conditions for demand-pull inflation to occur. As before, it is very important that policy makers have a good understanding of the economy to know how to apply the Taylor rule or use monetary policy tools, which is not an easy task at all.

.

Chapter 13

Macroeconomic Policy and Aggregate Demand and Supply Analysis

145

Monetary Policy at the Zero Lower Bound 10. a.

Policy makers were worried that a shock could push the economy into a deflationary spiral, in which the short-term nominal policy rate would be bound at the zero lower bound. At that point, conventional monetary policy would be ineffective. Policy makers viewed the risk of economic damage in the event of a deflationary spiral to be significant enough to overcome any potential inflation risk in implementing the policy. Thus, policy makers chose to err on the side of attempting to eliminate the deflationary threat. b. With the economy starting out at point A, an adverse shock would push the economy into a destabilizing deflation. An autonomous easing of policy would shift the MP curve down, and in the short run, the economy would end up at point B. Note that even though the economy is not at a long-run equilibrium, at that point, the self-correcting mechanism can move the economy to a stable long-run equilibrium because the ZLB inflection point lies to the right of the LRAS curve.

11. a.

A financial panic will increase f , thus raising the real interest rate on investments at any given inflation rate. A sufficiently large panic will push the economy to point B, where the selfcorrecting mechanism will lower inflation, and real rates will rise because the economy is beyond the ZLB. This results in a deflationary spiral in which the economy will move toward (and past) a point such as point C.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

146

b. A sufficient enough asset purchase will lower f , reversing the effects of the panic, and lower the real interest rate on investments at any given inflation rate. This moves the economy from point A to a point such as point B, where the economy is no longer at risk of a deflationary spiral.

At point B, the self-correcting mechanism can move the economy to a stable, long-run equilibrium because the ZLB inflection point lies to the right of the LRAS curve along that AD curve.

◼

Answers to Data Analysis Problems

1. a. b. c. d.

From 2012:Q2: 2013:Q1, the average inflation gap was –0.5 percent.

From 2012:Q2: 2013:Q1, the average output gap was –5.7 percent.

From July 2012 to June 2013, the average unemployment gap was 2.2 percent.

Yes, the divine coincidence applies based on the current data. Expansionary policy would close a negative inflation gap, a negative output gap, and a positive unemployment gap that exists in the current data. Given that the divine coincidence applies and based on the data, the economy would seem to be characterized by weak demand-side conditions over the second half of 2012 and first half of 2013.

2. The period from around early 2001 to around the end of 2003 appears to be influenced by demandpull inflation conditions because inflation is a bit lower than what appears to be normal at the time (2.5 percent), and the unemployment rate rises and remains above the estimated natural rate during this time. For a brief time from the middle of 2007 to the middle of 2008, the economy appears to be hit by a cost-push inflation episode because the inflation rate spikes and the unemployment rate rises above the natural rate of unemployment. From the middle of 2008 to the most current period, the middle of 2013, inflation remains at or below what appears to be the longer term trend of 2.5 percent, while the unemployment rate is well above the natural rate, suggesting that demand-pull forces are at work.

.

Chapter 13

Macroeconomic Policy and Aggregate Demand and Supply Analysis

a.

147

For the most recent period in 2013:Q1, the Fed Funds Rate is 0.14 percent, while the Taylor Rule predicts a slightly negative –0.07 percent, representing a gap of 0.21 percent. Compared to other significant deviations, this seems to be a fairly close correspondence, although the negative value is not possible in practice. b. See graph below. The Taylor rule since 2000 has periods in which they are fairly closely correlated, particularly from 2000 to 2002. However, there are significant gaps in other times, or periods in which they do not seem to move together, such as the period from 2002 to 2006. From 2008 onward, there are significant differences between the two, particularly the period late in 2008 through 2010, in which the Taylor rule predicts the Fed Funds Rate should be negative by as much as almost –4 percent, which is not possible. It also predicted a significant rise in the fed funds rate in 2011, which did not materialize. c. Because the Fed funds rate was at the zero lower bound during that time, conventional monetary policy through adjustments in the fed funds rate was not possible, and highlights a limitation of the Taylor rule: under “normal” conditions the Taylor rule provides a good approximation to appropriate fed funds rate policy. However in extreme situations such as the financial crisis period, the Taylor rule is less useful because other (unconventional) monetary policy tools are needed to achieve stimulus. d. See graph below. For the most part, the baseline Taylor rule and the hierarchical Taylor rule predict nearly the same fed funds paths. The only significant deviations are from 2008 onwards, where it predicts a significantly higher fed funds rate due to the inflation spike during that time.

Since 2010, it would predict a fed funds rate around 2 percent, which is much higher than during that time and what the baseline rule predicts. For the current period, under such a hierarchical Taylor rule, the fed funds rate would be predicted to be about 1.2 percent, much higher than the current 0.14 percent.

.

148

Mishkin • Macroeconomics: Policy and Practice, Second Edition

.

Chapter 13

Macroeconomic Policy and Aggregate Demand and Supply Analysis

149

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Policy and Practice: The Federal Reserve’s Use of the Equilibrium Real Interest Rate, r* Data Source Federal Reserve System: http://www.federalreserve.gov/monetarypolicy/fomc_historical.htm. From this page you can access previous blue and green books. There are also short descriptions of these publications.

Related Article Federal Reserve System: FOMC Transcripts and Other Historical Materials, 2004. http://www.federalreserve.gov/monetarypolicy/files/FOMC20040128bluebook20040122.pdf . This is the January 27–28, 2004 FOMC Meeting bluebook. Note the Policy Alternatives on page 7 of this document and the subsequent projections made by the FOMC staff.

Discussion Question Suppose a new wave of technological innovation shifts the long-run aggregate supply curve to the right.

Everything else the same, what would be the effect on the equilibrium level of the real interest rate?

Answer: According to the aggregate demand and supply model, a permanent shift to the right on the longrun aggregate supply curve permanently increases potential output and permanently decreases the inflation rate. According to the MP curve, the real interest rate consistent with a lower inflation rate would be a lower real interest rate. Therefore, a new way of technological innovation would encourage monetary policy makers to revise their estimates for the equilibrium real interest rate in the downward direction.

B. For Information About Policy and Practice: The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package Data Source Recovery.gov: http://www.recovery.gov/About/Pages/The_Act.aspx. This Website provides information about the American Recovery and Reinvestment Act of 2009, including how and when the stimulus money was spent.

Related Article CATO Institute: http://www.cato.org/special/stimulus09/cato_stimulus.pdf. This document shows the discontent that the stimulus package of 2009 created among many U.S. economists.

Discussion Question Explain why some economists suggest that a stimulus plan could have no effect on the economy.

Answer: Some economists argue that the increase in government spending (or the decrease in taxes) will have no effect on aggregate spending (and will therefore not shift the aggregate demand curve to the right).

This argument is based on the idea that increased government spending usually comes at the expense of decreased private investment. The idea is simple: The government borrows to pay for increased spending (remember that it will also collect fewer taxes) and therefore compete for funds with private investors. In addition, economists and other individuals who adhere to this position usually do not like to see the government to intervene in the economy.

.

150

Mishkin • Macroeconomics: Policy and Practice, Second Edition

C. For Information About Policy and Practice: The Fed’s Use of the Taylor Rule Data Source Federal Reserve Bank of Dallas: “Measuring the Taylor’s Rule Performance”: http://www.dallasfed.org/assets/documents/research/eclett/2007/el0706.pdf . This study explores how well the Taylor rule performs in explaining changes in the federal funds rate target.

Related Article Walsh, Carl E. “The Science (and Art) of Monetary Policy”: http://www.frbsf.org/publications/economics/letter/2001/el2001-13.html. This article discusses how monetary policy makers are aided by economic theory (science) but also have to evaluate current conditions and feel the pulse of the economy (art) when making decisions.

Discussion Question Suppose that current conditions determine a positive inflation gap but with a negative output gap (also known as “stagflation”). What would the Taylor rule suggest to with the federal funds rate?

Answer: From an empirical point of view, one would have to measure the magnitude of the inflation and output gaps to say what the Taylor rule would suggest to do with the federal funds rate. In the end, the recommendation could be to increase or decrease the target. However, this is the typical case in which the conduct of monetary policy is closer to an art than to a science: Policy makers have to rely on their experience and ability to interpret the signs of the economy, by considering much more information than data on inflation and unemployment.

D. For Information About Application: The Great Inflation Data Source Economic Report of the President (2010): http://www.gpoaccess.gov/eop/2010/2010_erp.pdf. Data for unemployment and inflation can be found in Appendix B: Tables B-42 and B-64, respectively.

Related Article Meltzer, Allan A., “Origins of the Great Inflation”: http://research.stlouisfed.org/publications/review/05/03/part2/Meltzer.pdf. This paper explores the causes of the great inflation.

Discussion Question Suppose somebody in charge of advising the president on economic topics suggests that the U.S. government should enact policy measures to reach a 2 percent unemployment rate. Would you agree with such a recommendation?

Answer: In light of the experience of the Great Inflation, this would be a great mistake. Trying to reach such a low unemployment rate (surely below the long-run rate of unemployment) would result in overly expansionary policy measures, probably creating the conditions for demand-pull inflation, as described in the text.

E. For Information About Application: Nonconventional Monetary Policy and Quantitative Easing Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/WMBSEC?cid=32215. Here you can check one of the aspects of nonconventional monetary policy put in practice in 2008: asset purchases.

.

Chapter 13

Macroeconomic Policy and Aggregate Demand and Supply Analysis

151

Related Article Federal Reserve System: “Monetary Policy Report”: http://www.federalreserve.gov/monetarypolicy/mpr_20130717_part1.htm. In this report the Federal Reserve explains its nonconventional monetary policies and its effects on the U.S. economy. Check the last subtitle: “The Expansion of Central Bank Balance Sheets” and see how the Federal Reserve explains how it “…sought to provide further economic stimulus through the adoption of unconventional policies…”

Discussion Question The Federal Reserve System is a central bank that has a good reputation as an inflation fighter. How do you think this good reputation might not work in the best interests of the Federal Reserve in the context of nonconventional monetary policy?

Answer: Quite paradoxically, in the context of a management of expectations strategy, to be a central bank with an excellent record as an inflation fighter might not be the best scenario. The problem is probably that individuals expect the Federal Reserve to allow inflation to increase but not by a significant amount.

Actually, inflation expectations in the United States have remained contained even after many announcements by the Federal Reserve to maintain short-term interest rates at very low levels for a long time.

F. For Information About Policy and Practice: Abenomics and the Shift in Japanese Monetary Policy Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/JPNCPIALLMINMEI?cid=32281. Click “Edit Graph” and change the dates to 2000 to the latest data available to check the evolution of the price index in Japan.

Related Article The Economist, “Abenomics. Not so Super”: http://www.economist.com/news/leaders/21579464-thirdarrow-reform-has-fallen-well-short-its-target-time-shinzo-abe-rethink-not. In this article you can find a description of “Abenomics” in its first steps and the controversy that ensued about its efficacy.

Discussion Question The central banks of both Japan and the United States tried to increase inflation expectations in the context of nonconventional monetary policy. What do you think the risk of increasing inflation expectations for a central bank is?

Answer: In the context of nonconventional monetary policy, increasing inflation expectations might work as a complement of quantitative easing and asset purchases to take the economy out of the downward spiral in output and inflation. However, it is a very delicate task because no central bank wants to fuel expectations of inflation that it cannot control in the future. Being “too” successful in increasing inflation expectations might create problems in the future if inflation expectations remain high for longer than needed.

.

Chapter 14 The Financial System and Economic Growth ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline The Role of the Financial System Direct Finance Indirect Finance Information Challenges and the Financial System Asymmetric Information Free-Rider Problem Financial Intermediaries Address Asymmetric Information Problems Collateral and Asymmetric Information Problems Application: The Tyranny of Collateral Government Regulation and Supervision of the Financial Sector Government Regulation to Promote Transparency Government Safety Net Role of Prudential Regulation and Supervision Financial Development and Economic Growth: The Evidence Application: Is China a Counter-Example to the Importance of Financial Development to Economic Growth?

Chapter 14 Web Appendix: Free Trade, Financial Globalization, and Growth

Chapter Overview and Teaching Tips With the financial crisis that overwhelmed the world economy from 2007–2009, the public has become more aware of the interaction between finance and economics. This part of the book provides an analytical framework for understanding the impact of finance on the economy, both in the short and the long run.

This part of the book will appeal particularly to students who are interested in pursuing careers in finance, but the material is so topical that almost all students will find it interesting.

Chapter 14 focuses on the long run and examines the role of finance in promoting economic efficiency and economic growth. The literature on how finance promotes economic growth is fairly recent (developed over the last twenty years) and is often not sufficiently appreciated either by the public or by many economists.

For example, it was only in the second edition of the leading undergraduate textbook on economic growth published in 2009 (David N. Weil, Economic Growth, 2nd edition, Addison-Wesley, 2009) that the role of finance in economic growth was actually discussed.

.

Chapter 14

The Financial System and Economic Growth

153

The chapter starts by discussing the role of the financial system, illustrating the two routes through which funds are channeled to households and business: direct and indirect finance. Figure 14.1 is particularly useful to provide students with the big picture of what the financial system does. The key point to get across to students here is that a financial system that is able to channel funds to households and businesses with productive investment opportunities is crucial to achieving high economic growth.

The next part of the chapter discusses why it is not easy to get the financial system to channel funds to households and businesses with productive investment opportunities. The key barrier to getting this to happen is asymmetric information, the fact that one party to a financial contract has different information than the other party. There are three key concepts that students need to master to understand the material in the rest of the chapter: adverse selection, moral hazard, and the free-rider problem. Because these three concepts are so important, it is worth asking students in class to come up with examples of these problems from their daily lives. This not only solidifies understanding of these concepts but also shows them how relevant these concepts are to real-world issues. The chapter then uses these concepts to explain why financial intermediaries like banks are so important in a financial system and why collateral is so prevalent in debt contracts. The application, “The Tyranny of Collateral,” then provides graphic examples of how barriers to having property serve as collateral helps keep some countries poor.

The concepts of asymmetric information, adverse selection, and moral hazard are used next to explain why the financial system is subject to so much government intervention. They provide the rationale for why governments adopt regulations to promote transparency, which reduces asymmetric information and hence adverse selection and moral hazard problems, and why the government needs to regulate and supervise financial institutions to promote their safety and soundness. The analysis in this section of the chapter also can be used to show that not all government interventions in the financial system are beneficial: The box on government-directed credit discusses research that shows that this form of government intervention is harmful to economic growth.

The final section of the chapter discusses the empirical evidence on the link between financial development and economic growth. Although the evidence is quite strong that financial development plays a key role in promoting economic growth, one economy that looks like a counterexample is China’s, because its financial sector is relatively undeveloped and yet the economy has had very rapid growth in recent years. Discussing this example in class, which appears as an application at the end of the chapter, raises not only fascinating issues but also interests students because they want to better understand the rise of China economically and possible pitfalls that China will face in the future.

The chapter has an appendix on the Web, “Free Trade, Globalization, and Economic Growth,” which shows how free trade and financial globalization help promote financial development and economic growth. Whether free trade and globalization are beneficial is a very hot topic in the media in recent years, and this issue is now a central one in political debates. Having students debate this topic in class not only generates a good discussion but also helps solidify many of the concepts discussed in the chapter.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions The Role of the Financial System 1. The financial system matches savers (those who have surplus funds) with borrowers who may have good investment opportunities but no savings of their own to invest. Without a well-functioning financial system, savings will not be channeled from those with excess funds to those who can make the most productive use of them. As a result, economic growth will suffer.

.

154

Mishkin • Macroeconomics: Policy and Practice, Second Edition

2. In direct finance, borrowers get funds from savers by selling them financial instruments (securities) such as stocks or bonds. These securities give the lenders (savers) a claim to the borrowers’ future income or assets. With indirect finance a financial intermediary (such as a bank, mutual fund, or pension fund) gets funds from the savers and lends them to the borrowers, a process known as financial intermediation. Indirect finance is the most important form of finance in all countries, but it is especially important in developing countries where markets for buying and selling financial instruments are poorly developed, if they exist at all.

Information Challenges and the Financial System 3. With both direct and indirect finance, the borrower generally has more information than the lender does about the risk involved. This asymmetric (unequal) information creates two problems for potential lenders. The people who are anxious to borrow are likely to take greater risks, making it more likely that a loan will be made to a poor credit risk. This adverse selection problem occurs before a loan is made. The moral hazard problem, which occurs after a loan is made, is the risk that a borrower will use the borrowed funds for a riskier purpose than the lender prefers, making it less likely that the loan will be repaid. These problems reduce the amount of lending that takes place, which can hamper economic growth and may lead to no loans being made at all.

4. Investors in financial instruments who engage in information collection face a free-rider problem, which means other investors may be able to benefit from their information without paying for it.

Individual investors, therefore, have inadequate incentives to devote resources to gather information about borrowers who issue securities. Financial intermediaries avoid the free-rider problem because they make private loans to borrowers rather than buy the securities borrowers have issued. Because they will reap all the benefits from the information they collect, their information collection activities will be more profitable. They, thus, have greater incentive to invest in information collection.

5. To overcome asymmetric information problems, banks screen potential borrowers before making loans (to lessen adverse selection problems), monitor borrowers’ financial conditions and how they are using borrowed funds after making loans (to lessen moral hazard problems), insert restrictive clauses into debt contracts to limit borrowers’ behavior (to lessen moral hazard), and require collateral against the loans they make (to lessen both adverse selection and moral hazard problems).

6. Developing countries likely have weaker accounting and reporting standards, so accurate information about private firms is more difficult to come by and also more difficult to analyze because of limited access to information technology. As a result, asymmetric information problems are greater in developing countries, and local firms, therefore, find it difficult to acquire funds through selling securities in financial markets. Because banks make private loans and have an incentive to gather information to solve asymmetric information problems, financial intermediation becomes even more important in developing countries’ financial systems than it is in developed countries.

Government Regulation and Supervision of the Financial Sector 7. The government can produce information about borrowers and provide it to investors free of charge, it can require borrowers to report honest information about themselves to investors, and it can set and enforce rules that govern the behavior of financial institutions so they do not take on too much risk.

These prudential regulations for banks include banning certain activities and asset categories considered too risky, establishing minimum capital requirements, and requiring disclosure of financial information to regulators and investors.

8. Even though banks are well suited to overcome the adverse selection and moral hazard problems inherent in lending because they make private loans and have incentives to invest in information production about the borrowers to whom they lend, bank depositors face an asymmetric information problem of their own: They do not know as much as bank managers do about how much risk banks

.

Chapter 14

The Financial System and Economic Growth

155

are taking and are uncertain about the safety of their deposits and their banks’ ability to pay them back in full. If some banks fail because they have become insolvent and cannot repay their deposits, these bank failures increase the uncertainty facing all depositors, who lack the information needed to determine whether their banks (and their deposits) are safe or not. This increase in uncertainty, the result of asymmetric information, can lead to bank runs in which depositors are scrambling to withdraw their deposits before their banks run out of cash and, in extreme cases, can lead to a contagion in which a large number of banks fail within a short period of time.

9. Governments provide safety nets to reduce the likelihood of bank runs and contagions because these have adverse effects on the financial system and the economy. Deposit insurance and government’s assurance that it will make funds available to troubled financial institutions are two forms that a safety net can take. Although government safety nets protect depositors and have succeeded in preventing bank panics, they unfortunately have an important negative consequence. Because depositors have less concern about the safety of their deposits and therefore less reason to monitor the degree of risk banks are taking, bank managers have more incentive to take on greater risk.

Perversely, then, the existence of a government safety net may make bank failures more likely.

Financial Development and Economic Growth: The Evidence 10. Financial deepening refers to a country developing the institutions necessary to have a wellfunctioning financial system. Where it has occurred, the benefits include increasing the rate of economic growth, faster growth of business firms that are dependent on external sources of financing, creation of more business firms, more efficient allocation of capital, and reductions in poverty and income inequality.

Answers to Problems The Role of the Financial System 1. A situation in which entrepreneurs cannot get credit to fund their investment projects is not a desirable one from an efficiency point of view. Although it is true that many ideas will not result in such a great business as overnight shipping, it is very important that entrepreneurs have access to funds. The alternative is one in which the economy will not be as healthy because new ideas will not be implemented as often (for lack of resources). A well-functioning financial system allows for this “trial-and-error” process to flourish, and therefore, the possibility for a great idea to see the light increases. As many new technologies or ideas have positive externalities, the economy as a whole benefits from a well-functioning financial system.

2. Funds were definitely not allocated to their most productive use. Funds are allocated to their most productive use when considerations about which individual or firm should receive these funds are based on risk and expected returns associated with the investment. The situation in which funds are allocated based on political positions results in an inefficient allocation of funds, and as a consequence, in an inefficient financial system. This is often the case in countries where corruption and badly designed institutions (e.g., the legal right of a political party to nominate state bank directors, lack of independent press) are prevalent. These endemic problems usually affect the efficiency of the financial system, not only directing funds to nonproductive uses (that often do not even pay them back) but also crowding out funds for productive uses.

Information Challenges and the Financial System 3. a.

The loan officer is trying to assess your credit risk by gathering information about your income (past and current employment) and credit history to avoid the adverse selection problem. The loan office is essentially making sure that you will have the ability and willingness to pay back your car loan.

.

156

Mishkin • Macroeconomics: Policy and Practice, Second Edition

b. By putting a lien on your car title, the bank solves (or reduces) the moral hazard problem. The bank wants to make sure you will use your loan to buy a car (a problem that is sometimes solved by writing a cashier’s check with the car dealer’s name on it) and that you will not sell the car, recover the loan, and use it for something else (that will decrease the probability you will pay back the loan). c. This is an example of a “restrictive covenant,” a clause that restricts the behavior of one individual entering a contractual agreement with another. The spirit of restrictive covenants is to reduce moral hazard problems. If the football player gets injured by skydiving, he will not be able to play, and this will prevent him from honoring his part of the agreement. Of course, no contract is ever “complete” (there is no way to possibly describe all actions that the football player should avoid doing), and therefore, moral hazard problems can only be mitigated by restrictive covenants, never completely eliminated by them.

4. During your visit at the bank you will probably realize that your will receive an annual interest rate of 1 percent or 2 percent if you buy a certificate of deposit, while an individual asking for a car loan will be required to pay an annual interest rate of 7 percent or 8 percent. At the beginning, it seems tempting for you to offer an interest rate of 4 percent, which would make both of you better off.

However, you would probably like to know that individual better, in particular his net worth (to assess his ability to pay you back), or his credit history (has he or she defaulted on a loan before?).

This process will probably be time consuming and costly for you. Even if you decide to engage in this transaction anyway, you will probably want to write a contract to be able to recover your money if this individual does not pay you back. As before, this will be costly. Your local bank is much more efficient in dealing with the adverse selection and moral hazard problems created by asymmetric information. So much so that you are better off by buying a certificate of deposit forgetting about all the transaction costs associated with making a loan.

5. Information asymmetries are also present in government bond markets. Usually investors resort to many information sources about the characteristics of particular governments to assess their ability or willingness to honor their debt. As the Argentinean case illustrates, sometimes this lack of information results in huge losses for bondholders. In this respect, the problem is not significantly different from an investor who decides which corporate bond to buy, although it may be fair to say that information about corporate bonds is more standardized (making it easier to compare firms). After the Argentinean default, investors were only willing to buy bonds issued by its government at a significant risk premium, making it very costly for Argentina to raise funds in bond markets.

6. Financial intermediaries operating in countries with relatively weak property rights and legal systems usually require a lot of collateral when making loans. The rationale for that behavior is that in the event that the borrower defaults, the bank knows that it will be quite difficult and expensive to recover its loan. Therefore, requesting extra collateral might help the bank speed up the process. In practice, a bank that has requested two other houses as collateral for a mortgage has better chances to recover its loan in the event of default. Of course this means that fewer individuals will have access to mortgages (even those with excellent credit risk are left out)because it is quite difficult to come up with such an amount of collateral (usually having your parents as co-signors and using your parents’ house as collateral is not enough). Inefficient financial systems make access to credit much more difficult in some countries, but it is fair to say that this might be the result of inefficient legal systems. As explained before, inefficient financial systems contribute to lower economic growth rates. This example illustrates how difficult it can be for a young individual to buy a house, resulting in less expenditure in residential investment.

Government Regulation and Supervision of the Financial Sector 7. In the U. S. financial system, trading in derivatives is concentrated in five large banks and transactions are kept relatively private, for the same reason that banks do primarily private loans (to

.

Chapter 14

The Financial System and Economic Growth

157

avoid the free-rider problem). Some senators want to create a clearinghouse to operate as a “middle man” in this market and to make information about derivatives prices publicly available to increase transparency. Banks that currently trade derivatives do not like this (as expressed by their lobbying efforts against these proposed regulations)because more transparency means that it will be more difficult to keep information private. This will probably reduce their profits. There is little doubt that the spirit of proposed regulations is to increase transparency and ensure the soundness of the financial system. As is usually the problem with new regulations, it is very difficult to design them to achieve their goal without increasing restrictions on the conduct and performance of the financial system.

8. Although it might seem a good idea to “copy and paste” regulatory frameworks that ensure the soundness of a financial system from one country to the other, this is usually not a good idea.

Developed and developing countries have quite different financial systems. Incorporating a system of deposit insurance will surely result in an increase in deposits at financial intermediaries. However, without proper regulations (i.e., prudential regulation and supervision) to limit the moral hazard problems associated with a system of deposit insurance, banks will probably accept more risks than they would otherwise do. This is obviously not a desired consequence. The increase in moral hazard problems will probably offset the benefit derived from avoiding bank runs (the most immediate effect of a system of deposit insurance).

Financial Development and Economic Growth: The Evidence 9. As more individuals and firms participate in the financial system, monetary policy becomes more effective. When more firms and borrowers rely on financial intermediaries, monetary policy tools have a more immediate effect on monetary aggregates. Monetary policy tools affect financial intermediaries’ ability to create loans and therefore to increase the supply of means of payment (i.e., money). If most individuals rely on the financial system as a source of funds, a contractionary monetary policy will be quite effective in restricting the access to credit for most firms or borrowers.

Conversely, expansionary monetary policy will be more effective in a country in which most individuals participate in the financial system, as opposed to situations in which people rely on other sources of funds (e.g., family members, loan sharks) whose behavior cannot be affected by the central bank. This gives central banks of developed countries one more tool (or a more effective tool) to manage short-run fluctuations in the economy.

10. Microcredit programs were very effective in defining a set of incentives that helped to deal with asymmetric information problems. As a result, microcredit loans usually exhibit higher repayment rates (the percentage of loans that are actually repaid) than regular loans made by financial intermediaries.

Solving the adverse selection problem was never the intention of microcredit schemes because the target population are the extreme poor, who are individuals who live on less than $1 per day and usually do not possess collateral. But making sure that the recipients of the loans have strong incentives to pay back the loan and work hard so that their investment is a success (i.e., dealing with the moral hazard problem) was very important. That is precisely why poor women are usually the recipients of this type of loans: Women are often the “head of the household” in very poor families, where men often have no habit of working, along with other problems. Creating a group of women to monitor expenditures ensures that funds are allocated to their most productive use and helps women to achieve their goals. Microcredit programs have been very successful in helping people escape poverty and in spurring entrepreneurship in poor countries.

◼

Answers to Data Analysis Problems

1. a.

For June 2013, the AA nonfinancial commercial paper spread was 0.05, and the AA financial commercial paper spread was 0.09. These are relatively small margins over the treasury rate and

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

158

fairly close to each other, indicating relatively low risk between commercial paper and the riskfree (treasury) rate. b. In June 2012, both AA nonfinancial commercial and the AA financial commercial paper spread was 0.12, slightly higher than the most recent reading and indicating slightly higher risk. In October 2008, these spreads widened significantly to 1.40 and 2.52, respectively. Asymmetric information played a large part in the financial crisis in late 2008; thus, interest rates rose sharply to compensate for the information problems. The spreads are much smaller today, indicating a much lower level of asymmetric information problems. c. See below. The spreads are very highly correlated with movements in the financial stress index.

Thus, as asymmetric information problems worsen and financial stress rises, credit spreads will also widen (and vice versa).

2. a.

From 2013:Q1 to 2012:Q2, the average percent of loans secured through collateral was 51.3 percent, down from 58.4 percent from the previous four quarters. During the same time frame, the average of senior loan officers reporting a net tightening was –7.9 percent during the recent period and –9.7 percent in the previous four quarter period, indicating an easing of credit standards over both one year periods. The St. Louis stress index averaged –0.4 from 2013:Q1 to 2012:Q2 and slightly higher at 0.1 during the previous four quarters. b. The average percent of loans secured through collateral in 2008 was 53.1 percent, up from 46.6 percent in 2007. During the same time frame, the average of senior loan officers reporting a net tightening was 57.2 percent in 2008, sharply up from 5.8 percent in 2007 and indicating a sharp tightening of credit standards in 2008. The St. Louis stress index averaged 2.2 in 2008, sharply up from –0.5 in 2007. c. As is evident in the most recent period as well as during the 2007–2008 period, as asymmetric information problems worsen, collateral demands by banks increase, and the credit standards used by banks gets stricter. This is entirely consistent with what you would expect. Banks use collateral requirements, screening, and monitoring of clients to alleviate asymmetric information problems, and as these become more problematic, banks are more likely to scrutinize loan

.

Chapter 14

The Financial System and Economic Growth

159

applicants more and require higher collateral. These help alleviate the adverse selection and moral hazard problems when asymmetric information problems heighten.

3. a. See table below. b. See table below. There is a clear relationship between financial/investment freedom and per capita growth in the data: from 1995 to 2005, the top three countries grew by 2.9 percent, while the bottom three grew by only 1.62 percent. From 2005 to 2011, the top three grew by almost 1 percent, while the bottom three shrank slightly with a –0.12 percent growth rate c. Changes in the overall score don’t seem to matter as much as the overall score itself. Czech Republic and Australia had relatively high scores to begin with, and they had strong per capita GDP growth. Among the countries that increased their score, they all had per capita GDP growth that ranked relative to their scores. In particular, the bottom three countries collectively improved their scores between 1995 and 2011, while the top three countries collectively declined in score slightly. Despite this, the top three countries fared much better in economic growth over the 2005 to 2011 period than the bottom three.

1995 to 2005 2005 to 2011

USA 2.28 –0.01

Italy 1.05 –0.54

1995 to 2005 2005 to 2011

Top 3 2.90 0.94

Bottom 3 1.62 -0.12

France 1.53 0.19

Czech Republic 3.19 1.89

United Kingdom 2.99 –0.04

Australia 2.53 0.98

◼ Answers to Review Questions and Problems in Appendix, “Free Trade, Financial Globalization, and Growth” 1. Financial repression refers to efforts to impede the development of financial markets and institutions in developing economies. It occurs because powerful special interests in those economies see financial development as a threat to their economic well-being and oppose institutional reforms that would make their countries’ financial systems more efficient and competitive.

2. Financial repression is supported by government officials and rich elites in developing countries.

Government officials profit from expropriating private property and promoting state-owned banks for their own benefit and that of their families and supporters. Rich elites who own businesses and financial institutions do not need or welcome the competition that accompanies free trade and financial development because it will lower their profit.

3. Free trade increases competition that reduces the revenues and profits of firms in developing economies and makes it more likely that they will need to seek external sources of financing. This gives the owners of these firms an incentive to support institutional reforms that will lessen the adverse selection and moral hazard problems that impede lending. These reforms will make the financial system more efficient in its allocation of capital and promote economic growth.

