All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Answers for the Day
1960s: The Short-run

Aggregate demand and the multiplier

1. In 1998 the Fed (Federal Reserve) drove down interest rates in the hopes of averting a serious recession caused by the Asian Crises.  Please explain how this policy could help keep the economy from slipping into a recession by increasing AD. 

The key to the policy's effectiveness was the responsiveness of aggregate demand to interest rates.  If spending were every responsive, then you would expect that the lowering of rates would increase spending and this would help offset the Asian crises.  The places where you would look for the impact would be residential investment (new homes) and consumer durables (automobiles).  

2. Detroit, MI has been known as the Motor City because of the high level of employment in the automobile industry.  Hartford, meanwhile, was known as the Insurance Capital because of a high concentration of insurance companies there.   Based on this information, which city would you expect to be hit hardest by a recession.

All industries do not follow the same cyclical patterns.   The most volatile are consumer durables while the most stable are services.  A city where much of the employment is in durables would be expected to be harder hit by a recession.    The recessions tend to hit the mid-west first which you can see as the states are the first to see rising unemployment rates.

3. If you heard that inventory investment was rising, would this be an indicator that the economy is heating up or slowing down?

Inventory investment is difficult to interpret since it has a desired and undesired component, but for now let's look at the change as the result of an undesired increase in inventories.  The increase occurs because demand is inadequate to meet current production levels and you could expect that firms would eventually begin to cut back on production to bring production more in line with demand.  The production cut would slow the economy so we should interpret the buildup of inventories as a leading indicator of a slowdown in the economy. 

4. The stock market is hot. But will it stay hot-or can we expect it to fall? We will talk about these later, but for now I would like you to describe to me the impact on the macroeconomy of a dramatic fall in the stock market. How will it affect aggregate demand?

Consumption spending depends upon a number of factors - one of which would be wealth. As the stock market booms people believe that they are wealthier and they are likely to increase their spending. When the crash comes, however, the process works in reverse and the decline in stock prices will lower aggregate demand which could trigger a recession.   

5.  John Kennedy proposed the unthinkable - a tax cut that many thought would create a budget deficit.  His response was: "Until we restore full prosperity and the budget-balancing revenues it generates, our practical choice is not between deficit and surplus but between two kinds of deficits: between deficits born of waste and weakness and deficits incurred as we build our strength... "  What is Kennedy referring to when he describes deficits borne out of weakness and deficits borne out of strength? 

A budget deficit could happen if the economy weakens and falls into a recession.When the economy slows down the government will collect less tax revenue and it will spend more on programs such as unemployment benefits.  A deficit could also happen if taxes were cut and the economy began to expand.  Although both would be deficits, the latter one would be associated with a stronger economy - at least in the short-run. 

6. In a speech at Yale University, Kennedy warned about the power of myth when he said: " the great enemy of truth is very often not the lie - deliberate, contrived, and dishonest - but the myth, persistent, persuasive, and unrealistic."  What is the myth that he was referring to in his speech?"  

The myth that Kennedy was referring to was the balanced-budget myth.  Classical economists had created the "myth" that the government needed to balance the budget and that any attempt to run a deficit would crowd out the private sector. 

Building in inflation

1. Dan Throop Smith, former Assistant Secretary of the Treasury for Tax policy (Eisenhower), testified before Senate Finance Committee in October of 1963. he testified against the Kennedy tax cut on a number of grounds.   One was his belief that: "Monetary and fiscal measures cannot solve the problems of structural ... unemployment..."  What is structural employment and how is it related to the concept "a rising tide lifts all boats?"

Structural unemployment is very different from cyclical unemployment which would be the type of unemployment that could be improved by discretionary monetary and fiscal policy.  Throop felt that the bouts of structural unemployment are not as likely to be affected by countercyclical macro policies which is what the tax cut was designed to be.  The rising tide lifts all boats concept, meanwhile, describes a situation where an expanding economy brings all segments of the labor force along for the ride.  According to this view, an expanding economy will create a wide array of jobs that will improve the employment situation for all workers.   Even if the growth is centered in the high tech industry, it will create income that will create jobs in the fast food and maintenance industries.   

2. What is the Phillips curve and how could you think of it as a menu of choices facing macro policy makers?

The Phillips curve is a visual representation of a trade-off between inflation and unemployment.  If a policy maker decides on a policy to push inflation rates lower, you can expect to see higher unemployment rates result from this decision.  Similarly, a policy to aggressively reduce unemployment will result in higher inflation rates. This presents the policy maker with a menu of choices for inflation and unemployment rates. 

3. No one likes unemployment and no one would vote for someone promising higher unemployment. But why then would we find some people urging us not to use macro policies to reduce high unemployment level. What am I missing?

There are no free lunches - even in macroeconomics. Keynesian policy makers accept the existence of the Phillips Curve - at least in the short-run. You might find a policy maker pushing for contractionary policies which would tend to help reduce inflation, but at the cost of higher unemployment.

4. There is talk today of a new labor force emerging where you will not only be asked to give up the notion of job security, you are even being asked to give up the concept of career security. What happens to the full-employment rate of unemployment when the pace of structural change in the economy accelerates? What would you propose as policy initiatives to help reduce the natural rate of unemployment?

