Great Macroeconomics series on PBS-U [Archive]

shanek

18th October 2003, 09:17 PM

Okay, for the benefit of people who don't have PBS You or for whatever reason can't or don't watch it, I thought I'd hit the highlights of each episode as my personal time permits. In compliance with the forum rules, this will not be a transcript of the entire episode (I ain't sitting down and typing out an hour's worth of lecture anyway), just the highlights based on what's the most important to know, and what we've talked about here in the forum.

So here's a partial transcript of the first episode, "The Macro View." This is just a basic primer to macroeconomics and sets the stage for what will be discussed in later episodes.

Bob Connolly: When I first studied economics, my teachers had all been profoundly influenced by the Great Depression. It dominated the economics debate for years, and we learned a lot from it. Now we have a new touchstone, though. In the two decades between 1965 and 1985, global gyrations of the economy redefined conventional economic wisdom. From studying this period, economists have gained an even deeper understanding of macroeconomic forces.

[...]

William Seidman, Former FDIC Chairman: We went to guns and butter, we began to run up the deficit, and that was followed by inflation because we spent more and we didn't support it with increased taxes or increased revenues.

President Lyndon Johnson: That the tragedy and the torment of these terrible days will bind us together.

Connolly: President Lyndon Johnson first came to Washington as a Democratic Congressman in Franklin Roosevelt's New Deal. His concerns for the poor, the uneducated, and the needy let to what he called the Great Society. It was the largest expansion of social spending in the history of the United States.

Prof. Richard Sylla, NYU: President Johnson basically said, "We're such a great country, we can have more guns and more butter." He was wrong, of course, and the result was inflation. Prices began to go up.

President Richard Nixon: Those who have served in this high office, only those who have served in this high office, can know the tremendous burdens and they have so much to offer.

Connolly: By 1971, Richard Nixon was in the White House. Spending continued at high levels, and with the Presidential electons coming, the state of the economy was a growing issue. Nixon, for the first time in American history, instituted a wage and price freeze. The controls defied everything economists preached.

Prof. William Allen, UCLA: In his memoirs, Nixon says, "I knew at the time, I understood, that this was lousy economic policy. This is simply not the way to run an economy." He understood the arguments against such controls. But then, why did he impose them? "Well," he said, "sometimes the politics of economics outweighs the economics of economics."

Connolly: A year after the election, the Arab-Israeli War erupted in the Mid-East. With it came OPEC, an oil embargo, rapidly rising energy prices, long lines at gas stations, and a lesson in energy independence.

Dr. Cecilia Conrad, Joint Center for Political and Economic Studies: And since oil is a major input into a large array of industries, as a result of that increase in price companies had to cut back on their output, and that meant they cut back on the number of people they employed. And so there were layoffs and reductions in employment. And as a result of that, income contracted and those workers couldn't spend the money on other goods and services, so there were reverberations throughout the economy from this increase in the price of oil.

[...]

Sylla: With rising inflation, rising unemployment, we had to have a special name for that because we had never seen rising inflation and rising unemployment. So we invented the term "stagflation."

These next three principles are very important:

Connolly: There are three important principles that you need to be aware of...Productivity, the role of money in understanding prices, and what we call the Phillips Curve, or the tradeoff between inflation and unemployment.

For any country, the standard of living for the population depends on their ability to produce goods and services. Economies with high productivity are economies with high standards of living. Those with relatively unproductive capital and labor have a lower standard of living because they can't produce as much.

Conrad: It's a combination of factors, but probably the key is the human capital: the characteristics of their population, the education they have, the investments that have been made in training, I would put that at the top of the list. Following that, I'd have to look at public infrastructure. Roads: do you have a way to get from farm to market? Because even if you produce a lot of output, if you can't take it to the market then it'll sit on the ground and rot.

Connolly: The second principle has to do with the connection between the money supply and inflation. We get inflation because the government prints too much money. That's the basic primary cause. And this idea that sustained inflation comes from the excessive expansion of the money supply is fairly well accepted across all of economics.

Sylla: Basically, it's too much money chasing too few goods or services. It means you cannot produce what business demands. And so it drives prices up.

Connolly: Our third principle is named for an English economist, A.W. Phillips, who first recognized that society has to make a tradeoff in the short run between inflation and unemployment. That is, over a period of a year or two, it's possible in a particular economy to reduce the unemployment rate by instituting policies thaty push up the inflation rate. In the long run, though, this tradeoff doesn't hold.

So, if nothing else, we've debunked the claim made by many in this forum that sustained inflation means a growing economy. It doesn't.

Now, a very important concept that seems to escape many is the Circular Flow Model:

Connolly: Inside any economy, there's the flow of goods and services between households and businesses. And it flows in a circular fashion....What happens is, households buy lots of goods and services, so there's a flow of income, or spending if you will, from households into the marketplace. And what comes back in the other direction are, of course, the goods....We also have to ask: Where did households get the money in the first place, and how did businesses get the products? So what we have to do is recognize that there's another set of markets for the factors of production, including the market for labor. In these markets, the households are going to be the suppliers, and the firms are going to be the buyers. So the idea here is that we have a sort of reversal of roles. Firms pay wages in order to acquire labor services, and households supply labor to the market in exchange for wages.

Now there are a couple of important points to take from this Circular Flow model. One point is, households and businesses have two places where they interact. You can think of the market for goods and services as the retail side, where households go to buy the things they need. And you can think of the market for the factors of production as the interaction in which businesses buy labor services, and that produces a flow of income, or wages, into the household. Meanwhile, firms transform these services into a finished product, which then goes into their retail outlets and is, in turn, purchased by households. But, of course, for the households to be able to afford to buy the product, they have to sell their services in the market for factors of production. An they're, of course, selling them to businesses, which use them to buy things. And it keeps going on like this in a circle. That's one point to take from this model.

The second point is this: If I want to measure how well an economy is doing, its standard of living and so forth, then I have to have some way to jump into this and decide how I measure all of this....There are two basic ways to approach this issue. I can jump into the market for goods and services and say, "Let's measure the value of all the goods and services that are sold in an economy"...We call this approach National Product. The other approach is to look at the other market, the market for factors of production, or inputs, and ask how much people were paid for their inputs, for their labor services and so on. We call this approach National Income.

Now the essential point I'd really like you to get out of the Circular Flow diagram is this: In macroeconomics it's impossible to separate wages and other household income from the payments that businesses receive for the products that they sell. Disturbances in either market...will spill over into the other market.

Of course, GDP is important to understand, because misusing GDP can lead you to all sorts of horrible mistakes. There's another episode that covers it more indepth, but this bit of transcript is good enough for now:

Connolly: Gross Domestic Product is the market value of all final goods and services produced within a country in a given period at a time...The idea [of Market Value] is that we're going to go into the market and measure value using prices as our yardstick. We're not going to try to compare apples and oranges, we're simply going to ask, "What's the price of apples, what's the price of oranges?" So our measuring tool is the market price. Now, what do we mean by "final goods and services"? Well, there are many stages in the production of goods and services, and we're not going to try to add up the value of goods in every stage of the process. In fact, all of the intermediate transactions are really going to be reflected in the price of the goods. So we ignore all of the intermediate steps, because that would essentially lead to double, triple, or even quadruple accounting. It's all captured in the final price of the product or service.

[...]

Connolly: We have to set some limit on a time period for our measurement. So typically in the United States, we measure GDP every quarter...But we report it each quarter at an annual rate...We report them by converting quarterly GDP to an annual basis. So if GDP in the quarter were actually $2 trillion, then we'd multiply it by four and report GDP at an annual rate of $8 trillion.

[...]

Connolly: If prices are generally rising from year to year, then an increase in nominal GDP can occur simply because there's a general increase in either inflation or production or both. But since real GDP uses the same prices from year to year, an increase in real GDP can only occur if there's a rise in production.

Let's look at the difference between real and nominal GDP...Because of higher inflation rates into the 1980s, in fact nominal GDP was rising very rapidly. But, of course, when you take out inflation it isn't rising rapidly at all...These aren't just numbers. Real people are affected, and so are the fates of nations. That's why we have to know the difference between real and nominal GDP.

There's actually a very simple way to convert nominal to real GDP. It's something called the "GDP Deflator," and it gives us a measurement in the difference between current prices and prices in the base year. We can define the GDP Deflator as nominal GDP in a particular year divided by real GDP in that same year....Now, how do we get nominal GDP? For every good and service, we multiply how many are sold by the price. In other words, we look at the total sum of the price times the quantity...The price of milk times the quantity of milk, plus the price of cereal times the quantity of cereal...you get the picture. And in the denominator you've got the price of each good from our base year times the current quantity...And what we're really seeing is the ratio of current prices to the base price, and this ratio directly reflects inflation.

[...]

Connolly: The Consumer Price Index is the measure of the overall cost of goods and services bought by the average consumer. To compute this measure, the first thing the Bureau of Labor Statistics does is go out and survey what people actually buy. They use this information to come up with a typical basket of consumer goods. And it's not based just on what people buy, but how much. After all, a package of light bulbs and a gallon of milk might be about the same price, but people probably spend a lot more of their income on milk than on light bulbs. So we want to weigh milk more heavily in our basket of consumer goods. Then we'll pick some year as our base year and see how the cost of this basket changes as time goes by. If the cost goes up by 10% in a given year, we say the rate of inflation is 10%. So the use, then, of this CPI is that it allows us to actually measure changes in the cost of the market basket of goods that consumers are actually consuming. It's not based on an arbutrary set of products; it's actually based on a survey of what people really buy.

I'll try and see if I can get the highlights from the next episode up sometime tomorrow.

DavidJames

18th October 2003, 10:00 PM

Are you kidding me, this is college level stuff? That Dr. Bob guy is brilliant. His "Circular Flow model" is PHD stuff.

"...firms transform these services into a finished product, which then goes into their retail outlets and is, in turn, purchased by households. But, of course, for the households to be able to afford to buy the product, they have to sell their services in the market for factors of production. An they're, of course, selling them to businesses, which use them to buy things"

Really? amazing, simply amazing.

And you say this escapes many, hmm. I wonder how many people here never understood that business hire people to make stuff and people get jobs to buy stuff. Hands please.

Pretty deep stuff!

corplinx, I think you are right, malachi would never be able to navigate the complex math and advanced economic theory as presented by Dr. Bob, just thinking about it is making my head spin.

Gem

18th October 2003, 10:10 PM

Are you kidding me, this is college level stuff? That Dr. Bob guy is brilliant. His "Circular Flow model" is PHD stuff.

I took macro and micro classes in my community college. Let me tell you something I learned in late chapters, it can get VERY complex, especially banks and loans. I remeber the Circular flow model, there is much more complex stuff than this.

Math in economics can be simple, but it's the abstract concepts that will get you.

And probably the most important thing they implied is this: We still don't understand EVERYTHING of economics. It's an ongoing scientific process (it uses the scientific method), with A LOT of variables which will influence your hypothesis unpredictably.

My opinion on the most important scientific concept of economics: Ceteris Paribus (everything else held constant).

Gem

P.S.: Hey Shanek, do you agree with me that Ceteris Paribus is more important than Demand/Supply concept?

shanek

19th October 2003, 07:52 AM

Remember, guys, this was just an introductory episode to an introductory macroeconomics course. Later episodes do get more involved.

Originally posted by Gem
Hey Shanek, do you agree with me that Ceteris Paribus is more important than Demand/Supply concept?

Hmm...that's kind of a toughie. Ceteris Paribus is important because you don't want to just ignore other variables that can influence the outcome, but OTOH the supply/demand model permeates through so many aspects of economics. Many of the problems I've had discussing things in this forum stem from people not understanding how supply and demand work. And when you explain it to them, they think it's some kind of abstract concept that has nothing to do with the real world.

corplinx

19th October 2003, 11:12 AM

Originally posted by DavidJames
Are you kidding me, this is college level stuff? That Dr. Bob guy is brilliant. His "Circular Flow model" is PHD stuff.

"...firms transform these services into a finished product, which then goes into their retail outlets and is, in turn, purchased by households. But, of course, for the households to be able to afford to buy the product, they have to sell their services in the market for factors of production. An they're, of course, selling them to businesses, which use them to buy things"

Really? amazing, simply amazing.

And you say this escapes many, hmm. I wonder how many people here never understood that business hire people to make stuff and people get jobs to buy stuff. Hands please.

Pretty deep stuff!

corplinx, I think you are right, malachi would never be able to navigate the complex math and advanced economic theory as presented by Dr. Bob, just thinking about it is making my head spin.

Hey, its Public Television so its toned down for Joe Sixpack to understand. They must have gotten the formula right since even 3 digit IQ wanna bees like you got it. :)

Seriously, most of the hard math is done in microeconomics. I doubt even if they had shows on microeconomics that they would include the math since its public broadcasting.

shanek

20th October 2003, 08:20 PM

More important base information in episode two. It's important to understand how and why economies grow, and this episode focuses on that.

Connolly: There are very significant differences in living standards around the world. People debate the causes endlessly, but the real reason is very simple. What it comes down to...is that the differences in living standards are related to the differences in productivity from country to country. The central question, at its most basic level, is this: for every hour of labor, what quantity of goods and services can be produced?