4. Financial globalization opens markets to flows of foreign capital and competition from foreign financial institutions. This gives domestic financial institutions incentives to become more efficient and adopt the procedures and technology that their new competitors use. Domestic regulators also learn the practices that foreign institution use and promote their use by domestic institutions. Globalization increases the availability of funds, which lowers interest rates and leads to greater investment and economic growth.

It can also increase public support for the adoption of accounting standards, disclosure requirements,

.

160

Mishkin • Macroeconomics: Policy and Practice, Second Edition

and other institutional reforms that make it easier to get useful information for lending decisions and to reform the legal system to protect lenders’ claims to collateral and to enforce restrictive covenants in loan contracts. Reforms such as these further promote economic growth.

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: The Tyranny of Collateral Data Source De Mel, Suresh et al., “Who Are the Microenterprise Owners? Evidence from Sri Lanka on Tokman v. De Soto”: http://econ.worldbank.org/external/default/main?pagePK=64165259&piPK=64165421& theSitePK=469372&menuPK=64216926&entityID=000158349_20080527134815. This paper uses an empirical approach to show that access to funds is not the only constraint to small enterprises’ growth.

This evidence complements the argument that small businesses and entrepreneurs in developing countries face many problems (the absence of collateral that prevents them from accessing funds being one of them).

Related Article Darlington, Shasta (CNN), “Rio slum transformed into canvas bursting with color”: http://www.edition.cnn.com/2010/WORLD/americas/11/17/brazil.beautiful.favela/index.html. In this CNN article, you can observe the scope of illegal construction in one of the largest metropolises of South America: Rio de Janeiro. This is mainly a consequence from the lack of collateral needed to get a mortgage loan (note especially picture 8).

Discussion Question During the most virulent phase of the 2007–2009 financial crises, the U.S. government enacted measures to prevent the increase in foreclosures, as many families were losing their homes. Many people criticized this action, arguing that seizing collateral in the event of default was part of the mortgage contract. Explain how this situation exemplifies the role played by collateral in solving asymmetric information problems.

Answer: Critics of the government’s actions defended that contracts must be properly enforced. Otherwise, potential borrowers will assume or anticipate that their assets pledged as collateral will not be seized by the lender in the event of default. This increases asymmetric information problems and reduces the financial system ability to channel funds from savers to borrowers. Of course the government wanted to mitigate the effects of the subprime financial crisis, but critics were considering the long-run effects of preventing lenders from seizing collateral.

B. For Information About Application: Is China a Counter-Example to the Importance of Financial Development to Economic Growth?

Data Source Federal Reserve Bank of St. Louis data base (FRED): http://research.stlouisfed.org/fred2/series/MKTGDPCNA646NWDB?cid=32329. Here you can find data for China’s GDP. Related Article Yin, Y.P. et al., “Decomposition of the Efficiency of the Chinese State-Owned Commercial Banks at the Provincial Level”: https://uhra.herts.ac.uk/dspace/bitstream/2299/2227/1/S100.pdf. This article measures the degree of efficiency of state-owned banks in China.

.

Chapter 14

The Financial System and Economic Growth

161

Discussion Questions Assuming China does not reform its financial system and keeps relying on state-owned banks to channel funds from savers to borrowers, which do you think would be the consequences in term of efficiency? Can you identify a potential benefit from state-owned banks channeling funds?

Answer: As empirical evidence suggests, a state-owned financial system tends to be less efficient than a system in which private institutions channel funds from savers to borrowers. This is due to a conflict of interest arising when public officials assign funds based on reasons other than efficiency. However, Chinese authorities might want to let go of this opportunity to increase the efficiency in their financial system in favor of equity. This could be the potential benefit from having a government-controlled financial system.

If the Chinese government keeps dictating how to allocate funds, then it has the potential to fund investment projects that will result in a better distribution of income. This, however, also remains to be seen in the future.

.

Chapter 15 Financial Crises and the Economy ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Asymmetric Information and Financial Crises Asymmetric Information Problems What Is a Financial Crisis?

Dynamics of Financial Crises Stage One: Initiation of Financial Crisis Stage Two: Banking Crisis Stage Three: Debt Deflation Application: The Mother of All Financial Crises: The Great Depression Stock Market Crash Bank Panics Adverse Selection and Moral Hazard Worsen Debt Deflation Recovery Begins International Dimensions Application: The Global Financial Crisis of 2007–2009 Causes of the 2007–2009 Financial Crisis Effects of the 2007–2009 Financial Crisis Residential Housing Prices: Boom and Bust Policy and Practice: Was the Fed to Blame for the Housing Price Bubble?

Height of the 2007–2009 Financial Crisis Why the 2007–2009 Financial Crisis Did Not Lead to a Depression Aggressive Federal Reserve Actions Policy and Practice: The Federal Reserve’s Nonconventional Monetary Policy and Quantitative Easing During the Global Financial Crisis Liquidity Provision Asset Purchases (Quantitative Easing) Management of Expectations: Commitment to Future Policy Actions Worldwide Government Intervention Through Bailouts Aggressive Fiscal Policy Policy and Practice: Japan’s Lost Decade, 1992–2002

.

Chapter 15

Financial Crises and the Economy

163

Policy Response to Asset-Price Bubbles Types of Asset-Price Bubbles Policy and Practice: Debate Over Central Bank Response to Bubbles Regulatory Policy Responses to Asset Bubbles

Chapter Overview and Teaching Tips Financial crises are inherently interesting because they are so dramatic. This has become even more the case with the recent worldwide financial crisis, which has had such devastating consequences for not only the U.S. economy but for Europe as well. Indeed, teaching this material on the financial crises has engaged students’ interest more than anything else I have taught in my entire career of more than thirty years of teaching.

This chapter makes use of an asymmetric information analysis (agency theory) to explain the dynamics and adverse impact of financial crises. Teaching Chapter 14 in full is not necessary to cover Chapter 15, as long as the instructor goes over the concepts of asymmetric information, adverse selection, and moral hazard. Although Chapter 15 defines these concepts, many instructors will prefer to go over these concepts in more detail using the material in the first part of Chapter 14.

After defining the basic asymmetric information concepts, the chapter outlines the dynamics of financial crises in advanced economics by separating crises into three phases: the initial phase in which financial innovation or liberalization occurs but is deeply flawed; the second phase of a banking crisis; and the third phase, which only occurs in the worst financial crises, of debt-deflation, in which a decline in the price level causes a further deterioration in household and businesses balance sheets. Figure 15.1 is particularly useful to get students to see the sequence of events and dynamics of financial crises, and going through all the stages in the figure helps students get the big picture of what is happening during financial crises.

Figure 15.2 links the analysis of financial crises to the aggregate demand and supply analysis of earlier chapters. Discussing in class Figure 15.2 provides another demonstration to students how useful the AD/AS model is to understanding business cycle fluctuations. Students will be most interested in using the analysis to discuss the application on recent financial crisis in 2007–2009, which was the worst financial crisis to hit the world since the Great Depression. Nonetheless, the application on the Great Depression is worth covering because it contains so many lessons for today and played an important role in the development of macroeconomics as a separate discipline in economics. One question to pose to students is why the outcome of the recent financial crisis was so different from what happened in the 1930s, when the financial crisis triggered a depression in the United States. The answer is that instead of the passive behavior of both the government and the Federal Reserve during the Great Depression, the Fed and the government pursued very aggressive actions to prop up both the financial system and the economy. The role of policy during the recent financial crisis is emphasized in two Policy and Practice cases. The first, “Was the Fed to Blame for the Housing Price Bubble?,” can be used in class to have a debate over whether the Federal Reserve was to blame for the 2007–2009 financial crisis, a debate that has been actively discussed by the economics profession and even politicians. The second, “Nonconventional Monetary Policy and the Monetary Transmission Mechanism,” examines the use of nonconventional methods by the Federal Reserve to conduct monetary policy both during and after the crisis and how these new methods impacted aggregate demand.

The chapter ends by discussing the policy response to asset-price bubbles. It provides an analytic framework by differentiating between different types of bubbles and then in the Policy and Practice case, “Debate Over Central Bank Response to Bubbles,” shows how this framework can be used to clarify the very active debate in policy circles that is currently taking place over what central banks should do about potential bubbles.

For instructors who want to have a more international orientation of their courses, there is a chapter available on the book’s Website, “Financial Crises in Emerging Market Economies,” that extends the

.

164

Mishkin • Macroeconomics: Policy and Practice, Second Edition

analysis in Chapter 15 to economies that are just entering the world marketplace. The analysis is parallel to that in Chapter 15, with Figure W.1, which is similar to Figure 15.1, outlining the dynamics of financial crises in emerging market economies. Then the Web chapter takes students through two detailed applications, South Korea in 1997–1998 and Argentina in 2001–2002, to illustrate how useful the analysis in the chapter is. The Web chapter ends with a Policy and Practice case, “Preventing Emerging Market Financial Crises,” which outlines what policy measures are needed in emerging market economies to make financial crises like the ones that happened in South Korea and Argentina less likely to occur.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Asymmetric Information and Financial Crises 1. Asymmetric information problems (adverse selection and moral hazard) are always present in financial transactions but normally do not prevent the financial system from efficiently channeling funds from lender-savers to borrowers. During a financial crisis, however, asymmetric information problems intensify to such a degree that this flow of funds is halted or severely disrupted, with harmful consequences for economic activity.

Dynamics of Financial Crises 2. The financial system moves funds from savers to households and business firms who borrow funds to finance productive investment opportunities such as building new homes and purchasing equipment.

When it works well, the financial system helps the economy to maintain a high level of economic activity. A disruption in the financial system, however, increases asymmetric information and the associated problems of adverse selection and moral hazard. As these problems spread, the flow of funds from savers to borrowers diminishes, and this causes economic activity to contract.

3. Financial crises can be started by mismanagement of financial liberalization, the bursting of asset-price bubbles, and increases in uncertainty that accompany major financial institution failures. Relaxing restrictions on the activities of financial institutions and innovating new financial products may lead financial institution managers to engage in new activities and expose them to risks for which they lack the expertise to manage effectively. At the same time, government agencies that oversee financial institutions may lack the resources to monitor the extent of their risk-taking. Losses that arise from these new activities reduce the net worth of financial institutions and cause them to cut back on their lending, which thwarts their ability to channel funds to borrowers with profitable investment opportunities.

The bursting of asset-price bubbles may similarly affect financial institutions and also reduces the net worth of borrowing firms. This increases the moral hazard risks of lending to those firms, as they now have less to lose from engaging in risky behavior. Both of these effects result in less lending.

Finally, the increased uncertainty that occurs when a major financial institution fails increases both adverse selection and moral hazard problems and leads to a decline in lending and economic activity.

4. Bank panics are an artifact of asymmetric information. When the risk that some banks may fail increases, depositors do not have the information to determine whether their bank is a “safe” one or is one of the banks at greater risk to fail. They have incentive to withdraw their deposits before their bank runs out of funds. Uncertainty about the soundness of banks then leads to runs on both good and bad banks and forces banks of both types to start selling their assets to obtain the funds to meet withdrawals. The “fire sale” of assets can lower asset prices so much that even good banks become insolvent. Bank panics represent a contagion spreading through the banking system. When banks close, adverse selection and moral hazard problems worsen and lending declines, leading to a decline in economic activity.

.

Chapter 15

Financial Crises and the Economy

165

5. Debt contracts are expressed in nominal terms, so an unanticipated decline in the price level raises the value of borrowers’ liabilities in real terms but does not increase the real value of their assets. When unanticipated deflation occurs, then the decline in borrowers’ real net worth (real value of assets minus real value of liabilities) heightens adverse selection and moral hazard problems and reduces lending and economic activity.

The Mother of All Financial Crises: The Great Depression 6. Credit spreads measure the difference between interest rates on corporate bonds and Treasury bonds of similar maturity that have no default risk. The rise of credit spreads during a financial crisis (as occurred during the Great Depression and again during 2007–2009) reflects the escalation of asymmetric information problems that make it harder to judge the riskiness of corporate borrowers and weaken the ability of financial markets to channel funds to borrowers with productive investment opportunities.

The 2007–2009 Financial Crisis 7. Advances in information technology and new statistical techniques lowered the cost of evaluating the risk of mortgages to subprime borrowers who did not meet the standards for traditional mortgage loans. Borrowers, for example, could get mortgage loans with little or no money down and could borrow more money relative to the value of the house they were buying and relative to their incomes than allowed with traditional mortgages. Information technology also lowered the cost of packaging numerous subprime mortgages into mortgage-backed securities that could be sold in financial markets, attracting more funds into mortgage finance. These innovations helped to fuel a rapid rise in housing prices, resulting in a housing price bubble. The eventual bursting of the housing price bubble caused some subprime borrowers to be “underwater” because they owed more on their house than its current market value. When this led to sharp increases in defaults on subprime mortgages, the value of the mortgage-backed securities based on them plunged, and many financial institutions suffered large losses because they had to write down the values of such securities they held in their assets. The drop this entailed in financial institutions’ net worth led to less lending and a decline in economic activity.

8. A principal-agent problem exists when agents’ actions further their own best interests rather than those of the principals who hire them. This situation arose in mortgage lending because many mortgage loans were originated by mortgage brokers (agents) who did not plan to hold the loans but instead sold them to investors (principals) as mortgage-backed securities. Because mortgage brokers did not intend to hold the mortgage loans they were making, they had little reason to be concerned about the risks of those loans. Instead, it was in their best interest to make lots of loans that could be bundled into mortgage-backed securities. It was obviously in the best interests of the investors in those securities to have low risks of default on the underlying mortgages.

Why the 2007–2009 Financial Crisis Did Not Lead to a Depression 9. Aggressive actions taken by the Federal Reserve and the $700 billion bank bailout bill passed by Congress helped prevent the financial crisis of 2007–2009 from becoming a depression. In August 2007, the Fed began lowering the federal funds rate target, despite a strong economy and rising inflation, reducing it from 5.25 percent to a range of 0 to 0.25 percent by December 2008. Having lowered the federal funds rate target to its zero lower bound with this conventional monetary policy approach, the Fed also engaged in quantitative easing by continuing to expand the money supply.

Furthermore, it committed to a policy of keeping the federal funds rate target near zero for an indefinite period of time, bought more than $1 trillion of mortgage-backed securities to lower mortgage rates, and expanded its lending facilities to increase liquidity. To this end, it lowered the discount rate and shrunk the gap between it and the federal funds rate target, set up a Term Auction Facility to lend to banks at a rate lower than the discount rate, and began new lending programs for investment banks and purchasers of commercial paper, mortgage-backed securities, and other asset-

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

166

backed securities. The Fed also lent heavily to AIG to prevent its failure. All these efforts helped limit failures of financial institutions and thus avoided the intensification of adverse selection and moral hazard problems that would have ensued had widespread failures occurred. Thus Fed and congressional actions helped keep the economy out of a depression.

Policy Response to Asset-Price Bubbles 10. Asset-price bubbles that push the market prices of assets such as houses and stocks far beyond their fundamental economic values can result from credit booms or from overly optimistic expectations.

Credit-driven bubbles pose the bigger threat to the financial system because of their self-reinforcing feedback loops: Expansion of credit increases spending on assets and increases their prices, which then promotes further expansion of credit by increasing the demand for loans and the value of assets that serve as collateral for them and also increasing financial institutions’ capital (net worth) and enabling them to lend more. However, when the bubble bursts and asset prices tumble, lending drops, asset prices fall more, lending drops again, and so on in a downward spiral. The bursting of a creditdriven bubble can bring down financial institutions whose balance sheets have deteriorated because of the declining value of their assets and the resulting negative effect on their net worth. Weaker financial institutions increase the adverse selection and moral hazard problems in lending.

11. There is much debate on this topic, and the position one takes on it may depend on whether the bubble is caused by a credit boom or by irrational exuberance. Many people argue central banks should not do anything in response to bubbles caused by excessive optimism because such bubbles are difficult to identify and the government officials who would be charged with doing so are no smarter than market participants. When asset prices are rising at the same time as a credit boom, however, it is more likely that a bubble is in progress and government officials are more likely than market participants to recognize this. Others point out that central banks should respond to asset-price bubbles that affect economic activity and inflation. However, monetary policy is a blunt instrument with which to slow or halt an asset-price bubble because it would affect all asset markets, not just those in which bubbles were occurring. In addition, increases in interest rates to slow a credit-driven bubble may be ineffective at slowing the asset price increases but harm the aggregate economy.

Answers to Problems Asymmetric Information and Financial Crises 1. a.

This example illustrates an adverse selection problem. One party does not have enough information about the transaction before the transaction takes place. This example is not significantly different from the one encountered by a potential investor deciding which bond to buy. Usually bond ratings guide investors’ decisions by providing information about bonds’ default risk. b. This example illustrates that the lack of information (or information known to be of poor quality) can frustrate a transaction. Again, this happens in financial markets quite often, especially when information is of dubious quality. In that case, bondholders usually decide to move away from corporate bonds (because they cannot distinguish the good ones from bad ones) and increase their demand for government bonds (which are the default-free bonds). When information about bonds’ ratings is perceived as being of low quality, fewer corporate bonds are bought and sold (transactions decrease). This is why many financial market regulations are aimed at ensuring a constant flow of good quality information.

Dynamics of Financial Crises 2. Gross issuance of MBS in the United States grew at a fast pace from 2001 until mid-2007. (In March 2007 gross issuance of MBS amounted to around $70 billion, around half of the gross issuance for all 2008). This peak coincides with the deterioration of the real estate market (i.e., the decline in home prices). When home prices declined and foreclosures increased, the gross issuance of MBS also decreased, as these securities became more risky assets to hold. Note that during the most virulent

.

Chapter 15

Financial Crises and the Economy

167

phase of the crisis, there were almost no MBS issued (late 2008–early 2009). After actions undertaken by the Federal Reserve and the U.S. Treasury to provide liquidity and restore confidence in the financial markets, trading resumed in the market for MBS, and the volume increased during the first half of 2009.

3. During the 2007–2009 crisis, the Federal Reserve received a lot of criticism. Some critics argued that it failed to act as a proper financial system regulator, and as a consequence, many firms were allowed to accept too much risk and had to be “rescued” later. Because asymmetric information problems characterize virtually every transaction in the financial system, it is of the utmost importance that proper regulations encourage the provision of good quality information. It is not only critical to enact appropriate regulations but also to enforce them properly. One of the distinctive characteristics of the U.S. banking system is the number of regulatory agencies with sometimes overlapping oversight and control of financial intermediaries. The Federal Reserve is mostly in charge of controlling bank holding companies and thus cannot impose regulations on other financial intermediaries, like investment banks, or insurance companies (some of which failed during the 2007–2009 crisis). It is not clear whether the Federal Reserve failed to encourage these firms to reduce their exposure to “toxic” assets, or if it did not have the power to do so. It is probable that new government financial system regulation will be enacted during 2010, most surely reshaping the Federal Reserve and other agencies’ regulatory oversight roles.

4. As the boom in the real estate market reached its peak (by Fall 2006), home sales started to decline in many regions. Some of these regions observed a steeper decline in home sales and home prices, thereby increasing the probability that homeowners would default on their mortgage payments.

Although many of these mortgages were bundled and securitized (not shown on the banks’ balance sheets), banks located in these regions suffered when borrowers could not afford their payments or simply decided to walk away, since the value of their house was now less than the amount owed on its mortgage. Not surprisingly, almost 50 percent of bank failures during 2008 were concentrated in the regions where the real estate market experienced a more severe contraction.

5. a.

Subprime mortgages were loans made to borrowers with lower credit scores and overall lower probability of paying back their loans. Not surprisingly, more subprime borrowers defaulted on their payments than prime borrowers when real estate market conditions deteriorated. b. The ratio of adjustable-rate mortgages to fixed-rate mortgages considered delinquent is close to 3 for subprime mortgages and close to 3.5 for prime mortgages. As interest rates increased during 2004 to 2006, so did the monthly payments for borrowers with adjustable-rate mortgages. This explains why these individuals defaulted on their payments more often than borrowers whose monthly payment was fixed.

Why the 2007–2009 Financial Crisis Did Not Lead to a Depression 6. Section 13.3 of the Federal Reserve Act (Powers of Federal Reserve Banks) was designed to give the Federal Reserve the opportunity to lend (by discounting securities) to individuals or corporations under unusual circumstances. This is exactly what the Federal Reserve did during 2008 and 2009, by creating many lending facilities directed to specific sectors of the financial system (e.g., commercial paper market, primary dealers, etc.) The debate centered on the interpretation of the terms “unusual and exigent circumstances.” As these actions were criticized, the Federal Reserve stated that it was acting under the provisions of the Federal Reserve Act. It is quite clear now that Federal Reserve actions to support the U.S. financial system were very effective, although they were quite controversial at the time.

7. According to aggregate demand and supply analysis, low levels of interest rates might stimulate aggregate demand and create inflation. If the Federal Reserve keeps its policy instrument (i.e., the federal funds rate) at low levels while the output gap is positive, it will be effectively shifting the

.

168

Mishkin • Macroeconomics: Policy and Practice, Second Edition

demand curve to the right and triggering subsequent shifts to the left of the short-run aggregate supply curve. Based on that reasoning, some policy makers (even inside the Federal Reserve) questioned the Federal Reserve’s actions. However, most members of the FOMC saw inflation expectations at very low levels and therefore decided not to raise the federal funds target. The fact that the unemployment rate remained at high levels (9.7 percent by March 2010) also indicated that the recovery has not yet reached the labor market, and therefore, inflationary pressures would probably remain subdued for quite some time. In addition, the Federal Reserve should be quite attentive to any sign of future inflation and act quickly in order to avoid an increase in inflation expectations. The federal funds target will most surely be increased at the first sign of inflationary pressures (maybe when the unemployment rate starts to decrease). The Federal Reserve has been actively promoting its so-called “exit strategy” to send the message that it has many tools at its disposal to remove the excess liquidity pumped into the financial system. The whole purpose of the “exit strategy” is to reassure market participants that the Federal Reserve is committed to fighting inflation.

Policy Response to Asset-Price Bubbles 8. a. This example can be characterized as a credit-driven asset-price bubble. b. The central bank could try to burst this bubble, as it can potentially have a deeper negative effect on the economy than a bubble driven by overly optimistic expectations. In doing so, the central bank should be aware of the limitations of the use of monetary policy as a means to burst a bubble. c. If there is no increase in lending to the floral industry, then probably this price bubble is driven by overly optimistic expectations. There is a stronger case for the central bank not to try to burst this bubble, as its bursting will probably have no important consequences for the economy.

9. Using monetary policy to burst an asset-price bubble would imply raising interest rates, hoping asset prices would decline. As aggregate supply and demand analysis suggests, this always imposes some hardship in the economy. Access to funds is now more difficult, and we should expect investment and consumption expenditure to decline (and unemployment to increase above its natural rate). These effects might be considered one side of the tradeoff (the cost) of avoiding the hardship of an assetprice bubble (the benefit). However, if there were no price bubble to begin with, then the Federal Reserve will have undertaken these actions for nothing. In addition, some weak sectors of the economy might suffer from increased interest rates, which might create a recession. This illustrates the fact that central banks in general have to be very cautious about their actions, especially when trying to burst an asset-price bubble.

10. The process of financial innovation is good for the economy: Its goal is to create new financial instruments as a response to the ever-changing preferences of financial system participants. One of its most beneficial effects is to increase the efficiency of the financial system. This process also can be risky at times. The creation of new financial instruments is often associated with its mismanagement.

Sometimes this can result in the creation of asset-price bubbles, as happened with mortgage-backed securities (or CDOs or SIVs) in the 2007–2009 crisis. When these instruments are improperly priced, this can disrupt the financial system. Regulators can at best be one step behind in this process because usually as a profitable opportunity is created (e.g., by trading MBSs, CDOs) many financial intermediaries will follow this path. Only after there is a thorough understanding of the structure and risk of new financial instruments can proper regulations be written and enforced. But this usually only happens after there is a disruption in the financial system.

11. There is no easy answer to this question. As implied by most central banks’ position (including Bernanke’s Federal Reserve), the worst mistake would be to burst a bubble when it was not necessary. Most central banks are quite conservative with respect to taking actions against asset-price bubbles. This does not mean that central banks will not take actions to support the economy after a

.

Chapter 15

Financial Crises and the Economy

169

price bubble disrupts the financial system and the availability of credit. Assuming central banks have many policy tools to counteract the effect of a price bubble burst, it is usually considered wiser to leave bubbles alone and eventually act if needed. However, a critical step in this analysis is the evaluation of the possible effect of an asset-price bubble. If this effect is estimated to be quite disruptive, then incentives to act to decrease asset prices are greater. Finally, this is yet one more example of how difficult it is to conduct monetary policy.

◼

Answers to Data Analysis Problems

1. a.

See table below. From the most recent available data from 2012:Q2 to 2013:Q1, all four data series are showing healthy gains and are sensibly related to each other. Because homeowner’s equity and retirement or stock portfolios are the two biggest sources of wealth for households, you would expect those to be closely related to net wealth of households. And because net wealth grew substantially, you would expect autonomous consumption to rise, which appears evident in the growth in consumption of more than 3 percent. b. See table below. The period prior to the financial crisis and the crisis period itself are starkly different. In the 2005 period, house prices were rising quickly, and stock prices were growing steadily, contributing to a strong increase in household net wealth and strong autonomous consumption growth. During the deepest parts of the financial crisis in late 2008 into 2009, the data reverses strongly, with large, sharp declines in stock prices, house prices, and net wealth leading to shrinking consumption by households. c. The most current data overall shows modest growth in these household indicators compared to the pre-crisis period in 2005, although home price growth and net wealth are close to the precrisis growth rates. However, they are growing from relatively low levels, so is probably not reflective of a bubble in the current data. The current data are significantly better than the crisis period.

2012:Q2 to 2013:Q1 2005:Q1 to 2005:Q4 2008:Q3 to 2009:Q2

Consumption Growth Rate 3.1 6.0 –3.6

2. a.

S&P 500 Stock Price Growth 11.9 5.8 –36.8

Case-Shiller Home Price Growth 9.2 14.7 –17.9

Household Net Wealth Growth 9.3 11.0 –15.5

See the table on the next page. The most recent four quarters available, from 2012:Q2 to 2013:Q1 indicates that financial frictions as measured by the stress index have fallen and corporate net worth is growing at 7.3 percent; both of these factors have led to an improving lending and investment environment, with investment growing at nearly 4 percent during this time. b. See the table on the next page. During the pre-crisis period in 2005, financial frictions increased slightly. However, net worth of corporations was increasing at more than 10 percent on an annual basis, providing significant reassurance to lending institutions that strong corporate balance sheets would reduce lending risk. As a consequence, investment grew at more than 5 percent on average for the year. During the crisis period, there was a strong increase in financial frictions; with asset prices declining, this lead to rapid deterioration of corporate balance sheets and net worth, and as a consequence, lending and investment contracted sharply. This is entirely consistent with the first stage of a financial crisis, where declining asset prices lead to lower net worth of firms, and lending contracts sharply. Moreover, financial frictions increased sharply during that time, which is indicative of asymmetric information problems rising.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

170

c.

Because financial frictions have been lowering during the last year, this is indicative of a more normal economic environment; coupled with healthy but not overly strong growth in investment in the current period compared to 2005, this data suggests a bubble is probably not present.

2012:Q2 to 2013:Q1 2005:Q1 to 2005:Q4 2008:Q3 to 2009:Q2

Change, Stress Index –0.69 0.13 0.99

Corporate Net Worth Growth Rate 7.32 10.65 –20.15

Investment Growth Rate 3.90 5.10 –34.90

3. a. See table below. b. See table below. c. During the most recent period, credit spreads have been relatively small, and the federal funds rate hasn’t moved much because the economy is currently near the zero lower bound. As a consequence, the Fed has been using nonconventional monetary policy and expanding its balance sheet, currently at around a 5 percent rate (this will slow in the future as the economy grows and moves away from the zero lower bound). The balance sheet growth now is higher than the precrisis period, when conventional monetary policy was in effect. In this case, balance sheet growth was relatively low and steady, and as credit spreads rose in the 2007 period, the Fed decreased the federal funds rate by 131 basis points. Going into the crisis period, high credit spreads persisted, and once the federal funds rate hit the zero lower bound, the Fed began rapidly expanding its balance sheet, growing at much more than 100 percent during the height of the crisis period.

June 2012 to June 2013 January 2007 to January 2008 September 2008 to September 2009

Average YOY Growth Rate, Fed Assets 5.13 3.32

Change from Previous Year, FFR –0.07 –1.31

Average Credit Spread 0.09 0.62

118.04

–1.66

0.43

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: The Mother of All Financial Crises: The Great Depression Data Source Stock Charts: http://www.stockcharts.com/charts/historical/djia19201940.html. Note the magnitude of the decrease in the Dow Jones Industrial Average index in October 1929.

Related Article Bernanke, Ben S., “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression”: http://www.nber.org/papers/w1054. This article, by the former Chairman of the Federal Reserve, focuses on the effects of the financial crisis in the ability of the U.S. financial system to allocate funds efficiently.

Discussion Question By the 1930s the international financial system was not as interconnected as it was at the end of the 20th century. Which was the main channel by which financial crises affected foreign countries (i.e., other than the country where it originated)?

.

Chapter 15

Financial Crises and the Economy

171

Answer: As true with previous financial crises (i.e., in the 1800s), the most important transmission channel was international trade. The sharp decrease in aggregate demand in the United States decreased U.S. purchases of foreign goods, thereby decreasing the net exports component of aggregate demand in other countries. To make things worse, protectionism flourished, as many nations decided to enact tariffs and other restrictions to international trade. As of 2010, meetings of the most powerful nations of the world (i.e., the G-20) are trying to prevent countries from engaging in protectionism again.

B. For Information About Application: The 2007–2009 Financial Crisis Data Source S&P/Case-Shiller home prices index: http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDTType&blobcol=urldocumentfile&blobtable=SPComSecureDocument&blobheadervalue2=inline%3B+filen ame%3Ddownload.pdf&blobheadername2=ContentDisposition&blobheadervalue1=application%2Fpdf&blobkey=id&blobheadername1=contenttype&blobwhere=1245231571069&blobheadervalue3=abinary%3B+charset%3DUTF8&blobnocache=true. Here you can get the latest release of the S&P/Case-Shiller home price index.

Related Article The Federal Reserve System, “Monetary Policy Report to the Congress, July 2008”: http://www.federalreserve.gov/monetarypolicy/mpr_20080715_part2.htm. In this section of the report (Part 2), you can find an exhaustive analysis of the U.S. economy during the most virulent phase of the 2007–2009 financial crisis.

Discussion Question What are the lessons from the 2007–2009 financial crisis about the process of financial innovation?

Answer: The 2007–2009 financial crisis left many lessons for both financial market participants and policy makers. One of them is that the process of financial innovation should be considered as a potentially great tool (e.g., answering to the needs of both savers and investors) to enhance the efficiency of the financial system but also as a dangerous process if exploited without enough information. The securitization process that led to the creation of mortgage backed securities (MBS) is a good example: It served the needs of both savers and investors for some time, but when financial institutions decided to issue MBS backed by subprime mortgages, the seeds of the crisis were planted. It is quite likely that new financial products will be created in the future; the lesson to derive from the most recent crisis is that these products should be used carefully, as it will be difficult by nature (they will be “new” and therefore people will have no experience in pricing them) to assess their degree of liquidity and risk. This creates a challenge for financial market participants, but also for policy makers.

C. For Information About Policy and Practice: Was the Fed to Blame for the Housing Price Bubble?

Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/FF?cid=118. Here you can find data about the effective federal funds rate determined by the Fed. Related Article Bernanke, Ben S., “Monetary Policy and the Housing Bubble”: http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm. In this speech Chairman Bernanke responded to the notion that Fed’s actions encouraged the housing bubble.

.

172

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Discussion Question Explain why the unusually low target for the federal funds rate (0 to ¼ percent) set after the 2007–2009 crsis did not create an asset-price bubble.

