All Terrain Thinking

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

Answers for the Day
Introduction to Macroeconomics

1. The accompanying graph describes the pattern of sales at Sam's Market during much of the 1970's. As you can see, in 1974 Sam's suffered a substantial drop in sales and has never regained the loss. Sam, the owner of this intermediate size market in Westerly, attributes the loss in sales to a problem with the quality of some of the produce supplied to his market for a brief period in 1974. The error was quickly corrected, but Sam contends that faithful customers were lost during this period and that they never returned. He is therefore attempting to collect from the supplier an amount of money equal to the difference between projected sales and the actual sales over the period 1974-78.

Your job is to prepare a defense for the supplier in this case. You are to outline your plan and describe the rationale for it. Be sure to indicate what you consider the important factors to be considered and what data you would use, how you would obtain the data, and how you would utilize it.

Before we move on to discuss the significance of scale, let us return to one of our initial problems, SAM's market. You will recall that SAM's had brought suite alleging that their sales had been damaged as a result of a mishap in the store. The benchmark in their case was a projection based on a simple extrapolation of the previous trend. But is this an appropriate benchmark ? In the two graphs below, the pattern of State sales has been used as a benchmark. In the first, the indexes of SAM's sales and state supermarket sales are plotted because SAM's sales are in millions and the state sales are in hundred of millions. It seems clear from the graph that SAM's sales decline is in line with the declines in the State, which raises questions regarding the extent to which the mishap was responsible for the sales decline.

A somewhat different view of the situation, but one that brings us to the same conclusion, is the graph of the ratio of SAM's sales to the State's. This measure of relative sales also fails to show the deteriorating position of SAM's. In fact, we see that SAM's share of State sales increased after the mishap as SAM's sales fell less than sales in the State. In fact, when reviewing the two graphs it looks as though SAM's was able to weather the recession of 1973 better than the rest of the supermarkets in the State.

2. In macroeconomics we tend to focus our attention on business cycles-short term fluctuations in the economy. But what about the cycles in attitudes towards public policy, views on the self-adjustment powers of the economy, and the economic 'crises' that have produced these cycles. Please explain the parallel movements in economic policy, economic theory, and economic performance.  Be sure to look closely at the Great Depression era and the stagflation of the 1970s.

There tends to be a relationship between the three. For example, let's look at the Great Depression. At the time the Depression began in 1929, the prevailing view was that the economy operated well on its own - that the markets tended to correct any imbalances. The Policies derived from this Classical view were essentially 'hands-off' policies - balance the budget and maintain the gold standard. When the Depression lengthened and the theorists and policy makers were unable to explain the problem, let alone cure it, the time was right for an alternative view. The theorist was Keynes and the policy makers followed - the best example being the Kennedy tax cut in 1964. In the 1970s, however, the Keynesians were not able to explain the stagflation - the performance. Into the void stepped the New Classical economists and the supply-side policies we attribute to Reaganomics.

2. The AS-AD model plays much the same role in macroeconomics that the S-D model plays in microeconomics.  It provides a way of structuring your thinking as you read the business news and try to make sense of the movements in the economy.  You are to demonstrate with the aid of the AS-AD model the impact of the following events:

• a. a significant recession in Asia
• b. a substantial slide in the value of the yen
• c. a decrease in the price of oil as Iraq's oil production returns to the market

The AS-AD graph that is at the center of this questions appears below.  The approach is similar to the cookbook approach with the S-D model.   In each question we need to identify which curve it shifts and what is the nature of the shift.  The answers that are sketched out below should not be viewed as the complete answer in that there are certainly additional linkages that could be identified, but these are major links that will provide you with a sense of how you can utilize the diagram to sort through the impact of events on the US economy.

a. A recession in Asia.  On the demand side, a recession outside of the US will likely reduce demand for US exports which are a component of AD.  This would shift the AD curve inward moving the intersection down and to the left.  The recession in Asia would put downward pressure on income and prices in the US.  This was widely accepted as one of the reasons that the Fed did not take action to slow down the economy in the summer of 1998. The belief was that the Asian crisis would slow it down and thus the Fed would not need to step in.

b. A substantial slide in the value of the yen.  The decline in the yen is the flip side of an increase in the value of the dollar.  A declining yen will reduce US exports and increase US imports since US goods are now more expensive in Japan and Japanese goods are now cheaper in the US. This will reduce AD and the AD curve will shift inward putting downward pressure on output and prices.  The decrease in the price of Japanese imports will be reflected in a lower level of prices in the US which is comparable to a reduction in the cost of production.   This will shift the AS curve outward which will put upward pressure on output and downward pressure on prices.  The combined effect is a clear lowering of prices (inflation) with a less certain change in output

c. A decrease in the price of oil as Iraq's oil production returns to the market.  The decrease in the price of oil will lower the cost of production.  This will shift the AS curve outward which will put upward pressure on output and downward pressure on prices.  This is the opposite effect from what we saw in 1973 when the OPEC nations dramatically raised the price of oil and sent the US economy into stagflation.  The increase in the price of oil shifted the AS curve in putting downward pressure on output (Stagnation) and upward pressure on prices (inflation).

3. What is the relationship between the budget deficit and the trade deficit?

There is no simple relationship between them, but the national income identity does provide a framework for looking at that question.  The AS = AD version of the identity appears below. 

(1) Q = C + I + G + X - M

As we saw in the section on the national income identity, this equation can be transformed into one which explicitly contains the trade and budget deficits.  The trade deficit is defined to be the value of imports minus the value of exports (M-X).   The budget deficit is defined to be the value of outlays minus the value of receipts (G-T).  The resulting equation is:

(3) (S - I) = (NFP - TDEF) + BDEF

With a little reworking of the algebra we get the following:

TDEF =  BDEF + [NFP + (I - S)]

Based on this equation we should expect a positive relationship between the budget and trade deficits, although the relationship may not be a very good one since there are other factors to consider - the balance between savings and investment (S-I) and the level of net foreign payments (NFP).  For example, we could have a trade surplus [TDEF < 0] and a budget deficit  [BDEF > 0] if (I - S) < 0 which would be the case if the country had a high savings rate and/or a low rate of investment. 

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