The bottom line is, generally speaking, increases in the standard of living over long periods of time in any particular country are not related to social institutions, the rise of unions, the nature of government, or whether there are Democrats, Republicans, conservatives or liberals in charge. The truth is, the source of income growth in the long run is related to improvements in the productivity of labor.

[...]

It's clear that...developing nations will grow economically only if their workers become more productive, if each worker produces more goods and services tomorrow than they did today or yesterday.

[...]

Let's start by looking at Japan between 1890 and 1990. In 1890, real per capita GDP was about $842...In 1990, real per capita GDP was about $16,000. [This] turns into a growth rate of 3% per year...In Brazil, from 1900 to 1987, per capita income rose from $436 to $3,400. That's a growth rate of 2.39% per year. Very good, but not quite 3%. For the United States, by comparison, from 1870 to 1990...real income per person rose from about $2,250 to $18,250. The growth rate was 1.76%. A fine increase, but still a growth rate that's just slightly more than half the growth rate of Japan.

[...]

It's important to understand why this growth happened because there are many claims made about why it is that growth rates in one country are inferior to growth rates in another. It turns out...that the reason for a change in GDP really isn't hard to find at all. It all comes down to productivity.

And here we come into an important model called the "Production Function," which sounds a bit like something from Schoolhouse Rock. (Maybe if they'd done some good economics episodes things would have been better?) Anyway...note Connolly's extensive use of ceteris paribus, although he doesn't use that term.

The principle determinants of productivity are: capital, labor, and natural resources. We're going to capture this in a model called the "Production Function," which is the relationship between the quantity of inputs used to make a good and the quantity of the output of that good...If the availability of physical capital increases, we expect the amount of output being produced to increase. It also says that if the quantity or the quality of the labor force increases, we also expect that the amount of output will increase. Finally, if you improve or increase the availability of natural resources, output tends to rise.

[...]

Much of the discussion of productivity and growth comes down to the connection between productivity and output. If you hold the labor force and the availability of natural resources constant, and you provide workers with more and better machinery and other equipment, you can expect that the productivity of those workers will go up. And so you can say, if we increase the capital stock, we expect the amount of output being produced to increase. So the way governments and economists have often thought about growth is that any policy that produces higher rates of capital investment will lead to more growth in the long run. And that certainly is the case. Now, it doesn't necessarily follow that all capital investments will make people feel like they're better off than before. But it's still the case that in broad terms, increases in capital intensity lead to higher standards of living and greater productivity.

[...]

The next major determinant of productivity is labor. Fix the amount of capital and natural resources at some amount, and see what happens as the amount of labor available in that economy increases. Actually, I want to think about labor in a little broader fashion; specifically, what I want to think about here is not just the number of workers per se, but what we call "human capital." The idea here is that human capital encompasses all of the knowledge and skills that workers acquire through education, training, and experience. And what we're thinking about in this context is the following kind of experiment: if there's an increase in human capital, what does that do to productivity in the economy? Well, to answer that I'm going to borrow an idea from microeconomics, and the idea is this: In microeconomics, we know that if the quantity or quality of labor services goes up, we know we can expect to see more output. I could get an increase in productivity with the same number of workers if those workers were, in fact, more experienced or in some other way had higher human capital.

[...]

We've talked about the role of physical capital and human capital, but there's another very important issue to discuss here, and that has to do with the availability of natural resources, or what economists sometimes call the "natural resource endowments." It's very clear from studying the economic history of the US that one reason the standard of living in the US is relatively high is that there are plentiful supplies of extremely important natural resources in the US: coal, petroleum products, iron ore, and other metals are all found in great abundance in this country. And that has historically been very important in providing inputs to the production process inside the US...Japan, on the other hand, is not well endowed with natural resources. They have to import virtually all their petroleum products and a wide range of other raw materials. Yet, the growth rate in Japan is enormously high. How can this be? Aren't natural resources one of the three components of productivity and growth? Absolutely. But because the Japanese have been able to import scarce resources, and have been able to use them very efficiently, their growth rate has been spectacular, especially by comparison with all other nations. They are the leaders.

Those are the three basic elements of the Production Function. But there's one very important aspect, that of technology:

Now, I haven't said anything yet about technological progress. To see the impact of this, let's look at how the Production Function relates to labor. We'll hold the level on natural resources constant, and we'll allow the amount of labor to vary. And we'll ask what happens to the quantity of output, the amount of products, that's being produced. It turns out that the relationship between labor and output starts out rising steeply, and then begins to flatten; that is, every time we increase the amount of labor what we find is that total output increases until we get some quantity of labor where we get this diminishing returns phenomenon. Diminishing returns is the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases. In other words, output is still going up, but not as quickly or as steeply as before.

Now here's the point: L units of labor gives us Q units of total output in that economy. The idea behing technological progress is, that for the same availability of capital and natural resources, that same amount of labor is able to produce a higher level of output than before, which we'll call Q'. So we think about technological progress as shifting the Production Function upward. That same level of labor produces a new and higher level of physical output. In fact, the way we recognize an improvement in technology is that it actually raises the total amount of output that you can produce with a given amount of resources...The same amount of labor produces more output than before. If we hadn't had the technological progress, if we hadn't changed the Production Function, then to get from Q to Q' we would have needed to go from L to L'. This means that technological progress in an economy looks in many ways as if we had an increase in resource availability. So that's why even nations that find themselves limited in natural resources may find that they can overcome this limitation by improving their production technology.

The Pacific Lumber Company is home to the largest redwood sawmill in the world. It produces more than 250,000,000 board feet of lumber each year. When the company was founded in 1869, horses and oxen were used to pull the cut trees through cleared fields. But since then, advances in technology allow Pacific Lumber not only to move lumber more efficiently, but also to get more usable wood out of every tree. With over 193,000 acres of forest, the company uses a state-of-the-art computer system to determine which trees are ready for harvest. Once the logs are in the mill, laser-guided saws are used to cut down on waste. There was a time when cuttings less than 3½' in length had to be discarded. But now, they can be glued together and passed through a high-frequency electronic field that sets the glue and creates a product just as strong as a solid board. All these innovations allow the company to get more lumber out of each tree.

[...]

The bottom line I want you to take away from the discussion is this: Technological progress is a potentially very important source of growth. Countries that have no technological improvements in their industries are countries which are not likely to grow rapidly, unless there are significant increases in physical capital, or human capital, or the availability of natural resources. And we see that the countries with the highest growth rates also have high rates of technologocal progress.

There are also other factors which influence the levels of the elements that make up the Production Function:

We know that increases in the capital stock happen because of investment. And investment occurs because we're able to find savings to convert into capital goods, and, therefore, investment. So the issue is: do we see any connection between saving and investing in economic growth? And, of course, the answer is, yes, in fact, we do. What we typically see is that growth and investment tend to be reasonably highly correlated. Where we see high growth, we see high investment, and vice-versa. Now the problem with that is simple. It's possible that we see this high correlation because that economies that grow rapidly are also able to save a fair amount of income, and that leads to more investment later. So while the investment might have caused the growth, it's also possible that the growth caused the investment, or, of course, there might be no causal linkages at all. So the fact of correlation doesn't imply causation. Nonetheless, it is the case that capital accumulation is correlated with growth, and we really can't ignore that; and, in fact, we usually do interpret this correlation to mean that high levels of investment lead to high levels of economic growth.

[...]

There's another issue which is important, called the "catch-up effect." The catch-up effect is the property that says, countries that start off poor tend to grow very rapidly. Another way to think about this is, if you've already got a really low standard of living, any noticeable improvement is going to look like a fabulous growth rate...So in the long run, it's clear when you start from a small base, it's easy to look like you're growing very rapidly. But if you start from a relatively high standard of living, it often appears that you're not growing very rapidly, even though the standard of living may be far higher. That means that if you want to be the country with the highest standard of living, which basically is the US, then the fact that your growth rate isn't high, that your improvement in the standard of living isn't that large, may not be terribly relevant. Yet, I would rather be in the US, and probably you would, too, than in a country with a very high growth rate that they achieved because they started from a very low standard of living.

One other determinent of the growth process is the role of what we call Foreign Direct Investment (FDI). Now the idea behind FDI is that some of the growth that takes place in a country occurs because investors or sources of capital from one country choose to invest in another country. It turns out that in the mid=to=late 1990s, British investors accumulated more assets in the US than investors from any other country. That's an example of FDI. And that turns out to be important in open economies in explaining the growth rate in GDP; that is, remembering our Production Function, the amount of output depends on capital, labor, and natural resource availability. But nothing says that the capital has to come from inside the country. So if foreign citizens choose to invest their capital in a particular country, that country's growth rate may increase simply because of that FDI.

[...]

It's also possible to produce higher output if there is an increase in the labor force's level of education...For instance, in Germany, many companies run apprentice training programs that last several years and are very much like community or technical college in the US. But imagine another country has no such requirement. One of the things that will happen then is workers who come into the labor force in the country with the higher training and education requirements come with higher human capital. So even though two countries might have the same number of workers, and the same capital stock, and the same natural resource availability, the productivity and output and the standard of living will be higher in the country with the better educated work force.

Seidman: Well, the American worker is 1) better educated than most workers in the world, 2) works harder than most people in the world, 3) is not bound in union rules and all the kinds of things that unions have brought in that are nonproductive, and so we have a much freer economy which allows new businesses to start and other businesses to grow.

Connolly: So it's important not to underestimate the role that education plays in understanding growth in developing nations.

The opposite side of this coin is what's referred to as the "brain drain." Basically, this is the emigration of highly educated workers from poor countries to rich countries.

Conrad: When we look at the education characteristics of our immigrant population overall, of our recent immigrants, we're starting to see an upward trend in education levels. And I anticipate that we will see that even more because high-tech industries, science industries, are concerned about the available pool of technically trained workers in the US.

Connolly: Another example of the so-called "brain drain" can be seen in the former Soviet Union, where engineers and computer scientists are emigrating in greater numbers to other countries in Europe, Asia, or North America, becaus etheir skills command a higher wage in those countries. But that in turn means that the nations of the former Soviet Union are being stripped of their highly educated workers and will find that their capacity to grow has been significantly reduced...This leads us to an interesting feature of US immigration policy. The US actually allows industries to have shortages of workers with particular skills to apply to the INS to be able to import talented bur scarce labor...We don't want to limit the growth potential of the US by limiting the immigration of talented people who can contribute to the country, and that's at least part of the reason why we have an immigration policy that allows for exceptions to the otherwise ironclad rules about how many people can enter the US from other nations.

Let me give you the bottom line: Human capital comes from many sources; some of it's domestic, and some of it's foreign. And we need to understand that the movement of capital, of people across borders, can have an important impact on a country's potential for growth, because it affects the quantity of human capital available for the production of goods or services in those countries.

So, we see here what really causes long-term economic growth in an economy. And I think if you'll look closely, this episode, without even trying, debunks most of the BS our politicians are trying to use to convince us about the terrible dangers to our economy...many of these "dangers" are part of the Production Function, and contribute to growth, not inhibit it. Never forget that these aren't abstract concepts; they are real, and they effect real people and the real state of our, or any, economy.

shanek

23rd October 2003, 07:02 AM

This episode covers the fundamentals of the market for loanable funds and how it creates the capital needed to increase the standard of living. It also shows the inhibiting effects of taxes and government deficits.

Long Run: Savings, Investment, and Finance

Bob Connolly: In every economy, there's a set of people who save, and a different set of people who invest. Investors are people who build factories and purchase capital equipment, what we call "investment spending." The worker who buys a corporate bond is not investing. This person is saving money by purchasing bonds; that is, this person is lending money to the corporation. It's the corporation that's doing the investing. And they're doing it by borrowing money. Savers become lenders, and investors become borrowers...But the question from an economy's perspective is, how do we allocate the savings of citizens in a way that maximizes the growth potential of the economy? The way this gets done is to recognize that capital is scarce, and it needs to be allocated with that scarcity in mind. The principle that economists use to address this issue is this: Scarce resources should be allocated to uses that offer the highest return. Otherwise, we could always change the allocation and make everybody better off. So the thing you should be thinking about is this: what would happen if we didn't use our capital in the most efficient way?

[...]

The savings process involves the decisions of individual households, and sometimes by firms, not to consume their entire income...The question is, what do they do with the [money]? In the US, most people put it into a bank or some other financial institution, which, in turn, channels these savings to individual firms or businesses to invest the money and pay back the loan with interest. In countries where there are no banks and no financial markets, growth prospects are usually very limited because in order to grow, we need to have capital, labor, and natural resources available for the production process. But capital is often quite expensive, and so in order to acquire the appropriate capital equipment, businesses often need to borrow the money to buy it. Then they pay the loan back with the proceeds of the output that they're now able to produce with the new capital equipment. But if there's no way to borrow the money, then it's almost impossible to buy the machinery, and if you can't buy the machinery, then the economic growth process proceeds very, very slowly...Part of the variation in economic growth that we see across countries depends on how efficiently the financial system is able to channel money from savers to borrowers...When the process works smoothly, economic growth tends to reach its full potential. When that transfer process works badly, we tend to see relatively low rates of economic growth.

[...]