Answer: The fundamental reason why the exceptionally low level of the federal funds rate did not create an asset-price bubble immediately after the 2007–2009 crisis is that the economy was entering a recession when the decrease in the target took place. Aggregate demand was sharply decreased, and even such a low target for the federal funds rate was unable to lift the economy from the recession. Financial market institutions were very careful with their lending policies, not even lending to other financial institutions for fears of default (a credit-driven bubble was ruled out). In addition, expectations about the future performance of the economy were bleak at best, therefore also ruling out the other motive for asset price bubbles. For more information about asset price bubbles refer to the last Policy and Practice case.

D. For Information About Policy and Practice: The Federal Reserve's Nonconventional Monetary Policies and Quantitative Easing During the Global Financial Crisis Data Source Federal Reserve System (FOMC statement, November 3, 2010): http://www.federalreserve.gov/newsevents/press/monetary/20101214a.htm. Note the fourth paragraph, in which the FOMC is still announcing “exceptionally low levels for the federal funds rate for an extended period.”

Related Article Federal Reserve Act, Section 13: http://www.federalreserve.gov/aboutthefed/section13.htm. Section 13 (paragraph 3) formally gives the Fed the power to provide liquidity to “individual, partnership or corporation.” The interpretation of this piece of legislation was the subject of intense debate during 2008.

Discussion Question Suppose that in the next FOMC statement the Fed does not include the phrase “exceptionally low levels for the federal funds rate for an extended period.” How do you think market participants will interpret that?

Answer: Whenever the Fed lowers the federal funds rate for some time, financial market participants “bet” on when the target will be raised again. The timing of these “bets” is implied by the pricing of futures options and other financial derivatives. If the Fed no longer thinks that current conditions will guarantee low levels of the federal funds rate target, then market participants will assume that an increase in the federal funds rate is imminent, maybe in the next FOMC meeting (in which case “bets” will be based on the magnitude of the increase).

E. For Information About Policy and Practice: Japan’s Lost Decade, 1992– 2002 Data Source Hayashi, Fumio and Edward C. Prescott, “The 1990s in Japan: A Lost Decade”: http://www.minneapolisfed.org/research/wp/wp607.pdf. In this paper you can find data about the characteristics of the Japanese stagnation in the 1990s and an interesting approach: Authors claim that it was not caused by problems in the financial sector but rather to low productivity (TFP) growth.

.

Chapter 15

Financial Crises and the Economy

173

Related Article Hoshi, Takeo and Anil K. Kashyap, “Will the U.S. Recapitalization Succeed? Eight Lessons from Japan”: http://www.nber.org/papers/w14401. This paper draws lessons from the Japanese experience in an effort to better asses the U.S. banks, recapitalization process.

Discussion Question One of the characteristics of Japan’s lost decade was a decrease in the overall price index: a deflation.

During the 2007–2009 financial crisis in the United States, deflation was a concern for policy makers, especially at the Fed. What are the consequences of deflation?

Answer: Although generally considered not as bad as inflation, deflation can be equally disruptive for the economy. It adds uncertainty to economic decisions and affects the real interest rate through the Fisher equation. An increase in the real interest rate makes borrowing to fund investment projects more costly, which results in less investment, a critical component of long-term growth. In addition, deflation is usually the symptom of a crisis, which makes dealing with a deflationary economy more difficult. During 2007– 2008, the percentage change in the CPI was very low, and sometimes zero, worrying Fed officials that deflation could drag down the U.S. economy even more.

F. For Information About Policy and Practice: Debate Over Central Bank Response to Bubbles Data Source Stock Charts: http://www.stockcharts.com/charts/historical/djia19401960.html. Note that the bullish market during the 1950s (referenced by the article on footnote 9) cannot be characterized as a bubble (i.e., it did not end in a drastic correction or market crash).

Related Article Dudley, William C., “Asset Bubbles and the Implications for Central Bank Policy”: http://www.newyorkfed.org/newsevents/speeches/2010/dud100407.html. In this speech, Dudley explains the menu of options available for central banks when faced with a potential asset-price bubble.

Discussion Question Describe the consequences of a central bank-engineered increase in interest rates to avoid an asset-price bubble if it turns out that the asset-price bubble did not exist (i.e., the increase in the asset price could be explained by market fundamentals).

Answer: If a central bank decides to increase interest rates to avoid a nonexistent asset-price bubble, the consequences can be serious. If this is the case, the whole economy can suffer from an unnecessary tightening of monetary policy. In addition to making the access to credit more difficult, it can artificially decrease the price of the asset in question (e.g., stocks, housing), thereby creating unnecessary losses that can backfire (e.g., banks could be in trouble if default rates increase; the flow of funds from savers to borrowers could be restricted). This is one of the reasons most central bank officials are reluctant to act even if market analysts suggest there might be an asset-price bubble forming: They risk the chance of creating unnecessary hardship in the economy.

.

Chapter 16 Fiscal Policy and the Government Budget ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline The Government Budget Government Spending Revenue Budget Deficits and Surpluses Government Budget Constraint Size of the Government Debt Growth of U.S. Government Debt Over Time Policy and Practice: The Entitlements Debate: Social Security and Medicare/Medicaid International Comparison: The Size of Government Debt Sovereign Debt Crises Policy and Practice: The European Sovereign Debt Crisis Fiscal Policy and the Economy in the Long Run Why High Government Debt Is Not a Burden Why Government Debt Is a Burden Policy and Practice: Tax Smoothing Fiscal Policy and the Economy in the Short Run Aggregate Demand and Fiscal Policy Expenditure and Tax Multipliers Policy and Practice: The 2009 Debate Over Tax-Based Versus Spending-Based Fiscal Stimulus Fiscal Multipliers at the Zero Lower Bound Aggregate Supply and Fiscal Policy Supply-Side Economics and Fiscal Policy Balancing the Budget: Expansionary or Contractionary?

Policy and Practice: Two Expansionary Fiscal Contractions: Denmark and Ireland Policy and Practice: The Debate Over Fiscal Austerity in Europe Budget Deficits and Inflation Government-Issued Money Revenue from Seignorage

.

Chapter 16

Fiscal Policy and the Government Budget

175

Budget Deficits and Ricardian Equivalence Implications of Ricardian Equivalence Objections to Ricardian Equivalence Bottom Line on Ricardian Equivalence Policy and Practice: The Bush Tax Cuts and Ricardian Equivalence Chapter 16 Web Appendix: Other Measures of the Government Budget Deficit

Chapter Overview and Teaching Tips In this part of the book, we continue with our discussion of macroeconomic policy: first fiscal policy and then international economic policy. Chapter 16 focuses on the long-run and short-run effects of fiscal policy and addresses questions such as: Do budget deficits burden future generations? Are budget deficits inflationary? Does expansionary fiscal policy create jobs and increase economic activity? Given the huge federal budget deficits in recent years, students really want to know the answers to these questions.

To get students to understand what government budgets look like, it is worth starting with a discussion of Table 16.1 in class, which shows the different spending and revenue items in government budgets in the United States. An important point to make is that the federal government is only part of the story because spending by state and local governments is almost as large as federal spending. This table can also be used to show how budget deficits or surpluses are measured. (An appendix to this chapter on the book’s Website shows that there are actually many different measures of government budget deficits or surpluses, showing that interpretation of these numbers is not completely straightforward.) With this understanding of budget deficits, the chapter then discusses how government budget deficits cause government debt to increase over time and compares the size of government debt relative to the economy across countries. The Policy and Practice case, “The Entitlements Debate: Social Security and Medicare/Medicaid,” can stimulate a good class discussion on the looming fiscal crisis that students will face during their lifetimes.

The chapter then provides analysis of the impact of fiscal policy on the economy in the long run and discusses the debate over whether government debt is a burden on future generations. The Policy and Practice case on tax smoothing raises an interesting policy issue for students, that it does not always make sense to balance the budget as some politicians seem to suggest because it is worth running large budget deficits temporarily in order to smooth taxes when there are temporary surges in government spending as during war time.

The chapter next describes the dynamic of sovereign debt crises, which have become a much bigger problem in the aftermath of the global financial crisis that has weakened government finances throughout the world. The Policy and Practice case on the European sovereign debt crisis is particularly worth covering in class because, not only has it been much in the news lately, it illustrates that the United States may be in a dangerous environment where it too could experience a sovereign debt crisis. The next topic is the impact of fiscal policy on the economy in the short run. Here the chapter uses the AD/AS model to go into more detail about how large an effect fiscal policy has on economic activity. This analysis allows students to debate how effective the Obama fiscal stimulus was on spurring economic activity and whether tax cuts would have been more effective than spending increases to stimulate the economy, which is discussed in the Policy and Practice case, “The 2009 Debate Over Tax-Based Versus Spending-Based Fiscal Stimulus.” This section of the book also conducts an analysis of how fiscal multipliers may change when the interest rate hits the zero lower bound. This analysis is particularly relevant today because it suggests that fiscal multipliers may be higher than usual currently because of the zero lower bound.

Although standard Keynesian analysis suggests that shrinking budget deficits is contractionary, the chapter indicates that this may not always be true, with the Policy and Practice case, “Two Expansionary Fiscal Contractions: Denmark and Ireland,” providing two examples where shrinking government budget deficits

.

176

Mishkin • Macroeconomics: Policy and Practice, Second Edition

may have been expansionary. Another Policy and Practice case, “The Debate Over Fiscal Austerity in Europe,” can be used to stage a debate in class over whether fiscal austerity is the right answer for Europe.

The chapter next uses the concept of the government budget constraint introduced earlier in the chapter to show that sustained budget deficits can lead to inflation. The chapter ends by discussing the concept of Ricardian equivalence, which suggests that tax cuts have no effect on private spending and national saving, and so budget deficits resulting from tax cuts do not burden future generations or lead to inflation.

The arguments both pro and con for Ricardian equivalence are discussed, and then an example that sheds light on whether Ricardian equivalence holds is discussed in the Policy and Practice case, “The Bush Tax Cuts and Ricardian Equivalence.”

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions The Government Budget 1. The four main components of government spending are expenditures to purchase goods and services, which can be subdivided into government investment spending on capital goods such as highways and schools and government consumption spending on such things as operating national parks and providing police and fire protection; transfer payments such as Social Security and Medicare benefits; grants in aid through which the federal government assists state and local governments with, for example, spending to provide homeland security; and net interest payments to holders of government bonds, net of interest paid to government. The four main revenue sources are personal taxes, contributions for social insurance (Social Security taxes), taxes on production (mainly sales taxes) and imports (tariffs), and corporate profits taxes.

2. A government budget deficit means that government spending over some time period is greater than the revenues government has collected over that period. According to government’s budget constraint, when revenues are insufficient to pay for spending, government must either borrow by issuing new bonds and going deeper into debt or print money, which increases the supply of high-powered money (currency in circulation and bank reserves) and increases the money supply. The U.S government finances its budget deficits mostly by selling bonds.

Size of the Government Debt 3. Heavy government borrowing (deficit spending) during World War II caused the debt-to-GDP ratio to increase sharply. Rapid real GDP growth and inflation both contributed to the ratio falling just as sharply in the post-war era, until the large income tax cuts of the Reagan administration in the 1980s reversed this trend. Strong economic growth and an effort to balance the budget in the 1990s caused the ratio to fall, but the Bush tax cuts and increases in government spending in the 2000s sent it upward once again. Given the large budget deficits of the Obama administration and the rapid growth of Social Security and Medicare anticipated during the coming decades, the ratio is likely to continue rising.

Fiscal Policy and the Economy in the Long Run 4. Government debt will not burden the future generations that must repay it if it is used to finance investments in government and human capital that increase their productivity (and income) and if those repaying the debt also hold the government bonds (in which case they are simply paying themselves). A number of counterarguments, however, support a less rosy assessment of the burden of the debt: Budget deficits reduce national saving and crowd out private investment; most government spending is for government consumption rather than investment, which does not increase future productivity and incomes; much of the debt is held by foreigners so that the holders of government bonds are not also taxpayers; even if the debt were held only by a nation’s citizens, paying it off would involve transferring income from relatively poor taxpayers to relatively rich bondholders; high levels of debt

.

Chapter 16

Fiscal Policy and the Government Budget

177

may lead to debt intolerance and increase the risk of default; and future tax increases necessary to pay off the debt can create negative incentive effects that reduce future productivity and incomes.

Fiscal Policy and the Economy in the Short Run 5. Government can increase the quantity of aggregate output demanded by increasing government spending or by cutting taxes. Both changes increase planned spending at any given rate of inflation and shift the aggregate demand curve to the right. Both also produce a change in equilibrium output that exceeds their own size. For example, a $500 billion increase in government spending may lead to an increase in equilibrium output of $1.25 trillion, while a $500 billion tax cut may lead to an increase in equilibrium output of $750 billion. The impact of a change in government spending is greater than the impact of a change in taxes because each additional dollar of government spending represents an additional dollar of demand for output, whereas each additional dollar of tax cuts generates less than an additional dollar of demand for output because a portion of each dollar of increased disposable income will be saved rather than spent to buy output.

6. An analysis based on aggregate demand generally concludes that a tax cut increases aggregate demand, shifts the aggregate demand curve to the right, and increases both aggregate output and inflation in the short run but only inflation in the long run. Supply-side analysis argues that tax cuts that are permanent also have significant positive effects on aggregate supply (and conversely, permanent tax increases have significant negative effects). By generating greater rewards for investing and working, tax cuts encourage people to engage in more of these productive activities. As a result, both the longand short-run aggregate supply curves shift to the right, increasing potential output and possibly reducing inflation. Some supply-siders argue that the resulting growth of aggregate output will be great enough to increase tax revenues despite the drop in tax rates. Though this claim is controversial, it is possible that supply-side responses to tax cuts may offset some of the revenue lost from the lower rates.

7. Not necessarily. Efforts to reduce the budget deficit by reducing government spending or raising taxes shift the aggregate demand curve to the left but can also lower expected future taxes and motivate more investment and work effort. This acts as a positive supply shock that, if large enough, can shift the long- and short-run aggregate supply curves to the right. The prospect of smaller future budget deficits, lower future taxes, and higher potential output can encourage households and businesses to increases their spending, offsetting the negative impacts on aggregate demand of raising taxes or reducing government spending.

8. Fiscal multipliers are higher when the zero lower bound occurs because expansionary fiscal policy not only adds to aggregate demand directly but also raises inflation. The higher inflation rate at the zero lower bound then results in a decline in the real interest rate, which leads to a further increase in aggregate demand. This additional effect thus makes the fiscal multiplier higher than it otherwise would be.

Budget Deficits and Inflation 9. Whether budget deficits lead to inflation in the long run depends on how they are financed. As long as they are financed by issuing new bonds, they will not be inflationary if the monetary authorities focus on price stability and can employ contractionary policies to offset the impacts of the budget deficits. However, if a developing country’s government cannot borrow by issuing bonds or if a developed country’s budget deficit becomes so large that investors are no longer willing to buy its bonds, government will resort to printing money (increasing the money supply) to finance its budget deficit. In the long run, the inflation rate depends on the growth rate of the money supply, so large deficits that lead to large proportional increases in the money supply will cause high inflation.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

178

Budget Deficits and Ricardian Equivalence 10. The traditional view, based largely on Keynesian economics, holds that tax cuts increase aggregate demand, result in higher inflation, and reduce national saving, which leads to an increased burden on future generations resulting from lower private investment spending or lower net exports and greater indebtedness to foreigners. The Ricardian equivalence view holds that tax cuts have no effect on spending and national saving because consumers are forward looking, so when taxes are cut, they save their increase in disposable income because they recognize that today’s tax cut means higher taxes tomorrow. Because private saving increases when taxes are cut, aggregate demand does not increase, national saving does not fall, and there is no increase in inflation or in the burden on future generations. Critics of the Ricardian equivalence view argue that consumers are not as forward looking as it assumes. Borrowing-constrained consumers spend their entire disposable income on consumption, and if a tax cut gives them additional disposable income they are likely to spend it, too.

Critics also doubt that consumers give much thought to how future tax increases will affect future generations. If these arguments are correct, the traditional view yields better predictions of the results of tax cuts.

Answers to Problems The Government Budget 1. a. The government deficit is: Deficit = 2.5 + 1 + 0.5 − 3 = $1 trillion. b. The primary deficit is: Primary Deficit = 2.5 + 1 − 3 = $0.5 trillion.

2. a.

A decrease in the number of employed people results (holding Social Security tax rates constant) in a decrease in contributions for social insurance. This decreases tax revenue and, therefore, increases the size of the government deficit. This effect often takes place during contractions, when unemployment increases. b. Even if employment remains constant, an increase in unemployment insurance benefits (e.g., more people applied for unemployment insurance, or the time period for unemployment insurance is extended) increases government transfer payments and therefore adds to the government deficit.

3. There seems to be no definite consensus about the definition of the government deficit. This example illustrates many possible approaches to labeling expenditures and receipts. If Social Security contributions were considered a loan to the government, to be repaid later (plus interest) in the form of benefits, this would have no effect on the government deficit. However, according to the current definition, an individual’s contribution to Social Security decreases the government deficit today (i.e., increase in tax revenue) and increases the government deficit in the future (increase in transfers), when this individual receives its benefits. The implications for the size of the deficit of different accounting methods indicate that this debate will persist for some time.

Size of the Government Debt 4. The prevalence of chronic diseases like diabetes increases the cost of health care in the future. Even if the dependency ratio is considered to remain constant, this will mean either fewer benefits for individuals in need of health care, or an increase in Social Security taxes, for the deficit to remain unchanged.

Chances are that treatment for many diseases derived from increasing obesity rates will be in short supply in the future. Unless dramatic changes in obesity rates (or other similar health risk factors) occur in the future, next generation’s workers will probably have to pay higher taxes. Efforts aimed at reducing child obesity rates or encouraging individuals to exercise not only affect these individuals’ quality of life, but can potentially reduce government deficits in the future. These include the AAP and the current White House administration initiative for the prevention and treatment of childhood overweight and obesity.

.

Chapter 16

Fiscal Policy and the Government Budget

179

Fiscal Policy and the Economy in the Long Run 5. a.

This particular type of spending should be considered government investment because it is aimed at increasing productivity in the future. b. If this type of investment is successful in increasing workers’ productivity, we should expect an increase in potential output in the future. This will result (holding tax rates constant) in an increase in tax revenue, which will reduce the government deficit and therefore the government debt burden for future generations. It is critical for this type of investment that they have the desired effect in the economy (i.e., increase productivity) and do not end up being wasteful spending. In the latter case, they should be considered “government expenditure” and will have the opposite effect on the government debt burden.

6. a.

An increase in Treasury note interest rates represents an increase in net interest payments for the U.S. government and therefore increases the deficit. b. Although it is not plausible to happen in the near future, there could be some trouble ahead for the U.S. government to sell its debt. This potential decrease in the demand for U.S. Treasuries should be considered a wake-up call. Investors are taking into consideration the size and persistence of the U.S. deficit and are not as willing as they were a few years ago to buy U.S. debt. Trust in the U.S. government’s ability to repay its debt is still high, but maintaining such big deficits and for such a long time might create some problems in the future, especially if investors decide to buy fewer U.S. Treasuries. If that ever happens, the United States will have to choose between two options: immediate contractionary fiscal policy to reduce the deficit or increase the monetary base to pays for its deficit. Not a nice trade off.

Fiscal Policy and the Economy in the Short Run 7. a.

According to the estimates of the expenditure and tax multipliers, one should recommend conducting expansionary fiscal policy by increasing government expenditures, as this will have a bigger effect on aggregate demand. In this case, government expenditures should be wisely directed to productive uses, with the potential to improve infrastructure and increase productivity in the long run. b. If there is some crowding-out effect, the original increase in government expenditure (or investment) will be realized at the expense of some private investment. A priori, there is no reason to believe that the government allocates resources (i.e., allocates funds to the most productive investment) more efficiently than the private sector. It is not clear that expansionary fiscal policy based on increased government spending will be a good idea in the presence of crowding out. A counterargument to the latter proposition is that the government could potentially use increased spending to fund specific sectors with large spillovers that will result in more technology or higher productivity in the long run (sectors in which the private sector usually under invests): education, renewable energy sources, and research and development.

8. a.

The prospect of a government committed to long-run fiscal discipline increases both types of autonomous expenditure. Usually a commitment to long-run fiscal discipline is one of many characteristics of a government committed to long-run economic growth. It is quite possible that such an administration will promote free trade, secure property rights, and encourage research and development. This spurs consumption and investment spending and adds to aggregate demand. Although it is possible that a tax increase or a government spending decrease has a negative effect on aggregate demand in the short run, it will most surely positively affect the economy in the long run, if properly understood by the society. b. Another effect of a proper understanding of the long-run goals of fiscal discipline might result in a decrease in government bond interest rates. As investors realize that the current contractionary

.

180

Mishkin • Macroeconomics: Policy and Practice, Second Edition

fiscal policy is a first step toward long-run fiscal discipline, this will increase that government’s ability to pay back its debt. Therefore, long-term bonds should experience a decrease in their yields as they become safer assets.

9. a.

A decrease in taxes shifts the IS and the AD curves to the right, resulting in an increase in output and inflation in the short run. As inflation increases, the real interest rate increases along MP1 from point A to point B. With the increase in inflation in the short run, the real interest rate rises along the MP curve, which crowds out some of the impact of the tax decrease. In the short run, the economy will be at point B.

.

Chapter 16

Fiscal Policy and the Government Budget

181

b. A decrease in taxes of equal magnitude shifts the IS and AD curves rightward by the same amount as in part (a) above. However, if the economy is below the zero lower bound, the expansionary effect resulting in higher inflation results in a decline in the real interest rate.

Because no crowding out takes place, the impact on investment, and hence output, is larger than in part (a), indicating a bigger fiscal multiplier under the zero lower bound condition.

Budget Deficits and Inflation 10. If the inflation rate is very high, the tax size (i.e., the inflation rate) will be high, but the tax base (i.e., the real money supply) will be really low and decreasing, as the price level keeps increasing. As a result, the revenue from seignorage will eventually decrease, as happens with any tax when the tax rate is high and as a result the tax base decreases. Intuitively, the government will be printing money to buy very expensive goods and services. By doing so, it will be collecting some revenue at the expense of creating more inflation. This problem arose during episodes known as “hyperinflations,” when governments abused their ability to print money to pay for goods and services. Eventually people quit using money as a medium of exchange, and the economy reverted to a barter economy.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

182

Budget Deficits and Ricardian Equivalence 11. a.

Even if individuals are forward looking and decide to save in advance to pay higher future taxes, an underdeveloped financial system might not allow them to do so. One of the characteristics of an underdeveloped financial system is its reduced supply of financial instruments. Usually developing countries do not have efficient bond or stock markets that allow individuals to buy assets to postpone current consumption. If that is the case, they will either consume more today or find another way of postponing consumption (outside the financial system). An increase in current consumption will decrease national saving. b. If individuals realize that financial instruments do not satisfy their demand (e.g., the bond or stock market is not properly developed, and the banking system offers low interest rates and no protection against inflation) but are forward looking and care about their offspring, they will probably try to overcome this limitation. One of the most common ways of overcoming these financial system constraints is to use any unexpected increase in disposable income (derived from a tax cut) to buy an asset that could be used as a bequest for future generations. This asset is often real estate property in developing countries with a relatively good system of property rights.

◼

Answers to Data Analysis Problems

1. a.

For 2013:Q1, debt to GDP was 101.6 percent; in 2012:Q1 it was 97.3 percent, and in 2008:Q1 it was 64.3 percent. The last time it reached a peak was in 1995:Q2, when it was 65.1 percent; this is considerably lower than the current value of 101.6 percent. b. Over the last year, debt to GDP has increased 101.6 percent – 97.3 percent = 4.3 percentage points; over the last five years, it has increased 101.6 percent – 64.3 percent = 37.3 percentage points. c. From 2012:Q1 to 2013:Q1, GDP has increased by 3.1 percent; from 2008:Q1 to 2013:Q1, GDP has increased by 12.7 percent. d. Over the last year, debt to GDP ratio has increased by 4.3 percentage points, and GDP has increased by 3.1 percent. This implies that debt has increased by a considerably greater amount than GDP (approximately 7.4 percent) to result in an overall higher debt to GDP ratio. Over the last five years, the debt to GDP ratio has increased by 37.3 percentage points, and GDP has increased by 12.7 percent. This implies that debt has increased by an even greater amount than GDP (approximately 50 percent) to result in an overall higher debt to GDP ratio from 2008:Q1 to 2013:Q1.

.

Chapter 16

Fiscal Policy and the Government Budget

183

2. a.

In 2013:Q1, foreign and international investors held 34.3 percent of all U.S. government debt.

This is a relatively high number and, as seen below, is in fact an all-time high considering the steady increase over time in foreign debt holdings. b. See graph below. The amount of U.S. debt held by foreigners has steadily increased since the early 1980s, with its share more than doubling over that period. Clearly, as the U.S. debt has increased over the last decade, the need to rely on foreign investors has increased. This is somewhat troubling, as it implies lower national saving, lower net exports, and an increase in burden of future generations to pay these debts held by foreign investors.

3. a.

See the figure on the next page. Not surprisingly, from 1980 to 2012, there appears to be a very strong relationship between deficits and the change in bond holdings by the public, as the fitted line is very steep (and has a high R2 if using a regression line). b. For the change in holdings by the Federal Reserve, there appears to be a positive relationship, but this is much less obvious (and using a fitted regression line indicates a much smaller relationship, with less predictive power). c. There appears to be some amount of debt monetization in the scatterplot data: in general, as the deficits get larger, the change in bond holdings by the Fed gets larger, indicating the central bank is facilitating higher deficits. However, this appears to be driven by the large outlier deficits in the 2008 – 2012 period. Removing these data show a much smaller and weaker relationship between Federal Reserve debt holdings and deficits (see below; both the R2 and the coefficient are close to zero). This is not surprising because the Federal Reserve instituted several large-scale asset purchase programs during this time, much of which was purchases of U.S. Treasuries at a time when the U.S. was running very large deficits.

.

184

Mishkin • Macroeconomics: Policy and Practice, Second Edition

.

Chapter 16

Fiscal Policy and the Government Budget

185

◼ Answers to Review Questions and Problems in Web Appendix, “Other Measures of the Government Budget Deficit” 1. a. and b.

Primary Deficit

Current Deficit

Country A

800 + 700 − 1,500 = 0

800 + 700 − 200 − 1,500 = − 200

Country B

2,000 + 1,300 − 2,800 = 500

2,000 + 1,300 − 200 − 2,800 = 300

2. According to data, country A is able to pay for its current purchases of goods, services, and transfer payments. Although the traditional measure of government deficit is positive (800 + 700 + 220 − 1,500 = 220), country A’s primary deficit is zero. Country B is not able to pay for its current purchases of goods, service, and transfer payments, as its primary deficit measure indicates. Even subtracting net interest payments from its traditional government deficit measure, country B is not able to finance its current spending.

3. According to the current deficit measure, country A is increasing its holdings of net assets (i.e., negative current deficit). Although country A is running a total government deficit, 25 percent of its purchases can be considered government investment, and therefore, its current deficit measure is negative.

Country B is running both a positive total government deficit (2,000 + 1,300 + 400 − 2,800 = 900) and a positive current deficit. Only 10 percent of country B’s government purchases can be considered government investment. Country B is, therefore, decreasing its holdings of net assets.

4. The inflation-adjusted deficit for country A is: $100 billion = 0 (primary deficit) + 0.02  5,000.

Accounting for the real value of net interest payments, the government of country A has a $100

.

186

Mishkin • Macroeconomics: Policy and Practice, Second Edition

billion inflation-adjusted deficit. The inflation-adjusted deficit for country B is $600 billion = 500 (primary deficit) + 0.02  5,000. As with country A, a positive real interest rate increases the primary deficit (as countries hold a positive stock of outstanding debt).

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Policy and Practice: The Entitlements Debate: Social Security and Medicare/Medicaid Data Source Congressional Budget Office: Social Security Disability Insurance: Participation Trends and Their Fiscal Implications”: http://www.cbo.gov/doc.cfm?index=11673. Here you can access the entire report made by the Congressional Budget Office about the impact of social security disability insurance.

Related Article U.S. Census Bureau, “Aging Boomers Will Increase Dependency Ratio, Census Bureau Projects”: http://www.census.gov/newsroom/releases/archives/aging_population/cb10-72.html. This article focuses on the evolution of the dependency ratio according to recent trends in the U.S. demographic characteristics.

Discussion Question Considering that the “baby boom” phenomenon also happened in Europe, how do you think the burden of social security programs will affect the government deficits of European countries in the future?

Answer: As the “baby boom” generation ages and retires, social security programs will increase the pressure on European countries’ government transfers. In an effort to reduce future government transfers, the French government proposed some changes in the current legislation. One of the most controversial proposals was to increase the retirement age. This and other suggestions were fiercely opposed by unions, students, and the public in general, reducing the chance that these reforms will ever see the light. In the long run, however, European social security systems, as in the United States, will have to be transformed in some ways, or they will contribute to government deficits in no small part.

B. For Information About Policy and Practice: The European Sovereign Debt Crisis Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/IRLTLT01GRM156N?cid=32330. Here you find data about Greece’s interest rate on its debt.

Related Article European Central Bank, “Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London, 26 July 2012”: http://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html. This is the speech in which Mario Draghi stated that the ECB will do “whatever it takes” to preserve the euro.

Discussion Question Why do you think that the sovereign debt crisis spread to countries like Ireland, Spain, and Italy but not to others?

Answer: When rumors about Greece’s ability to honor its debt increased, individuals started to closely monitor other countries’ debt-to-GDP ratios to assess their ability to honor their debts. Although the debt-

.

Chapter 16

Fiscal Policy and the Government Budget

187

to-GDP ratio is not the only indicator to evaluate a country’s ability to pay back its debt, countries like Ireland, Spain, and Italy exhibited both high debt-to-GDP ratios and decreasing government revenues.

This combination of events (and the almost certainty that it would be very difficult for these countries to close their budget deficits) led to sharp increase in interest payments for these countries but not for others that had smaller debt-to-GDP ratios.

C. For Information About Policy and Practice: Tax Smoothing Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/M318501Q027NBEA?cid=107. Click on “Edit Graph” and select 1990 to the latest available data to check the Federal Government budget surplus or deficit.

Related Article Ferguson, Nial, “Reasons to Worry” (June 11, 2006): http://www.nytimes.com/2006/06/11/magazine/11national.html. In this article the author reviews relatively recent trends in U.S. indebtedness, noting that “tax smoothing” was used by previous governments.

Discussion Question Considering current and future generations, which is the relevant tradeoff to consider when a government engages in tax smoothing? Do you think it is ethical to impose a burden on future generations (considering they cannot vote and therefore agree to them)?

Answer: The relevant tradeoff is between increasing expenditures today and pay for current expenditures, while imposing higher taxes in the future (to pay for current expenditures). The idea is that current expenditure should pay off in the future, maybe by improving infrastructure or encouraging research and development.

There is, however, the possibility that current expenditure has no long-run effects and the next generations are left only with the deficit burden. There is no easy answer to the second question. Sometimes, however, policy makers do not even consider the burden they are imposing on future generations.

D. For Information About Policy and Practice: The 2009 Debate Over TaxBased Versus Spending-Based Fiscal Stimulus Data Source Congressional Budget Office, “Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output From July 2010 Through September 2010”: http://www.cbo.gov/doc.cfm?index=11975. You can find the Congressional Budget Office estimates of expenditure multipliers in page 14 of the PDF version.

Related Article Leduc, Sylvain, “Fighting Downturns with Fiscal Policy”: http://www.frbsf.org/publications/economics/letter/2009/el2009-20.html. This article discusses the relevance of fiscal policy versus monetary policy as instruments to fight recessions. You can also find estimates of tax cut and expenditures multipliers.

