All Terrain Thinking

A Compendium of things I think are Important

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

1960s: Stabilization Theory

The Setting

"The Congress hereby declares that it is the continuing policy and responsibility of the Federal Government to . . . promote maximum employment, production and purchasing power."  1946 Full Employment Act

"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... 1962 Economic Report of the President January 1963

" the great enemy of truth is very often not the lie - deliberate, contrived, and dishonest - but the myth, persistent, persuasive, and unrealistic."

"I say that the time-tested rules of financial policy still apply.  Spending for spending's sake is patently a false theory... In effect we are stealing from our grandchildren in order to satisfy our desires of today....Imagine how much better the country would feel if it had no debt at all but a healthy surplus."  Eisenhower, Saturday Evening Post May 18, 1963 (15-16)

"The tax bill before you, ... seems on balance to be a bad piece of legislation. ... The country cannot afford economic experiments which are almost certain at some time or other to weaken confidence in the dollar, both internally and externally.... [D]eficit spending...was tried and presumably discredited in the 1930s.... Not only is a large tax reduction foolhardy, it is also likely to be futile in dealing with the most serious aspects of our very real problem of unemployment.  In recent months there has been increasing recognition of the fact that unemployment is concentrated in particular groups of the population...

Monetary and fiscal measures cannot solve the problems of structural  ...  unemployment...

    This discrimination makes our tax system commensurately more progressive..." Dan Throop Smith, former Assistant Secretary of the Treasury for Tax policy (Eisenhower), Testimony before Senate Finance Committee,  October 1963      

"Economics has come of age in the 1960s.... The paralyzing grip of economic myth and false fears on policy has been loosened, perhaps even broken.  We at last accept in fact what was accepted in law 20 years ago in the Employment Act of 1946, namely, that the federal government has an overarching responsibility for the nation's economic stability and growth.  And we have at last unleashed fiscal and monetary policy for the aggressive pursuit of those objectives.
    These are profound changes.  What they have wrought is not the creation of a 'new economics,' but the completion of the Keynesian revolution - 30 years after John Maynard Keynes fired the opening salvo." Walter Heller, New Dimensions of Political Economy, 1966 (1-2)

Questions of the day

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. 
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.
3. If you heard that inventory investment was rising, would this be an indicator that the economy is heating up or slowing down?
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?
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? 
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 and what did Kennedy propose as the "truth?" 

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

Building in timing

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

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?
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.
3. How are the budget deficits of today rooted in the work of Keynes?
4. As a policy maker would you want an economy to have a large or small multiplier? Explain briefly.
5. What are the limitations of the multiplier analysis?

An outline

• Detailed treatment of aggregate demand (what and why)
  • Consumption
  • Investment
  • Net Exports
  • Government
• Building in inflation
  • Phillips curve
  • decomposition of unemployment
  • macro vs structural problems
• Building in timing
  • expectations
  • lags
• Forecasting
  • time series
  • econometric

The Theory:

• Detailed treatment of aggregate demand

Consumption (disaggregation, relationship to income(Y), determinants (Friedman)
C = a + b*Y

C/Y = a/Y + b
Investment (disaggregation, relationship to interest, determinants, dual effect)

• Building in inflation

Inflation - unemployment tradeoff: the Phillips curve

Diagram 2
Phillips Curve

Phillips curve and AS-AD diagram

Diagram 3
AS-AD Diagram Phillips Curve

Improving the tradeoff:

• shifting the Phillips curve
• decomposition of unemployment (frictional, cyclical, structural)

Diagram 5
A Shift in the Phillips Curve

• Building in timing

• lags
• uncertainty

Diagram 1

• Economic forecasting

• time horizon
  • Long-term (drivers)
  • Short-term (decomposition of time-series)
• techniques
  • the ruler
  • the relationship
  • the experts

The Policies

Kennedy tax cut

Johnson tax surcharge

Add to Your Social Bookmarks: Del.icio.us Digg Furl Reddit Simpy Spurl Y! MyWeb - StumbleUpon