Sometimes this transfer takes place through financial markets. In the stock market, lenders make their accumulated finances available to firms by purchasing a piece, or share, of the firm's stock. This makes them an equity owner. If you buy stock, you own a piece of the firm...When you [purchase shares of a stock] what really happens is, you don't buy it from the company, you buy it from another shareholder, who is now no longer a shareholder, or at least they don't own as much as before. But now that person is in a position to take the funds that you paid them for their investment and make an investment of another variety. In fact, what they may be doing is selling their shares to go out and start their own company. So in that respect, your savings have fueled the start of another company.

Another financial market of great importance is the bond market. Here again, individual savers are making their savings available to others, but in a very different form. In the stock market, when people buy shares, they give up their savings in exchange for a piece of the cash flow earned by the firm. If the firm earns a bunch of money, it goes to the shareholders. But if they earn nothing, the shareholders earn nothing. Bond holders, by contrast, get the promise of earning a fixed sum; that is, what they do is they transfer their savings to the company and they get a corporate bond back. And the bond entitles them to a fixed payment at specified intervals. So if the company does badly, they still have to pay the interest on the bonds. If the company doesn't make any money, the bond holders still get their money back; shareholders don't.

[...]

Another way that money gets channelled to borrowers is through the bank loan process...Banks create money. If you put $5,000 in the bank, the Fed requires banks to keep a small percentage of that in reserve. But the rest is available to loan to businesses and individuals. And that can add up in a hurry...

Note: a future episode covers this in more detail.

Conrad: What we anticipate when a company is taking out a loan is that they're going to use that money to help the company grow. And in the course of that, they'll be hiring workers. And the workers will benefit from having additional income. The workers will then take those dollars out to stores and spend them. So the stores will now have additional income, so they in turn will purchase more products so they'll have more to sell, and that creates new jobs, [and so on].

[...]

Connolly: Remember, we're talking about a market here; that is, there's a market for loanable funds. Who supplies the funds? People who aren't consuming their entire income, who are putting money away in banks and bonds and the stock market. Who demands the funds? Investors who want to set up firms or expand businesses and make money from the money they borrow. The interest rate plays a very central role in allocating the amount of money that savers put into the market for borrowers to use. The key here is that the interest rate is the price of borrowing money. That's essential. The price of money is the interest rate. Put the quantity of loanable funds on the horizontal axis and the price, the interest rate, on the vertical axis. The idea is this: savers are willing to save more, to put more money in banks and bonds, as the interest rate gets higher. The supply of loanable funds is upward-sloping. The higher the interest rate a saver can get, the more likely they are to save. And that makes more funds available through financial markets or commercial banks for lending. On the other side of the market, on the borrower's side, we have exactly the opposite behavior. As the interest rate falls, borrowers are willing to borrow more; and so the demand curve for loanable funds is downward-sloping. So what does this say? It's really pretty simple: There aren't many borrowers who are able to pay very high rates of interests because there aren't that many investment projects with really high rates of return. There are probably lots more projects with more modest rates of return, so until the interest rate falls, people who have these more modest projects, they're just not going to step in and borrow money. People are going to allocate their savings based on the interst rate, and at the intersection of the supply and demand curves for loanable funds, we find the equilibrium interest rate, RE, and, of course, the equilibrium quantity, QE. So, which projects will be financed? The answer is, all projects with a rate of return of RE or higher will get financed...[other projects] don't have a rate of return high enough to justify borrowing money.

The interest rate changes if the demand or supply for loanable funds happens to shift. Think about an economy in which there's suddenly a great increase in the demand for products, which is what happened in the US computing industry in the 1990s. Remember, return on investment in the computer business depends on how many computers can be sold, and at what price. So if there's a big increase in demand for computers, then the capital equipment that makes the computers will have a greater return attached to it. Therefore, we'll see a rightward shift in the demand for loanable funds. The point is this: anything that affects the productivity of capital in an economy has to have some impact on the demand for loanable funds.

Let's analyze a tax on interest earned on savings...Some economists argue that taxing interest on savings actually limits the supply of savings. after all, why bother to save if taxes are going to eat up a big chunk of the interest that you earn? So they argue that if we repeal the tax on interest on savings, that will ultimately lead to greater capital accumulation, more investment, and higher growth. Will this work? Let's take a look. The idea is, if you reduce the tax rate the supply of loanable funds will shift rightward. As the tax rate goes down, people are willing to save more than before at any given interest rate, which means they're lending more than before, and that's why we have a rightward shift in the supply curve. The new quantity is higher than before, and the new equilibrium interest rate is lower than before. So what happened here? In the new equilibrium, after the tax rate has been reduced, interest rates go down, more projects are being funded, the rate of capital accumulation increases, and the expectaiton is that productivity will go up and growth will increase.

[...]

There is another really interesting example of tax-related effects on the demand side. Let's take capital equipment: machinery, buildings, and so forth. Of course, there's a price you have to pay to acquire the equipment. And so the borrow asks: Given the cost of capital equipment, and the price at which I expect to be able to sell the output that comes from the equipment, can I afford to borrow at this particular interest rate? Well, imagine that they get a tax credit for purchasing the capital equipment. That would effectively lower the price of the equipment, making the output more profitable than before. So with a tax credit, firms will demand more loanable funds at any given interest rate than before. And this means the demand curve for loanable funds will shift rightward. Equilibrium interest rate will increase, and the equilibrium quantity of loanable funds will also increase.

Now, you might ask the question, "Isn't there a lesson in here somewhere about government budget deficits? Don't they have something to do with the supply of loanable funds?" Indeed they do...We know that GDP has four components: Consumption, Investment, Government purchases, and Net exports. Let's take the Net exports out and assume that that's 0. If we rearrange this: Investment=GDP-C-G. It also turns out that GDP-C-G=Savings. So we have this equation that's very important to GDP accounts, which is: Savings=Investment. Now, with a little bit more manipulation, we can see that savings can also be written as GDP-Taxes-C+Taxes-G. Now, you might notice that I used a little bit of algebra, kind of a trick. I added and subtracted taxation from the right hand side. Now we've got two things here: GDP-Taxes-C is private saving, and Taxes-G is the government budget position. This allows us to see that savings has two pieces: private saving plus government saving. If the government runs a budget deficit, this last term is, in fact, a negative. That means that whatever level of private saving there is, if the government runs a budget deficit some of that private saving is being soaked up, and so total saving has to be smaller than it would be otherwise. But if the government runs a surplus, that is, if government spending is less than taxation, then the amount of saving available for investment is private saving plus government saving and now it's larger than before.

[...]

Here's what happens if the government runs a budget deficit: The deficit will consume some portion of private savings, so at every interest rate, a smaller quantity of loanable funds will be available than before. In other words, if the government runs a deficit, the supply of loanable funds schedule shifts to the left. So, rather than having an equilibrium at RE and QE, we get a new equilibrium at RE' and QE', a higher interest rate and a lower quantity of loanable funds. This means that there's less money available for firms to borrow and less money availalable for them to invest. The rate of investment is lower, the rate of capital accumulation falls, and productivity and the standard of living won't increase as rapidly as they would otherwise. The claim is often made, with some justification, that if the government would reduce its budget deficit then the supply of loanable funds would shift out, interest rates would decline, more projects would be financed, the rate of capital accumulation would increase, and productivity and the standard of living would also increase.

Conrad: When the government goes in and borrows money for a project that we can think of as adding to infrastructure...then there is a sense in which it may not be crowding out private investment. However, there are many economists who believe that when the government is borrowing money essentially to finance non-infrastructure-type projects, either to finance public defense expansion or to finance tansfer payments of other sorts, then it may be crowding out private investment.

Connolly: This means that tax policy can have a big impact on the equilibrium in this market, as can government spending. So these consequences have to be taken into account whene valuating fiscal policy.

Tmy

23rd October 2003, 07:32 AM

1:00am on PBS YOU!!!!!! This must be the most boring program ever if its pulling down the worst time slot on PBS YOU of all places. I bet you were the sole rating.

talk about a waste of tax dollars. THey should make prisoners watch this as a form of punishment.

Gem

23rd October 2003, 10:53 AM

Ok, something I want to add: If businesses invest via loans, then how does the argument that corporate income tax reduces investment, if the investment is financed via loans?

Gem

P.S.:tmy, I took a year of college economics. People should know about this stuff. You don't have to go deep into how banks work, but understanding basics like supply/demand and fiscal policy is very important when voting.

Thanz

23rd October 2003, 11:09 AM

Shanek -

Thanks for putting in the effort to post this in the forum.

Are you cutting and pasting from a transcript that is online, or are you typing this in yourself? If you are cutting and pasting, what is the URL for those who may want a more indepth look rather than the highlights?

Earthborn

23rd October 2003, 01:33 PM

Don't listen to Tmy, Shanek. It is fascinating stuff. Although it must be said that because I have no way of receiving PBS YOU, I am totally relying on your transcript, and it is difficult to follow sometimes. It isn't nicely paragraphed and it is very much talkative language, which is difficult to read. I used a text-to-speach program to keep track of where I was, but it made it only a little easier.
Will it be downloadable from the web?

I also hope that the show featured some graphs or at least someone at a whiteboard, because it is very difficult to follow without.

Some things I thought interesting...

Human capital: I think it is quite obvious that investing in people is going to be beneficial. But I can think of another way companies can increase the quality of their workers: by selection. They tend to select the workers that they think might be best at the job. This would cause, I think, that workers who are considered not so good to be locked out. I'm thinking of for instance lazy people, handicapped people or people who are not valued quite so much for other reasons. If these people receive some sort of benefits, they themselves would not be so bad off. If on the other hand these people had to compete with other people on the same jobmarket, and if they want to surive they need to be hired too, companies on average need to cope with a lower 'quality' of workers. These people would probably require more investment to keep the productivity up, would they not?

Catch-Up effect: Makes perfect sense to me that an economy that starts out on a low level should grow faster than one that is already pretty good. But... You, Shanek, have been throwing graphs and figures at us that show a slow down in growth and argued that it was because of government interference. You have agrued that a steady percentage growth is what should have happened, and would have happened if it wasn't for the government.
Couldn't it be that such a slow down is caused because the econmy was at a lower level in the past, and as it started to grow, less growth should have been expected and is not so much caused by the government as it is caused by the growth itself? How would you differentiate between such effects anyway?

Investment = GDP - C - G, etc: Now here it would have been handy to be able to see how this person wrote it down exactly. It doesn't appear too hard, but it is difficult to follow in this format.
To be sure I knew what this is about, I looked up Gross Domestic Product on Wikipedia (http://en.wikipedia.org/wiki/Measures_of_national_income). I'm a little puzzled about the definition: "The total value of final goods and services produced within a country's borders in a year." It is quite clear, except for the 'final goods'. It is something I never quite understood. Suppose everything is recycled, old tires become roads, empty bottles are filled again, burnable waste becomes energy, and everything else becomes hills on a new golf course... Couldn't it be argued that ultimately there are no final goods? That everything is just an intermediate good, and 'consuming' them is just a form of making something new from it? Or is the definition for a final good just that someone has decided that you have to pay to have it disposed, even if he's going to put it to profitable use himself?

Just some random incoherent thoughts...

Earthborn

23rd October 2003, 01:35 PM

btw: Some of these things are also discussed in Commanding Heights (http://www.pbs.org/media/commandingheights/), also from PBS. I have recently downloaded it and watched it with great interest. It discusses putting free market principles in practice in Globalisation, and shows some good examples of what can happen. Sometimes it works out great, other times it fails horribly (Yes, of course, Shanek. Only if it isn't implemented correctly. :rolleyes: )

I downloaded the 'Mini' and '56' versions. Note that some of them are more than 10 megabytes even then, with a total of over 500 megabytes! The first number is the episode, the second is the section. You need only one of each section, the others are just the same sections chopped up in pieces. It is easiest if you right-click the names and choose Save Target As...

I have no idea if this is legal or not, but I love it. I really wish I could get PBS around here. From what I can watch on the web, it seems a pretty good channel. Effectively disproves the notion that the US government can do nothing good. :p

shanek

23rd October 2003, 03:33 PM

Originally posted by Gem
Ok, something I want to add: If businesses invest via loans, then how does the argument that corporate income tax reduces investment, if the investment is financed via loans?

I would guess that the argument is that they would be able to spend even more money on capital-building items having the loan money plus the money that would have gone to taxes rather than just the loan money.

shanek

23rd October 2003, 03:35 PM

Originally posted by Thanz
Thanks for putting in the effort to post this in the forum./quote]

You're most welcome.

[quote]Are you cutting and pasting from a transcript that is online, or are you typing this in yourself?

I'm typing it in myself, while I play it back after my PVR records the episode every Wednesday.

shanek

23rd October 2003, 03:54 PM

Originally posted by Earthborn
Will it be downloadable from the web?

Not to my knowledge. You might want to check with a local college, though. They may have it or something like it in their video library, at least, colleges in the US tend to have these kinds of things available.

I also hope that the show featured some graphs or at least someone at a whiteboard, because it is very difficult to follow without.

Yeah, there are graphics showing what he's talking about as he lectures.

Human capital: I think it is quite obvious that investing in people is going to be beneficial. But I can think of another way companies can increase the quality of their workers: by selection. They tend to select the workers that they think might be best at the job. This would cause, I think, that workers who are considered not so good to be locked out.

But those workers who are locked out of one job might find themselves the prime candidates for another. Lazy people have proved not to be so lazy when they're given a job they love doing. Handicapped people can usually perform as well as or better than most other workers, provided the job doesn't revolve around what they're handicapped from doing. In either event, if these people went without jobs that means there would be a certain amount of human capital that isn't being used. The market is going to try to maximize the total output of everyone willing and able to work. It's inefficient to have people sitting around twiddling their thumbs.