Discussion Question Why is the debate about a stimulus package based on the size of tax and expenditure multipliers?

Answer: Usually statistical offices and independent researchers try to estimate the magnitude of tax cuts and increases in government expenditure effects on aggregate demand. These estimates, known as tax or expenditure multipliers, respectively, are meant to guide policy makers when making decision. Policy makers want to affect aggregate demand as much as they can by either cutting taxes or by increasing government

.

188

Mishkin • Macroeconomics: Policy and Practice, Second Edition

expenditure as little as possible. Therefore, the magnitude of these multipliers is critical for fiscal policy.

However, there seems to be not a great deal of consensus with respect to these estimates.

E. For Information About Policy and Practice: Two Expansionary Fiscal Contractions: Denmark and Ireland Data Source Giavazzi, Francesco and Marco Pagano, “Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries”: http://www.nber.org/papers/w3372. This paper studies the effect of fiscal contractions on long-term growth for Denmark and Ireland.

Related Article Bergman, U. Michael and Michael M. Hutchison, “Expansionary Fiscal Contractions: Re-Evaluating the Danish Case”: http://people.ucsc.edu/~hutch/expansionaryfiscalcontractions.pdf. This paper provides evidence in favor of the hypothesis of a positive effect on both private consumption and aggregate output of the Danish fiscal contraction.

Discussion Question In the aftermath of the “lost decade” (the 1980s), many Latin American countries engaged in fiscal contractions. According to the text, which would be the expected consequences of such programs?

Answer: After these programs were enacted, one would expect government deficits to decrease and remain at low levels thereafter. Most of the theory predictions were borne out by data. Huge budget deficits are now in the past for most Latin American countries. However, distortionary taxes did not decrease by much, so that the efficiency argument cannot be confirmed (i.e., the shift to the right in the long-run aggregate supply curve). Although most Latin American countries experienced positive growth rates in the late 1990s, contractionary fiscal policy came at a high cost, in particular for the segments of the population that relied on government programs that disappeared.

F. For Information About Policy and Practice: The Debate Over Fiscal Austerity in Europe Data Source Organization for Economic Co-operation and Development, “Responding to the crisis: What are OECD countries doing to strengthen their public finances?”: http://www.oecd.org/newsroom/respondingtothecrisiswhatareoecdcountriesdoingtostrengthentheirpu blicfinances.htm. Here you can find a detailed account of the design and application of fiscal austerity measures and their impact on key macroeconomic indicators for some European countries.

Related Article CNN, “European Debt Crisis Fast Facts”: http://edition.cnn.com/2013/07/27/world/europe/europeandebt-crisis-fast-facts/. This Webpage shows in detail the most important events related to the European debt crisis. Note the events between December 2009 and March 2010, when major protests arose in response to austerity measures.

Discussion Question The implementation of austerity plans in many European countries implied that government funding for research was drastically reduced. What do you think will be the long-term effect of such policies on economic growth?

Answer: The drastic drop in research programs funding meant that many scholars decided to move to other countries where they could continue their research. It also meant that the pace of technological

.

Chapter 16

Fiscal Policy and the Government Budget

189

advancement probably decreased for countries that implemented such policies. In the long run, this means that the rate at which technological change and new ideas are accumulated will probably be lower.

According to standard economic growth models, this means that long-run economic growth might be set at a lower rate.

G. For Information About Policy and Practice: The Bush Tax Cuts and Ricardian Equivalence Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/PSAVERT?cid=112. Here you can find data about the personal saving rate.

Related Article Steindel, Charles, “The Effect of Tax Changes on Consumer Spending”: http://www.newyorkfed.org/research/current_issues/ci7-11/ci7-11.html. This article explores the impact of the summer 2001 tax cuts on consumer spending.

Discussion Question Suppose that a fifty-year-old couple cares a lot about their two children. They also consider the possibility that they will not be able to maintain their current lifestyle when they retire (probably due to cuts in Social Security benefits). Which are the implications of these two elements for the Ricardian equivalence result (e.g., how will this household respond to a tax cut)?

Answer: These two considerations have opposing effects on the decision of this couple as to how to respond to a tax cut. On the one hand, lower taxes today mean more taxes in the future, and knowing this (and caring for their offspring), this couple would be likely to save more and leave a large bequest for their children. On the other hand, if this couple faces a declining lifestyle, chances are that a tax cut (which increases their disposable income) will be spent during their retirement years.

.

Chapter 17 Exchange Rates and International Economic Policy ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Foreign Exchange Market and Exchange Rates Foreign Exchange Rates The Distinction Between Real and Nominal Exchange Rates Macroeconomics in the News: Foreign Exchange Rates The Importance of Exchange Rates Foreign Exchange Trading Exchange Rates in the Long Run Law of One Price Theory of Purchasing Power Parity Exchange Rates in the Short Run Supply Curve for Domestic Assets Demand Curve for Domestic Assets Equilibrium in the Foreign Exchange Market Analysis of Changes in Exchange Rates Changes in the Demand for Domestic Assets Application: The Global Financial Crisis and the Dollar Application: Why Are Exchange Rates So Volatile?

Exchange Rates and Aggregate Demand and Supply Analysis Intervention in the Foreign Exchange Market Foreign Exchange Intervention Intervention and the Exchange Rate Fixed Exchange Rate Regimes Fixed Exchange Rate Regime Dynamics The Policy Trilemma Monetary Unions Application: How Did China Accumulate Over $3 Trillion of International Reserves?

Policy and Practice: Will the Euro Survive?

To Peg or Not to Peg Advantages of Exchange-Rate Pegging Disadvantages of Exchange-Rate Pegging Policy and Practice: The Collapse of the Argentine Currency Board

.

Chapter 17

Exchange Rates and International Economic Policy

191

Chapter 17 Web Appendix: The Interest Parity Condition Chapter 17 Web Appendix: Speculative Attacks and Foreign Exchange Crises

Chapter Overview and Teaching Tips Chapter 17 discusses policy issues related to the exchange rate and the international economy. This chapter is self-contained, and for instructors who have less of an international orientation to their courses, this chapter can be skipped without loss of continuity. The chapter focuses on three basic questions: How do swings in the exchange rate affect economic activity? What determines fluctuations in the exchange rate? How do fluctuations in exchange rate affect macroeconomic policy?

Chapter 17 explains behavior in the foreign exchange market by using a modern asset-market approach to exchange rate determination. This asset-market approach is now the dominant method of analyzing exchange rate movements in the economics literature, and it has major advantages over the more conventional treatment of the foreign exchange market typically found in macroeconomics textbooks. As the second application in the chapter, “Why Are Exchange Rates So Volatile?” indicates, the asset-market approach, in contrast to earlier approaches emphasizing import and export demand, can be used to explain a feature of the foreign exchange market that has received much attention in the press in recent years: the high volatility of exchange rates. This phenomenon is not well explained by the earlier flow approach because it does not predict that exchange rates should be highly volatile.

The asset-market approach is developed in several steps. First, the long-run determinants of the exchange rate are laid out, and then the information about the long-run determinants is embedded in a model of the short-run determination of exchange rates. The key idea that must be transmitted to the student is that the demand for domestic currency (say, dollar) assets is determined by the relative expected return on these assets. To help students achieve an intuitive grasp of how the relative expected return on domestic assets, and hence the demand curve shifts, tell them to put themselves in the shoes of an investor who is thinking about putting his or her money into foreign or domestic assets. When a factor changes, have them ask themselves whether at the same exchange rate, they would earn a higher expected return on domestic assets—if so, the demand curve has shifted to the right. This kind of thinking will help them manipulate the demand curve, so they can predict which way the exchange rate changes.

The application, “The Global Financial Crisis and the Dollar,” shows how useful the supply and demand analysis provided in this chapter is in explaining exchange rate fluctuations, in this case the exchange rate for the U.S. dollar during the recent financial crisis episode.

With the knowledge of what determines exchange rates, the next question is how fluctuations in exchange rates affect inflation and economic activity. The chapter answers this question by looking at how changes in exchange rates affect the aggregate demand and supply curves in our AD/AS model. This analysis is conducted in Figure 17.6, and it provides a deeper understanding of the international dimension in business cycle fluctuations.

The rest of the chapter shows how international financial transactions have important implications for the conduct of monetary policy. It explains how foreign exchange market intervention affects the exchange rate, a country’s international reserves, liquidity in the economy, and interest rates. It also explains how fixed exchange rate systems work and the application on how China has accumulated more than $3 trillion of international reserves, a subject of great interest to students, makes the material come alive for them. A particular type of fixed exchange rate system is a monetary union, and this is worth discussing in class because of the rise of the Eurozone and concerns about whether the euro will survive, a topic that is discussed in a Policy and Practice case. Another two applications in an appendix available on the book’s Website, “Speculative Attacks” and “Foreign Exchange Crises,” which look at the September 1992 foreign exchange crisis and recent foreign exchange crises in emerging market countries, capture the imagination

.

192

Mishkin • Macroeconomics: Policy and Practice, Second Edition

of students because huge profits were made during these crises and because government intervention in the markets was massive. These applications also give students further practice with the model of the foreign exchange market developed in Chapter 17.

The final section on exchange rate pegging can be staged as a debate in class of the pros and cons of fixed versus flexible exchange rate regimes. The Policy and Practice case, “The Collapse of the Argentine Currency Board,” provides an excellent example of how exchange rate pegs can go horribly wrong.

For instructors who would like to increase the focus on international finance, the chapter has an appendix on the book’s Website that discusses the interest parity condition. For students with a mathematical bent, this condition can be used to derive all the results on what determines the exchange rate very quickly and directly.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Foreign Exchange Market and Exchange Rates 1. Currencies and bank deposits denominated in particular currencies are traded in the foreign exchange market. These transactions determine foreign exchange rates—the price of one currency in terms of another—between various currencies. Spot foreign exchange transactions involve the immediate exchange of currencies or bank deposits; forward transactions are agreements to exchange currencies or bank deposits at a given future date.

2. The nominal exchange rate tells you how many euros you can buy with your dollars. The real exchange rate tells you how cheap or expensive U.S. goods and services are relative to European goods and services. Because of sticky prices in the short run, nominal and real exchange rates move together, so that a change in the amount of euros per dollar means that the quantity of European goods and services a dollar can buy also changes. When the dollar appreciates (is worth more in terms of euros), European goods and services are less expensive for Americans to buy, while American goods and services become more expensive to Europeans. The opposite changes occur when the dollar depreciates (is worth less in terms of euros). Thus, U.S. goods and services will sell better in both Europe and the United States in the short run when the dollar depreciates. In the long run, however, prices are not sticky; therefore, real exchange rates are not influenced by changes in nominal exchange rates in the long run.

Exchange Rates in the Long Run 3. The law of one price says that if two countries produce an identical good and transportation costs and trade barriers are low, the price of the good should be identical in both countries, no matter which currency is used to pay for it. This means that the real exchange rate will be 1.0, and the nominal exchange rate is determined by the relative prices of the good in each country’s currency. The theory of purchasing power parity applies the law of one price to countries’ aggregate output of goods and services by holding that, in the long run, exchange rates will adjust to reflect relative national price levels between countries. (For example, if a country experiences 10 percent inflation, the nominal exchange rate for its currency will depreciate 10 percent to keep the real exchange rate at 1.0.) PPP theory does not hold in the short run because countries do not produce identical products and many of the goods and services they produce are not traded with other countries.

Exchange Rates in the Short Run 4. If the foreign exchange rate Et is above its equilibrium value E*, there is excess supply of dollar assets in the foreign exchange market. More people want to sell dollar assets than want to buy them,

.

Chapter 17

Exchange Rates and International Economic Policy

193

and the value of the dollar falls. As it does so, the expected appreciation of the dollar relative to its expected future value Eet+1 rises, which increases the expected return on holding dollar assets, increases the quantity of those assets investors wish to buy, and works to reduce the excess supply.

The exchange rate for the dollar will fall until the excess supply of dollar assets is completely eliminated. If the foreign exchange rate is below its equilibrium value, an excess demand for dollar assets causes the dollar’s value to rise, which reduces its expected appreciation and the expected return on dollar assets, and reduces the amount of dollar assets investors wish to purchase. This process likewise continues until the dollar has risen sufficiently to completely eliminate the excess demand for dollar assets.

Analysis of Changes in Exchange Rates 5. The exchange rate for a currency will rise if the domestic real interest rate increases, if the foreign interest rate falls, or it the expected future exchange rate for the currency rises. The latter will occur if investors anticipate an increase in demand for the country’s exports.

Aggregate Demand and Supply Analysis of Exchange Rate Effects 6. Because appreciation of the domestic currency increases the real as well as the nominal exchange rate in the short run, it makes exports more expensive and imports less expensive. This causes net exports to decline and shifts the aggregate demand curve to the left. While the currency’s appreciation also shifts the short-run aggregate supply curve downward, because it makes imports less expensive and lowers the aggregate price level, this effect is typically smaller than the impact on aggregate demand.

The overall impact, therefore, is that aggregate output and the inflation rate both decrease.

Depreciation of the domestic currency has the opposite effect of raising both inflation and output.

Intervention in the Foreign Exchange Market 7. Central banks intervene in foreign exchange markets to adjust their holdings of international reserves (foreign-currency denominated assets), influence exchange rates, or both. When a central bank buys assets denominated in the domestic currency, it is selling some of its foreign-currency denominated assets, and so its international reserves decline. Alternatively, a central bank that sells assets denominated in the domestic currency is buying international reserves. The impact on exchange rates depends on whether the intervention is sterilized or unsterilized. An unsterilized purchase of domestic currency (sale of international reserves) reduces bank reserves, lowers the money supply, and causes the domestic interest rate to rise, so the domestic currency appreciates. Conversely, an unsterilized sale of domestic currency (purchase of international reserves) increases bank reserves and the money supply and reduces the domestic interest rate, so the domestic currency depreciates. Sterilized interventions, however, do not affect exchange rates because the central bank offsets them with open market operations that leave bank reserves unchanged.

Fixed Exchange Rate Regimes 8. In a fixed exchange rate regime, the value of one currency is pegged to another currency (called the anchor currency), and central banks intervene in foreign exchange markets to keep the exchange rate between the two currencies at this fixed value. In a floating exchange rate regime, there is no preset exchange rate that central banks are trying to maintain. Instead, exchange rates are determined by supply and demand and, therefore, are allowed to “float” up or down depending on market forces. A managed or dirty float exchange rate regime is one in which central banks intervene as they see fit to influence exchange rates.

9. A currency is overvalued relative to another currency if the fixed exchange rate (par value of the currency) is higher than the equilibrium exchange rate between the two currencies in the foreign exchange market. To keep the exchange rate from falling to the equilibrium value, the central bank must intervene to buy domestic currency by selling its international reserves. This is a problem

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

194

because sooner or later the central bank will exhaust its international reserves and be unable to maintain the exchange rate for its currency at the par value. When this occurs, the currency must be devalued, which means the fixed exchange rate is reset at a lower value. Anticipation that this may occur leads to speculative attacks on the currency in which speculators sell large quantities of the currency and drive its equilibrium market value lower, which puts more pressure on the central bank’s international reserve position and hastens the expected devaluation.

10. The policy trilemma is the reality that a country or monetary union cannot simultaneously have free capital mobility, a fixed exchange rate for its currency, and an independent monetary policy. It can choose any two of these policies but must give up the remaining one.

To Peg or Not to Peg 11. Exchange-rate pegging helps keep inflation low and anchors inflation expectations in the pegging country to those in the anchor country. It replaces the pegging country’s monetary policy, which may not have done a good job in the past of stabilizing the economy, with that of the anchor country.

Exchange-rate pegging has racked up some successes at quickly reducing inflation expectations in emerging market countries. However, it also has some important disadvantages. The pegging country cannot pursue an independent monetary policy, which severely impairs its ability to respond to domestic shocks that do not also hit the anchor country. It also exposes the pegging country to the risk of speculative attacks on its currency.

Answers to Problems Foreign Exchange Market and Exchange Rates The real exchange rate is: (16  0.75)/10 = 1.2, which means that U.S. wine is more expensive that French wine (i.e., the real exchange rate is higher than 1). b. The real exchange rate is now: (12  0.75)/10 = 0.9, which means that U.S. wine is less expensive that French wine (i.e., the real exchange rate is lower than 1).

1. a.

Exchange Rates in the Long Run 2. a.

For the law of one price to hold, the nominal exchange rate should be 5 yuan per dollar, so that an individual holding $2 can buy the same coffee priced at 10 yuan in China. b. The purchasing power parity theory predicts an appreciation of the Chinese currency, from 7 yuan per dollar to 5 yuan per dollar (0.143 dollar per yuan to 0.2 dollar per yuan). Alternatively, we can think of this as a depreciation of the U.S. dollar (the same dollar is exchanged for fewer units of the foreign currency).

3. a.

In the case of sugar, trade restrictions prevent the law of one price from holding. The United States imposes significant trade restrictions, mostly in the form of quotas. This makes sugar more expensive in the United States. This is an example of a tradable good, but subject to transportation costs and trade restrictions, both of which do not allow the law of one price to hold. b. A house and the service it provides, known as “housing,” is a good example of a nontradable service. You cannot possibly move one apartment from Mexico City to Manhattan and take advantage of the price difference. The inability to trade this service keeps the law of one price from holding. c. Even if this example refers to a pound of chocolate, these two goods are not perfect substitutes for each other. We should expect their prices not to be same in different countries, or even in the same country. The law of one price does not hold because these goods are not perfect substitutes.

.

Chapter 17

Exchange Rates and International Economic Policy

195

Analysis of Changes in Exchange Rates 4. a.

An expected reduction in the size of asset purchases would lead to an increase in expected future interest rates, which would increase the demand for dollar denominated assets, and hence an appreciation of the dollar.

b. Some of the effects in part (a) would be reversed. That is, expected future interest rates would be lower than initially expected from part (a), and thus demand for dollar denominated assets would fall. This would lead to a depreciation of the dollar.

5. a.

b. The percentage change from November to December 2012 is: (1.3095–1.2953) / 1.2953 = 0.55 percent. The percentage change from January to February 2013 is: (1.3197 – 1.2983) / 1.2983 = 1.6 percent. This example illustrates the fact that exchange rates can be quite volatile.

Recent developments in Greece (i.e., concerns about big budget deficits) affected the relative expected return of the euro during this period.

6. a.

According to the purchasing power parity theory, high expected inflation rates result in an expected depreciation of a given currency. In the case of the United States, if its monetary authority cannot send the message that it is committed to price stability, then we can expect a future lower nominal exchange rate (units of foreign currency per dollar).

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

196

b. A future lower value of the nominal exchange rate decreases the relative expected return of U.S. dollar-denominated assets. Graphically, the demand curve shifts to the left and the spot exchange rate decreases. Intuitively, if investors expect the dollar to depreciate in the future, they will not be as willing to hold U.S. dollar-denominated assets today.

Aggregate Demand and Supply Analysis of the Effects of Exchange Rates 7. a.

An increase in Brazilian net exports will result in an inflow of foreign currency. If the central bank of Brazil does not want to accumulate foreign assets, it will sell them and get Brazilian reals in exchange. This reduces Brazil’s money supply and increases domestic interest rates.

Alternatively, the inflow of foreign currency can create inflation and increase the real exchange rate. These are just two reasons as to why Brazil’s exchange rate will increase. b. Even if the oil exporting industry thrives in Brazil, it can potentially have negative consequences for other exporting industries if the Brazilian currency becomes more expensive (i.e., if the exchange rate increases). The more expensive currency makes exports more expensive, and other industries are severely affected. This effect is often referred to as the “Dutch disease,” based on the experience of the Netherlands’ discovery of natural gas reserves in the 1960s. As this is clearly not a good prospect for the Brazilian economy, monetary authorities probably will try to minimize the effect of the foreign currency inflow on Brazil’s exchange rate.

Intervention in the Foreign Exchange Market 8. a.

The Federal Reserve exchanged U.S. dollars for foreign assets (i.e., the Fed bought foreign assets and paid for them with U.S. dollars). As a consequence, the Fed now holds more foreign assets, and deposits with the Fed have increased. b. The exchange rate for the dollar will decline because the increase in reserves will increase the U.S. money supply and lower U.S. interest rates. If the Fed wants to sterilize this foreign exchange intervention, it has to decrease reserves by $5 billion. This can be achieved by conducting an open market sale of $5 billion worth of U.S. Treasury securities. After that transaction, the Federal Reserve will be holding fewer U.S. Treasury securities, but it will have successfully decreased reserves by $5 billion. This will restore reserves to their previous level, and therefore, the monetary base will remain unchanged, a sterilized foreign exchange intervention.

Fixed Exchange Rate Regimes 9. Even if a central bank adheres to a floating exchange rate regime (i.e., to allow its currency to respond to supply and demand conditions in the foreign exchange market), it might still have incentives to intervene in the foreign exchange market. An excessive appreciation of its currency will hurt that country’s exports, as exports will become more expensive in terms of the foreign currency.

.

Chapter 17

Exchange Rates and International Economic Policy

197

Whenever a central bank allows excessive fluctuation in its exchange rate, part of the external sector (exporters or importers) will be hurt. Because countries have become increasingly interdependent, the external sector has increased in importance for almost every world economy, and therefore, exchange rate considerations are very important as well. Even though many countries state that they will allow their currencies to float, most of them routinely intervene in the foreign exchange market to avoid excessive fluctuations in the value of their currencies, effectively adhering to a system known as “managed” or “dirty” float.

To Peg or Not to Peg 10. a.

An increase in the interest rate of the anchor country results in an overvaluation of the pegging currency. In addition to fears of a speculative attack, an overvalued currency reduces net exports by making exports more expensive. Importing firms will benefit from a stronger currency, and imports of capital goods may increase. b. One of the most interesting effects of devaluation experiences is the negative effect on the net worth of households and firms whose debts were denominated in the foreign currency. After the devaluation occurs, it will take more units of domestic currency to repay your debts. This type of consequence was common during many of the devaluation experiences described in the textbook.

In terms of the domestic currency, households’ and firms’ liabilities increase overnight, while their assets remain at the same value. This constitutes yet one more reason as to why it might be quite risky for a country to peg the value of its currency to another currency.

◼

Answers to Data Analysis Problems

1. a. See table below for August 2, 2012 and 2013. b. The euro (EUR) and Chinese yuan appreciated against the dollar. The yen (JPY), Canadian dollar (CAD), and British pound (GBP) depreciated against the dollar. Thus, you would expect exports to the euro area and China from the United States to rise, and imports from the euro area and China to the United States to fall. Likewise you would expect exports from the United States to Japan, Canada, and the United Kingdom to decrease, and imports from those countries to the United States to increase.

Date 2012-08-02 2013-08-02

USD per EUR 1.2149 1.3268

JPY per USD 78.22 99.04

CAD per USD 1.0061 1.0379

USD per GBP 1.5500 1.5277

Yuan per USD 6.3671 6.1293

2. a.

The exchange rate for August 2, 2013 was $1.5277/£ or 0.6546£/$. The real exchange rate is then [(0.6546£/$) × ($23,495/Boston mini )]/[£17,865/London mini] = 0.86 London mini/Boston mini. b. The real exchange rate is less than one so that you can buy less minis in London than in Boston: In other words, minis are relatively less expensive in Boston. c. If the real exchange rate equaled 1, this would imply 1 London mini/ 1 Boston mini = [(0.6546£/$) × ($23,495/Boston mini )]/[X£/London mini]; solving for X yields a price of £15,379 for a London mini.

3. a See table below for data from August 2, 2012 and 2013. b. The British LIBOR rate decreased against the dollar LIBOR rate, thus you would expect the British pound to depreciate relative to the dollar. The euro and yen LIBOR rates both increased relative to the dollar LIBOR rate; thus, you would expect the euro and yen to appreciate relative to the dollar.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

198

c.

See table below. The interest rate differentials would have predicted that the British pound would have depreciated, the euro and the Japanese yen would have appreciated. However, the Japanese yen actually depreciated, which is the opposite of the prediction, while the euro appreciated and pound depreciated as predicted. The incorrect prediction for the Japanese yen suggests that there are other factors affecting the exchange rate aside from interest rate differentials.

Date 2012-08-02

Date 2012-08-02 2013-08-02

USD LIBOR 0.44185

GBP LIBOR 0.73375

EUR LIBOR 0.24821

JPY LIBOR 0.19571

8/2/2012

USD GBP LIBOR –0.29190

USD EUR LIBOR 0.19364

USD - JPY LIBOR 0.24614

USD per GBP 1.5500 1.5277 GBP depreciated

USD per EUR 1.2149 1.3268 EUR appreciated

JPY per USD 78.22 99.04 JPY depreciated

4. a. See table below for July 2008 to July 2013. b. See table below. The Chinese yuan has a much smaller band that it moves in relative to the average value; at only 11 percent of the average, this is three to four times smaller than the Canadian dollar and South Korean won bands that they fluctuated in over the last five years. c. The results are consistent with part (b); China’s currency is the least volatile relative to the dollar with a standard deviation around half that of the Canadian dollar and South Korean won (as a percentage of the average).

Canadian South Korean Chinese yuan dollar won Average 6.5697 1.0462 1163.9063 Maximum 6.8539 1.2645 1449.6159 Minimum 6.1342 0.9553 1015.0545 Standard Deviation 0.256 0.076 93.632 Max Min Difference/Average SD/Average

10.95% 3.89%

29.55% 7.29%

37.34% 8.04%

◼ Answers to Review Questions and Problems in Web Appendix, “The Interest Parity Condition” 1. The interest parity condition holds that the domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency. If capital is mobile and domestic and foreign assets are perfect substitutes, the interest parity condition holds. It implies that the nominal expected returns on domestic and foreign assets are equal for both domestic and foreign investors

.

Chapter 17

Exchange Rates and International Economic Policy

199

because otherwise investors would prefer to hold only domestic or only foreign assets, depending on which one had the higher expected return.

2. a

The expected return of dollar assets in terms of Japanese yen would be 4 percent higher than the interest rate paid by the dollar-denominated asset. In addition to the 2 percent earned in dollars, an investor will earn 4 percent due to the appreciation of the dollar. The expected return of dollar-denominated assets in term of the Japanese currency is therefore 6 percent. b. According to the current values of the domestic (2 percent) and foreign (5 percent) interest rates and the expected appreciation of the dollar, the interest parity condition is not holding (i.e., 2 percent is not equal to 5% – 4%). According to the current figures, investors will rush to buy the dollar-denominated assets, as they yield a higher expected return than the Japanese yendenominated assets. As a consequence, the dollar appreciates today, and its expected future appreciation decreases, forcing the interest parity condition to hold again. This process stops when the dollar is expected to appreciate by 3 percent only (i.e., 2% = 5% – 3%).

3. As long as the interest rate on the domestic asset is lower than the interest rate on the foreign asset, the interest parity condition implies an expected appreciation of the domestic currency. This happens because the domestic asset can offer a lower interest rate (compared with the foreign asset) as long as the domestic asset is expected to increase in value in the future. According to the data, the dollar is expected to appreciate by 4 percent in the future, so that the interest parity condition holds because 5% = 9% – 4%.

4. Rumors about a future depreciation of the domestic currency lower the expected appreciation of the domestic currency by (everything else the same) lowering the value of the expected future exchange rate (foreign currency per domestic currency). This results in an increase in the righthand side of the interest parity condition, which measures the return on the foreign asset. Algebraically, a smaller value is subtracted from the same foreign interest rate, raising the relative expected return of the foreign asset. This immediately decreases the demand for the domestic asset, depreciating the domestic currency. This is a typical example of a “self-fulfilling prophecy,” in which mere rumors about a future lower value of the exchange rate can actually result in a depreciation of the domestic currency today.

5. According to the interest parity condition, the dollar is expected to depreciate by 1 percent: 4% = 3% – (– 1 percent). This means that E E− E = − 0.01 . Using the fact that today 7 Chinese yuan are traded for e t +1

t

t

a U.S. dollar (i.e., Et = 7 ), we can write: E 7−7 = − 0.01 . Solving this equation yields a future expected exchange rate of 6.93 yuan per dollar. e t +1

6. According to the interest parity condition, if a government decides to peg the value of its currency to the value of another currency, this effectively means that the expected appreciation of the domestic currency is zero. In other words, both the domestic and foreign interest rates would be equal. This implies that the domestic country loses the opportunity to conduct its own monetary policy (i.e., the domestic interest rate is now determined by the foreign interest rate, or by the foreign central bank).

◼ Answers to Review Questions and Problems in Web Appendix, “Speculative Attacks and Foreign Exchange Crises” 1. Speculators attack a currency when they believe it is overvalued and that the government is near to exhausting its international reserves or its willingness to use them to continue intervening in the foreign exchange market to support its currency’s value. The speculative attack occurs when speculators believe that a depreciation or devaluation of the currency is imminent.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

200

2. The countries in the ERM faced difficulties when the German Bundesbank sharply increased interest rates to deal with the jump in inflation that accompanied German reunification in the early 1990s because they would have to raise their interest rates also to keep the exchange rates for their currencies fixed relative to the German mark as the ERM specified. This was difficult for many of them, especially Britain, because it was facing a severe recession and was not willing to enact the autonomous monetary policy tightening needed to raise its interest rates for fear of making the recession worse. The currency crisis occurred when currency speculators realized that there was a high probability that the ERM countries would not be able to bear the cost of keeping their exchange rates fixed relative to the mark. Also contributing to the crisis was the fact that Germany was unwilling to cut its interest rates by more than a token amount, necessitating the ERM countries to raise their interest rates substantially.

3. If a country’s fiscal policy decisions result in budget deficits that it cannot finance by selling government bonds, its money supply will rise because it will have to either simply print money to finance its deficit spending or call on its central bank to purchase the bonds it issues. If this increase in the money supply results in higher inflation, the expected future exchange rate for the currency will decline and currency speculators will anticipate that the currency’s value will depreciate immediately. This can lead to a currency crisis and a speculative attack on the currency.

4. Problems in the banking sector can lead to a currency crisis in a couple of different ways. If a country’s banking system is weakening and there is a financial crisis leading to a slowdown in the economy, a country might be unwilling to raise interest rates in order to support the value of its currency. If weakness in the banking system leads to government assistance for financial institutions and depositors, this could result in large budget deficits whose financing might necessitate increases in the money supply that lead to higher inflation and put downward pressure on the currency’s exchange rate. Both of these could lead to crisis and speculative attacks on the country’s currency.

5. a.

The central bank of the overvalued currency should intervene in the foreign exchange market and buy its own currency (paying with international reserves) in order to increase the value of its domestic currency. Doing so will result in a shift to the right of the demand curve for domestic assets to D2 (where the currency is not overvalued anymore). b. If this country does not have enough international reserves to support its own currency, then it will not be possible to buy its own currency and solve this situation. The stage for a speculative attack on this currency is set. As soon as investors realize that the devaluation of this currency is imminent (the only other option for this country now), then the relative demand for the domestic asset will fall even further and the domestic currency would be eventually devalued. This type of speculative attack on currencies happened during the Bretton Woods years. (The Bretton Woods system of exchange rates was a system of fixed exchange rates where countries tied the value of their currencies to the U.S. dollar.) Countries that ran out of international reserves to support their own currencies were either forced into devaluation or to accept the terms offered by the International Monetary Fund in exchange for loans to support their currency. The prevalence and disastrous effects of such speculative attacks was one of the reasons why the Bretton Woods system eventually collapsed in the early 1970s.

.

Chapter 17

Exchange Rates and International Economic Policy

201

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: The Subprime Financial Crisis and the Dollar Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/DTWEXM?cid=105. Here you can find data for the foreign value of the U.S. dollar. You can edit the graph to see data from 2006 to 2010 to see the value of the U.S. dollar as described in the Application.