If the rate of structural change in the economy increased then the natural rate of unemployment is likely to rise. At any level of aggregate demand, there is a higher level of unemployment. The policy approach to cure this would be targeted at helping workers rebuild their skills and finding new employment so that workers in declining industries could quickly move into the expanding sector.

5. What are the important differences between a worker at Raytheon who loses a job due to the decline of defense spending and the auto worker that is out of work due to falling demand caused by the Asian crises in 1998?

The first of these is an example of structural unemployment while the latter is an example of cyclical unemployment. When you look at the two, those out of work because of structural unemployment tends to be out for longer periods of time and their bouts of unemployment are not as likely to be affected by countercyclical macro policies. 

Building in timing

1. Would you expect a temporary tax cut to have a larger impact on consumption or investment spending?

As we saw in the question above, temporary tax changes have little impact on consumption since consumption spending is dependent on long-term changes in income.  A very different situation arises when we look at taxes / subsidies on investment.  For example, consider the situation faced by a business deciding when to make a purchase of $100,000 worth of computers.  If the government offered a ten percent investment tax credit this year, then the costs of the computers would be reduced by $10,000 this year.  If you bought them today, you would save $10,000 which is likely to have a substantial effect on investment spending.

2. What did we learn from the Johnson tax increase of 1968?  How can the theory of consumption spending explain differential response of consumption to the Kennedy and Johnson tax changes?

There were a few lessons. The first was that Keynes may have not fully anticipated the political nature of discretionary fiscal policy. In this case the politics of an unpopular war and an upcoming election were factored into the economics of a tax increase. On the one hand, the Keynesian theory gave politicians a new tool that they could use to "buy" votes which Tufte describes in his book, Political Control of the Economy. According to Tufte, the evidence clearly indicates that politicians have utilized standard macroeconomic theory to deliver a strong economy with happy, employed workers on election day - even if it meant a recession induced reversal soon after the election. We also learned that a potential difficulty with discretionary policy are lags.

The second lesson was that not all tax policies are created equal. In this case of the Johnson surtax, we found that temporary tax cuts to individuals will likely have a limited impact on consumer spending. The reason, given by Milton Friedman, is that individual spending levels are based on permanent rather than current income and that because temporary cuts have little impact on permanent income, they have limited impact on spending.

Forecasting and fine-tuning

1. If you had some inside information that a recession was only three months away and that a countercyclical policy could help soften the blow, would you choose monetary or fiscal policy as the means of softening the fall?

There is no easy answer on this one since the lags in monetary and fiscal policy are so very different. There is no difference in the recognition lag, but the implementation lag is much shorter with monetary policy.   Essentially all you need is the Chair of the fed to decide on a policy and it is done.  An example would be the decisions by Alan Greenspan in late 1998 to lower interest rates in an effort to offset the recessionary influences of the Asian crises.   Once the pollicies have been agreed upon and implemented, monetary policy tends to have longer action lags - the time from implementation to actual changes in aggregate demand.  The bottom line - the correct choice depends upon a number of lags and there is no clear winner in terms of the shortest over all lag. 

2.  Assume that you were asked by your boss to come up with a forecast of company sales over the next two years.  Describe briefly how the the approach to developing a forecast would differ between a time-series and an econometric forecast.

A time-series forecast would require a thorough review of past sales data to determine any seasonal, cyclical, and trend components and then these patterns of change would be projected into the future.  An econometric forecast, meanwhile, would likely start with a model that links company sales with some indicator of the economy - maybe GDP.  Once that link had been established, then a forecast of GDP would be the key input into a forecast of future company sales.

3. How are the budget deficits of today rooted in the work of Keynes?

When Keynes wrote The General Theory the world was caught in a period of severe excess capacity and his multiplier model provided policy makers with a tool to grow the economy. The tool was fiscal policy and in the post WW II era the anti depression model was transformed into a fine-tuning, business cycle dampening model. The idea was simple: a year is an arbitrary measure of time when we think about economies. The appropriate time frame is the business cycle and over a business cycle the government should balance its budget. It does not, however, need to balance it each year. In fact, to smooth the economy's cycles we could envision a deficit in tough times and a surplus in good times. Politicians, however, seemed much more willing to cut taxes than raise taxes. This was a lesson that was not lost on those who watched the derailment of Walter Mondale's run for the President after he indicated that there would need to be a tax increase and George Bush who was nailed for raising taxes after telling the American people to read his lips where they saw the message "No new taxes." What Keynes appeared to have missed was the asymmetry in fiscal policy imposed by the political process.

4. As a policy maker would you want an economy to have a large or small multiplier? Explain briefly.

This is a good news bad news situation. A large multiplier would mean that the economy is very responsive to external shocks. It would also mean that any fiscal policy would produce much 'bang' for the 'buck'. Thus, while policy makers would see their policies have larger quantitative impact when the multiplier is large, it would tend to destabilize the country.

5. What are the limitations of the multiplier analysis?

This is the flip side of the previous question since the limitations have to do with how accurate the assumptions are when we are not in a very depressed economic state. The discussion here will focus on the assumptions regarding the other markets. A discussion of how the multiplier would be affected if we did not have unlimited excess capacity in the labor market and excess supply in the capital market. The questions to ask here would be: What would happen if interest rates did rise? What would happen if the increase in employment drove up wages? In both cases we would find that some of the multiplier effect would be diminished.

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