It goes the other way, too. A company is not going to hire people who are overqualified for a job because they know there's a very big chance they'll just turn around and get a better job soon and the company will have to hire all over again.

Catch-Up effect: Makes perfect sense to me that an economy that starts out on a low level should grow faster than one that is already pretty good. But... You, Shanek, have been throwing graphs and figures at us that show a slow down in growth and argued that it was because of government interference. You have agrued that a steady percentage growth is what should have happened, and would have happened if it wasn't for the government.
Couldn't it be that such a slow down is caused because the econmy was at a lower level in the past, and as it started to grow, less growth should have been expected and is not so much caused by the government as it is caused by the growth itself? How would you differentiate between such effects anyway?

You're misunderstanding the catch-up effect. The catch-up effect is there to try to explain why you can't really compare growth rates across different cultures and boundaries because they all started from different points. America, for example, started with a plethora of natural resources: trees, oil, coal, steel, etc., whereas Saudi Arabia started with almost nothing except for oil. The catch-up effect says that Saudi Arabia will grow at a faster rate than the US because they started with almost nothing. And Japan started with even less and has been surpassing almost every other country in economic growth.

This doesn't have anything to do with maintaining these levels of growth. There's absolutely no reason to believe that the rate of growth will decrease as time goes on.

I'm a little puzzled about the definition: "The total value of final goods and services produced within a country's borders in a year." It is quite clear, except for the 'final goods'. It is something I never quite understood.

It's really very simple. When you buy a newspaper, that money goes into GDP, because it's a final good. But the company who produced the newspaper had to purchase ink and paper to make it. Those costs were passed on to you when you purchased the paper, so we don't want to count them again. The newspaper is the "final good," and the cost of the newspaper includes the cost of all of the goods and materials that went into making the newspaper. So if you counted the ink, paper, etc. into GDP, you'd be doubling up on those costs.

Suppose everything is recycled, old tires become roads, empty bottles are filled again, burnable waste becomes energy, and everything else becomes hills on a new golf course... Couldn't it be argued that ultimately there are no final goods?

The difference is, those goods were not purchased for the purpose of making roads, bottles, or landfills. They were purchased for the purpose of driving with them on your car, drinking a beverage, etc. You wouldn't buy a whole bunch of brand new tires just to chop them up and make a road out of them; it'd be cheaper just to buy the rubber as a raw material to begin with. The tire has a certain value because of the manufacturing process which makes it work very well on a car. Once its use as a tire is consumed, once it's worn down to the point of no longer being useful as a tire, it goes back into being a raw material again.

In other words, manufacturing creates value, consuming uses up that value. The product where the value starts to actually be used is a final good.

shanek

23rd October 2003, 03:58 PM

I'd love to see Free to Choose again. That's the PBS economics series with Milton Friedman. My favorite episode was when he was talking about inflation. He was standing in front of one of the presses at the Federal Reserve, where huge sheets full of I think $5 bills were just flying past at a phenominal rate. He said that if you wanted to reduce inflation, that there was a very simple way...and then he shut the machine off!!!

I think if PBS has a series of theirs available for download over the internet, that would be quite legal.

Gem

23rd October 2003, 04:02 PM

I would guess that the argument is that they would be able to spend even more money on capital-building items having the loan money plus the money that would have gone to taxes rather than just the loan money.

Or it would lower the risks of investing, since small losses, or unexpected costs can be hastily paid with profits.

But I thought all profits of a corporation went into stockholders, or can corporations have there own little purses?:p

Gem

xouper

23rd October 2003, 04:29 PM

shanek: I'm typing it in myself, while I play it back after my PVR records the episode every Wednesday.Wow, that's a lot of work (and I can say that from first-hand experience). I had assumed you were saving the closed captioning to a disk file.

shanek

23rd October 2003, 04:44 PM

Originally posted by Gem
Or it would lower the risks of investing, since small losses, or unexpected costs can be hastily paid with profits.

Hmmm...well, let's see, if it lowered the risk of investment, then that would mean that investors would be willing to borrow more money at each level of interest rate. So that would push the demand curve out to the right. Since the demand curve is downward-sloping, that would mean that equilibrium interest rates would rise and equilibrium quantity of loanable funds would also rise.

Ha! See how easy it is to think things through when you understand the concepts?

But I thought all profits of a corporation went into stockholders, or can corporations have there own little purses?:p

Yes and no. Basically, a stock is a piece of paper (or, nowadays, bits in a computer) that tell you you have x amount of a company's worth. The value of your stock will change as the company's worth changes. They're still free to invest the money just as the bank is free to invest the money you deposit into it; the only difference being the bank has to pay you your money back, but when the value of the company goes down you lose out if you hold stocks.

shanek

23rd October 2003, 04:46 PM

Originally posted by xouper
Wow, that's a lot of work (and I can say that from first-hand experience). I had assumed you were saving the closed captioning to a disk file.

No, I'd love to do it that way, but I never got mine to work. I can get it to show the captions on the screen, but it never works to try and capture them to a file. The timer just doesn't want to fire. And this is after updating all of ATI's software to do it.

Maybe I'll give it another try next episode. It sure would save a lot of time...

Suddenly

23rd October 2003, 06:41 PM

Ain't no one going to question your dedication to your cause Shane. That's for sure.

Just a backhanded compliment. Enjoy!!!

:)

Yep, Im drunk again. Viva Chivas!!!!

Gem

23rd October 2003, 06:45 PM

Ha! See how easy it is to think things through when you understand the concepts?

Same thing could be said of science.

Yes and no. Basically, a stock is a piece of paper (or, nowadays, bits in a computer) that tell you you have x amount of a company's worth. The value of your stock will change as the company's worth changes. They're still free to invest the money just as the bank is free to invest the money you deposit into it; the only difference being the bank has to pay you your money back, but when the value of the company goes down you lose out if you hold stocks.

I did some reading on dividends. There is a clear contrast of interest because of separation of ownership and control. The CEO (control) might want to use the profits for a bigger salary, or expand his business further. But the stockholders (control) would like to have bigger dividends.

Ergo: The CEO and stockholders must come to a deal between salary, dividends and business investment.

Gem

Edited to add: Remember kids, keep your college economics books with you!

Jessica Blue

23rd October 2003, 07:04 PM

Originally posted by Suddenly
Ain't no one going to question your dedication to your cause Shane. That's for sure. He is the Very Model of a Modern Libertarian...

http://world.std.com/~mhuben/plofker.html

Suddenly

23rd October 2003, 07:10 PM

I don't watch PBS (A libertarian endorsing a PBS program reeks of irony, but lets move on).

Yes, if I user the phrase "Lets move on" then I'm sampling the sweetest of the brown liquors, as Lionel Hutz would say. Except I'm drinking Scotch, as I'm out of bourbon. I'm a baaaad southerner. Except I'm a Yankee. Lets move on... Viva Bill Simmons!!! (who I stole the "lets move on" phrase from. Check out ESPN.com's "page two". Hunter S. Thompson makes the odd (sic) appearance there.)

I've got a couple of economic questions for ole' Shane of the N.C. Libertarian delegation about economics. Some free shots if you will.

1) If you abandon the assumption that government will spend money stupidly, how do taxes hurt the economy, considering that all money taxed will be returned to the economy in some form?

2) From above I remember how government is necessary to maintain efficient and stable markets, or some such. Please explain a) Where that money should come from, if not taxes, and b) Why, since a communist rebellion would effect markets, should taxes not go towards cushioning the natural swings inherent in a pure capitalist system, even at the cost of some overall growth?

(Please excuse misspellings. I am stricken with a version of Dislexia (did I spell that right) and have taken some measures to overcome / conceal that fact. I suspect you are symathetic. I don't feel like making the 20 or so visits to dictionary.com it would normally require to write this paragraph.)

3) Going to your graph in the "fun with fed tax stats thread." Can you explain why increases in what you call "quality of life" do not coincide with cuts in taxes, as the growth is not effected by RWR's 1980ish tax purge, and there is an apperant uptick at Bush's tax hike?

Thanks.

Suddenly

23rd October 2003, 07:17 PM

Originally posted by Jessica Blue
He is the Very Model of a Modern Libertarian...

http://world.std.com/~mhuben/plofker.html

BWAHAAAA!!!!!!!!!!!!

This created more of a sense of mirth than:

WVU: 28
Va. Tech: 7

If that is possible.

Wow. I need a smiley.

:bgrin:

I mean, I might hurt myself. I almost spilled my drink.

Hello favorites list !!!!

I mean, wow.

shanek

23rd October 2003, 08:15 PM

Originally posted by Suddenly
Ain't no one going to question your dedication to your cause Shane. That's for sure.

I just thought it was a great opportunity to put my money where my mouth is. For so long, I've been saying things are basic macroeconomics that you'll learn in any introductory course and having people say that it's invalid, or that it's a crackpot idea, or something like that. Well, here is an actual series of lectures on macroeconomics, that you can actually take for college credit, taught by someone who's been a professor of economics for 25 years. Transcribing portions of it allows us to discuss the real concepts being taught in real introductory macroeconomics courses, and telling everyone what time and channel it's on, even if not everyone can get it, opens the door to at least someone coming in here and busting me if I start making stuff up. It also makes for a good thread to refer back to later on.

shanek

23rd October 2003, 08:28 PM

Originally posted by Suddenly
I don't watch PBS (A libertarian endorsing a PBS program reeks of irony, but lets move on).

Hey, it's just an opportunity to cover these fundamental conceptswith a source no one can accuse of having any sort of bias, since it has to be in a form whereby college credits can be obtained.

1) If you abandon the assumption that government will spend money stupidly, how do taxes hurt the economy, considering that all money taxed will be returned to the economy in some form?

Well, the latest transcript answered that one quite a bit. If government were to spend its money only on infrastructure, then arguably it would be of the same benefit as if that money were spent in the private sector. But the government taxing people to expand defense or make transfer payments makes no such contribution. That's why government taxes take almost 50% of the National Income but government spending only comprises about 20% of the GDP.

A small, libertarian government would spend practically all of its money on infrastructure.

2) From above I remember how government is necessary to maintain efficient and stable markets, or some such. Please explain a) Where that money should come from, if not taxes, and b) Why, since a communist rebellion would effect markets, should taxes not go towards cushioning the natural swings inherent in a pure capitalist system, even at the cost of some overall growth?

Because, as has become obvious, that just doesn't work. The market forces are there to make sure the swings are as short as possible without being any more drastic than they have to be. Any interference will just upset that balance. You might decide to, say, artificially induce inflation in order to shorten the amount of time an economy spends overproducing. But what you actually would be doing is accelerating the downward trend, keeping it going long after the market would have started its recovery.

And also, if nothing else, it's as Nixon said: that when it comes to government policy, "the politics of economics outweighs the economics of economics."

3) Going to your graph in the "fun with fed tax stats thread." Can you explain why increases in what you call "quality of life" do not coincide with cuts in taxes, as the growth is not effected by RWR's 1980ish tax purge, and there is an apperant uptick at Bush's tax hike?

Because those tax cuts were not met with corresponding spending cuts. That resulted in increased deficits, and as the latest transcript shows deficit spending has an inhibiting effect on how capital can be accumulated to increase the standard of living.

Suddenly

23rd October 2003, 10:18 PM

Originally posted by shanek

Hey, it's just an opportunity to cover these fundamental conceptswith a source no one can accuse of having any sort of bias, since it has to be in a form whereby college credits can be obtained. So I guess there's one government program that is positive.

Well, the latest transcript answered that one quite a bit. If government were to spend its money only on infrastructure, then arguably it would be of the same benefit as if that money were spent in the private sector. But the government taxing people to expand defense or make transfer payments makes no such contribution. That's why government taxes take almost 50% of the National Income but government spending only comprises about 20% of the GDP.

A small, libertarian government would spend practically all of its money on infrastructure.

I'm sorry. Are you saying when government spends for defense that money doesn't a) wind up in the economy from either employees of defense contractors or military personel spending their pay, or b) contribute to the stability of the market by preventing the British from burning Baltimore?

Because, as has become obvious, that just doesn't work. The market forces are there to make sure the swings are as short as possible without being any more drastic than they have to be. Any interference will just upset that balance. You might decide to, say, artificially induce inflation in order to shorten the amount of time an economy spends overproducing. But what you actually would be doing is accelerating the downward trend, keeping it going long after the market would have started its recovery. So, the fact that there hasn't been a great depression since the FDR era is a fluke? Or is there some definition of "obvious" you are working off of that I'm failing to grasp?

And also, if nothing else, it's as Nixon said: that when it comes to government policy, "the politics of economics outweighs the economics of economics."

Is this your point or mine?

Because those tax cuts were not met with corresponding spending cuts. That resulted in increased deficits, and as the latest transcript shows deficit spending has an inhibiting effect on how capital can be accumulated to increase the standard of living.

Maybe you should tell "W" about this one. Doesn't explain the uptick during the Clinton years (after the Bush tax hike). Or was Clinton the most Libertarian president of the last 30 years as he actually balanced the budget?

shanek

24th October 2003, 07:47 AM

Originally posted by Suddenly
I'm sorry. Are you saying when government spends for defense that money doesn't a) wind up in the economy from either employees of defense contractors or military personel spending their pay, or b) contribute to the stability of the market by preventing the British from burning Baltimore?