Related Article Colvin, Geoff, “What’s Sinking the Dollar?” (11/13/2007): http://money.cnn.com/magazines/fortune/fortune_archive/2007/11/26/101232904/index.htm. In this article, you can find some arguments for the decrease in the value of the U.S. dollar during the first stages of the financial crisis. Later, the dollar would appreciate, as noted in the Application.

Discussion Question By mid-2010, Greece experienced financial problems, mostly related to the size of its budget deficits.

Country members of the European Union debated how to support Greece, as rumors of other countries being in the same situation circulated. How do you think these events affected the exchange rate between the euro and the U.S. dollar?

Answer: Greece’s announcement about its huge budget deficits, linked to rumors of default of other European countries, affected the expected value of the euro. As the text analysis suggests, the euro lost value with respect to the U.S. dollar. The European central bank and the IMF came to Greece’s aid, but this happened after intense negotiations. Helping Greece fueled expectations that large budget deficits would be tolerated in the future, thereby affecting expectations about the future value of the euro. As a consequence, the relative expected return on dollar assets increased.

B. For Information About Application: Why Are Exchange Rates So Volatile?

Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/DEXMXUS?cid=269. Here you can find daily data for the Mexican peso–U.S. dollar exchange rate (peso per U.S. dollar). Note the volatility of this series. (You can change the data range to one year to see daily fluctuations even more clearly.)

Related Article Aghion, Philippe et al., “Exchange Rate Volatility and Productivity Growth: The Role of Financial Development”: http://www.nber.org/papers/w12117. This paper introduces the idea that the impact of exchange rate volatility on economic growth depends critically on its level of financial development.

Discussion Question Suppose that during the same day that the United States announces extremely high productivity growth rates, Mexico’s monthly inflation rate increases above 10 percent, and the European Central Bank announces a rescue plan for Ireland, Portugal, and Spain. Which would be the consequence of these events for the value of these currencies? Conclude by discussing the implied volatility of exchange rates.

Answer: News about increased productivity growth in the United States will increase the expected value of the U.S. dollar. Higher inflation rates in Mexico will decrease the expected value of the Mexican peso, while rescue plans for European countries would signal current and future trouble for the euro. All of these

.

202

Mishkin • Macroeconomics: Policy and Practice, Second Edition

events, which can be expected to happen over a day or a week, will impact the price of these currencies, thereby adding to the volatility of exchange rates. News like this is being constantly monitored by large banks and institutional investors that trade currencies. The actions (i.e., buying and selling) of these agents result in daily swings in exchange rates.

D. For Information About Application: How Did China Accumulate Over $3 Trillion of International Reserves?

Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/EXCHUS?cid=282. Here you can find monthly data for the China/U.S. foreign exchange. Note how recent efforts by the United States and other countries forced China to allow an appreciation (a decline in this series) of the Chinese currency.

Related Article Seo, EunKyung (Bloomberg, 09/28/2010), “G-20 Officials Seek Currency Policy Compromise”: http://www.bloomberg.com/news/2010-09-28/g-20-seeks-exchange-rate-truce-amid-charge-nationscheapening-currencies.html. This article shows how difficult it is for governments to agree on an exchange rate policy. Note in particular the pressure exerted over the Chinese currency policy by many countries.

Discussion Question Describe the effect on the value of the U.S. dollar of a sell-off of U.S. Treasury bonds and purchase of euro denominated assets by the Chinese government.

Answer: If the Chinese government decides to use its holdings of U.S. Treasury bonds to buy eurodenominated assets, the value of the dollar would probably decrease, although the amount of the size of this potential effect is a matter of debate. This is because the Chinese government holds a large amount of U.S. government bonds. In addition, it would result in an appreciation of the euro, thereby hurting European exporters. The threat of conducting this trade has been used by the Chinese government to defend itself from the pressure received from the United States and other countries’ governments to change its currency policy.

D. For Information About Policy and Practice: Will the Euro Survive?

Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/graph/?id=ESPULCTOTQPNMEI. Click “Edit Graph” and select years 2000 to the latest data available. Here you can find data about unit labor costs in Spain, and note that because Spain cannot devalue its currency (it is a member of the euro zone), the way around that “straitjacket” is “internal” devaluation, which amounts to a significant decrease in unit labor costs.

Related Article Bergsten, C. Fred, “Why the Euro Will Survive: Completing the Continent’s Half-Built House”: http://www.iie.com/publications/papers/paper.cfm?ResearchID=2202. This article analyses the question of whether the euro will survive or not and concludes that it will most probably leave this crisis behind greatly strengthened. Note the use of the terms “internal devaluation” on the last subtitle “Restoring Growth in Euroland.”

Discussion Question Why do you think that Eurozone member countries that suffered from their inability to set their own monetary policy did not simply exit the Eurozone and came back to using their own currency?

.

Chapter 17

Exchange Rates and International Economic Policy

203

Answer: Although it was clear that the inability to set their own monetary policy did not help countries that were in trouble during the recent crisis in Europe, it is also important to note that the establishment of the euro represents much more than a monetary union. It also represents a more comprehensive integration process that has greatly benefited Europe as a whole. It is that sense of integration that European countries want to preserve, in particular because it has helped many nations to thrive since the inception of the euro.

Therefore, exiting the euro means abandoning much more than a monetary union or a system of fixed exchange rates like the Bretton Woods system.

E. For Information About Policy and Practice: The Collapse of the Argentine Currency Board Data Source The University of British Columbia (Pacific Exchange Rate Service): http://fx.sauder.ubc.ca/data.html.

Use this application to access data about the Argentine peso/U.S. dollar exchange rate (select “Argentine peso” as target currency and then select 2000 to 2002 for the data range).

Related Article BBC News (12/23/2001), “Argentina Default Impact Limited”: http://news.bbc.co.uk/2/hi/business/1726265.stm. This article summarizes the effects of the announcements about the Argentinean default. Note the expected effects on its currency, expressed in the third paragraph: “currency uncertainty.”

Discussion Question Which are the main consequences on monetary policy flexibility of establishing a currency board?

Answer: By definition, when a country establishes a currency board, it forgoes its ability to conduct independent monetary policy. This is precisely what happened to Argentina: After the Mexican peso crisis, Argentine authorities could not make use of monetary policy to mitigate the effects of the economic crisis that followed. As usual with the establishment of currency boards, there were positive consequences: The decrease and subsequent control of inflation. However, the lack of flexibility in the conduct of monetary policy can have disastrous consequences for the economy, which is precisely the lesson Argentina learned in 2001.

F. For Information About Application: The Foreign Exchange Crisis of September 1992 Data Source The University of British Columbia (Pacific Exchange Rate Service): http://fx.sauder.ubc.ca/data.html.

Use this application to access data about the British pound/German mark exchange rate (select “British pound” as base currency and “German mark” as target currency and then select 1992 to 1993 for the data range). Check what happened to that exchange rate in the aftermath of Wednesday, September 16, 1992.

Related Article The New York Times, “When Soros Decided to ‘Go for the Jugular’: http://dealbook.nytimes.com/2010/06/04/when-soros-decided-to-go-for-the-jugular/?_r=0. This article references the book “More Money Than God: Hedge Funds and the Making of a New Elite,” in which Soros’ role in the events of the September 1992 crisis are detailed.

Discussion Question In light of the events of September 1992, what do you think the most important peril of engaging in a system of fixed exchange rates when cooperation among countries is difficult to achieve is?

.

204

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Answer: The events of September 1992 clearly illustrated the idea that a system of fixed exchange rates can have serious shortcomings. Germany’s unwillingness to lower interest rates was a crucial event in launching the speculative attack against the British pound and other European currencies. The possibility of a speculative attack is certainly the most important shortcoming of a system of fixed exchange rates. In addition, note that these events played no small part in determining that the United Kingdom will not participate in the euro experiment in 2001.

G. For Information About Application: Foreign Exchange Crises in Emerging Market Countries: Mexico 1994; East Asia 1997; Brazil 1999 and Argentina 2002 Data Source The University of British Columbia (Pacific Exchange Rate Service): http://fx.sauder.ubc.ca/data.html.

Use this application to access data about the Mexican peso/U.S. dollar exchange rate (select “Mexican pesos” as target currency and then select 1994 to 1995 for the data range). Note the evolution of the exchange rate beginning in December 19, 1994.

Related Article Mishkin, Frederic S., “Lessons from the Tequila Crisis”: http://www.bates.edu/PREBUILT/10LatinAMishkin.pdf. In this paper, the author of the textbook identifies the most important differences between financial crises in emerging and industrialized countries and draws conclusions about how to deal with financial crises in emerging market economies.

Discussion Question Suppose that in 2001 you bought an apartment in Buenos Aires, Argentina, valued at $100,000 Argentinean pesos. For that purpose, you took a mortgage loan for $80,000 U.S. dollars. What do you think happened to the value of your loan in Argentinean pesos after the Argentinean peso was devalued by more than 50 percent on January 2002?

Answer: In 2001, the exchange rate between the Argentinean peso and the U.S. dollar was 1. This meant that the value of your loan was $80,000 Argentinean pesos in 2001. In 2002, the value of the Argentinean peso dropped, and by May 2002 you needed 3 Argentinean pesos to buy 1 U.S. dollar, which means that the value of your loan in Argentinean pesos tripled, and you now needed $240,000 Argentinean pesos to settle your debt. This simple example illustrates what happened to many Argentineans, Brazilians, and Mexicans after the value of their currencies dropped because it is common for banks to make long-term loans only in foreign currency, like the U.S. dollar.

.

Chapter 18 Consumption and Saving ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline The Relationship Between Consumption and Saving Intertemporal Choice and Consumption The Intertemporal Budget Constraint The Intertemporal Budget Constraint in Terms of Present Discounted Value Preferences Optimization The Intertemporal Choice Model in Practice: Income and Wealth Response of Consumption to Income Response of Consumption to Wealth Consumption Smoothing The Intertemporal Choice Model in Practice: Interest Rates Interest Rates and the Intertemporal Budget Line The Optimal Level of Consumption and the Intertemporal Budget Line Borrowing Constraints The Keynesian Theory of Consumption The Keynesian Consumption Function: Building Blocks Keynesian Consumption Function The Relationship of the Keynesian Consumption Function to Intertemporal Choice The Permanent Income Hypothesis The Permanent Income Consumption Function Application: Consumer Confidence and the Business Cycle Relationship of the Permanent Income Hypothesis and Intertemporal Choice Macroeconomics in the News: The Consumer Confidence and Consumer Sentiment Indices Policy and Practice: The 2008 Tax Rebate The Life-Cycle Hypothesis Life-Cycle Consumption Function Saving and Wealth Over the Life Cycle Application: Housing, the Stock Market, and the Collapse of Consumption in 2008 and 2009

.

206

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Two Modifications of the Theory: The Random Walk Hypothesis and Behavioral Economics The Random Walk Hypothesis Behavioral Economics and Consumption Policy and Practice: Behavioral Policies to Increase Saving Chapter 18 Web Appendix: Income and Substitution Effects: A Graphical Analysis

Chapter Overview and Teaching Tips This chapter begins Part Seven of the book, which focuses on the microeconomic foundations of microeconomics. Those instructors who want to stress a microeconomic approach to macroeconomics may want to teach this chapter before Chapter 4. Other instructors may want to treat consumption and saving as a special topic and so would prefer to teach it later in the course. Other instructors might not have time to teach this material, and since the chapter is self-contained, can skip it without loss of continuity. The following chapters in this part of the book, Chapters 19 and 20, can be treated similarly: They can be taught before Chapter 4 or can be treated as special topics and taught later. The bottom line is that all the chapters in Part Seven of the book can be used completely flexibly depending on the instructor’s preferences.

Chapter 18 lays out the theory of consumption and saving. It is first important to let students know that consumption and saving are just two sides of the same coin, so a theory of consumption is a theory of saving, and vice versa. The chapter then begins its analysis of consumption theory with the workhorse model in this literature, the intertemporal choice model, first laid out by the great American economist Irving Fisher. It looks at the decisions to consume today versus tomorrow with a standard microeconomic framework of a budget line (in this case, an intertemporal one) and indifference curves. The development of this theory is done with a similar step-by-step approach used in principles of economics or microeconomics textbooks. The intertemporal budget line and indifference curve are explained in detail, the concept of equilibrium where the intertemporal budget line is tangent to the indifference curve is carefully developed, and then the model is put through its paces by asking what happens when there are changes in income, wealth, or interest rates. The chapter also clearly lays out the argument for consumption smoothing and what happens when consumers are subject to borrowing constraints.

The chapter then goes on to discuss the three basic theories of consumption: the Keynesian consumption function, the permanent income hypothesis, and the life-cycle hypothesis. One key feature of the treatment in this text, which is typically not always present in others, is that it shows how all three theories are related to the basic intertemporal choice model, thereby showing the relationships between them. One Application that should interest students given their natural interests in what went wrong during the recent financial crisis is “Housing, the Stock Market, and the Collapse of Consumption in 2008 and 2009.”

The chapter ends with two recent modifications of consumption theory: the random walk hypothesis, which indicates that changes in consumption should be unpredictable, and behavioral economics modifications of consumption analysis, which brings psychological factors into the theory. The behavioral economics approach has resulted in some new policies from the Obama administration to stimulate saving, and these are discussed in the Policy and Practice case, “Behavioral Policies to Increase Saving.”

The chapter has a Web Appendix that provides a detailed graphical analysis of the income and substitution effects in the intertemporal choice model. The body of the chapter does discuss the intuition behind these two effects, but for instructors who would like to go into the analysis behind them more deeply, the Web Appendix allows them to do so.

.

Chapter 18

◼

Consumption and Saving

207

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions The Relationship Between Consumption and Savings 1. Letting S represent private saving, C consumption expenditure, and Y disposable income, it is true that Y = C + S. Because of this, a theory that explains what determines consumption expenditure will also explain what determines private saving, and vice versa.

Intertemporal Choice and Consumption 2. The intertemporal budget constraint is based on the idea that a person’s lifetime consumption depends on (is constrained by) his or her lifetime resources. Borrowing allows people to increase their current consumption at the expense of future consumption, and saving rewards them for foregoing current consumption by making possible greater future consumption. The diagrammatic form of the intertemporal budget constraint rests on several assumptions made by Irving Fisher: There are only two time periods, current and future income and wealth are given, the real interest rate is given, and consumers leave none of their lifetime resources to heirs. The slope of the intertemporal budget constraint is –(1 + r), which is the amount of future (period 2) consumption that is sacrificed for each dollar of current (period 1) consumption. In other words, it is the opportunity cost of period 1 consumption because each dollar borrowed in period 1 means that $1(1 + r) must be repaid out of period 2 income (and hence reduces the income available for period 2 consumption) and each dollar of period 1 income would have provided $1(1 + r) of period 2 consumption if it had been saved rather consumed in period 1.

3. Indifference curves show various combinations of current (period 1) and future (period 2) consumption among which consumers are indifferent (that is, they have no preference for any one combination over the others) because the combinations all provide the same level of satisfaction (or happiness or utility). Indifference curves slope downward because consumers will be indifferent between two combinations of current and future consumption only if the combination that contains less consumption in period 1 also has more consumption in period 2. Indifference curves are convex because consumers tend to prefer stable consumption across time periods to fluctuations in consumption over time, so it is always possible to find an average of two combinations lying on the same indifference curve that consumers actually prefer to either of the two combinations. The only way this average can lie on a higher indifference curve, and thus give consumers a higher level of satisfaction, is if the indifference curves are convex.

4. The consumer wishes to choose the combination of current and future consumption that will yield the highest level of satisfaction possible. The intertemporal budget constraint mandates that a consumer’s current and future consumption lie on the intertemporal budget line. Given this constraint, the highest indifference curve the consumer can achieve is the one that is just tangent to the intertemporal budget line. This point of tangency determines how the consumer’s lifetime resources will be divided between current and future consumption.

The Intertemporal Choice Model in Practice: Income and Wealth 5. Increases in current income, future income, and wealth all shift the intertemporal budget line (IBL) to the right. As a result, current and future consumption both increase. This outcome reflects consumers’ ability to borrow or save in period 1 and their preference for consumption smoothing; that is, for more rather than less stable consumption over time. Decreases in current or future income or wealth shift the IBL to the left, causing consumption to fall in both time periods.

.

208

Mishkin • Macroeconomics: Policy and Practice, Second Edition

The Intertemporal Choice Model in Practice: Interest Rates 6. Increases in the real interest rate make the IBL pivot around the “no borrowing or lending point” at which current consumption equals current income plus wealth. If the real interest rate rises, the IBL becomes steeper (pivots clockwise) to reflect the higher opportunity cost of current consumption and the higher maximum future consumption that results from higher interest earnings possible on period 1 saving. The impact this has on current and future consumption can be broken into two parts, the substitution effect and the income effect. According to the substitution effect, because the higher real interest rate increases the reward for saving in period 1, a consumer will save more in period 1, shifting more of his or her consumption to period 2. However, according to the income effect, the higher real interest rate increases available resources in period 2 and, therefore, may increase consumption in both time periods. The substitution effect is considered to be more important than the income effect, meaning that current consumption will fall (and current saving rise) and future consumption will rise when the real interest rate rises. A decline in the real interest rate would produce the opposite changes.

7. Consumers face a binding borrowing constraint if they prefer to consume more than their income in period 1 but are unable to borrow to do so. This prevents them from achieving the optimal balance between their current and future consumption. The IBL for these consumers is kinked and becomes a vertical line at their period 1 income. These consumers cannot reach as high an indifference curve nor attain as high a level of satisfaction as they could if they were able to borrow and increase their current consumption. Binding borrowing constraints thus make consumers’ period 1 consumption lower and period 2 consumption higher than they otherwise would be.

The Keynesian Theory of Consumption 8. Keynes’s consumption theory is based on the notions that as disposable income rises, consumer spending also rises, but by a smaller amount, and that consumers spend a smaller proportion and save a larger proportion of their income as income rises. Keynes assumed that the marginal propensity to consume, the increase in consumption expenditure that resulted from a $1 change in disposable income, was a fraction between 0 and 1. Keynes’s consumption theory rather simplistically assumes that consumption depends only on current income, implying that all consumers face binding borrowing constraints.

The Permanent Income Hypothesis 9. Milton Friedman’s permanent income hypothesis divides income into two components, permanent income that a consumer expects to persist over time (and therefore reflects his or her lifetime resources) and transitory income that fluctuates over time. The permanent income hypothesis assumes that consumption is a constant proportion of permanent income. An increase in permanent income increases consumption in all time periods, while an increase in transitory income has very little impact on consumption in the time period it occurs, largely affecting saving instead.

The Life-Cycle Hypothesis 10. The life-cycle hypothesis assumes that people smooth their consumption over their entire lifetime, saving some of their income during their working lives to finance their consumption during retirement. Their lifetime resources consist of earned income and wealth that accumulates as people save during their working years and then diminishes as they consume their wealth during retirement.

Changes in consumption result from changes in income and wealth, and older people have a higher marginal propensity to consume out of wealth and a lower marginal propensity to consume out of income than younger people do.

.

Chapter 18

Consumption and Saving

209

Two Modifications of the Theory: The Random Walk Hypothesis and Behavioral Economics 11. The random walk hypothesis posits that consumers are forward looking and base their consumption decisions on their current expectations about future income and lifetime resources. Changes in consumers’ expectations are unpredictable in that they occur when unanticipated new information becomes available, so changes in consumption are unpredictable and follow a random walk. In particular, changes in consumption will be difficult to engineer through changes in taxes. Behavioral economics suggests that the pull of instant gratification causes consumers to give inappropriate weight to future consumption and instead to put greater stress on current consumption, resulting in a suboptimal allocation of their lifetime resources that is tilted too much toward current consumption at the expense of future consumption.

Answers to Problems Intertemporal Choice and Consumption If Prakash decides to consume nothing in period 2 (C2 = 0), then C1 = $5,000 + $30,000 + $35,000/(1.05) = $68,333.34. When Prakash decides to consume only in period 2 (i.e., when C1 = 0), then C2 = (1.05) ($5,000 + $30,000 – 0) + $35,000 = $71,750. Thus the intertemporal budget line intersects the horizontal axis at C1 = $68,333.34 and the vertical axis at C2 = $71,750. b. C1 = $35,000 when Prakash decides to have no savings at the end of period 1. C2 is therefore $35,000.

1. a.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

210

2. a.

b. Maria’s indifference curves are straight lines (note that these are indifference curves, not intertemporal budget lines). Maria’s indifference curves are straight lines because this is the only way the average of two consumption points can be on the same indifference curve as both points.

The marginal rate of substitution is constant: As consumption in the next period decreases, the marginal rate of substitution (i.e., the negative of the slope of the indifference curve) does not change.

The Intertemporal Choice Model in Practice: Income and Wealth 3. An increase in future income shifts the intertemporal budget line to the right. If next period’s income increases by $3,000, the intertemporal budget line shifts to the right by the present value of $3,000, which equals $2,857.14 = $3,000/(1.05).

.

Chapter 18

4. a.

Consumption and Saving

211

When the home is valued at $250,000 the intertemporal budget line is represented by IBL1, and therefore, the optimum consumption point is point A, at which C1 = $55,000 and C2 = $50,000.

This is the point at which the MRS equals the slope of IBL1. The highest indifference curve this individual can attain is IC2. Although point C is on the same IBL1, it is not the optimum, as this individual can reach a higher indifference curve (IC2 instead of IC1). b. When the home is valued at $200,000 the intertemporal budget line is represented by IBL2, and therefore, the optimum consumption point is point B, where C1 = $45,000 and C2 = $35,000. This is the points at which the MRS equals the slope of IBL2. The highest indifference curve this individual can attain now is IC1. As a result of the decrease in the home value, consumption decreases in both periods, and the individual can only reach a lower level of utility (i.e., happiness or satisfaction) than before.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

212

The Intertemporal Choice Model in Practice: Interest Rates 5.

A decrease in the interest rate rotates the intertemporal budget line counterclockwise. The new intertemporal budget line shares the point at which the individual has no savings at the end of period 1 (i.e., when the individual consumes exactly the value of his or her wealth and period 1 income). As a result, consumption in period 2 unambiguously decreases. The substitution effect increases consumption in period 1 because consumption in period 2 is now more expensive (C2/(1 + r) has increased). Alternatively, you can think that incentives to save have decreased because the interest rate earned on savings is now smaller. The income effect decreases consumption in period 1, as the lower interest rate decreases available resources for period 2 and therefore reduces consumption in both periods, but it is smaller than the substitution effect, so consumption in period 1 increases when the two effects are combined.

The Keynesian Theory of Consumption 6. a.

.

Chapter 18

Consumption and Saving

213

b. Nicole’s average propensity to consume is $23,750/$5,000 = 4.75 when she is 15 years old (and her income is $5,000). Similar calculations indicate that her average propensity to consume is 1.32 and 1.03 when her income is $35,000 and $70,000, respectively.

7. According to the Keynesian consumption function, a rich country should have a lower average propensity to consume than a poorer country does because the rich country has a higher income.

Poorer countries would spend a higher percentage of their income on necessities, as opposed to saving (which is a luxury). The United States is a typical example of a rich country (high income) with low saving, but not the only one. There is no definite answer to this situation provided by the Keynesian consumption function. It is possible that the average propensity to consume does not decrease or even that autonomous consumption expenditure keeps rising every period.

The Life-Cycle Hypothesis 8. Pensions and other types of supplemental income during retirement play a significant role for many individuals. According to the life-cycle hypothesis, an unexpected decline in this type of income will catch individuals with lower savings than desired. Individuals who relied on supplemental income saved less prior to their retirement. As a consequence, they will have to consume their accumulated wealth at a slower rate. This decreases their consumption possibilities during their retirement years.

Two Modifications of the Theory: The Random Walk Hypothesis and Behavioral Economics 9. a.

If taxes increase by less than expected, individuals’ disposable income will be higher than expected, which will result in higher current consumption. According to the random walk hypothesis, current consumption will increase, even if taxes have increased because individuals were already expecting a decrease in their disposable income. b. Graduation from college is a fairly expected event and should not affect your consumption plans.

According to the random walk hypothesis, this event should have already been incorporated to your decision-making process and will not affect current consumption (i.e., this is not unexpected information that affects your current consumption). c. A stock market crash is almost by definition unpredictable (an application of the concept of rational expectations to the behavior of stock market investors yields this result). Because this constitutes new information, it will unexpectedly decrease a household’s wealth and result in a decrease in current consumption.

10. The application of behavioral economics ideas to consumption behavior concludes that measures like the creation of IRAs would not have a significant effect on individuals’ consumption (and therefore savings) decisions. Instruments like IRAs encourage savings by protecting contributions to a savings plan from taxes. However, such instruments do not solve the problem that people usually seek immediate gratification and, therefore, will probably not save enough, even if they have a tax advantage. Not surprisingly, the introduction of such measures did not change the U.S. savings rate by much in the last decades.

◼

Answers to Data Analysis Problems

1. a.

For 2011 and 2012, the real interest rate is 0.56 percent and –0.48 percent, averaging 0.04 percent. Consumption (in $billions) is $10,291.3 and $10,517.6, respectively. b. The present discounted value of the most recent year of consumption in 2012 is $10,517.6/(1 + 0.0004) = $10,513.4. c. 2011 consumption is worth $10,291.3 × (1 + 0.0004) = $10,295.4 in 2012.

.

214

Mishkin • Macroeconomics: Policy and Practice, Second Edition

2. See table below. For the periods of 2011:Q3 to 2012:Q2 and 2012:Q3 to 2013:Q2, it does not support Keynes’ third conjecture. Disposable income on average rose slightly over that period of time, by about 2.9 percent between the two four quarter periods. However, the average of the APC was essentially constant (increased ever so slightly). The behavior of the APS seems to reinforce this, as the average propensity to save declined slightly as income rose over the two periods. Keynes’ third conjecture predicted that the APC should decline and the APS increase with higher disposable income, which doesn’t appear to be the case in the data here.

Average Average Average DPI, APC APS $Bil. 2012:Q3 to 2013:Q2 0.917 0.0500 12,351.9 2011:Q3 to 2012:Q2 0.912 0.0541 12,001.1 3. a. See table below. b. The population went slightly “younger” from the 1980s to the 1990s, suggesting under the lifecycle hypothesis that the MPC out of permanent income should increase over that time. In the 1990s onward, those 55 years and older became an increasingly larger fraction of the whole population, as a result, the MPC out of permanent income on average should decrease. c. In the 1980s, the population was much younger; thus, a sharp decline in wealth would overall affect consumption less because there is a relatively small amount of older people who would be consuming out of wealth. Today, older people make up a substantially larger fraction of the overall population, so an equal decline in net wealth would impact consumption more as more older people rely on wealth as a source of consumption.

Average, 55+ Population Ratio 1980s 27.4 1990s 26.4 2000s 28.7 2010:Q1 to 2013:Q2 32.3 4. Yes, they behave as expected. From 2011:Q4 to 2012:Q4, the consumer sentiment index increased by 79.4 – 64.8 = 14.6. Over the same time, consumption grew to $10,584.8 billion, from $10,373.1 billion, a 2.04 percent increase. Because consumer confidence increased, this should reflect households’ expectation of higher permanent income. Thus, higher consumer confidence appears strongly linked to higher consumption from an increase in permanent income.

◼ Answers to Review Questions and Problems in Web Appendix, “Income and Substitution Effects: A Graphical Analysis” 1. The substitution effect refers to how an individual’s consumption in periods 1 and 2 would respond to a change in the relative price of consumption in each time period, holding his or her wealth and income in each period constant. This relative price is given by the slope of the intertemporal budget line, 1 + r. When the relative price of consumption in each time period changes, the slope of the intertemporal budget line changes. This is depicted graphically by a steepening of the line if the interest rate rises and consumption in period 2 becomes cheaper relative to consumption in period 1, or a flattening of the line, for a decrease in the interest rate, that pivots it around the individual’s initial optimization point.

2. The income effect is an individual’s response to a change in his or her income when the relative price of consumption is held constant. Because this relative price is held constant, the slope of the

.

Chapter 18

Consumption and Saving

215

intertemporal budget line does not change; instead, the line shifts out to the right if income increases and in to the left if income decreases.

3. According to the substitution effect, because the higher real interest rate increases the reward for saving in period 1, Carmencita will save more in period 1, reducing her consumption in period 1 and increasing her consumption in period 2. According to the income effect, the higher real interest rate increases her available resources in period 2 and, therefore, may increase her consumption in both time periods. The substitution effect generally is considered to outweigh the income effect, suggesting that Carmencita’s current consumption will fall (and current saving rise) and her future consumption will rise when the real interest rate rises.

4. As shown in the graph, an increase in the interest rates shifts the intertemporal budget clockwise, from IBL1 to IBL2 (this shifts is represented by the green arrow). In this case, the income effect is assumed to be larger than the substitution effect, and therefore, the consequence of an increase in the interest rate on present consumption is an increase from C1A to C1B . The substitution effect can be measured for both present and future consumption as the change from point A to point C. The income effect is represented by the change from point C to point B. Note: “new” curves are shown in red in the graph below.

.

216

Mishkin • Macroeconomics: Policy and Practice, Second Edition

5. a. When the interest rate decreases, the intertemporal budget line pivots counterclockwise, from IBL1 to IBL2. Note that both IBL lines share one point (the point at which the individual saves nothing after period 1). b. If the income effect is smaller than the substitution effect, present consumption increases, as noted in the graph (point B). The substitution effect results from the fact that future consumption becomes relatively more expensive, and therefore present consumption increases. The income effect decreases lifetime resources and present and future consumption both decrease. Because we are assuming that the substitution effect prevails, present consumption increases.

.

Chapter 18

Consumption and Saving

6. a.

217

The change in the intertemporal budget line from IBL1 to IBL2 is the result of a decrease in the interest rate, as the intertemporal budget line has a slope equal to: – (1 + r). b. The substitution effect on present consumption derived from the decrease in the interest rate is $150 (calculated as the difference between $500 and $650). The decrease in the interest rate makes future consumption relatively more expensive, and the individual increases his or her present consumption. This is obtained by applying the new slope of the intertemporal budget line to the original indifference curve IC1 (represented as point B in the graph). There is also an income effect, as the decrease in the interest rate decreases the value of lifetime resources.

According to the graph, the income effect on present consumption is the change from $650 to $700 (or $50). Present consumption increases by $200, and the larger effect is the substitution effect.

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: Consumer Confidence and the Business Cycle Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/UMCSENT. Here you can find data about the University of Michigan consumer sentiment index.

Related Article Bloomberg, “Consumer Confidence in U.S. Plunges to Lowest Since 2009 on Jobs Outlook”: http://www.bloomberg.com/news/2011-08-30/u-s-consumer-confidence-drops-to-lowest-since-09as-index-slumps-to-44-5.html. This article details the drop in consumer sentiment that occurred in fall 2011.

Discussion Question Determine the effect on consumer confidence, and therefore on autonomous consumption, of news that indicates a deterioration of economic conditions in the future.

.

218

Mishkin • Macroeconomics: Policy and Practice, Second Edition

Answer: News that pictures a gloomy future will most probably decrease consumer confidence or consumer sentiment, thereby decreasing autonomous consumption. Note that sometimes this could be a self-fulfilling prophecy: Expectations of a dim future can actually (by depressing aggregate demand) turn those expectations into reality.

B. For Information About Policy and Practice: The 2008 Tax Rebate Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/PSAVERT?cid=112. Here you can find data and a graph about the personal savings rate (as a percentage of disposable income). You can edit the graph to see the values of this variable for 2008 only, as in the Policy and Practice case.