You have to understand that the purpose here is to increase the standard of living by increasing wealth, and that means that the end product must have a value greater than the sum of its parts and be consumed in a way that derives benefit. Ultimately, defense spending for the largest part does meet the first of these, but either you don't have a war, in which case the value of these goods is never utilized, or you do have a war, in which case the consumption of the good results in the destruction of wealth, in the form of buildings, lives, etc.

There are reasons why you'd want a national defense, of course, but spurring the economy ain't one of them.

So, the fact that there hasn't been a great depression since the FDR era is a fluke?

The GD itself was a fluke. There was nothing like it before either. It was brought on by bad economic policy, by the government interfering in the economy without understanding what it was doing.

Maybe you should tell "W" about this one. Doesn't explain the uptick during the Clinton years (after the Bush tax hike).

Perhaps you should read the transcripts:

The bottom line is, generally speaking, increases in the standard of living over long periods of time in any particular country are not related to social institutions, the rise of unions, the nature of government, or whether there are Democrats, Republicans, conservatives or liberals in charge. The truth is, the source of income growth in the long run is related to improvements in the productivity of labor.

And as computer technology advanced rapidly, and the internet grew to its present form, our ability to produce more with the same number of resources is what led to the uptick. It didn't have one single thing to do with taxes or tax cuts or deficit spending.

Or was Clinton the most Libertarian president of the last 30 years as he actually balanced the budget?

Except that he didn't. The surplus didn't really exist. It was creative accounting.

Suddenly

24th October 2003, 08:17 AM

Originally posted by shanek

You have to understand that the purpose here is to increase the standard of living by increasing wealth, and that means that the end product must have a value greater than the sum of its parts and be consumed in a way that derives benefit. Ultimately, defense spending for the largest part does meet the first of these, but either you don't have a war, in which case the value of these goods is never utilized, or you do have a war, in which case the consumption of the good results in the destruction of wealth, in the form of buildings, lives, etc. The value of defense can be utilized by there being no war. A strong defense deters both invasion and attacks on interests abroad. Piracy on the high seas isn't quite the issue it was before massive standing naval forces, for one general example.

I understand the purpose. I'm all for the purpose. I'm of the opinion that your general approach is a bit simplistic. That's it. I'm just trying to reconcile economic theory with real events.

There are reasons why you'd want a national defense, of course, but spurring the economy ain't one of them. True. Defense spending does not create wealth. It does work to maintain markets. Which is my point. Much (maybe all)government spending can be looked at as ultimately geared towards creating a stable marketplace. The question is how many resources are necessary to reach optimal conditions.

And as computer technology advanced rapidly, and the internet grew to its present form, our ability to produce more with the same number of resources is what led to the uptick. It didn't have one single thing to do with taxes or tax cuts or deficit spending. Which was the point in the other thread that the rate of growth from 1947 - 1970 was more a factor of America developing a huge industrial capacity during WWII while other countries were blowing theirs up. Come the end of the war, America was unopposed economically, and the economy expanded. You ignored that point when arguing that growth was due to economic policy in that you said the "great society" was responsible for the end of that growth.

But here, you note the possiblity. I actually agree with your analysis w/r/t the 90's expansion.

[/B][/QUOTE]

shanek

24th October 2003, 09:40 AM

Originally posted by Suddenly
The value of defense can be utilized by there being no war.

Only insofar as it prevents the destruction of wealth. But with some exceptions (the infrastructure that comes with a defense system), it doesn't actually create any wealth or grow the economy.

True. Defense spending does not create wealth. It does work to maintain markets.

Not really; the markets maintain themselves. Defense only acts to prevent outside forces from destroying or inhibiting markets.

The question is how many resources are necessary to reach optimal conditions.

Exactly, and so although defense spending can up to a point protect the markets, there comes a point where it does more harm than it needs to.

Which was the point in the other thread that the rate of growth from 1947 - 1970 was more a factor of America developing a huge industrial capacity during WWII while other countries were blowing theirs up.

But look at the economies of the countries that got blown up—particularly Germany and Japan—after the war. Their growth left ours in the dust. There's just no reason to believe that the growth in the US from 1947-1970 was the result of WWII because we were largely unaffected by WWII, outside of the short-term effects of having to deal with so much of our workforce being sent overseas to fight the war.

But here, you note the possiblity. I actually agree with your analysis w/r/t the 90's expansion.

I just want to know how the expansion due to a technological boom can be compared to the situation in the US after WWII.

Q-Source

24th October 2003, 10:35 AM

Originally posted by shanek

I just thought it was a great opportunity to put my money where my mouth is. For so long, I've been saying things are basic macroeconomics that you'll learn in any introductory course and having people say that it's invalid, or that it's a crackpot idea, or something like that. Well, here is an actual series of lectures on macroeconomics, that you can actually take for college credit, taught by someone who's been a professor of economics for 25 years.

Good work. But the point of view of a monetarist about macroeconomics DOES NOT neccesarily is true for a post- keynesian or marxist, or marginalist or..... etc. This macroeconomic series also includes economic policies (which seem to be biased towards monetarism), so please do not confuse the readers saying that "Macroeconomic Theory" supports your own personal position.

Anyway, this is a good series about macro and monetarism.
Q-S

Earthborn

24th October 2003, 10:58 AM

It's inefficient to have people sitting around twiddling their thumbs.Well, yeah! Tell me about it...

In the Netherlands, one of the biggest problems for the social security system is the fact that almost a million people live on disability benefits. And a whole bunch of people living on welfare without the obligation to apply for jobs because of disability. Most of these people are willing to work. Many of them are capable, because the system has been abused in the past to lay people off. Companies figured that it was nicer to put people on disability with higher benefits than to put them on unemployment.

So now we have a whole lot of people twiddling their thumbs. But are they being hired? I'm afraid not. Companies are afraid to hire people who lived on disability for a while, because they are afraid such people are more likely to call in sick. And since they haven't worked for a while, they are considered to be less experienced. Even subsidies to minimize the risks for these companies are not really having an effect. Free market companies that have now largely taken over government programs in reintegrating people on disability to the jobmarket are only mildly more successfull.

Lowering the benefits or abolishing them (aka making people personally responsible for their own income) isn't an option. It is political suicide, any party advocating that can never again work together to form a government. The Liberal party, the only one that could potentially dare to propose such a thing, will not be able to work together with either the Social Democrats or the Christian Democrats.
Not only that: the worker's unions, powerfull organizations with more members than most political parties will protest and organize solidarity strikes. They have done so in the past with other reforms in the disability benefit legislation. They argue that there needs to be a safety net for workers who become disabled, and it needs to be pretty good. Such a safety net is definitely something people are willing to strike for. Strikes are not good for the economy.

And if you manage to get past all that, you'll end up with a whole group of people without income waiting for the free market to kick in and hire them. Paraphrasing a macroeconomist you don't care much about: "And in the end, they're all dead."

So, tell us, Guru of Macroeconomics (and I don't mean that in a bad way!)... What is the Free market solution to this wastefull use of human capital? If you know one, please send it to:
Prime Minister Jan Peter Balkenende
The Hague
The Netherlands

:DYou're misunderstanding the catch-up effect.Okay, maybe so. Still isn't it reasonable to assume that markets grow until there is a limiting factor (for instance it becoming harder to find more natural resources)? Why are we supposed to assume that a steady percentage growth is what should have happened?But the company who produced the newspaper had to purchase ink and paper to make it.Yes, but the company who produced the paper had to buy old newspapers! You end up with a full circle, and every in step material and energy is lost, and in every step people end up paying to get the product of someone else.So if you counted the ink, paper, etc. into GDP, you'd be doubling up on those costs.Yes, I understand that. But I think what is a 'final good' is quite arbitrarily defined. Why should I pay for the priviledge of supplying a recycling company with waste? Why doesn't it pay me for producing it? (In the case of paper, they actually do!)The difference is, those goods were not purchased for the purpose of making roads, bottles, or landfills.I don't see what 'purpose' has got to do with it. A paper manufacturer doesn't produce paper to make newspapers. It produces paper to sell to what is from their perspective a consumer. The local Scouting doesn't sell old newspapers to the paper manufacturer with the purpose of producing paper, for they do it just to make money from what is for them a consumer. They don't care what their consumer does with it. It makes no difference.In other words, manufacturing creates value, consuming uses up that value.So, the only difference is that I can't find anyone to pay me as much (or more) as I paid for it myself?

And in the case of junkmail, where I don't have to pay for it myself, it is the advertiser who is the consumer and my mailbox is just that part of nature where it dumps its waste? Okay, I think I get it now... :D

Earthborn

24th October 2003, 11:23 AM

Originally posted by shanek
[B]I'd love to see Free to Choose again. That's the PBS economics series with Milton Friedman.What? Another PBS series on economics? What are they trying to do: dig their own grave? :DHe said that if you wanted to reduce inflation, that there was a very simple way...and then he shut the machine off!!!Yes, that's a good one. But like many arguments it is only convincing because it shows only part of the truth. I'm pretty sure the Federal Reserve also destroys a lot of old worn out banknotes, doesn't it? If it produces more than it destroys you get inflation, but if it produces less there would be less and less money in the economy, and I have a feeling that wouldn't be so good for the economy either.

If the size of production of money is directly controlled politics, that could become a problem if the government is low on cash and still wants to pay for its civil servants and recievers of social security. It could become very tempting to start producing more money to finance these things.
Could you explain to me what kind of measures there are to prevent the US government from doing this? I get a feeling that the Federal Reserve isn't as independent from politics as the European Central Bank is, which has the sole purpose of reducing inflation. But I like to hear your opinion about it.

Could you also explain to me what the effect is when more and more people start buying on credit (and possibly not being able to pay it all back). If people start to pay in virtual money (they don't have!), isn't that a form of money creation also, and doesn't it also cause inflation?I just thought it was a great opportunity to put my money where my mouth is.Many thanks for that! :cool:

shanek

24th October 2003, 11:32 AM

Originally posted by Earthborn
So now we have a whole lot of people twiddling their thumbs. But are they being hired? I'm afraid not. Companies are afraid to hire people who lived on disability for a while, because they are afraid such people are more likely to call in sick. And since they haven't worked for a while, they are considered to be less experienced.

And that results in them not being as valuable to a potential employer. They're not worthless, they just can't command that high a wage. Which poses a particular problem for their employment if the country has a minimum wage greater than their net worth.

Lowering the benefits or abolishing them (aka making people personally responsible for their own income) isn't an option. It is political suicide, any party advocating that can never again work together to form a government.

Which brings me back again to the Nixon quote: "The politics of economics outweighs the economics of economics." It's unfortunate, but the only solution I can see is to educate people on economics. What we're discussing in this thread should be taught in high school, IMO.

What is the Free market solution to this wastefull use of human capital?

Simple. Get rid of government programs such as the minimum wage and mandatory benefits packages and let companies hire them for the minimal amount they're worth. As they get back into the workforce, they'll become better workers, they'll prove themselves to their current and potential bosses, and their wages will rise as a result. Pretty soon, they'll be back in full force.

Okay, maybe so. Still isn't it reasonable to assume that markets grow until there is a limiting factor (for instance it becoming harder to find more natural resources)?

Not at all. Again, Japan, with virtually no natural resources at all, has been able to grow their economy quite nicely. The US, facing shortages of coal and steel (or at least what coal and steel remained was becoming more expensive to obtain), stated arranging to have these resources imported from other countries. If you'll reread the transcripts, you'll see how technology makes the resources go farther and reduces waste. All of these things can make up for an increasing lack of natural resources.

Why are we supposed to assume that a steady percentage growth is what should have happened?

Because there's simply no other catalyst which occured at that time that can account for the drop. And we do know for a fact that the government spending increased, and know the inhibiting effect that can have on an economy.

Yes, but the company who produced the paper had to buy old newspapers!

Not necessarily; they could have made paper from new stock. But even recycled newspapers have lost their value. Once the person has read the newspaper, and once the newspaper has reached a certain age, it no longer has the value that it did. That's why the newspaper is the point of consumption. After its value is used up, it is recycled to make newer (and therefore, more valuable) newspapers.

You end up with a full circle, and every in step material and energy is lost, and in every step people end up paying to get the product of someone else.

But value is only lost at the time of comsumption. At every other point, value is added to the product.

But getting back to your original question, at this point it becomes a "final good" because the price of that good reflects all of the prices of all of the resources that went into it. So by counting the price of the final good, you make sure everything is counted once and you're not doubling up on anything.

I don't see what 'purpose' has got to do with it. A paper manufacturer doesn't produce paper to make newspapers. It produces paper to sell to what is from their perspective a consumer.

And if you as a consumer buy the paper to put into your printer at home and use for your own personal reasons, then it becomes a final good. But if you use that paper to start a newsletter and sell it, then it's the newsletter, not the paper, that is a final good. Purpose has everything to do with it, because purpose is where value is defined.

The local Scouting doesn't sell old newspapers to the paper manufacturer with the purpose of producing paper, for they do it just to make money from what is for them a consumer.