Related Article Feldstein, Martin, “The Tax Rebate Was a Flop: Obama’s Stimulus Plan Won’t Work Either”: http://www.nber.org/feldstein/wsj080708.pdf. This article argues that the 2008 tax rebate did not have the expected effects on aggregate demand.

Discussion Question Suppose that a tax rebate originally intended to be transitory becomes permanent (i.e., Congress keeps extending the duration of the tax rebate). What would be the consequences on consumption according to the permanent income hypothesis?

Answer: Originally, while individuals consider the tax rebate to be transitory, there should be no significant change in consumption; most of the tax rebate will be saved and spent over many years.

However, if at some point individuals realize that year after year their taxes are set at a lower level, then they will interpret this as a permanent tax rebate, which increases their disposable income. As disposable income increases permanently, the permanent income hypothesis suggests that consumption will increase.

C. For Information About Application: Housing, the Stock Market, and the Collapse of Consumption in 2008 and 2009 Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/graph/?id=PCE. Here you can find monthly data on personal consumption expenditures (in billions of dollars). Set the observation date range to 2006–2010 to see the decrease in consumption referenced by the Application.

Related Article Mishkin, Frederic, “Housing and the Monetary Transmission Mechanism”: http://www.kansascityfed.org/Publicat/Sympos/2007/PDF/Mishkin_0415.pdf. Check pages 9–17 (367–375 of the PDF file) for a survey on the marginal propensity to consume out of wealth.

Discussion Question Why did the decline in stock prices have a significant effect on consumer’s wealth? After all, many people own their houses, but not many own stocks. Explain.

Answer: It is true that many people own their houses, but it also true that many people own stocks, albeit not directly. A lot of retirement funds are used to buy stocks. Although usually pension funds and mutual funds are very careful at selecting the proper mix of bonds (with relatively low risk and return) and stock (with relatively high risk and return) for their asset portfolio, it is not uncommon for these financial institutions to lose a lot of money during a financial crisis. The drastic drop in stock prices meant that

.

Chapter 18

Consumption and Saving

219

future retirees saw their balance to decrease, painting a bleak picture for their retirement years (many decided not to retire for a few years more).

D. For Information About Policy and Practice: Behavioral Policies to Increase Saving Data Source The White House, “Helping Workers Save for a Secure Retirement”: http://www.whitehouse.gov/blog/2010/02/11/helping-workers-save-a-secure-retirement. Here you can read about the White House efforts to help workers save for retirement, as mentioned in the Policy and Practice case.

Related Articles Choi, James J. et al., “Defined Contribution Pensions: Plan Rules, Participant Decisions, and the Path of Least Resistance”: http://www.nber.org/papers/w8655. This article tests some of the implications of behavioral economics: Employees often follow the path of least resistance (which presents the opportunity to manipulate that path to change decisions).

Discussion Question The idea of libertarian paternalism is the center of an intense debate. Its critics argue that precisely because people tend to follow the path of least resistance, one can induce them to enroll in retirement plans. Do you think the same argument can be made about primary education? Are the long-term consequences of a more educated population and a population that saved more comparable?

Answer: Compulsory primary (and secondary in most countries) education can be understood from the point of view of libertarian paternalism. The society as a whole (through governments) obligates children to attend school up until some age, in which they can make the decision to keep attending school or not (i.e., go to a tertiary education institution). Both elements are present: the choice to not continue one’s education (liberty) and the compulsory attendance of the first years (paternalism). The consequences of a more educated population are very similar to those of a population that saved more for retirement. A more educated population benefits the whole society as well as the individual. An individual who saved more is better off in his later years and while he or she saved more, he or she contributed (assuming an efficient financial system) to the long-term growth of the society by providing funds to long-term investment.

.

Chapter 19 Investment ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Data on Investment Spending The Neoclassical Theory of Investment Determining the Level of Capital Stock User Cost of Capital Determining the Desired Level of Capital From the Desired Level of Capital to Investment Changes in the Desired Level of Capital Stock Summary: Neoclassical Theory of Investment Inventory Investment Motivation for Holding Inventories The Theory of Inventory Investment Tobin’s q and Investment Tobin’s q Theory Tobin’s q Versus Neoclassical Theory Application: Stock Market Crashes and Recessions Residential Investment Policy and Practice: U.S. Government Policies and the Housing Market Chapter 19 Web Appendix: A Model of Housing Prices and Residential Investment Determination of Housing Prices From House Prices to Residential Investment Changes in the Demand for Housing Summary: Residential Investment Application: Boom and Bust in the Housing Market, 2001-2009

Chapter Overview and Teaching Tips This chapter continues the discussion of the microeconomic foundations by developing two basic models of investment: the neoclassical theory and Tobin’s q theory. It starts by describing some of the basic data on investment spending and then develops the neoclassical theory of investment, which shows that investment is determined by interest rates, tax policy, and expected returns on investment. The development of this theory proceeds step by step, with first, the desired level of the capital stock derived from equating the

.

Chapter 19

Investment

221

marginal product of capital to the rental cost of capital; second, the rental cost of capital is linked to the concept of the user cost of capital; and third, showing how the desired level of capital determines investment.

The factors that change the desired level of the capital stock, and hence investment, are then laid out, and the overall neoclassical model is summarized with Table 19.1, which shows how each factor causes the desired level of capital and investment to change. This summary table can be used to give students practice in class by writing down each change in a factor and then asking students to fill in the table by drawing the diagrams and showing how investment responds in each case.

The theory of inventory investment is then described briefly because it is just a variant of the neoclassical theory, and then the chapter develops Tobin’s q theory. It is important to get across to students that Tobin’s q theory is completely consistent with neoclassical theory but emphasizes the impact of asset prices on investment. An example of how asset prices can play an important role in investment fluctuations is discussed in the Application, “Stock Market Crashes and Recessions.” This Application also links the analysis on investment in this chapter to the aggregate demand and supply analysis in earlier chapters by using AD/AS analysis to show how stock market crashes can help promote contractions in economy activity and recessions. The final section of the chapter provides a brief discussion of residential housing investment using the neoclassical framework. It includes a Policy and Practice case, “U.S. Government Policies and the Housing Market,” which is fun to discuss in class because these policies have become very controversial in the wake of the bust in the housing market.

Student interest given the recent housing boom and bust is so high that teaching a more complete model that discusses the determination of housing prices and investment can be very interesting. The more extensive model is described in an online appendix that can be found on the Companion Website at www.pearsonhighered.com/mishkin. The model on the Website is a combination of the neoclassical model and Tobin’s q theory, so teaching it also has the advantage of giving students more practice with both theories. It proceeds step by step, with the neoclassical model being used to show how housing prices are determined and then Tobin’s q theory showing how higher house prices translate into increased residential housing construction. The factors that change housing prices and hence investment are then discussed and summarized with Table 19.A1.1, which shows how each factor causes housing prices and residential investment to change. Again, this summary table can be used to give students practice in class by writing down each change in a factor and then asking them to fill in the table by drawing the diagrams and showing how housing prices and residential investment responds in each case.

Given recent events in the housing market, the Application in this online appendix, “Boom and Bust in the Housing Market: 2001–2009,” not only gives student practice with the theory of residential investment, but also shows how useful this model is in explaining recent events.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Data on Investment Spending 1. The three components of investment spending are business fixed investment, which includes spending by business firms on equipment, software, and buildings; residential investment, which is spending on new housing; and inventory investment, changes in the value of inventories of raw materials and parts and semi-finished and finished goods held by business firms.

The Neoclassical Theory of Investment 2. The user cost of capital is the expected real cost of using (or renting) a unit of capital over a particular time period. It is determined by the real price of a unit of capital, the real interest rate (which measures the interest cost or opportunity cost of the funds used to purchase the unit of capital), the expected

.

222

Mishkin • Macroeconomics: Policy and Practice, Second Edition

rate of change in the real price of the unit of capital over the rental period, and the depreciation rate (which is the fraction of its value the unit of capital loses due to wear and tear over the rental period).

Increases in the real price of the unit of capital, the real interest rate, and the depreciation rate cause the user cost of capital to rise; an increase in the expected rate of change in the real price of capital causes it to fall.

3. The user cost of capital is fixed by the values of the real price of a unit of capital, the real interest rate, the expected rate of change in the real price of capital, and the depreciation rate. As the capital stock increases, the expected marginal product of capital diminishes. The desired level of capital is the capital stock that equates the expected marginal product of capital and the user cost of capital. If the expected marginal product of capital exceeds the user cost of capital, adding more capital will increase firms’ profits, and they will keep adding capital until the expected marginal product of capital falls to the level of the user cost of capital. If the expected marginal product of capital is below the user cost of capital, firms will get rid of capital until the expected marginal product of capital rises to the level of the user cost. When the expected marginal product of capital equals the user cost of capital, firms’ profits are maximized.

4. Firms compare their desired level of capital with their current capital stock to determine the change in their capital stock that will bring it to the desired level. The net investment spending they must undertake per year depends on how quickly they want to close the gap between the current capital stock and the desired level of capital. To this level of net investment, they add the amount by which their capital stock depreciates each year. The result is the gross investment spending necessary to replace capital that has depreciated and move their capital stock to the desired level over the time span they choose.

5. The expected marginal product of capital changes when expected future income changes. If total factor productivity or employment is expected to rise, expected future income rises, firms’ expected marginal product of capital increases, and the desired levels of capital and investment both go up. When expected future income falls, the desired levels of capital and investment both drop. Increases in the user cost of capital cause the desired levels of capital and investment both to fall, and when the user cost of capital falls, they both rise. When the tax rate on businesses increases, the after-tax expected marginal product of capital goes down, reducing the desired levels of both capital and investment. A lower tax rate on businesses causes the desired levels of both capital and investment to rise.

Inventory Investment 6. Firms hold inventories for several reasons. Inventories of raw materials, components, spare parts, and work in progress are important resources used in the production of goods and services. Holding inventories of finished goods enables firms to maintain stable flows of production even if their sales occur unevenly over time. Otherwise, they would have idle workers and machines when sales are low and then have to scramble to keep up with demand when sales are high. With steady production over time they add to their inventories during periods of low sales and draw them down when sales are high. Firms also hold inventories to avoid stock-outs. Running out of needed materials, parts, and finished goods can be costly if it disrupts the flow of production or causes customers to take their business elsewhere. Macroeconomists are concerned about inventory investment because it is the most volatile component of investment spending and plays an important role in business cycles.

Tobin’s q and Investment 7. Tobin’s q is the ratio of the market value of installed capital to the replacement cost of that capital.

For an individual firm, the market value of installed capital is reckoned as the stock market’s valuation of the firm’s stock. When q is greater than 1, the stock market values the firm more highly than the replacement cost of its capital, giving the firm’s managers incentive to increase the level of capital by increasing net investment. If q is less than 1, the value of new capital to the firm is less than the cost of acquiring it, and the firm’s managers will want to shrink rather than increase the

.

Chapter 19

Investment

223

firm’s level of capital. The managers will choose to invest less than the amount by which the firm’s capital depreciates. As a result, the firm’s net investment will be negative, and its level of capital will decline over time. Tobin’s q theory predicts that investment spending will increase or decrease with similar movements in stock prices because q changes in the same direction as stock prices.

8. The prediction from Tobin’s q theory that investment will increase when stock prices rise is reflected in the neoclassical prediction that investment will increase when expected profits from adding capital rise because higher expected profits lead to rising stock prices that increase the value of q. The neoclassical prediction that investment will fall with a rise in the user cost of capital is consistent with Tobin’s q theory because increases in user cost raise the replacement cost of installed capital and, hence, reduce the value of q.

Residential Investment 9. There are four determinants of residential investment. A rise in mortgage rates raises the user cost of housing and, hence, lowers the desired residential capital stock and residential investment. A rise in expected appreciation of housing leads to a fall in the user cost of housing and, hence, raises the desired level of residential capital and residential investment. A rise in household formation or households’ expected future income raises the marginal product of housing and, hence, raises the desired residential capital stock and residential investment. Tighter financing constraints lead to lower residential investment.

10. The U.S. government has given tax preferences to encourage home ownership by allowing tax deductibility of mortgage interest payments. It has also encouraged home ownership by establishing government agencies such as the FHA and Ginnie Mae, and government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, that help lower mortgage interest rates.

Answers to Problems The Neoclassical Theory of Investment 1. a. User cost for construction equipment = $600,000  (0.05 – 0 + 0.10) = $90,000 b. User cost for computers = $20,000  (0.05 – 0 + 0.35) = $8,000 2.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

224

3. a.

Everything else the same, easing monetary policy implies lower real interest rates, which results in a decrease in the user cost of capital. The decrease in the user cost of capital translates into a higher level of desired capital stock for the next period. b. Everything else the same, an increase in the depreciation rate of capital increases the user cost of capital, thereby decreasing the desired level of capital stock for the next period. c. Everything else the same, an increase in productivity shifts the expected marginal productivity of capital curve to the right, increasing the level of desired capital stock for the next period.

4. The Obama administration announced an investment tax credit as a part of a more comprehensive plan (the American Recovery and Investment Act of 2009) to encourage investment and employment in the United States during the 2007–2009 crisis. An investment tax credit of 30 percent is applied to companies that make equipment for renewable energy systems in general. The goal of such a policy is to decrease the after-tax cost of investment for some U.S. firms and thereby, according to the neoclassical theory of investment, promote higher levels of desired capital stock for future periods.

Empirical evidence, however, suggests that there is a weak link, if any, between fiscal policy and investment spending across countries. The consequence of such a policy, as many measures taken by the U.S. government during that period, was hotly debated.

5. Less-developed financial systems often result in more difficult access to funds for firms that want to increase their capital stock. The relative inefficiency of developing countries’ financial systems usually arises from improperly designed property rights and the prevalence of asymmetric information problems.

Firms usually struggle to borrow in developing countries and often are the victims of credit rationing (i.e., nonprice allocation mechanisms that assign credit based on other characteristics). As a consequence, firms that want to increase their capital stock might not be able to raise funds to do so, and the level of investment falls. In its worse expression, credit rationing can create conditions in which nonproductive investments are financed (e.g., overly expensive residential investment for corrupt government officials) at the expense of productive investments. In conclusion, less-developed financial systems can result not only in a less-than-desired investment level but also in less productive investment.

6. a. New or stricter regulations that ask for tighter controls or enhanced security usually result in more expensive drilling operations. Everything else the same, the user cost of capital increases, as companies have to incur the cost of monitoring their activities and making sure they comply with new standards. b. As a result of the increase in the user cost of capital, we should expect a decrease in the desired stock of capital for the next period(s). Everything else the same, investment should decrease in this industry.

Inventory Investment 7. Private inventories did not change by much during the first quarters of 2007. As the subprime financial crisis affected the economy and firms observed a decline in the demand for their products, production fell and companies decreased their inventories of finished goods and raw materials at a relatively low pace. (Change in inventories was still positive for some time, as firms could not sell their finished goods.) As conditions in the economy worsened (from 2008 to the second quarter of 2009), private inventories decreased further, as firms decreased their raw material orders and stopped production in anticipation of a sharp reduction in the demand for their products. Another reason for the decrease in inventory investment was the credit crunch (i.e., financial intermediaries decreased their lending as a result of deteriorating balance sheets during that period of the crisis). As the economy improved by the second part of 2009, firms increased both production and their raw material orders, stocking more intermediate and finished goods. Note that private inventory fluctuations are much bigger in relative (percentage) size than real GDP fluctuations.

.

Chapter 19

Investment

225

Tobin’s q and Investment 8. The doubling of stock prices raised the market value of firms relative to the replacement cost of installed capital, so Tobin’s q rose. As a result, buying new capital increased the value of firms because the market value was greater than the cost of acquiring it. The increase in profitability of buying new capital would then lead to increased investment.

Residential Investment 9. The recent trend of single-person households can be interpreted as an increase in the demand for housing, as more individuals demand housing. In the short run, the increase in housing demand results in an increase in the price of housing. As time goes by and this becomes a trend, housing supply increases, and the price of housing decreases to its previous levels. Residential investment increases in the short run, as the housing demand faces a relatively inelastic supply curve. In the long run, more residential investment supplies more housing, and its price comes back to its original level.

10. An increase in real interest rates would increase the user cost of residential investment, and so the desired stock of residential housing would fall, leading to a decline in residential investment.

◼

Answers to Data Analysis Problems

1. a.

Inventory investment for 2013:Q2 equals total investment minus business fixed investment minus residential investment, which is $66.65 billion; thus, there was a net increase in inventories for the quarter. b. From 2000:Q1 to 2013:Q2, the average share of inventory investment is 1.22 percent. Although this is fairly small, it is not zero. If inventories are costly to hold, then ceteris paribus you would expect over time that inventory increases would be met with offsetting decreases, and vice versa, so that on average, inventories would be close to zero. However, this is not the case in the data, as the longer term average is somewhat above zero. This indicates that even though inventories may be costly to hold, there are benefits from holding inventories, such as production smoothing and stock-out avoidance.

2. a.

For 2013:Q2, net investment is $594.1 billion, and gross investment is $3,225.2 billion. The two are not equal, as the difference represents the amount of capital depreciation. There is a considerable difference between the two, suggesting a large amount of capital regularly depreciating and in need of replacement. b. Depreciation = $3,225.2 – $594.1 billion = $2,631.1 billion. c. The total size of the capital stock equals depreciation/δ = $2,631.1/0.1 = $26,311 billion, or $26.3 trillion.

3. a.

Between 2012:Q2 and 2013:Q2, the average mortgage rate decreased from 3.80 percent to 3.69 percent; during this same period, residential investment increased from $425.7 billion to $513 billion, an increase of 20.5 percent. This is sensible because lower mortgage rates should decrease the user cost of capital and thereby increase residential investment. b. See scatterplot on the next page. There is a clearly an inverse relationship between the two, as would be expected. As more bankers tightened credit standards in the 2007–2008 period, residential investment growth declined sharply. More recently, there has been a net easing of credit standards from 2012:Q2 to 2013:Q2 (indicated by the negative numbers), and this has translated to significant increases in residential investment growth.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

226

c.

See scatterplot below. The fitted equation is %ΔRI = –0.5424NT + 3.7542, with a reasonably good fit to the data as R2 = 0.71. For every 10 percentage point increase (tightening) of credit standards (NT), residential investment growth (%ΔRI) is predicted to decrease by about 5.4 percentage points.

◼ Answers to Review Questions and Problems in Web Appendix, “A Model of Housing Prices and Residential Investment” 1. At any given time, the existing stock of houses is fixed, and fluctuations in housing prices result from fluctuations in demand. Increases in the demand for housing cause the price of housing to rise relative to the general price level. This increase in the relative price of housing works much like increases in Tobin’s q to stimulate residential investment—the construction of new houses and apartments—because they indicate that the market valuation of new housing has risen relative to the replacement cost, the cost of building new housing. In neoclassical terms, this analysis assumes that the replacement cost of a new house moves in line with the general price level, so that the profit from building houses increases when the relative price of housing increases.

2. The neoclassical theory of investment provides the answers here. In neoclassical theory, the desired level of capital depends on the expected marginal product of capital and the user cost of capital.

When the expected marginal product of housing rises, the demand for housing increases. This occurs when households are willing to pay higher (explicit or implicit) rents because either their expected future income is higher or there is an increase in the number of households that bids up rents. A decline in real mortgage rates and a higher expected appreciation of housing prices also lead to a higher demand for housing because they lower the user cost of capital. Increases in the demand for housing raise the relative price of housing, which in turn increases residential investment.

.

Chapter 19

Investment

227

3.

The positive effect on housing prices and housing starts of low mortgage rates, which would lower the user cost of housing, was offset by concerns that housing prices might keep falling which would raise the user cost of housing. In addition, households’ difficulty in getting mortgages limited the demand for housing, which also helped to depress housing starts and housing prices. The result of these countervailing factors to the low mortgage rates resulted in the housing market continuing to be depressed.

4.

An increase in real interest rates increases the user cost of residential investment and, therefore, decreases the demand for housing. Graphically, the demand curve shifts to the left, and the new equilibrium point determines a lower relative price of housing. In turn, residential investment decreases as the relative price of housing decreases.

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: Stock Market Crashes and Recessions Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/GPDI?cid=112. Here you can find quarterly data on gross domestic private investment. Edit the observation date range to 2006 to 2010 to observe the decline in gross domestic private investment in that period.

Related Article Federal Reserve Bank of Boston, “Lessons for the Future from the Financial Crisis”: http://www.bostonfed.org/news/speeches/rosengren/2009/120309.pdf. In this presentation by Eric S. Rosengren, you can observe the decline in the stock market between 2007 and 2009 and its relationship with the Great Recession. (Check Figure 2 on page 21 and Figure 14 on page 33 for information about stock markets and inflation.).

Discussion Question Suppose that Tobin’s q for a given company is currently less than 1. What would you do if you were Gordon Gekko?

Answer: Gordon Gekko is a fictional character in the movie Wall Street (1987) who exploited profitable opportunities by buying firms in trouble and then selling that company piece by piece. In this scenario, a less than 1 Tobin’s q precisely means that the replacement cost of capital (the sum of all capital owed by the company) exceeds the market value of the firm. If you can decide what to do with all this capital, then you can exploit that profitable opportunity by taking control of the firm (by buying stock) and then selling

.

228

Mishkin • Macroeconomics: Policy and Practice, Second Edition

the firm piece by piece. When Tobin’s q is low, exploiting profitable opportunities means selling existing capital and thereby not investing (i.e., adding to the capital stock).

B. For Information About Policy and Practice: U.S. Government Policies and the Housing Market Data Source Making Home Affordable program: http://www.makinghomeaffordable.gov/. On this Website you can find a lot of information about the Obama administration’s home ownership policy.

Related Article Washington Times, “Cover story: Buying home still American dream” (11/22/2010): http://www.washingtontimes.com/news/2010/jul/22/cover-story-buying-home-still-americandream/?page=1. This article comments on survey data about Americans’ willingness to become home owners despite the recent crisis.

Discussion Questions Besides being part of the “American Dream,” as some claim, what are the other benefits of becoming a homeowner? Are these reasons enough to justify government policies to promote home ownership?

Answer: Although having one’s own home might well be the most important reason individuals choose to become homeowners, there are a few other important consequences of owning a house. Apart from financial gains (e.g., tax benefits and the potential use of a house as collateral), people usually takes better care of their own property than of rented or leased units. This has an effect on the quality of housing. This reasoning applies both to individual houses and neighborhoods. Finally, there might be long-term benefits: Becoming a homeowner decreases the probability of moving; it is also linked to better performance of children at school (and therefore in their lifetime incomes). There is no easy answer to the second question.

One would have to be able to measure the benefits of home ownership (a very difficult task) and weight them against the costs associated with the implementation of government policies to promote ownership (also a very difficult task) to provide a relevant answer.

C. For Information About Application: Boom and Bust in the Housing Market, 2001–2009 Data Source S&P Case/Shiller Housing Price Index: http://us.spindices.com/index-family/real-estate/sp-case-shiller Here you can find the index and year-to-year changes in housing prices in the United States during the 2000s.

Related Article Board of Governors of the Federal Reserve System, “A View from the Federal Reserve Board: The Mortgage Market and Housing Conditions”: http://www.federalreserve.gov/newsevents/speech/duke20130509a.htm. In this speech by Governor Elizabeth A. Duke, you can learn about recent developments in the mortgage market and housing conditions in the United States and the view of the Federal Reserve about its role in the previous crisis.

Discussion Question The Federal Reserve lowered the federal funds rate target to near zero in late 2008 and maintained that target until late 2010. This lowered mortgage rates but did not spur an increase in residential investment.

Using the neoclassical theory of investment, explain why this decrease in mortgage rates did not result in increased residential investment.

.

Chapter 19

Investment

229

Answer: Even if mortgage rates were low during 2008–2010, residential investment did not increase at the rates observed during the early 2000s (when the Fed was blamed for creating the conditions for the housing price bubble). Although lower mortgage rates decreased the user cost of capital, another effect increased the user cost of capital by more than the decrease triggered by lower mortgage rates. This effect can be interpreted as a change in financial constraints: Lending standards were upgraded after the financial crisis of 2007–2009, thereby restricting home mortgages again only to those who qualified. One can conclude that the second effect (i.e., financial constraints) was larger in magnitude than the first effect (lower mortgage rates).

.

Chapter 20 The Labor Market, Employment, and Unemployment ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Developments in the U.S. Labor Market Employment Ratio Unemployment Rate Real Wages Supply and Demand in the Labor Market The Demand Curve for Labor The Supply Curve Equilibrium in the Labor Market Response of Employment and Wages to Changes in Labor Demand and Labor Supply Changes in Labor Demand Changes in Labor Supply Application: Why Has Labor Force Participation of Women Increased?

Application: Why Are Returns to Education and Income Inequity Increasing?

Dynamics of Unemployment Flows Into and Out of Employment Status Duration of Unemployment Causes of Unemployment Frictional Unemployment Policy and Practice: Unemployment Insurance and Unemployment Structural Unemployment Wage Rigidity Policy and Practice: Minimum Wage Laws Natural Rates of Unemployment The Role of the Natural Rate of Unemployment in the AD/AS Model Sources of Changes in the Natural Rate of Unemployment Application: Why Are European Unemployment Rates Generally Much Higher Than U.S. Unemployment Rates?

.

Chapter 20

The Labor Market, Employment, and Unemployment

231

Chapter Overview and Teaching Tips Chapter 20 provides an analysis of the labor market and answers basic questions such as: Why has the labor force participation of women increased so much? Why have the returns to college education risen?

Why has income inequality increased? What explains fluctuations in the natural rate of unemployment, and why is it generally higher in Europe than in the United States?

The chapter starts with a look at the data on labor markets, which is a good way of introducing students to the questions posed above. To answer these questions, the next section develops a supply and demand analysis of the labor market. This analysis is then used to answer three of the questions above in the Applications, “Why Has Labor Force Participation of Women Increased?” and “Why Are Returns to Education and Income Inequality Increasing?” The Application on returns to education is especially relevant to students because it explains why they should study hard and stay in school.

The rest of the chapter focuses on the dynamics and causes of unemployment. It is important to get students to understand how dynamic the labor markets are with large flows into and out of unemployment, with some workers having very long spells of unemployment. Then students should be introduced to the idea that some unemployment is frictional and other is structural, often occurring as a result of wage rigidity.

This helps them see that the natural rate of unemployment, the unemployment rate that remains even when wages have fully adjusted, which can also be described more loosely as the full-employment unemployment rate, is well above zero. The Policy and Practice cases, “Unemployment Insurance and Unemployment,” and “Minimum Wage Laws,” then show students that the natural rate of unemployment is not an immutable constant but is affected by government policies. Changes in the natural rate of unemployment also have an important role in the aggregate demand and aggregate supply framework, and this is also discussed. The Application, “Why Are European Unemployment Rates Generally Much Higher Than U.S. Unemployment Rates?” shows how the analysis can explain differences in the natural rate of unemployment across countries.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Developments in the U.S. Labor Market 1. The employment ratio, the ratio of employment to the civilian working-age population, has risen during the past fifty years. Significantly, the increase in this ratio results solely from a large increase in the employment ratio of females while the employment ratio of males has fallen.

Supply and Demand in the Labor Market 2. Firms’ hiring decisions are made on the basis of profit maximization. Firms compare the marginal product of labor, the benefit of adding new workers, with the real wage rate, the cost of hiring them.

The marginal product of labor is subject to diminishing returns, so as the firms’ labor force increases with the hiring of new workers, the marginal product of labor declines. New workers are added until the marginal product of labor falls to the real wage rate. Workers will not be added beyond this point because the marginal product of labor would fall below the real wage rate and profits would decline.

Based on this reasoning, if real wages increase, the firm will reduce the number of workers it hires (that is, reduce the quantity of labor it demands) until the marginal product of labor rises to the now higher real wage rate, and if the real wage rate falls, the firm can profitably hire more workers until the marginal product of labor falls to the now lower real wage rate.

3. The quantity of labor supplied is positively, not inversely, related to the real wage rate. Workers have two basic choices regarding the allocation of their time—work or leisure (all activities away from their job). An increase in real wages makes work more rewarding and increases the opportunity cost of leisure

.

232

Mishkin • Macroeconomics: Policy and Practice, Second Edition

time, so it is generally thought that higher real wages will induce workers to increase the quantity of labor they supply. Conversely, a decline in the real wage rate renders work less rewarding and makes enjoyment of leisure less costly, so workers will reduce the quantity of labor supplied. The positive slope of the labor supply curve reflects these responses. This explanation focuses on the substitution effect of changes in real wage rates. The income effects would be just the opposite. Earning higher real wages, workers might decide they could afford the luxury of more leisure time; receiving lower real wages, they might be forced to work longer hours to make ends meet. The upward-sloping labor supply curve assumes that the substitution effects of changes in real wage rates outweigh these income effects.

Response of Employment and Wages to Changes in Labor Demand and Labor Supply 4. Negative demand shocks that reduce aggregate demand and lead to lower aggregate output will reduce the marginal product of labor. The resulting leftward shift of the labor demand curve causes the equilibrium level of employment and real wages to fall. Negative supply shocks to production also cause aggregate output to fall and so will have the same labor market effects. Decreases in the supply of labor will shift the labor supply curve to the left. As the labor market adjusts to equilibrium, employment will fall, but real wages will rise.

Dynamics of Unemployment 5. The three categories are employed, unemployed, and not in the labor force. Discouraged workers are workers who were classified as unemployed but became so discouraged at not finding a job that they stopped looking for work. When this occurs they are no longer classified as unemployed. An increase in discouraged workers, then, means more people are moving from the status of unemployed to that of not in the labor force.

Causes of Unemployment 6. Frictional unemployment is the unemployment that results because workers spend time searching for good jobs (however they may define that) and firms likewise spend time searching for good candidates to fill their openings. Only desperate workers or employers would take the first available job or hire the first applicant without searching at least a little longer to see if a better job opportunity or applicant comes along. Workers, firms, and the economy all benefit from better matches between workers and jobs because workers are likely to be more productive and stay longer in jobs for which they are better suited.

7. Structural unemployment refers to the chronic unemployment that arises when job applicants do not possess the skills employers are seeking. This may be because they lack the basic literacy and life skills to perform any job satisfactorily, or it may result from the unemployed have a set of specific job skills that are no longer sought by employers as a result of changes in consumer demand or production methods.

8. Real wage rigidity means that real wages cannot adjust to the level that would equate labor demand and supply. When the demand for labor decreases or the supply of labor increases, real wages do not fall to the new equilibrium real wage rate, so unemployment occurs because the quantity of labor supplied exceeds the quantity demanded at the rigid real wage rate. Minimum wage laws, union monopoly power, and efficiency wages that reflect firms’ desire to pay real wages above the marketclearing level in the belief that this gives their workers incentives to be more productive all cause real wage rigidity because they prevent real wages from falling when there is an excess supply of labor.

Natural Rate of Unemployment 9. The natural rate of unemployment measures the unemployment that exists in the long run because, even when wages have time to adjust to changes in demand and supply in the labor market, frictional and structural unemployment keep the unemployment rate above zero. It is the unemployment rate that is consistent with full employment. The natural rate of unemployment changes as the age composition of the labor force changes. Young workers tend to have higher unemployment rates than

.

Chapter 20

The Labor Market, Employment, and Unemployment

233

older workers do, so the natural rate of unemployment will be higher the larger the percentage of young workers in the total labor force, and it will decline as this percentage falls. Increases in the prison population and relaxation of federal rules that govern eligibility for disability insurance have lowered the natural rate of unemployment by removing people who are more likely to be structurally unemployed from the labor force. Increases in temporary employment have also lowered the natural rate of unemployment by giving people who likely would be frictionally unemployed an opportunity to work as they continue looking for permanent employment.

10. Cyclical unemployment is the difference between the actual unemployment rate and the natural rate of unemployment. Cyclical unemployment accounts for most of the increase in unemployment that occurs during business cycle recessions when the actual unemployment rate can be much higher than the natural rate.