And they do it by collecting resources (in this case, old paper whose value has been lost) and the paper companies purchase those resources. It is the consumer that caused the newspapers not to be as valuable as they once were, to the point where their value as simply paper stock is worth more than their value as a finished newspaper.

And in the case of junkmail, where I don't have to pay for it myself, it is the advertiser who is the consumer and my mailbox is just that part of nature where it dumps its waste?

Actually, in a sense, yes. The junk mail producer is making and sending out junk mail because they believe the return that they're getting from that will exceed the amount of resources they put in to sending out the junk mail. Once a person receives the junk mail, and makes the decision whether or not to buy the product (or even whether or not to consider what the junk mail even has to say), the junk mail has lost its value because its purpose has been fulfilled.

shanek

24th October 2003, 11:43 AM

Originally posted by Earthborn
What? Another PBS series on economics? What are they trying to do: dig their own grave? :DYes, that's a good one. But like many arguments it is only convincing because it shows only part of the truth. I'm pretty sure the Federal Reserve also destroys a lot of old worn out banknotes, doesn't it? If it produces more than it destroys you get inflation, but if it produces less there would be less and less money in the economy, and I have a feeling that wouldn't be so good for the economy either.

Actually, it's whether or not the net increase in money (total money produced - total money destroyed) is greater or less than the increase in the amount of goods and services in the economy. If it's greater, you get inflation. If it's smaller, you get deflation.

If the size of production of money is directly controlled politics, that could become a problem if the government is low on cash and still wants to pay for its civil servants and recievers of social security. It could become very tempting to start producing more money to finance these things.

And that is exactly what has been happening.

Could you explain to me what kind of measures there are to prevent the US government from doing this?

Right now, there aren't any, unfortunately.

I get a feeling that the Federal Reserve isn't as independent from politics as the European Central Bank is,

It's not. Upcoming episodes of this series talk more about the Fed and the role of inflation and deflation in a market economy.

Could you also explain to me what the effect is when more and more people start buying on credit (and possibly not being able to pay it all back).

That's largely covered by the last transcript. Future episodes, particularly when discussing the business cycle, will also look at this. Basically, purchasing on credit creates money in the economy. Banks are only willing to give out money on credit if, on the balance, they take in more than they loan out, which means that production in the economy will increase to cover the costs of the credit. If the economy starts producing more than can be consumed, that's the top part of the business model and that's where a recession starts.

It's all covered in a future episode.

If people start to pay in virtual money (they don't have!), isn't that a form of money creation also, and doesn't it also cause inflation?

It is a form of money creation. Whether or not it causes inflation depends on whether or not it results in a corresponding increase in the overall amount of goods and services in the economy.

shanek

1st November 2003, 01:50 PM

All about unemployment and its causes.

Connolly: Unemployment is a vital and often controversial issue in any discussion of the long-run macro economy...Our first task is to define the labor force. Some people aren't counted in the labor force. Children, for example or adults who don't have a job and aren't out looking for one. The labor force is defined as the total number of workers in the economy, counting both people with jobs and people out looking for jobs. Now, of course, people with jobs are considered employed. People who don't have jobs but are out looking for work are called unemployed. And people who don't have a job and aren't out looking we don't count them in our numbers. We simply don't count them. So the total labor force is the employed + the unemployed. Nobody else...So to get the unemployment rate, we simply divide the number of unemployed people by the size of the labor force...So if someone's home taking care of children, and that's this person's full-time occupation, they wouldn't be counted in the labor force, because they're not employed for money and they're not out looking for a paying job. But if next month that same person starts searching for a paying job,...then that person is counted both as part of the labor force and as unemployed.

Let's do a short numerical example. Let's say that the labor force is 100,000,000 individuals. Further, let's say that 96,500,000 are actually employed. The unemployment rate would be 3.5% in this case: (100,000,000 - 96,500,000) (leaving 3,500,000 unemployed) / 100,000,000 * 100 = 3.5...The pont I'd like you to see is that as we travel through the business cycle, not only does the demand for labor change, but labor force participation changes as well. And both of these factors have an impact on the unemployment rate...The unemployment rate is based only on labor force participation. In fact, if societal factors make it harder for certain people to find jobs,...then some people may simply give up looking for work. This means that they fall out of the unemployment statistics, even though they might look for and accept employment if they thought there was any prospect of getting it.

[...]

Over the course of the Business Cycle, we tend to see movement in the unemployment rate. The term "Business Cycle" refers to the broad swings of an economy from recovery, expansion, and boom into recession. So it's the upward and downward swings in GDP. If we look at the unemployment rate from 1970 to 1995, we'll see a great deal of variation from year to year...The question is, what produces that movement in the unemployment rate? There are several key components, including the demand for labor, demographic factors, and economic growth. The essential connection is that the demand for labor depends on the demand for goods and services in the economy. So in an upturn, when the economy is expanding, there's a greater demand for goods and services, and consequently, a bigger demand for labor. And that leads to higher numbers of employed individuals in the labor force. So the unemployment rate...tends to fall.

And now, a very important distinction I've mentioned on this forum several times before:

All unemployment is not created equally. There are two different kinds of unemployment: cyclical and natural. First, we'll deal with cyclical unemployment, which rises and falls as we go through the Business Cycle. This happens when the economy slows down and the demand for goods and services simply isn't high enough to supply jobs to everyone who wants one. When the economy is bustling, there is little to know cyclical unemployment. But when the economy is slow, cyclical unemployment can be very high. This brings up another issue: the phenomenon of the discouraged worker. Remember that if people don't have jobs but are looking for one, we count them as unemployed. But if someone has been looking doesn't find anything, gets discouraged, and stops looking, then they're not counted as unemployed and they're not figured into the unemployment rate. But from a broader social perspective, this is a potentially productive person who doesn't have a chance or opportunity to use their skills. Many economists and policy makers think that because these discouraged workers are not counted in the unemployment statistics, we're probably not measuring unemployment very well. We're ignoring people who have been unable to find employment and are no longer looking...

There's another central issue in cyclical unemployment: the duration of a period of joblessness. If someone's unemployed, how long do they remain unemployed? [A carpenter] might finish a job at one building, but not be hired on to the next job for a couple of weeks. In that short period, the Bureau of Labor Statistics might happen to find this carpenter and ask about his situation. The answer would come back, "I'm unemployed, but I'm in the labor force. I'm waiting for a job to come along." Then this carpenter would then be counted as unemployed, and with luck and pluck, the spell of unemployment would end very rapidly. This spell of unemployment, perhaps several weeks, probably less than a year, is fairly typical, especially in certain professions. And it's unemployment that's not caused by deficient demand, but is simply due to the nature of a particular industry, in which individuals work at a place for awhile and then move on to the next job after the first one's finished. Now, this is more like natural unemployment...[But] imagine someone who's working in a manufacturing plant, and the plant closes because demand across the economy has fallen off. This worker has been laid off, and since demand has fallen and we're in the low part of the Business Cycle, a recession, it might take awhile for that person to find a new job. And, of course, the worse an economy is, the longer they're likely to be out of work.

Now, unemployment, whether it's cyclical or natural, tends to be fairly short. But if labor is relatively immobile, unemployment can persist for a very long time. For example, in parts of the south, when the textile business was shrinking in the '70s, '80s, and '90s, some people who worked in the mills were unwilling to leave their hometowns and their families after losing their jobs. These people might find that their unemployment lasts for many months, if not years. Now, if labor is mobile—which is today, if people are willing to relocate—then unemployment tends to be briefer, simple because people can search in more areas for a new job.

[Natural unemployment] has to do with the fact that, even in a healthy economy, change is always going on. People leave their jobs because they're unhappy or they want to move...and sometimes a product just dies out, like the slide rule, and of course the people who worked in the slide rule plants got laid off and they had to find jobs in other industries. That, of course, could take a little while. So even in a very healthy economy, we'll have some unemployment. Now, generally it's short-lived and pretty small, but it's not going to be zero...

So, what causes natural unemployment?

There are a number of factors that determine how high the natural rate of unemployment will be. Minimum Wage laws will have an impact, and here's why: In the labor market, we have a demand for labor, and that comes from firms. And the supply of labor, of course, is the supply offered by individuals. This determines and equilibrium quantity [of jobs] and some equilibrium wage rate. This wage rate functions as the price of labor; a price which ensures that the supply of labor and the demand for labor are equal to one another. The Minimum Wage is a legal restriction that keeps wages from falling eblow some point chosen by the government; and of course for the Minimum Wage to make any difference, it has to be above the equilibrium wage that the market determines on its own. Otherwise, what's the point? But at the Minimum Wage, the quantity supplied of labor is more than they quantity demanded. So what we have is a certain amount of unemployment in the labor market that occurs because the wage rate is too high, and the government's made it illegal for it to go any lower. Now, there have been a number of debates in the US over the social advantages of the Minimum Wage versus its unemployment costs. It is clearly the case that the Minimum Wage is laregly irrelevant for most married heads of households in the US. Most of these people are employed at wage rates that sometimes far exceed the Minimum Wage. However, for teenage workers...there have clearly been times where the Minimum Wage was greater than the equilibrium wage. And there is evidence that increases in the Minimum Wage are probably connected to the relatively high unemployment rates for teenage workers in the US...The point is...the Minimum Wage actually contributes to a higher natural rate of unemployment. Imagine, though, what would happen if the demand for labor increased quite a bit; so much that the demand curve shifted out [to the right]. In that case, what we would find is that the new equilibrium wage rate, in fact, exceeded the Minimum Wage...In this situation, the Minimum Wage is simply no longer relevant because firms don't want to go any lower than the market wage. So it's possible that the Minimum Wage may contribute to unemployment—to a higher natural rate of unemployment—but that effect is dependent on what else is going on in the economy.

That is one of the "crackpot economic theories" that many people spent several pages denying. But as I pointed out at the time, it's something you will learn in a beginning macroeconomics class, and lo and behold, there it is!

Now, other causes:

Another reason why the natural rate of unemployment could be greater than zero is due to the effect of labor unions...One of their primary goals is to raise the wage rate that's being paid to workers in a particular industry...This higher wage produces a smaller demand for labor in the market, just as we saw with the Minimum Wage. And the amount of unemployment caused by the higher union wage, of course, depends on the exact shape fo the demand and supply curves for labor, and on how much the union wage exceeds the market equilibrium wage...

Conrad: When unions bid up a wage above what the market clearing wage is, it can generate unemployment in that sector; it can generate an excess of the number of people who are willing to work at that going wage, relative to the number of workers that firms want to hire at that going wage. And this is always something that unions have to consider as a balancing act; because if they bid up wages very high, their membership starts to shrink.

[...]

Here's another theory that's very important in understanding unemployment. It's called "Efficiency Wages," and here's how it works: Normally, we can assume that firms will pay the going market wage to employ labor, and there's no reason to pay above the equilibrium wage, because, in the simple model, the firm can hire all the labor it needs at that rate. Now, the diea behind the efficiency wage argument is that it's possible to be more profitable in some circumstances by paying above the market wage. How can that be?

There are several possibilities. One is, when you pay a higher wage rate, you get healthier and more efficient workers; that is, the higher wage allows for better nutrition and better health care. So employees miss fewer days and are more productive when they're on the job. In turn, this leads to higher profits...

Another Efficiency Wage idea...is related to labor turnover. If workers are engaged in a very simple production process, then there's no reason to worry about workers quitting. The firm can just hire a replacement, and a replacement worker can pick up what they need to learn pretty quickly. But if the work is more complicated, then it may take quite awhile for a new hire to be trained and to gain the experience and acquire the efficiency of the original worker. So the firm has to pay to train this employee, and in the meantime has to accept lower productivity than before. This raises costs, which cuts into profits. So the firm now has an incentive to pay higher than the equilibrium wage. Why? Because this keeps workers from leaving and allows the firm to avoid the cost of worker turnover...

Other firms might pay more than the equilibrium wage simply to provide an extra incentive for workers to work hard, to bust a gut. In some firms, there can be areas where managers are either unable or unwilling to manage workers closely, or ot may be it's simply very expensive to do this. In settings like this, it pays workers an incentive to do the right thing: to be highly productive. Essentially, an above-market wage rate can substitute for time and expense associated with closely monitoring workers. It's a way to keep down the level of shirking. Job seekers who know about this may well hold out for one of these high-paying jobs. They'll stay unemployed longer than they might otherwise, because they're hoping to land one of these better positions, and so the natural rate of unemployment will be higher...

A fourth reason why above-normal wage rates might be paid is that wage rates also serve the purpose of creating a ready and waiting pool of workers for the business. There was a classic example of efficiency wages in 1914 when Henry Ford, who founded the auto assembly line, introduced the $5 work wage. That's a $5 wage for a whole day's work. My, how times have changed! This was about double the going wage at the time, and while many people thought that Henry Ford was out of his mind, and was going to bankrupt the entire auto industry, it turned out that this wage ensured a very stable, high-quality work force at the Ford Motor Company. In turn, that helped to ensure the success of the Ford Motor Company. So the idea si this: If the firm pays an above-normal, or above-equilibrium, wage rate, they will find themselves with a large pool of workers who would like to have a job at that firm. This employer is then in a position to select only the very best workers. Now, that in turn leads to higher unemployment because, once again, many people would choose to stay in the pool of unemployed workers in the hopes that they can get a job in a business that pays above-normal wage rates.

Our final reason for a positive natural rate of unemployment is the cost of the job search process itself. It's not easy to find a good job. It costs time, money, and a lot of energy. Anyone who's ever looked for work knows how hard, and sometimes how discouraging, it can be: gathering information, searching for leds, sending out letters, pounding the pavement. This is not a trivial task...

Note that some of these forms of unemployment are desired, and others are not. That's why you can't just look at the overall level of unemployment and draw a whole bunch of conclusions, as people tried to do in the Minimum Wage thread and elsewhere.

All of this leads to a key question: What's the ideal natural rate of unemployment? Well, that's not an easy question to answer. The higher the rate of natural employment, the greater number of people who are out of work, not earning money, not advancing their careers, and unable to support their families...We might be willing to put up with higher unemployment, with longer spells of unemployment, if it meant a higher qaulity of life in the long run. So there are tradeoffs here, and the answer isn't obvious. Europe has chosen to go with a stronger safety net than the US, and they've accepted a higher natural rate of unemployment in exchange. So the question is, are we better off with higher wage, better benefits, and a reduced work week, and higher unemployment? Or are we better off with relatively lower wages, relatively longer work weeks, and lower unemployment?

Jet Grind

1st November 2003, 03:07 PM

Well shanek I enjoyed reading that, but I don't see what's so special. It's just standard neoclassical stuff. If people are really denying that minimum wage laws destroy entry level jobs that showing this probably won't change anything.

shanek

1st November 2003, 03:49 PM

Originally posted by Jet Grind
Well shanek I enjoyed reading that, but I don't see what's so special. It's just standard neoclassical stuff. If people are really denying that minimum wage laws destroy entry level jobs that showing this probably won't change anything.

Well, those people I think are beyond hope. They just absolutely cannot see beyond their personal biases and preconceived notions. This thread is for the lurkers and others who may be on the fence about these issues, as well as giving me some good material to refer back to in future threads.

shanek

6th November 2003, 09:33 PM

Okay, boys and girls, Episode 5 is a lecture that concerns money and the money creation process through commercial banks managed by the Federal Reserve. First, a talk about what money is:

Connolly: Coins, historically, have been a commodity money in the following sense: the coins were made out of gold, and the value of the coin was related to the value of the underlying commodity, which was gold. But increasingly what we've come to is coins which are made out of a material of very, very low intrinsic value. For example, there isn't a nickel's worth of nickel in a US nickel; that is, if you were to melt down a US nickel, you wouldn't have 5¢ worth of metal there. Likewise, a $1000 bill clearly doesn't have $1,000 worth of ink and paper in it. This is a break from thinking about commodity money to what's known as fiat money.

Richard Sylla, PhD., Prof. of Economics and Financial History, NYU: Well, colonial America was part of the British Empire, and Americans relied to a great extent on foreign trade and financing on the British. Now, within the American colonies, they came up with an innovation: They invented fiat money, first time in the western world.

Connolly: Fiat comes from a Latin word which means, "to make something come into existance." Fiat money is money because the governmetn has declared by order that it is money. In fact, in the US, if you look on paper money, it actually says, "This note is legal tender for all debts, public and private." This means that this money has to be accepted by everybody. That's what we mean when we talk about fiat money: it's money without intrinsic value that is used as money because of government decree. It's got value and utility and use because it's been decided by the government that it has that value...

If we go back to the turn of the century, money was primarily in the form of checking accounts, which are also called "demand deposits," and in the form of coins and bills. There were very few other sources, or kinds of money at that point. Today, we've got a number of different definitions of money, and the definitions have changed radically over the 20th Century, because there's been enormous technological innovation in how the financial system operates, how the banking system operates, and how we do transactions. So at the end of the 20th Century, money has a number of different forms, and this is reflected in several different definitions.

Our first definition is what we refer to as "M1." M1 includes currency, traveller's checks, demand deposits, and other checkable deposits. M2, a broader definition of money, includes everything in M1, but we add in savings deposits, small time deposits, and money market mutual funds...We do this because people are able to convert savings deposits into cash or to use them in transactions very easily...M1 was about $1.1 trillion in 1996. M2 was about $3.7 trillion in 1996. And if you jump inside of M1 and ask, "What portion of this is accounted for by coins and bills?" you'll find that an extremely small percentage of that $1.1 trillion consists of currency. Most of it, the enormous majority of it, is demand deposits or checking accounts...So in 100 years, our entire idea and definition of what money is has changed very radically.

These definitions are further complicated by technological changes in the banking system. Several things that happened late in the 20th Century include debit cards and e-cash, or electronic cash. These are ways for people to pay for goods and services, store value, and they embody the unit of account. But they're not exactly a checking account, they're not exactly a small-time deposit, they're not quite a credit card (because a credit card isn't really money; it requires you to use money to settle your balance with the credit card company—yes, you can complete transactions, but there's no store of value). A debit card is a little different animal. What a debit card allows you to do is to pay for things directly and the debit card transaction is cleared against your bank account. So this is the sense in which debit cards look a great deal more like money and the sense in which credit cards really are not money. E-cash is a close cousin of the debit card. You can complete transactions across the internet, and to settle your accounts without actually having to send cash or a check or a money order or anything else. So here we have some interesting and important new innovations. It's also important that you realize that the reason why these innovations are occuring is that there's an incentive for the banks and the financial institutions to find more and more efficient ways to complete transactions...

Now, onto how money is actually created. Not to gloat, and I won't mention any names, but there was a certain poster who spent a large part of a thread insisting that I was wrong about this, and even offered to donate $1000 the JREF if I could find even one banker supporting it (which he then weaseled out of). But here we are, just like I said, an introductory macroeconomics lecture describing the process almost exactly the way I said it was:

What should be the role of different government agencies and branches in the economic policy-making process?

William Seidman, former FDIC Chairman: If the Federal Reserve does its job well, you'll never know it's there, because it is simply charged with keeping the money supply moving upward as the economy moves up, and really not disrupting the economy but simply keeping the money supply being supplied in a smooth way and letting the economy operate through the market system.

[...]

Connolly: Banks, of course, take in deposits from customers and make loans, and this turns out to be very important in the money supply process...When we talk about the money supply process, we have to remember that currency, that is, coins and paper, makes up a very small portion of the money supply. A much greater portion exists in the form of checking accounts—demand deposits. And this is where the commercial banks come in, because they handle most of the country's checking accounts. So what I'd like to do is introduce a really simple accounting system allowing us to see what it is that goes on in the money supply process. So I'm going to use what's called a "T-Account." A T-Account is called that because it looks like a "T." Further, I'm going to use the standard accounting conventions and put assets on the left and liabilities on the right of this T-Account...Here's how it works: If you go to a commercial bank with $100 of currency in your pocket and plunk it down on the counter and say, "I'd like to put this in my account," then here's what happens to the bank: It gets a $100 item under Assets. That $100 item is called "Reserves." On the liabilities side, it has a 4100 item and this is called a "Deposit."

Assets Liabilities
--------------------
R $100 | D $100
|

...The bank has $100 cash in its bank vault. We have to ask, "What does the bank do with that cash?" If the bank were really cautious, it might just keep it there in the vault; after all, you have the right to come back at any time and demand the money back. The bank would be in pretty big trouble if it didn't have it on hand to give to you. On the other hand, the bank has lots of depositors, and it's unlikely that all of them will want all of their cash at the same time. So the bank could take some of its reserves, loan them out to people, and charge them interest...The question is, what portion of the deposits have to be held in reserve by the bank? The Fed sets this percentage, which is called the "reserve requirement." Here's the point: In systems where you have 100% reserve requirements...the bank can't lend out any of the deposits, and there's no possibility for the banking system to create any new money. So the banking system essentially is irrelevant as far as the money supply process goes. But we don't have a 100% reserve system in the US. In fact, what we use is a "fracitonal reserve" system. Fractional reserve banking means that the reserve requirement is less than 100%. The bank may be required to hold, say, 25% of its deposits in reserve. There's actually a fairly complicated system of reserve requirements for banks in the US, depending on where the bank is located and how big the bank is. They range from about 25% of deposits down to about 8-10%.

Let's assume that the reserve requirement is 10%, or .10. This means the bank has to hold 10% of your $100 deposit in reserve. That would come to $10. So after the bank puts the $100 in its vault, it has $10 in required reserves and $90 in excess reserves. That is, $90 that it doesn't have to hold in its vault. Reserves actually have a very specific definition in the US monetary system: cash in the vault plus treasury securities—bonds or other debt securities issued by the US Treasury. Those securities can either be in the commercial bank itself, or on deposit in the bank's account at one of the Federal Reserve District Banks...So what we've done is we've rewritten the assets side of the balance sheet for the bank. And what we see is that if there's a 10% reserve requirement, this bank has $90 in excess reserves. The bank can lend out these excess reserves, and what you'll see in the end is that the loan creation process actually turns out to be the money supply process. When a bank creates a loan, they actually create a new demand deposit account. And since demand deposits are money, that's why the loan creation process and the money supply process are identical to one another. Now, what's happened so far is that the bank took your $100 cash and set up a $100 checking account for you. Now, the Fed has a 10% reserve requirement, so the bank has to take $10 of that currency and hold it in reserve, basically take it out of circulation. But it can take those other $90 and do what it wants with them: it can keep them on hand as excess reserves, or the bank can could lend them out and charge interest on them. And since the bank wants to earn a profit, that's what it does. So on the Assets side of my T-Account, I'm going to change those $100 of reserves into $10 in reserves and a $90 loan.

Assets Liabilities
--------------------
R $10 | D $100
L $90 |
|

...Now remember when the bank loans out the money, the bank has actually created a $90 demand deposit, $90 in new money. And that is the essence of the money supply process.

Assets Liabilities
--------------------
R $10 | D $100
L $90 |
|
| D $90
|

But that's just the first step. The bank created the account so that the borrower could take the money and spend it. And when that happens, it may then be deposited either back in the initial bank, or deposited in some other bank. And since a deposit has occured, just like before, the money creation process starts up again, just like before, except this time, we're working with a $90 deposit instead of $100.

Assets Liabilities
--------------------
R $10 | D $100
L $90 |
|
R $90 | D $90
|

The bank has to hold 10%, or $9, in reserve, but it gets to lend out the other $81...thus creating another $81 of new money. What this means is that, so far, the bank has $190 in deposits on the liability side, and $19 in reserves and $171 in loans on the asset side.

Assets Liabilities
--------------------
R $10 | D $100
L $90 |
|
R $ 9 | D $90
L $81 |

Then when this $81 gets spent, it gets deposited again in another account. The bank has to hold 10%, which is $8.10, in reserves, but it gets to lend the rest out. And this process keeps going on and going on. Of course, the figure we're talking about gets 10% smaller each round, so eventually after quite a few cycles it has to peter out. Remember, we're simplifying a process here. In the real world, everything gets a little more complicated. In fact, sometimes it gets a lotmore complicated...If we were to follow this process through to the end, $100 in new currency, with a 10% reserve requirement, would end up leading to a $1,000 increase in the money supply. That $100 was multiplied ten times. The higher the reserve requirement, the less money the banks can offer in the way of loans, so the smaller the increase in the money supply. The lower the reserve requirement, the more the banks can make in the way of loans, and the higher the multiplier effect will be. If we were to work this out algebraically, which we won't, We'd find that the multiplier is actually equal to 1/the reserve requirement. So for our example, 1/.1 = 10. That means if the banking system got $100, the loan creation process would eventually turn that $100 into a total $1000 of new money.

Finally, here are tools the Fed uses to try and control the money supply, and the reasons why it can't really control it completely:

...If the government wants to increase the amount of reserves, then the Fed buys some of the [government] bonds back from the public. Every dollar's worth of bonds that it buys adds $1 to the amount of reserves. And if the Fed wants to reduce the amount of reserves, it does the reverse; it just sells bonds from its own holdings. Every dollar that the Fed takes in is $1 removed from the money supply. These open market operations are an easy way for the government to adjust the money supply directly.

Another way the Fed controls the money is through the reserve requirement...The reserve requirement is kind of an indirect tool for the Fed, because it really depends on what the banks do with their excess reserves. But what happens when a bank miscalculates, and its customers demand more currency than the bank expected? Well, the bank would find itself holding too few reserves. What the banks do is, they borrow reserves from the Federal Reserve system, and they borrow through what's called the Discount Window...The idea is that the Fed operates, in part, as a sort of lender of last resort. If commercial banks were short on reserves...the bank could turn to the Fed and borrow the reserves they needed to meet their customers' needs. Now, in order to be eligible to borrow at the Discount Window, commercial banks have to provide collateral for the loan...The Fed would count up the collateral, and it would discount it and give, say, $95 per $100 of collateral. In the end, the commercial bank was required to pay back the full $100. So the bank discounts the original assets when it gives the loan and you pay back the whole amount, hence the term, Discount Window. But how does this discount rate affect the money supply? If the discount rate is low, then banks keep their reserves very close to the required minimum, because they know that they can get more reserves from the Fed at very low cost if they have to. But if the discount rate is high, then borrowing reserves from the Fed is expensive, so in order to avoid that sort of thing, commercial banks keep a little more extra in reserve. And that, of course, cuts down on the amount of loans that they can make...So the Discount Window is very important because it provides a source of liquidity for a commercial bank that's in need...