Answers to Problems Supply and Demand in the Labor Market 1. a. and b.

2. When wages change, workers’ decisions as to how many hours to work are affected. In this case, a wage increase will allow Anthony to earn more income and will, therefore, affect Anthony’s decision to allocate his time between work and leisure. As his hourly wage increases, the opportunity cost of leisure also increases, and Anthony will decide to spend less time not working. However, the wage increase also makes Anthony richer and increases his willingness to spend more leisure time (i.e., leisure is a normal good). Depending on the size of the aforementioned effects (substitution and income effects, respectively), Anthony might decide to work more or fewer hours after the wage increase. In this case, these effects offset each other, and Anthony decides to work the same number of hours. Anthony’s labor supply curve would be fixed at 40 hours per week and will not be very responsive to changes in the real wage.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

234

Response of Employment and Wages to Changes in Labor Demand and Labor Supply 3. The marginal product of labor curve shifts to the right and the real wage rate rises, as does the quantity of labor, as is shown in the graph below.

4. A recession shifts the demand for labor curve to the left, while the increase in day care costs will probably encourage at least one parent to stay home or work part time to take care of children. This results in a shift to the left of the supply curve. These effects unambiguously decrease employment.

Depending on the relative size of these effects, the real wage might increase or decrease. On the graph below, the demand curve shifts by more, and therefore, the real wage also decreases.

Dynamics of Unemployment 5. a.

When an individual quits his job and does not look for a job, the labor force (i.e., employed + unemployed) decreases, and the number of people not in the labor force increases. The unemployment rate increases as the denominator (labor force) decreases, while the numerator (unemployed) remains the same. b. When an unemployed person decides to look for a job, he or she joins the labor force. Both the labor force and the unemployment rate increase. The unemployment rate increases because the percentage increase in the numerator (unemployed) is bigger than the percentage increase in the denominator (unemployed + employed).

.

Chapter 20

The Labor Market, Employment, and Unemployment

235

6. When the unemployment rate increases during recessions, it becomes increasingly difficult to find a job. This lengthens the spell of unemployment for most unemployed individuals and results in more discouragement. As time goes by, more individuals desist from looking for a job and, therefore, abandon the labor force (note that an unemployed individual not looking for a job is not part of the labor force). The number of discouraged workers increases during recessions. This makes it even more difficult to interpret unemployment rates during recessions, as a decrease in the unemployment rate might be due to the increasing number of discouraged workers.

Causes of Unemployment 7. The advent of Websites that allow potential workers to process more information more quickly has definitely had a positive impact on frictional unemployment. Workers are now able to post their resumes online, as opposed to mailing copies to potential employers. This resulted in a decrease in transaction costs (time and money) associated with the process of job search. New technologies also allow employers to filter more candidates for a job position, making personal interviews more efficient.

8. a.

Structural unemployment will probably increase for some time, depending on the skill level required to work at factories producing the manufactured goods. As the new sector grows stronger, more workers will find it profitable to acquire the newly required skills. During this process, the growing manufacturing sector might encounter a shortage of skilled workers. If sophisticated machinery requires significant skills, then it is probable that unemployed workers from the agricultural sector will not find a job in the growing sector of the economy. b. A possible solution to this problem is for the government to create a training program that encourages or facilitates the acquisition of skills. Some of these programs actually exist. Some developed countries that lost many manufacturing jobs to emergent economies have designed training agencies that help workers who lost their jobs acquire new skills. There is some controversy around the effectiveness of such programs.

9. a.

Unemployment is the surplus of labor that prevails at a wage equal to w1: L3 – L2. Put differently, at a wage equal to w1 there are L3 – L2 million workers who would work for such a wage but cannot find a job. b. One reason is that minimum wage laws are preventing wages to decrease to their market clearing level of w2. Another reason might be that firms have an incentive to pay their workers above market clearing wages. Efficiency wages will reduce turnover rates (the rate at which one job position is filled during a year by a different worker) and other problems like absenteeism or low productivity at work. Finally, wages might be rigid in the downward direction due to collective bargaining agreements between unions and employers.

Natural Rate of Unemployment 10. Quite naturally, the U.S. labor market should look more promising to you than the French labor market. Everything else the same, the probability of finding a job would be higher in the United States. Higher natural rates of unemployment in France, as in many European countries, usually result from higher unemployment benefits and stronger unions. The more dynamic U.S. labor market comes at the expense of less job security (in general, it is easier for firms to fire workers in the United States, in terms of lower severance payments) and fewer benefits in case of unemployment. The tradeoff is not an easy one to solve, which probably explains why these equilibria persist (i.e., neither the United States nor European countries are eager to change the structure of their labor markets).

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

236

◼

Answers to Data Analysis Problems

1. a.

From 2012:Q4 to 2013:Q1, real wages decreased from 103.91 to 102.54, or –1.33%, and employment increased very slightly from 143,303,000 to 143,367,000 or +0.04%. This is consistent with labor supply increasing (shifting to the right) and labor demand decreasing (shifting to the left). b. From 2012:Q1 to 2013:Q1, real wages increased slightly from 102.205 to 102.54, or +0.32%, and employment increased from 141,882,000 to 143,367,000 or +1.05%. This is consistent with labor supply increasing (shifting to the right) and labor demand increasing (shifting to the left).

2. a.

The labor force for July 2013 equals 144,285,000 (E) + 11,514,000 (U) = 155,799,000. The working-age population is the sum of those in the labor force and not in the labor force, which equals 155,799,000 + 89,957,000 = 245,756,000. b. The employment population ratio = 144,285,000/245,756,000 = 0.587, or 58.7%.

3. a.

See table below. In general, the labor force participation rate has held fairly constant between both groups, although the gap has narrowed somewhat in the last five years. Overall, labor force participation is significantly higher among men than women. The unemployment rate is flipped somewhat, with women having a somewhat lower unemployment rate than men. Part of the explanation for this may be the lingering effects of the financial crisis disproportionately affecting financial services and construction, two mostly male populated sectors.

July 2013 July 2012 July 2008

Labor Force Participation Rate Men Women Difference 69.9 57.4 12.5 70.2 57.6 12.6 73.1 59.4 13.7

Unemployment Rate Men Women Difference 7.7 7.0 0.7 8.4 8.1 0.3 6.2 5.3 0.9

b. See table below. The labor force participation rate between African American and whites has been fairly steady, with white workers having about 2.5 percentage points higher participation than African Americans. The unemployment rate is a different story, with a very large gap between African American and white unemployment rates. This gap increased significantly after the financial crisis, indicating African Americans have had a much harder time finding work than white workers have.

Labor Force Participation Rate Unemployment Rate African African American White Difference American White Difference July 2013 61.4 63.7 –2.3 12.6 6.6 6.0 July 2012 61.6 63.9 –2.3 14.1 7.4 6.7 July 2008 63.8 66.4 –2.6 10.0 5.2 4.8

.

Chapter 20

c.

The Labor Market, Employment, and Unemployment

237

See table below. Labor force participation among college graduates is high, and much higher than for workers with just a high school education. Moreover, this gap has increased from 14 percentage points to more than 16 percentage points after the financial crisis, suggesting that many with a high school education may have dropped out of the labor force. The unemployment rate tells a similar story, with the rate much lower for college graduates than for high school graduates. This gap also increased after the financial crisis, indicating that less-skilled workers have had a harder time finding employment than in skilled positions.

July 2013 July 2012 July 2008

Labor Force Participation Rate High College School Difference 75.5 59.0 16.5 75.8 59.6 16.2 77.1 63.2 13.9

Unemployment Rate High College School Difference 3.8 7.6 –3.8 4.1 8.6 –4.5 2.5 5.4 –2.9

4. a.

The unemployment rate for July 2013, July 2012, and July 2011 was 7.4 percent, 8.2 percent, and 9.0 percent, respectively. The natural rate of unemployment during that time was 5.5 percent.

Thus cyclical unemployment was 1.9 percent, 2.7 percent, and 3.5 percent respectively. b. The economy has been steadily growing out of recessionary conditions during the two years from July 2011 to July 2013. However, there is still a substantial amount of cyclical unemployment, so the economy has not completely closed the gap to full employment.

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: Why Has Labor Force Participation of Women Increased?

Data Source Bureau of Labor Statistics: http://www.bls.gov/cps/wlf-databook2011.htm. Here you can find extensive data about women in the labor force, including labor force participation rates, weekly earnings, and more.

Related Article Issues in Labor Statistics, “Women Still Underrepresented Among Highest Earners”: http://www.bls.gov/opub/ils/pdf/opbils55.pdf. This publication by the BLS discusses recent data (2006) on earnings of men and women at the top of the wage distribution.

Discussion Question Do you expect gender discrimination in the labor market to be similar across countries? Explain.

Answer: Empirical evidence shows that gender pay gap (the difference in earnings between men and women for the same position and required skills) varies across countries. Some countries still have a gender pay gap around 50 percent, while countries like the United States have an estimated gap of 25 percent (France reported a gap of 10 percent in 2000). This is most likely due to idiosyncratic differences across countries, how women are perceived by the society, and which role women think they should play in the economy. Most of these cultural values are long lasting, and traditions change very slowly over time.

.

238

Mishkin • Macroeconomics: Policy and Practice, Second Edition

B. For Information About Application: Why Are Returns to Education and Income Inequity Increasing?

Data Source Bureau of Labor Statistics: http://www.bls.gov/cps/earnings.htm#education. Go to “Earnings by Education,” select “archives,” and then the most recent data. Check table 6 for information on the employment status of the civilian noninstitutional population by education attainment.

Related Article Bureau of Labor Statistics, “Back to College”: http://www.bls.gov/spotlight/2010/college/. This is a comprehensive study on the returns to education in the United States. (Inside you can find data and charts about this topic.)

Discussion Question Assuming that skill-biased technical change and globalization are the reasons for the wage premium increase, do you expect that income inequality will increase or decrease in the future?

Answer: If skill-biased technical change and globalization are the reasons for the wage premium increase, then chances are that income inequality would rise in the future. Neither skill-based technical change nor globalization are trends that are likely to be reversed in the future. Most people agree that technological change will move forward. The globalization process makes low-skilled workers more easily substitutable (see Rodrik, “Has Globalization Gone Too Far?”), and it is also not likely to stop in the future. This is why many governments, including the U.S. government, are engaged in trying to encourage low-skilled workers to come back to school to acquire the necessary skills to access a high paying job in the future.

C. For Information About Policy and Practice: Unemployment Insurance and Unemployment Data Source U.S. Department of Labor: http://www.dol.gov/opa/media/press/eta/ui/current.htm. Unemployment insurance weekly claims report. Here you can find current and historical data on unemployment insurance claims.

Related Article Summers, Lawrence, “The Economic Case of Extending Unemployment Insurance”: http://www.whitehouse.gov/blog/2010/07/14/economic-case-extending-unemployment-insurance. This article explains the White House arguments to extend unemployment insurance in the aftermath of the 2007–2009 crisis.

Discussion Question Contrast the White House view on unemployment insurance with this article prepared by the Cato Institute: http://www.cato.org/pubs/handbook/hb107/hb107-32.pdf.

Answer: The White House perspective and the Cato Institute’s view about unemployment insurance show how intense the debate about this topic is. The Obama administration argues that the extension of unemployment insurance provides relief for many households, while the Cato Institute argues that unemployment insurance should be abandoned, if not less extended. These views could not be further apart, a phenomenon that not only happens in the United States: Many other countries have unemployment insurance programs, and the corresponding discussion about its benefits and costs.

.

Chapter 20

The Labor Market, Employment, and Unemployment

239

D. For Information About Policy and Practice: Minimum Wage Laws Data Source Bureau of Labor Statistics: http://www.bls.gov/cps/minwage2012.htm. Here you can find data about the characteristics of minimum wage workers for 2012.

Related Article Cato Institute, “Minimum Wage Hikes Deserve Share of Blame for High Unemployment”: http://www.cato-at-liberty.org/minimum-wage-hikes-deserve-share-of-blame-for-high-unemployment/.

This article (and video) argues fervently against minimum wage laws in general and recent minimum wage increases in particular.

Discussion Question Which would be the effect of an increase in the minimum wage on income inequality?

Answer: In order to settle this question, one would have to measure the effect of the minimum wage increase in unemployment (reducing income for those who cannot find a job and stay unemployed) and the effect on those who keep their job and see an increase in their earnings. These are of course quite difficult tasks, and not surprisingly, the empirical evidence is mixed. Those who claim that the first effect prevails argue that increases in the minimum wage result in higher income inequality. On the other hand, those who think that the second effect is larger would suggest that the minimum wage should increase periodically (at least to keep up with inflation).

E. For Information About Application: Why Are European Unemployment Rates Generally Much Higher Than U.S. Unemployment Rates?

Data Source Eurostat: http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&language=en&pcode=teilm 020&tableSelection=1&plugin=1. Here you can find unemployment rates for individual European countries as well as the European Union.

Related Article Walker, Marcus and Roger Thurow, “U.S., Europe Are an Ocean Apart on Human Toll of Joblessness” (Wall Street Journal, 05/07/2009): http://online.wsj.com/article/SB124155150793788477.html. This article shows how differences in employees’ benefits can explain unemployment rates in the United States and Europe during the most recent financial crisis.

Discussion Question Consider the different structures of the U.S. and European labor markets (i.e., workers’ benefits, unions, work rules). Which region do you think will see a faster return to its previous unemployment rate (i.e., after both recover from the 2007–2009 financial crisis)?

Answer: The structure of the European labor market makes it more rigid than the U.S. labor market. This means that the U.S. labor market responds faster to changes in economic conditions. For example, because it does not cost as much to hire (or fire) a U.S. worker, U.S. firms can add (or subtract) workers more easily. Once the unemployment rate increases for so long, it is quite difficult for it to decrease, but the situation becomes worse the more rigid the labor market. Although the United States has been experiencing an stubbornly high unemployment rate of around 10 percent (even after the economy recovered, as measured by many other indicators), chances are that unemployment rates in Europe will take longer to come back to their natural rate level.

.

Chapter 21 The Role of Expectations in Macroeconomic Policy ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Rational Expectations and Policy Making Adaptive Expectations Rational Expectations Microeconomic Rationale Behind the Theory Rational Expectations Theory and Macroeconomic Analysis Rational Expectations Revolution Lucas Critique of Policy Evaluation Econometric Policy Evaluation Application: The Consumption Function Policy Conduct: Rules or Discretion?

Discretion and the Time-Inconsistency Problem Types of Rules The Case for Rules Policy and Practice: The Political Business Cycle and Richard Nixon The Case for Discretion Policy and Practice: The Demise of Monetary Targeting in Switzerland Constrained Discretion The Role of Credibility and a Nominal Anchor Benefits of a Credible Nominal Anchor Credibility and Aggregate Demand Shocks Credibility and Aggregate Supply Shocks Application: A Tale of Three Oil Price Shocks Approaches to Establishing Central Bank Credibility Inflation Targeting Policy and Practice: Ben Bernanke and the Adoption of Inflation Targeting Nominal GDP Targeting Appoint “Conservative” Central Bankers Policy and Practice: The Appointment of Paul Volcker, Anti-Inflation Hawk Increase Central Bank Independence

.

Chapter 21

The Role of Expectations in Macroeconomic Policy

241

Chapter Overview and Teaching Tips Part Eight of the book examines the latest developments in business cycle theory that have been driven by a greater focus on microeconomic foundations of macroeconomic analysis. Over the last thirty years, the role of the public and the market’s expectations has moved to the front and center of the thinking about how the macro economy works. Chapter 21 discusses the most widely used theory to describe the formation of household and business expectations, rational expectations, and develops it from microeconomic principles.

Using the AD/AS model developed earlier in the book, it then explores how this theory has shaped current policy making and debates.

To put rational expectations theory in context, the chapter starts by discussing an older theory, adaptive expectations, which just states that expectations are formed from past realizations of the data. It then defines rational expectations as the optimal forecast (best guess) of the future using all available information. There are five key points to help students understand this concept. First, it is derived from microeconomic principles because using the best guess of the future to guide economic decisions maximizes welfare or profits. Second, rational expectations can be inaccurate even if they are the best guess of the future. Third, because rational expectations use all available information, information about monetary and fiscal policy has a direct effect on expectations. Fourth, only new information causes expectations to change. Fifth, if there is a change in the way a variable moves, the way in which expectations are formed will change as well.

The chapter next uses the concepts above to outline one of the most important ideas in macroeconomics in the last thirty years, the Lucas critique, which says that macro-econometric relationships based on past data will change when the way policy is conducted is changed, so policy evaluation with these models can be very misleading. The intuition behind the Lucas critique is illustrated in an application with a simple example using the consumption function. There are numerous other examples, an instructor might want to discuss in class.

The chapter next turns to a set of policy issues. The first is the debate over whether policy makers should follow rules or instead conduct policy with complete discretion, in which policy is conducted on a day-today basis. The argument for rules is based on the time-inconsistency problem, another one of the most important ideas in macroeconomics over the last thirty years. The problem with discretion is that policy makers can’t commit to good long-run strategies. Instead they have incentives to renege on the good strategy and instead pursue policy that leads to poor outcomes. I like to illustrate this concept in class by presenting everyday examples. One is how we eat. We don’t want to eat unhealthy food, but when we see that juicy hamburger, we just can’t resist it. Another example is the inability to stay on a diet, as discussed in the text. I also like discussing the problem of child rearing and the temptation to give in to bad behavior.

This example also illustrates why having a rule helps solve the time-inconsistency problem. Rules, however, do face the difficulty that, as the adage says, “rules are made to be broken;” that is, we may not know enough to have a rule that always works well. The Policy and Practice box, “The Political Business Cycle and Richard Nixon,” provides a graphic historical example of the time-inconsistency problem at work, while the second Policy and Practice box, “The Demise of Monetary Targeting in Switzerland,” illustrates how following rules can lead to policy mistakes. A solution to the problems with both rules and complete discretion is provided by the concept of “constrained discretion,” a term that Ben Bernanke and I coined in a paper published in 1997. Constrained discretion imposes rule-like behavior on policy makers by imposing a discipline on them but which allows for some flexibility. This is exactly the approach in the policy framework of inflation targeting, which is discussed later in the chapter.

The next policy issue the chapter discusses is the role of credibility and a nominal anchor. Here, the rational expectations conclusion that expectations about policy affect inflation expectations is embedded in the AD/AS model, which is then used to show that having a credible commitment to a nominal anchor produces better outcomes on both inflation and output when there are either demand or supply shocks. To demonstrate to

.

242

Mishkin • Macroeconomics: Policy and Practice, Second Edition

students that the analysis is relevant to real-world outcomes, it is worth discussing in class the Application, “A Tale of Three Oil Shocks,” to show that a surge in oil prices has very adverse affects on the economy when the commitment to a nominal anchor is weak, as occurred in the two oil price shocks in the 1970s.

On the other hand, when the Federal Reserve commitment to the nominal anchor of controlling inflation was strong, then an oil price shock like that in in 2007 did not have as adverse consequences (although the financial crisis did).

The final section of the chapter discusses different approaches to establishing a credible nominal anchor.

The first is inflation targeting, which involves announcement of an inflation target objective, with a commitment by the central bank to achieve it. I was a strong proponent of this policy framework when I was a governor of the Federal Reserve. The Fed adopted inflation targeting in January 2012, as is discussed in the Policy and Practice case, “Ben Bernnake and the Adoption of Targeting.” A related approach is nominal GDP targeting, in which the central bank announces an objective of hitting a particular level of nominal GDP that is growing over time. A third approach is the appointment of inflation hawks (dubbed “conservative” by Ken Rogoff) to head central banks. The Policy and Practice case, “The Appointment of Paul Volcker,” shows students that this strategy has indeed been used in the past when Paul Volcker was appointed as Fed chairman in 1979. The fourth approach is to give central banks independence from the political process. The evidence for the benefits of central bank independence is worth discussing in class, and students should be made aware that there has been a strong trend toward increased independence of central banks in recent years. Nonetheless, there have been increasing attacks on central bank independence, particularly in the United States in recent years. One way to stimulate thinking on this topic is to have students debate whether the Fed should be made more or less independent.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Rational Expectations and Policy Making 1. Adaptive expectations theory holds that people base their expectations on past experience only. As a result, expectations change slowly over time as past data changes. Rational expectations theory argues that people use all available information, including information about government policy, when forming their expectations of a variable’s future value. According to this theory, expectations can change rapidly as new information becomes available.

Lucas Critique of Policy Evaluation 2. Lucas argued that using macro-econometric models to evaluate the effects of proposed changes in economic policy is an invalid procedure because the coefficients in those models’ equations have been estimated from past data. How variables behaved in the past is not necessarily the way they will do so in the future, especially considering the rational expectations view that relationships among economic variables change when policy changes and when new information becomes available. Thus, the models’ equations do not incorporate the correct relationships among economic variables and furnish misleading predictions with which to evaluate proposed policies.

Policy Conduct: Rules or Discretion?

3. The time-inconsistency problem is the situation people experience of having perfectly good long-run intentions but making short-run decisions that lead to quite opposite outcomes. Applied to policy making, this problem arises when policy makers set a goal of long-run price stability but then succumb to temptations to deviate from this goal in order to use expansionary policies to stimulate the economy and keep unemployment low in the short run even though these expansionary policies do not promote long-run price stability. Because time-inconsistent behavior is more likely when policy makers operate with discretion, some economists advocate the imposition of rules to prevent

.

Chapter 21

The Role of Expectations in Macroeconomic Policy

243

policy makers from exercising their discretion and make it more likely they will achieve the long-run price stability goal.

4. Advocates of rules argue that they solve the time-inconsistency problem so that policy makers will achieve good long-run economic outcomes, that they will prevent repeating serious policy mistakes that have been made in the past, and that they will avoid political business cycles that might result if policy makers were free to adopt expansionary policies before an election followed by contractionary policies afterwards. Opponents argue that rules are too rigid and deny policy makers the flexibility they need to deal with unforeseeable problems, that they do not allow any role for judgment in policy making, that they may be based on incorrect models of the economy, and that they will lead to bad economic outcomes if the economy undergoes structural changes.

The Role of Credibility and a Nominal Anchor 5. A nominal anchor is a nominal variable—for example, the inflation rate, the money supply, or an exchange rate—that ties down the price level or inflation to help policy makers achieve price stability. Policy makers’ sincere commitment to the nominal anchor serves to limit their discretion and thus helps overcome the time-inconsistency problem. If the public believes policy makers are sincerely committed to the nominal anchor this helps to control inflation expectations and thereby to stabilize both inflation and output.

6. Positive aggregate demand shocks shift the aggregate demand curve to the right, causing both inflation and output to rise. Without a credible nominal anchor, the increase in inflation causes expected inflation to rise, which shifts the short-run aggregate supply curve upward and causes the inflation rate to increase further. With a credible nominal anchor, however, expected inflation does not change, so there is no upward shift in the short-run aggregate supply curve. Thus, with a credible nominal anchor inflation is more stable following the demand shock. The outcome is similar when a negative aggregate supply shock occurs. Inflation increases and output falls as the short-run aggregate supply curve shifts upward, but with a credible nominal anchor, expected inflation does not increase.

As a result, no further upward shifts of the short-run aggregate supply curve occur and the increase in inflation and decrease in output are not as great as they otherwise would be. Thus the credible nominal anchor brings about better outcomes for both inflation and output when a negative supply shock occurs.

Approaches to Establishing Central Bank Credibility 7. Inflation targeting has two basic purposes, to keep inflation under control and to increase the credibility of monetary policy makers’ commitment to price stability. These are achieved by announcing a numerical target for inflation and a commitment to price stability as the primary longrun goal of monetary policy, increasing communications with the public and financial market participants about the goals and processes of monetary policy making, and holding policy makers accountable for achieving the inflation target that has been set.

8. In countries where inflation targeting has been adopted, it has strengthened the credibility of the central bank’s commitment to a nominal anchor. Inflation has fallen in these countries and inflation, inflation expectations, and output have become more stable.

9. Central bank independence gives monetary policy makers more credibility by insulating them from the political process so that they can focus on long-run concerns like price stability. Within a sample of countries, those with the most independent central banks had the lowest inflation rates over the period 1973—1988 but were no more likely to have high unemployment or larger output fluctuations.

Opponents of central bank independence argue that letting an elite group that is relatively

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

244

unaccountable to the political process wield so much power is inconsistent with democratic ideals.

They further point out that independent central banks do not always use their freedom successfully.

Answers to Problems Rational Expectations and Policy Making 1. Nicole has been forming rational expectations during these last ten years. What makes a forecast an optimal forecast is that all relevant information is used, not only past information. Although Nicole’s expectations are rational, this does not mean that they are always accurate. It means that on average they will be accurate. To reach that conclusion, suppose that your last three forecasts were below the realized inflation rate. This now becomes part of the new information set used to form the next forecast; failure to incorporate that information will prevent your forecast from being optimal.

2. Mark’s expectations about future mortgage rates will be about the same as the current average mortgage rates because this is the only information included in his forecast. Gloria’s expectations will include new developments in how monetary policy is conducted. The appointment of a new chairman of the Fed is always an important event for this purpose, and often candidates are dubbed as inflation hawks or doves, depending on the importance they assign to fighting inflation. In this case, the nomination of an inflation dove would probably encourage Gloria to decrease her expectations about future mortgage rates.

Lucas Critique of Policy Evaluation 3. a.

According to the rational expectation theory, individuals might interpret this increase in the federal funds rate target as a signal that the Fed will commit to fight inflation. The increase in the federal funds rate determines an increase in real interest rates in the short run and results in a higher user cost of capital. Although this might reduce investment, it is possible that individuals recognize the Fed’s intentions and, therefore, decide to increase investment in anticipation of a low inflation economic environment that encourages investment. b. Lucas’s critique will point out the fact that the model was probably constructed by using past data in which domestic investment decreased after interest rates increased. But that model does not take into consideration that individuals might revise their expectations quite quickly and might decide to alter the way in which they respond to changes in economic variables, like the interest rate.

Policy Conduct: Rules or Discretion?

4. a.

The benefit of sticking to a set of rules when following a diet include reaching a given goal, probably defined in terms of a desired weight. The costs can be measured in terms of the lost opportunities to savor tasty food or desserts. In this case, costs are short lived, although it is quite easy to succumb to temptations. This could be compared to a central bank pursuing overly expansionary policy to surprise market participants and temporarily decrease unemployment.

Even if that pays off in the short run, it will most likely reduce the central bank’s credibility and make it more difficult to attain the long-run goal. b. The benefit of sticking to a set of rules in this case might be considered a little more controversial. Giving children a clear set of rules and making every possible effort to enforce them seems to have positive effects in the long run. However, this might be quite difficult, as many parents can confirm. Also, it might not be that clear that excessive rules have a positive effect on children. In any event, parents who decide to set up rules will eventually face the problem that giving in will decrease their reputation and compromise the credibility of future rules. The cost of following rules when raising children is that one cannot possibly think of all the situations that might arise in a child’s life, and it is therefore impossible to set a rule for everything. On top of that, enforcing every rule might create severe problems in the short run, as

.

Chapter 21

The Role of Expectations in Macroeconomic Policy

245

the lack of discretion might hurt the economy if fiscal policy is designed to follow strict rules (e.g., like forcing governments to balance their budget every year).

5. When a president has the authority to nominate or lay off the director of the central bank, it is quite plausible that the conduct of monetary policy would be discretionary. Adherence to monetary policy rules involves imposing some hardship on the economy sometimes. If the president can pressure the director of the central bank, then most likely monetary policy will be discretionary and follow the dictates of the president or his/her political party. This is actually what happened in many South American countries in the 1970s and 1980s. Not surprisingly, most of these countries could not reach long-run goals such as price stability during this period. Also, frequent changes in monetary policy (and fiscal policy) resulted in increased output volatility and low growth. Although most central banks are still subject to pressure from politicians, it has been understood that some independence is desirable.

The Role of Credibility and a Nominal Anchor 6. Announcements about the inflation targets and potential punishments for central bank officials are crucial for inflation targeting. It is very important for the public to be able to check whether the target has been reached or not. When central bank officials know that the public can easily check their performance, they have an extra incentive to do everything in their power to attain their goals, as their reputation is at stake. Even if their reputation is not that important to them, they have an incentive to do their job because they might be fired otherwise. When the central bank officials and the general public know “the rules of the game,” there is a higher probability that monetary policy will be more credible. In conclusion, transparency could be a good ingredient in the conduct of any specific type of monetary policy. This was recognized by the Federal Reserve some time ago. Even if the Fed is not engaged in inflation targeting (or any monetary policy with an explicit nominal anchor), it recognized the need to communicate with the public its decisions about the federal funds rate target some years ago.

7. This is a clear sign that the Fed enjoys a high level of credibility. This credibility was probably earned through the last two decades. Although the Fed never explicitly stated an inflation target, many people believe that Fed officials had an inflation target in their minds during this period. Even if it was not announced, this target was assumed to be above zero, and (here is where opinions differ) around 1.5 percent to 2.5 percent annual inflation rate. Even if the Fed has not announced an inflation target, and can therefore not be held accountable for missing it, it is quite clear that individuals believe that the Fed is and has been concerned about keeping inflation at low and stable levels.

Finally, even more impressive is the fact that the monetary base increased significantly as a consequence of the Fed’s actions to support the U.S. financial system, but this did not result in high expected inflation, either.

Approaches to Establishing Central Bank Credibility 8.

The statistical office’s mistake will obviously hurt the central bank’s credibility and will mean that the inflation target was missed. Depending on the set of rules governing the central bank, some officers might be dismissed. When pursuing an inflation target, accurate inflation measurement is critical. It could technically happen that a couple of prices might artificially pull up the price index, therefore increasing inflation measures more than necessary. This is true for some important prices, like the price of oil and gas, in most industrialized countries. To avoid this problem, other price indices, which do not consider the price of oil and gas, are constructed. When evaluating the performance of the central bank engaged in inflation targeting, more than one price index is analyzed.

In addition, effective and clear communication with the public and government authorities is crucial for everyone to understand the limits of these measures and the limits to the central bank’s actions. If this limitation is not properly understood, the central bank’s credibility will be hard to earn and maintain.

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

246

9. New Zealand’s experience is typical in the sense that right after the central bank was instructed to focus on bringing inflation to low levels, some indicators deteriorated. Economic growth was low, and unemployment increased for a short period of time, but later New Zealand enjoyed relatively high growth rates and unemployment decreased. One can interpret this experience as the short-run cost of a superior long-run policy that promotes economic growth and stable prices at the same time.

Although there might be a short-run link between inflation targeting and economic growth (especially if inflation was high and volatile in the previous years) this must be understood as a small cost compared with long-run gains in terms of an economic environment that encourages investment and economic growth, important ingredients to achieve low unemployment rates in the long run.

10.

Monetary policy officials more concerned about fighting unemployment than inflation are usually dubbed “inflation doves,” to illustrate their “soft” approach to inflation. If the majority of the Board of Governors was composed of inflation doves, then most likely the public’s expectations’ about future inflation rates will increase. This could be troublesome for the Fed’s credibility, as it might require more increases in interest rates than would be necessary otherwise to show the public that the Fed still focuses on fighting inflation. This debate was present in the United States in 2010 when President Obama was considering the nomination of two members of the Board of Governors. The press insisted on labeling these candidates based on their perspective and approach about fighting inflation or favoring low unemployment.

◼

Answers to Data Analysis Problems

1. a.

For 2013:Q2, actual inflation was 0.03 percent, and adaptive expectations forecast a 1.36 percent inflation rate. b. From 2011:Q3 to 2013:Q2, the average error was –0.65 percentage points; from 2008:Q3 to 2013:Q2, the average error was –0.36 percentage points. c. Under rational expectations, the two- and five-year average errors should be very close to zero.

Using adaptive expectations here, it appears that forecasted inflation is systematically overestimating actual inflation based on the negative average errors over the two- and five-year horizons.

2. a.

From 2012:Q3 to 2013:Q2, inflation averaged 1.43 percent, well below the current 2 percent target. Over the two year horizon from 2011:Q3 to 2013:Q2, inflation averaged 1.90 percent, still a bit below but much closer to the 2 percent target. b. There is a bit of a disconnect, at least in the near-term data between inflation and the 2 percent target. Consistently missing the target, all else equal, may lead the public to believe the Fed has lost its ability to keep inflation stable, which can potentially unanchor inflation expectations and lead to a decline in credibility. This is a concern in this case because falling inflation expectations in a very low inflation environment can eventually lead to falling actual inflation and, at a relatively low rate of inflation, can turn into deflation.

3. a.

From July 2008 to July 2013, the price of a barrel of oil declined on average by 4.3 percent; from 2008:Q2 to 2013:Q2, inflation decreased modestly from 1.9 percent to 1.5 percent. b. From January 1976 to January 1981, the price of a barrel of oil increased on average by 69.7 percent; from 1976:Q1 to 1981:Q1, inflation increased from 6.1 percent to 10.1 percent. c. The current monetary policy regime is much more credible in keeping inflation low and stable, although the decline in current oil prices masks this somewhat. However looking at the levels of inflation, it is clear that sharp increases in oil prices in the 1970s lead to bigger changes in the inflation rate, as well as an overall higher level of inflation as compared to the current period.

.

Chapter 21

The Role of Expectations in Macroeconomic Policy

247

◼ Data Sources, Related Articles, and Discussion Questions A. For Information About Application: The Consumption Function Data Source Lucas Jr., Robert E. and Thomas J. Sargent, “After Keynesian Macroeconomics”: http://minneapolisfed.org/research/QR/QR321.pdf. These authors argue that contemporary macroeconomic models were of no use in guiding policy. This paper was presented in 1978.

Related Article Official Website of the Nobel Prize, Press Release: http://nobelprize.org/nobel_prizes/economics/laureates/1995/press.html. Here you can find a summary of Lucas’ contributions to macroeconomics analysis, in particular about rational expectations and its applications.

Discussion Question Critics of the Dodd-Frank Act (a new set of regulations that affects the financial system) argue that it will restrict the size of large, complex financial institutions, preventing them from exploiting economies of scale. If you had a model based on past data that estimates the impact on financial intermediaries’ profitability over the long run, would this model still be relevant after these new regulations?

Answer: A model whose coefficients have been estimated using past data can yield reasonable estimates as long as the underlying conditions remain the same. This means that the conduct of monetary policy, regulations affecting the financial system, fiscal policy, and potentially many other factors should remain constant for the model to still be reliable. If one or many of these factors change, then the magnitude (maybe even the sign) of these coefficients might change, resulting in poor forecasts. This is yet one more example of the Lucas critique and a fundamental problem with structural models. In this particular case, if it is true that financial intermediaries’ actions are somewhat restricted, some coefficients should be changed to acknowledge this new regulatory system.

B. For Information About Policy and Practice: The Political Business Cycle and Richard Nixon Data Source Poole, William, “Monetary Control and the Political Business Cycle”: http://www.cato.org/pubs/journal/cj5n3/cj5n3-2.pdf. This article explores the link between monetary policy and the political business cycle emphasizing the role of the Federal Reserve System.

Related Article Wall Street Journal, “How Much Do Election Shakeups Affect the Nation’s Economy?” (11/03/2006): http://online.wsj.com/article/SB116240116581410311.html. This article describes two scholars’ points of views on the political business cycle.

Discussion Question Other countries do not have rules as clear as the United States with respect to the central bank’s independence. Do you think the political business cycle will be more or less prevalent in these countries?

Answer: In countries in which the central bank is not as independent from politicians’ influence the political business cycle is much more prevalent. In some countries the elected president has the power to appoint the director of the central bank and can fire her/him at his convenience. It is not uncommon for

.

248

Mishkin • Macroeconomics: Policy and Practice, Second Edition

three or more central bank directors to be appointed in a five-year period. Not surprisingly, monetary policy is highly volatile and not credible.

C. For Information About Policy and Practice: The Demise of Monetary Targeting in Switzerland Data Source Dueker, Michael and Andreas M. Fischer, “Inflation Targeting in a Small Open Economy: Empirical Results from Switzerland”: http://research.stlouisfed.org/wp/1995/95-014.pdf. This paper uses empirical evidence to analyze the Swiss experience with monetary targeting. (Note that the authors argue that monetary targeting was consistent with inflation targeting according to the Swiss Central Bank.)

Related Article Bernanke, Ben S. and Frederic S. Mishkin, “Inflation Targeting: A New Framework for Monetary Policy?”: http://www.nber.org/papers/w5893. This article describes the set of policies grouped as “inflation targeting” and analyzes some practical issues related to their implementation.

Discussion Question Most countries abandoned the strategy of monetary targeting when they realized that the link between monetary aggregates and intermediate targets of monetary policy was not that strong anymore. There seems to be some consensus about the fact that this happened due to the financial innovation process and the inclusion of new regulations. Because these two factors will probably keep evolving, conclude by discussing the future of the conduct of monetary policy.

Answer: Most policy makers agree that the process of financial innovation, fueled by the profit-seeking behavior of financial intermediaries, will keep changing the “rules” of how traditional monetary policy tools affect intermediate targets or goals of monetary policy. In addition, the set of government regulations affecting the behavior of financial intermediaries is likely to evolve over time, thereby shaping the industry as well. From the perspective of a monetary policy maker, this means that strategies will have to be updated as well, to make monetary policy effective. Even if today there seems to be a consensus about monetary policy strategies such as inflation targeting, this might have to change in the future, as it happened with monetary targeting in the past.

D. For Information About Application: A Tale of Three Oil Price Shocks Data Source Bureau of Labor Statistics: http://data.bls.gov/PDQ/servlet/SurveyOutputServlet?data_tool=latest_numbers&series_id=CUSR0000SA 0&output_view=pct_1mth. Here you can find inflation (percentage monthly change in the CPI). Select 1970 in the Change Output Options to get data and a graph from 1970 to 2010.

Related Article Bernanke, Ben S., “Outstanding Issues in the Analysis of Inflation”: http://www.federalreserve.gov/newsevents/speech/bernanke20080609a.htm. In this speech as Federal Reserve Chairman in 2008, Bernanke concludes about further research areas to improve monetary control.

Note the statement about the Fed’s commitment to fight inflation at the end of the fourth paragraph: “The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.”

Discussion Question As a response to the financial crisis of 2007–2009 the FOMC has lowered the federal funds target to close to zero for around two years now. However, long-term inflation expectations remained low during this

.

Chapter 21

The Role of Expectations in Macroeconomic Policy

249

period. Conclude with a comment about the public’s confidence on the Federal Reserve’s ability and willingness to fight inflation.

Answer: The fact that long-term inflation expectations did not increase (they remained mostly constant) can have at least two explanations. The first one is that the public considers the effects of the 2007–2009 financial crisis to be long lasting and estimates that aggregate demand will increase only moderately or not at all for a few years. The other is that the public might interpret that the U.S. economy will successfully start its expansion path but trust that the Fed will do as much as possible to control inflation. It is difficult to know which one is more plausible, but nonetheless it is quite clear that the public trusts the Fed’s ability and willingness to fight inflation.

E. For Information About Policy and Practice: Ben Bernanke and the Federal Reserve Adoption of Inflation Targeting Data Source Federal Reserve System, “FOMC statement”: http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm. In this statement issued on January 25, 2012 the FOMC declared its intention to follow the strategy of inflation targeting and set the target at 2 percent (check the fourth paragraph).

Related Article Bernanke, Ben S., “Inflation Targeting”: http://research.stlouisfed.org/publications/review/04/07/PanelDisc.pdf. In this 2004 panel discussion, Bernanke discusses the inflation targeting strategy and its possible use by the Federal Reserve.

Discussion Question The transition from Greenspan’s chairmanship to Bernanke’s chairmanship was quite smooth. Conclude with a discussion about the compatibility of the conduct of monetary policy with an implicit nominal anchor and inflation targeting.

Answer: The fact that the transition from Greenspan to Bernanke was quite smooth (only a few extra words pronounced by Bernanke during the first days at the Fed had some significant unexpected effect on stocks) means that these two strategies are compatible with each other. Greenspan’s Fed followed an implicit nominal anchor (the inflation rate) that was never announced but that most analysts estimated to be around 2 percent. When the new chairman arrived, even though everybody knew Bernanke’s point of view with respect to monetary policy, there were no major effects on the economy. This provides evidence that the public expected that the conduct of monetary policy would follow almost the same guidelines as during the Greenspan’s years.

F. For Information About Policy and Practice: The Appointment of Paul Volcker, Anti-Inflation Hawk Data Source Federal Reserve Bank of St. Louis database (FRED): http://research.stlouisfed.org/fred2/series/FEDFUNDS?cid=118. Here you can find data and a graph about the effective federal funds rate determined by the Federal Reserve. Note the spike in the series during the first years of Volcker’s tenure at the Federal Reserve.

Related Article Statement before the Committee on Banking, Finance and Urban Affairs (House of Representatives, 02/19/1980): http://fraser.stlouisfed.org/historicaldocs/788/download/28125/Volcker_19800219.pdf. This

.

250

Mishkin • Macroeconomics: Policy and Practice, Second Edition

statement by the Chairman Paul Volcker shows his views about the conduct of monetary policy and inflation in particular (check page 4, the last paragraph).

Discussion Question Suppose that after a long period of low and stable inflation but significant changes in output a new chairman has to be nominated. Do you think that an inflation hawk has more or less chances of being selected than an individual with a reputation of smoothing output fluctuations?

Answer: When a U.S. president has to nominate a Fed chairman, some of these questions arise. If inflation has been low and stable for quite some time, the public tends to forget or place less importance on inflation rates and focuses more on output volatility. Output volatility has the undesirable consequence (assuming imperfect insurance markets) of affecting consumption, investment, and the unemployment rate. During a recession, people often would like the Fed to forget about inflation and to focus on decreasing unemployment. In these circumstances, an inflation hawk would not be the favorite chairman, and although there is no election, the Congress has the opportunity to tell the president that another individual should be nominated. This was not the case with Paul Volcker, who was appointed with the goal of decreasing inflation after a period of high inflation.

.

Chapter 22 Modern Business Cycle Theory ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Real Business Cycle Model Productivity Shocks and Business Cycle Fluctuations Solow Residuals and Business Cycle Fluctuations Employment and Unemployment in the Real Business Cycle Model Objections to the Real Business Cycle Model New Keynesian Model Building Blocks of the New Keynesian Model Business Cycle Fluctuations in the New Keynesian Model Objections to the New Keynesian Model A Comparison of Business Cycle Models How Do the Models Differ?

Short-Run Output and Price Responses: Implications for Stabilization Policy Anti-Inflation Policy Chapter 22 Web Appendix: The New Classical Model

Chapter Overview and Teaching Tips Chapter 22 describes the two competing business cycle theories that emerged from the focus on microeconomic foundations of macroeconomics and the rational expectations revolution described in the previous chapter: real business cycle and new Keynesian models. Here is where the dynamic AD/AS framework used in this book is so valuable because it allows the instructor to give a coherent comparison of these two modern business cycle theories with more traditional Keynesian analysis and also shows how financial frictions can straightforwardly be made a key feature of macro models.

The chapter starts by presenting the basic idea behind the real business cycle model in the AD/AS diagram in Figure 22.1. The key point to get across to students is that complete wage and price flexibility means that the short-run aggregate supply curve becomes vertical and identical to the long-run aggregate supply curve. The real business cycle model is then one in which output fluctuations are entirely due to supply shocks and aggregate demand shocks play no role. The evidence cited in favor of the real business cycle model is the procyclicality of Solow residuals, and the evidence is evaluated in the chapter. It is worth first asking students in class what objections they think may have been levied against the real business cycle model and then discussing the subsection in the chapter on objections to the real business cycle model.

.

252

Mishkin • Macroeconomics: Policy and Practice, Second Edition

The new Keynesian model has some key elements of the real business cycle model—rational expectations and the view that supply shocks can be important to output fluctuations—but it allows for wage and price stickiness and thus has an upward-sloped short-run aggregate supply curve that differs from the long-run aggregate supply curve. The building blocks of the model are laid out in Equations 2–5, with the key innovation from the AD/AS model presented earlier that expectations of the future feature prominently in both the IS curve and the short-run AS curve. The resulting AD/AS model is one in which supply shocks (Figure 22.3) as well as demand shocks (Figure 22.4) drive business cycle fluctuations. The objections to the new Keynesian framework is that prices may not be sufficiently sticky and so demand shocks may not be as important to business cycle fluctuations as this model supposes.

Because the real business cycle, new Keynesian, and more traditional Keynesian models can all be couched in the AD/AS framework, it is easy to compare them, as is done in the chapter. First, Figure 22.5 shows that the difference in the real business cycle and new Keynesian models is one of degree. As wages and prices become more flexible the short-run aggregate supply curve has a steeper slope and rotates counterclockwise, and with complete wage and price flexibility, it becomes the same thing as the long-run aggregate supply curve. Thus the new Keynesian model becomes more like the real business cycle model as wage and price flexibility increases, and the real debate between them is how much of business cycle fluctuations should be attributed to demand shocks versus supply shocks. The real business cycle and new Keynesian models are then compared to a more traditional Keynesian model in which expectations are not rational by examining how output and inflation responds to policies to stabilize the economy or to reduce inflation (Figures 22.6 and 22.7). An earlier model that emerged from the focus on microeconomic foundations of macroeconomics and the rational expectations revolution was the new classical model, which is discussed in an online appendix on the Companion Website at www.pearsonhighered.com/mishkin. Some instructors will want to teach this online appendix because the new classical model was a precursor to the real business cycle and new Keynesian models. However, objections to this model discussed in the appendix led to it being superceded in the literature, and so it is less critical that it be taught to students.

◼

Answers to End of Chapter Review Questions and Problems

Answers to Review Questions Real Business Cycle Model 1. The real business cycle (RBC) model assumes that all wages and prices are completely flexible. This means that the short-run aggregate supply curve is identical to the long-run aggregate supply curve.

Therefore, all fluctuations in output result from real shocks that change potential output. The RBC model ascribes these shocks to positive or negative productivity shocks, specifically to changes in A, the total factor productivity variable in the aggregate production function, or to changes in workers’ willingness to work. Demand shocks affect inflation but have no impact on output. The RBC model also holds that unemployment is voluntary.

2. The RBC model explains fluctuations in employment and unemployment through intertemporal substitution. When productivity rises, thereby increasing output, workers earn higher wages today, and so intertemporal substitution indicates that they will be willing to work more, and so employment will rise, and unemployment will fall. When productivity and output falls, the opposite will occur, and employment will rise, and unemployment fall.

3. First, labor hoarding, in which firms maintain their workforce despite slowdowns in production, distorts the measurement of total factor productivity, so it does not actually decline during recessions as the real business cycle (RBC) model asserts. Second, critics doubt whether negative productivity shocks can occur, a point that RBC proponents dispute. Third, according to the RBC model, inflation

.

Modern Business Cycle Theory

253

should rise during recessions and fall during economic booms, and real wages should fall during recessions and rise during economic booms, but the evidence supports neither of these patterns.

Fourth, wages and prices are not perfectly flexible. Fifth, RBC opponents question the view that all unemployment is voluntary.

New Keynesian Model 4. In the new Keynesian model, firms change their prices infrequently, so prices are sticky, and individual firms do not all change their prices at the same time, so price changes are staggered. This means that inflation today depends on tomorrow’s expected inflation, not today’s, as well as on the output gap and price (or markup) shocks and that firms consider both current and future economic conditions when making their infrequent price adjustments. Because inflation rises today when current output exceeds potential output, the short-run aggregate supply curve is upward sloping and shifts upward or downward as future expected inflation rises or falls.

5. The new Keynesian model incorporates forward-looking behavior by consumers and firms so that consumption and investment spending depend on current and future output along with the real interest rate. This means that current output depends on today’s real interest rate and demand shocks and also on expectations of future monetary policy and real interest rates and on expectations of future demand shocks. Both curves still slope downward as they do in the basic short-run model covered earlier, but now they have become dynamic because they depend on expectations about the future that are subject to change.

6. Like the real business cycle model, the new Keynesian model recognizes that shocks to long-run aggregate supply can be an important cause of business cycle fluctuations. However, unlike the real business cycle model, the new Keynesian model also emphasizes the importance of demand shocks as a source of business cycle fluctuations. Whether these shocks to aggregate demand are positive or negative, their effects on output are greater if they are unanticipated. This is because if the shocks are anticipated, expected inflation changes and the short-run aggregate supply curve shifts upward, for positive demand shocks, or downward, for negative demand shocks. As a result of these shifts in the short-run aggregate supply curve, output deviates from potential output by a smaller amount, but the shock have a greater impact on inflation.

Comparison of Business Cycle Models 7. In the traditional Keynesian model expectations are adaptive and backward-looking; the other two models assume rational expectations. The real business cycle model assumes that prices are completely flexible; the other two models assume prices are sticky. In the traditional Keynesian model, supply shocks are not a source of business cycle fluctuations; in the real business cycle model, they are the only source of such fluctuations; and in the new Keynesian model, both demand and supply shocks are sources of fluctuations in output.

8. In all three models, expansionary policy shifts the aggregate demand curve to the right. In the traditional Keynesian model, the short-run aggregate supply curve does not shift, so the expansionary policy causes both output and inflation to rise. In the new Keynesian model, if the expansionary policy is unanticipated, the results are the same as in the traditional Keynesian model. However, if the expansionary policy is anticipated, the short-run aggregate supply curve will shift upward because expected inflation will increase, so the increase in output will be less than in the traditional Keynesian model, and the increase in inflation will be greater. In the real business cycle model, the expansionary policy will have no effect on output but will raise inflation more than anticipated expansionary policy does in the new Keynesian model.

9. In all three models, anti-inflation policy shifts the aggregate demand curve to the left. In the traditional Keynesian model, the short-run aggregate supply curve does not shift, so the anti-inflation policy

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

254

causes both output and inflation to fall. In the new Keynesian model, if the anti-inflation policy is unanticipated, the results are the same as in the traditional Keynesian model. However, if the antiinflation policy is anticipated, the short-run aggregate supply curve will shift downward because expected inflation will decrease, so the decrease in output will be less than in the traditional Keynesian model, and the decrease in inflation will be greater. In the real business cycle model, the anti-inflation policy will have no effect on output but will reduce inflation more than anticipated antiinflation policy does in the new Keynesian model.

10. The real business cycle model does not see any benefit from discretionary policy and only costs because it will not affect output fluctuations but will create volatility in inflation. The traditional Keynesian model views discretionary policy as highly effective because it can reduce business cycle fluctuations by shifting the aggregate demand curve to return the economy to full employment. The new Keynesian model is in between the two other models: discretionary policy can be beneficial, but it is difficult to do.

Answers to Problems Real Business Cycle Model 1. a Variable

Period 1 Period 2 Period 3 Period 4 Period 5 Period 6

Capital (K)

1

1

1.1

1

0.95

1

Labor (L) Output (Y)

32 10.0

33 10.6

32 11.6

32 10.8

323 10.4

2 10.8

Technology (A)

1.25

1.3

1.4

1.35

1.33

1.35

Growth rates: Variable

Period 2

Period 3

Period 4

Period 5

Period 6

Output (Y)

6.0%

9.4%

–6.9%

–3.7%

3.9%

Technology (A)

4.0%

7.7%

–3.6%

–1.5%

1.5%

b. According to the data presented in the table, there seems to be evidence supporting real business cycle theory. Solow’s residual and output growth rates follow each other quite closely. As observed in the table and in the graph, they are both positive and negative at the same point in time.

Output and Technology Growth Rates

10.0% 5.0% 0.0% 2

3

4

5

-5.0% -10.0% output

.

technology

6

Modern Business Cycle Theory

2.

255

According to data on unemployment and output growth, there does not seem to be much evidence in favor of the real business cycle theory tenet that employment is procyclical (or that unemployment is countercyclical). From 2006 until the second quarter of 2008, there was some fluctuation in output growth that did not have a significant effect on unemployment rates. After the second half of 2008, unemployment increased as the recession reached its worst stage. However, as output increased subsequently, unemployment rates continued to increase, and remained high even after output growth rates became positive.

Output growth and Unemployment (US data 2006-2010) 12.0 7.0 2.0 -3.0 -8.0 q3 q3 q3 q4 q1 q2 q3 q1 q2 q4 q1 q2 q4 q1 q2 q4 q1 06 006 006 006 007 007 007 007 008 008 008 008 009 009 009 009 010 2 2 2 2 2 2 2 20 2 2 2 2 2 2 2 2 2

unemployment

output growth

3. No, this is not consistent with the real business cycle model, in which all unemployment is voluntary.

If workers are employed part-time for economic reasons, they are involuntarily working less than they would like due to economic conditions out of their control. As a result of this, when demand for goods declines during recessions, rather than laying off workers, firms will reduce hours to maintain its labor force in anticipation of an eventual improvement in the economy. Thus, keeping workers on a part-time basis is a form of labor hoarding because employment can remain the same, but the production by part-timers would be lower and, hence, be reflected in lower labor productivity as measured on a per-worker basis.

New Keynesian Model 4. If the negative demand shock is unanticipated, the short-run aggregate supply curve does not shift initially, and output falls to Y2. If the shock is anticipated, firms expect lower inflation, and therefore, the short-run aggregate supply curve shifts immediately down to the right. The equilibrium is now at point 3, where output is at Y3 (a higher level than Y2).

.

Mishkin • Macroeconomics: Policy and Practice, Second Edition

256

5. An increase in consumer confidence about the future results in an increase in consumption expenditures, an important component of aggregate spending. In the New Keynesian model, this translates into a positive demand shock, shifting the aggregate demand curve to the right. If the shortrun aggregate supply does not shift because the shock is unanticipated, then output and inflation increase. If the shock is anticipated, the short-run aggregate supply curve shifts up to the left, and the increase in output is smaller, while inflation increases by more Comparison of Business Cycle Models 6. a.

The fact that most wages are the result of collective bargaining imposes significant rigidity in prices, especially in the downward direction. If expectations are adaptive (based on past data) and slowly changing as well, then the best fit for this set of conditions is the traditional Keynesian model. b. If prices are not that rigid and economic agents’ expectations are rational, then either the real business cycle or the New Keynesian models could potentially be a good representation of these conditions. Depending on assumptions about the source of business cycles, one could choose between these two models.

7. Bernanke’s speech had unintended consequences for the Fed’s reputation. Hours after he suggested the Fed might take all of these measures to avoid deflation, bond traders interpreted his speech as a sign that the Fed was turning soft on inflation. His statement was compared to a previous line by Milton Friedman (1960), when the latter suggested that the Fed could send a helicopter to drop dollar bills to get people spending if nothing else worked. Of course, this association did not help the Fed’s reputation, and Bernanke learned that these types of comments outside academic discussions can be severely misinterpreted.

8. According to the real business cycle model, the negative demand shock created by the increase in taxes will have no effect on output but would reduce inflation. Depending on the size and amount of distortion caused by taxation, it is plausible that the long-run aggregate supply curve could shift to the left as well, thereby decreasing output and keeping inflation at usual levels. The traditional Keynesian model does not distinguish between anticipated and unanticipated policy, so the effect is the same: a decrease in output and inflation derived from a negative demand shock. The new Keynesian model stipulates that if this policy is anticipated, then economic agents will incorporate their expectations about future negative output gaps into their current decisions. According to this, the short-run aggregate supply curve shifts to the right, and the decrease in output is smaller than predicted by the traditional Keynesian model. Inflation decreases by more than in the traditional Keynesian model.

9. Greater transparency and communication has the potential to guide expectations by price and wage setting agents, which can beneficially speed the adjustment process. Moreover, transparency and communication can enhance credibility, which helps the central bank maintain low, stable inflation.

However, in the traditional Keynesian model and real business cycle models, these factors do not matter because anticipated and unanticipated policies have the same effect. In only the new Keynesian model are these differences important. In this sense, improved transparency and communication by the Federal Reserve suggests a view that the new Keynesian model is probably most relevant to the Fed’s models of the economy.

10. a.

Output changed by –2.15 percent over that period, while inflation changed by –4.8 percentage points. Thus, the sacrifice ratio was 0.45. b. Because there were significant costs to the Volcker disinflation and a relatively high sacrifice ratio, this rules out the real business cycle model as a relevant framework because it predicts no costs to anti-inflation policies. Credibility doesn’t impact the outcomes from the traditional Keynesian model under an anti-inflation policy, so it is less relevant to understanding the Volcker

.

Modern Business Cycle Theory

257

disinflation and its effects. Low credibility by the Federal Reserve is similar to an unanticipated policy, in the sense that low credibility means agents won’t adjust expectations in response to announced policy actions or intentions (as if policies were unanticipated). Because the effects of anti-inflation policy on output are less under a credible new Keynesian regime than a noncredible one, this indicates that if the Federal Reserve had greater credibility, it could have reduced inflation with a lower sacrifice ratio under the new Keynesian model.

◼

Answers to Data Analysis Problems

1. a. For 2013:Q2, real GDP growth was 1.7 percent, and the Solow residual growth was 0.7 percent. b. The last time the Solow residual growth was negative was 2012:Q4 at –1.4 percent; real GDP growth in that quarter from the previous quarter was 0.1 percent. c. From 2008:Q2 to 2013:Q2, the correlation coefficient is 0.97, which is extremely close to perfect correlation of 1. d. Yes, the calculations do support the real business cycle model. Periods of low or negative Solow residual growth coincide closely with declines in real GDP. More generally, the two series have a very high correlation, confirming the co-movement of output and Solow residuals.

2. a.

From June 2012 to June 2013, employment growth was 1.1 percent, and inflation over that time was 1.3 percent. b. The end of the last recession occurred June 2009, when employment growth was –3.9 percent and inflation was –0.7 percent. c. No, the data do not support the real business cycle model. In both the most recent period of June 2013, as well as the end of the last recession in June 2009, both employment and inflation are clearly procyclical. This is counter to the real business cycle model, which indicates they should move in the opposite direction.

3. a.

Inflation recently was at its lowest point in 2009:Q3, when it was 0.2 percent. Prior to this, the highest recent inflation rate was 3.4 percent in 2006:Q2. Thus, inflation declined by a total of 3.2 percentage points over that time. b. From 2006:Q2 to 2009:Q3, real GDP decreased from $14,591.6 billion to $14,402.5 billion, representing a change of –1.3 percent in GDP over that time. c. The sacrifice ratio is given as –1.3/–3.2 = 0.41. d. The sacrifice ratio in the early 1980s period is –2.1/–4.8 = 0.44, which is fairly close to the more recent period, although the impetus for the declines are much different. The early 1980s disinflation was a direct result of anti-inflation policy. The decline in inflation over the more recent period is not the result of anti-inflation policy but driven mostly by demand contraction from the financial crisis.

◼ Answers to Review Questions and Problems in Web Appendix, “The New Classical Model” 1. According to the new classical short-run aggregate supply curve, aggregate output deviates from potential output when the actual inflation rate differs from the expected inflation rate. For example, if actual inflation exceeds expected inflation, then aggregate output will be greater than potential output. This result is caused by producers’ misperceptions when the prices of their goods are rising faster than their expected rate of inflation. Instead of interpreting this to mean that the general price level is rising at a faster pace than expected, they instead mistakenly interpret it to mean that the

.

258

Mishkin • Macroeconomics: Policy and Practice, Second Edition

relative prices of their goods are rising, and they, therefore, expect to profit by increasing the output of their products. With no misperceptions, aggregate output would always equal potential output.

2. If a policy change is unanticipated, then expected inflation does not change. Thus, when the policy change shifts the aggregate demand curve, the short-run aggregate supply curve does not shift.

Aggregate output and inflation both either rise (if expansionary policy shifts AD to the right) or fall (if contractionary policy shifts AD to the left). When the public anticipates the policy change, however, the short-run aggregate supply curve shifts because, with rational expectations, the public recognizes that the policy change will cause inflation to change. Therefore, with an expansionary policy change, expected inflation rises, and the short-run aggregate supply curve shifts upward, and for a contractionary policy change, expected inflation falls, and the supply curve shifts downward.

Despite the policy change, the economy remains at long-run equilibrium with aggregate output equal to potential output. Thus, anticipated policy changes have no effect on aggregate output or the business cycle, a new classical model result that is called the policy ineffectiveness proposition.

3. The policy ineffectiveness proposition emphasizes that policy changes have different effects depending on whether or not they are anticipated, which implies that policy makers cannot predict the impact their policies will have unless they know the public’s expectations. For example, suppose policy makers enact expansionary policies. These policies may either increase aggregate output (if not anticipated by the public), leave aggregate output unchanged (if anticipated by the public), or cause aggregate output to decline (if the policy is less expansionary than the public expected). It will be difficult to determine the public’s expectations and even more difficult to create a policy that surprises the public. Discretionary stabilization policy may actually be destabilizing and cause undesirable fluctuations around potential output. Policy makers therefore should reject discretionary policy and strive to minimize policy surprises.

4. The chief objection to the new classical model is that it cannot explain the persistence of business cycle fluctuations. Additional objections are that firms would not be fooled as misperceptions theory describes and that there is little empirical support for the policy ineffectiveness proposition.

.

Epilogue Policy and Practice: Where Do Macroeconomists Agree and Disagree? ◼ Chapter Outline, Overview, and Teaching Tips Chapter Outline Where Macroeconomists Agree Inflation Is Always and Everywhere a Monetary Phenomenon The Benefits of Price Stability No Long-Run Tradeoff Between Unemployment and Inflation The Crucial Role of Expectations The Taylor Principle The Time-Inconsistency Problem Central Bank Independence Commitment to a Nominal Anchor Credibility Institutions Rule Where Macroeconomists Disagree Flexibility of Wages and Prices How Much Time It Takes to Get to the Long Run Sources of Business Cycle Fluctuations Effectiveness of Stabilization Policy Cost of Reducing Inflation The Dangers of Budget Deficits The Future of Business Cycle Theory

Chapter Overview and Teaching Tips Macroeconomists are a contentious lot, and as an epilogue of the book, it is worth pointing out where macroeconomists agree and disagree. Although this epilogue will best be understood by students if they read the two previous chapters, instructors can still use this chapter even if the two previous chapters are not covered in the course to provide an informal discussion of where the macroeconomics discipline is at the current time.

The epilogue first lays out ten areas where macroeconomists generally agree: 1. Inflation is always and everywhere a monetary phenomenon.

.

260

Mishkin • Macroeconomics: Policy and Practice, Second Edition

2. Price stability is beneficial.

3. There is no long-run tradeoff between unemployment and inflation.

4. Expectations play a crucial role in macroeconomics.

5. The Taylor principle is a basic requirement for monetary policy.

6. The time-inconsistency is an important problem.

7. Central bank independence is valuable.

8. Commitment to a nominal anchor produces better economic outcomes.

9. Credibility is a key element of policymaking.

10. Good institutions are the key to achieving high economic growth.

The epilogue then outlines six basic issues on which macroeconomists still have major disagreements: 1. The flexibility of wages and prices 2. How much time it takes to get to the long run 3. The sources of business cycle fluctuations 4. The effectiveness of stabilization policy 5. The costs of reducing inflation 6. The dangers of budget deficits Once these areas of agreement and disagreement are discussed in class, the instructor can finish the course by speculating on where business cycle theory will be heading in the future, just as I have done at the end of the epilogue.

.