In the 1930s, there were bank runs and bank panics, times when depositors were so scared that their bank would fail that they rushed in to withdraw all of the money in their accounts. In a fractional reserve system, even a healthy bank can't meet this sort of demand. So a bank panic could easily ruin a bank that had nothing wrong with it. These panics let FDR to declare bank holidays, which simply shut the banks down so that people couldn't pony up and ask for their money back. Part of the problem...is that the Fed did not step in and provide liquidity at the time of the bank panics. The costs of this failure were enormous...

"I sincerely believe that banking institutions are more dangerous than standing armies." —Thomas Jefferson

The Fed has some difficulties with controlling the money supply. First, the Fed doesn't control the amount of money that households choose to hold in commercial banks. We began this example by talking about a $100 deposit in the commercial banking system, but the truth of the matter is, if households decided they didn't want to hold $100, but only wanted to put, say, $68 in the bank, that would have a large effect on the money supply, but the Fed would not be in a position to control this directly. A second problem in monetary control is that, even though the Fed sets the reserve requirement, individual commercial banks could just as easily decide not to lend out all of their excess reserves. So the fact that the Fed sets the reserve requirements doesn't necessarily mean that banks will turn around and lend out all their excess reserves; that means that there's another way in which the Fed is unable to control the money supply precisely.

Solitaire

7th November 2003, 07:56 PM

Originally posted by shanek
Well, those people I think are beyond hope. They just absolutely cannot see
beyond their personal biases and preconceived notions. This thread is for the
lurkers and others who may be on the fence about these issues, as well as
giving me some good material to refer back to in future threads.

It seems very much like my old high school economics course.
Odd question, supposed the goverment subsidized labour,
by this I mean got rid of welfare and minimum wage along
with a few other programs then gave everyone a kickback
on the old taxes to the tune of say four thousand a year.
What would happen to the supply and demand curves?

shanek

8th November 2003, 06:47 AM

Originally posted by Synchronicity
It seems very much like my old high school economics course.

You had an economics course in high school? Cool! My old high school never went anywhere near the subject. (Well, they had "home economics," but that's not the same thing.) I always thought this should be part of the curriculum in high schools.

Odd question, supposed the goverment subsidized labour, by this I mean got rid of welfare and minimum wage along with a few other programs then gave everyone a kickback on the old taxes to the tune of say four thousand a year.

That sounds like the Earned Income Credit to me.

What would happen to the supply and demand curves?

Since people would essentially be getting an extra $4,000, they'd be more willing to take jobs that paid $4,000 less than they ordinarily would. Since more people would be willing to work at lower wage levels, that would push the supply curve to the right. As a result, the equilibrium wage would actually drop while the equilibrium quantity of labor would increase. It could arguably be good for increased employment, but not for higher wages.

Solitaire

11th November 2003, 03:19 PM

Originally posted by shanek
You had an economics course in high school? Cool! My old high school
never went anywhere near the subject. (Well, they had "home economics,"
but that's not the same thing.) I always thought this should be part of the
curriculum in high schools.

I agree.
Unforunately, one doesn't get to keep the books and memories fade.

That sounds like the Earned Income Credit to me.

Yes.
It might be the solution to the problems of illegal
immigration and the high unemployment in minority communities.

Since people would essentially be getting an extra $4,000, they'd be more
willing to take jobs that paid $4,000 less than they ordinarily would. Since
more people would be willing to work at lower wage levels, that would push
the supply curve to the right. As a result, the equilibrium wage would actually
drop while the equilibrium quantity of labor would increase. It could arguably
be good for increased employment, but not for higher wages.

True. It appears to have no negative results. Hm.

P.S. I do find the transcripts interesting. :)

shanek

11th November 2003, 07:15 PM

Originally posted by Synchronicity
True. It appears to have no negative results. Hm.

Lower wages isn't a negative result? If you want to argue that the increased quantity of jobs is worth the lower wages, then that's an arguable position. But I don't see how you can say there are no negative results.

P.S. I do find the transcripts interesting. :)

Thank you.

Gem

11th November 2003, 09:39 PM

Finally, here are tools the Fed uses to try and control the money supply, and the reasons why it can't really control it completely:

That's funny, I thought bonds were also a tool for government control of the money supply. I think this is the prefered technique, since they can buy/sell them from a day to day basis.

I'm having a deja vu of college macro economics again. The matrix has me.

shanek

12th November 2003, 07:14 AM

Originally posted by Gem
That's funny, I thought bonds were also a tool for government control of the money supply.

Um, read the first paragraph after the part you quoted.

shanek

13th November 2003, 09:06 PM

More "crackpot economic theories," according to several posters on this board. Why, everyone knows that a little inflation is good for the economy, right?

Connolly: Inflation, like the flu, is not only contagious, but sometimes hard to shake. Let's begin by looking at the causes of inflation. It's important to start out with a specific idea of what we mean by inflation. Inflation is an increase in the overall level of prices. Now, we've seen a general tendency over the last 100 years for prices to rise, so even if they only go up 1-2% a year, we would still define that as inflation. Obviously, there's a big difference between a 1-2% rise in prices over a year and, say, a 12-15% rise in just a few months. First, we need to examine the connection between money and inflation. One of the best ways to understand inflation is to think about the price level as the measure of the value of money. We'll use the Consumer Price Index to talk abotu the value of money. CPI is the measure of the overall cost of goods and services bought by the average consumer. Now, inflation is the percent change in CPi from month to month or year to year. And the price level and the value of money are always inversely related. When prices are low, you can buy a lot of goods with your money, so the value of your money is high. But when prices are high, you just can't buy as much, so the value of your money is low.

Suppose on Jan 1 the CPI tells us it costs $100 to buy a market basket of goods. At the end of the year, if there were no inflation, it would still cost $100...We would say that the value of money hadn't changed at all. You could still purchase the same quantity of real goods and services at the end of the year as you could at the beginning...but if at the end of the year prices have gone up, and the $100 only buys, say, 80% of the real goods and services that it used to buy, what do we make of this? Clearly, the value of money has gone down. My $100 doesn't buy the same quantity of goods and services at the end of the year than it did at the beginning of the year. We would say the value of money has declined. If I looked at CPI, what I would see is that the price level generally had gone up. The level of prices is inversely related to the value of money...

Jack Kyser, Chief Economist, LA County Econ. Devel. Corp.: Basically, it's too much money chasing too few goods and services. It means you cannot produce what the public and what business demands, and so it drive prices up.

Connolly: We can turn this into a simple equation. Let's call the price level "P". The value of money is equal to 1/P. So as P, the price level, gets bigger, the value of money gets smaller...Let's say that on day 1 CPI is $100, meaning it takes $100 to buy the market basket of goods. The value of one dollar, then, is 1/100 = .01. One dollar buys you 1% of the market basket. But if the CPI at the end of the year is $200, then consumer prices have doubled and there has been an inflation. What's happened to the value of money? Since CPI = 200, the value of money has fallen to 1/200, or .005, half of .01...So inflation is the same thing as the drop in the value of money...

The next thing we need to do is understand the relationship between the price level and the value of money in the money market. So we have a slightly different type of market diagram. I need two vertical axes; on the right we'll put the price level, and on the left, the value of money. On the bottom, we'll measure the quantity of money. We start with a low price level at the top of the right axis and a high price level at the bottom, 1-4. On the left axis, the value of money, we'll start with a high value and move down to a low value of money.

Value Price Level
1 | | 1
| |
3/4| | 1.33
| |
1/2| | 2
| |
2/4| | 4
| |
--------------------------------
Quantity

What this diagram does is express the equation we talked about earlier...Now, let's assume for the moment that the Fed is able to fix the money supply at a certain level. (Of course, this is only hypothetical; the Fed really can't control the money supply quite so exactly, but this will help us examine how the relationship works.) So, hypothetically, we'll just draw the money supply as a straight vertical line. The demand for money...is a downward-sloping curve. Why would it be downward-sloping? Well, when we talk about the demand for money, we mean the amount of money consumers want to have handy to buy the things they need. When the value of money is high, it doesn't take a lot of money to buy the things you need...but as the value of money falls, it takes more and more cash, more and more money in your checking account, to buy the things that you need. So the amount of cash that people want to keep on hand is higher...So it's a demand curve, just like the other demand curves we've seen.

Value Price Level
1 | \_ | S | 1
| \_ | |
3/4| \| | 1.33
| |\_ |
1/2| | \_ | 2
| | \_ |
2/4| | \_ D | 4
| | \ |
--------------------------------
Quantity

Now, what's being determined at the intersection point? Normally what we'd have is some sort of equilibrium being determined. And if you think about the value of money as essentially the price of money, then that's exactly what's happening at the intersection of the demand and supply curves. We're determining an equilibrium value of money; adn the price level is the inverse of the value of money. So what we've done is pinpoint the price level at which the amount of money that people want to hold and the supply of money being provided by the monetary system are exactly the same. So, what happens if the money supply changes? Well, if the money supply goes up, the price level rises, and the value of money declines. The way this happens is what economists call, The Transmission Mechanism.

Imagine the supply and demand curves for some specific good. What happens when new reserves are injected into the banking system? We know commercial banks create loans, and people who get loans turn around and buy goods and services. So, in the markets where they're buying these goods and services, the demand curve, it's increasing. As it increases, the prices of those goods and services are being forced up, and as the prices of goods and services rise, what we're finding is that our CPI starts to increase. So as money is created in the form of loans, the people who get the loans will use the proceeds to buy goods and services, and that forces up the price of those goods and services. So when the money supply increases, we get a new equilibrium at a higher price level and a lower value of money.

Now you might ask, "Isn't it possible that the demand for money might shift?" It is, but it only happens for short periods of time and in the long run there's really no tendency for the demand for money to shift in any important way.

Kyser: Money supply is seen by people as the cause of inflation. If you grow your money supply to rapidly, then that means there's too much money chasing too few goods, so people use the money supply to try and control the economy. There is the classic statement by a Federal Reserve Chairman that just as the party gets going real good, the Fed comes to take the punch bowl away. They are putting the brakes on the money supply.

Connolly: This is called the Quantity Theory of Money. The Quantity Theory says that the quantity of money in a system determines the price level. And the growth in the money supply determines the inflation rate. That is, the price level is being determined esentially by rightward movements of the money supply schedule. The faster the money supply increases, the faster the price level increases...

So inflation and government monetary policy, as the earlier posted transcripts also confirm, don't spur production; they only change the nominal value of what's being produced.

Nominal variables are measured in monetary units, such as dollars, yen, or deutsche marks. Real variables are measured in physical units, such as a bushel of corn or a gallon of milk. So you can think of the corn harvest either in terms of bushels of corn, a real measure, or total dollar value, a nominal measure. If I compare the value of the corn harvest from year to year, and I use dollars in each of those years, I'll have a problem, because the value of money may have changed. So even if we're harvesting the same number of bushels each year, our nominal measure for corn will have changed...What we're talking about is often referred to as the Classical Dichotomy, which is the division of variables into real and nominal groups. It's very useful in understanding what goes on: nominal values are influenced primarily in the value of the monetary system, but that doesn't tell us much about the real variables, about the quantity of real things being produced. If I want to understand the growth of real income, I wouldn't look to the monetary sector to get an explanation. We can talk about the growth process interminably without ever once mentioning money. We would just talk about capital and labor and the role that technological progress might play, but not the monetary system. It's only the dollar values that depend on the money market. If we say that changes in the money market are irrelevant to the real variables, then what we're really doing is claiming what's referred to as "monetary neutrality." In the long run, money doesn't help or hurt real output. Money is neutral with respect to real variables. Now, in the short run, money is not neutral. In the short run, say, quarter to quarter or month to month, monetary policy, changes in the money supply, can have real effects, and in fact they do. But in the long run, year to year or over successive five year periods, it's very clear that changes in the money supply has absolutely no impact on real variables. This turns out to be a central theme in the distinction between short run and long run analysis that is one of the most important issues in macroeconomics...

Economists have come up with a certain way to talk about the idea of monetary neutrality and the impact of money on the economy. It's called the Quantity Theory of Money. It uses a very specific equation to describe what's going on in an economy. We have the price level, P, and we have real output in the economy, Y, and the money supply, M. We're going to add one more variable: V, the velocity of money. the Velocity of Money refers to how fast money is being used in an economy, how many times each dollar in the money supply gets spent each year. These terms come together in the equation: M×V=P&timesY. This is referred to as the Quantity Equation. Let's break this down into its components. Suppose we produced a million 2x4s at $10 apiece. Then Y would be the million 2x4s, and P would be $10. So how do we find the nominal value? We take a million 2x4s and multiply that by $10 and get $10 million, the nominal output. By the same token...if we have $5 million in the economy, and each of those is spent only once in the year, then the total value of goods and services that are purchased is $5 million. On the other hand, if each of those $5 million is spent twice, that is, if M is $5 million and V is 2, then the total value of goods and services purchased each year will be $10 million. M×V and P&timesY are both the same thing: they're the monimal value of output.

Now, the velocity of money is very stable. It hardly changes at all from year to year. So V is stuck in place and monetary policy doesn't really change it at all. Y is detemined by technology, availability of natural resources, and human capital, and in the long run it's not affected by the money supply, either. So when the supply of money changes, it's the price level that's affected, not the quantity of output. Since V is stable, if the Fed changes the supply of money, it causes a proportionate change in the nominal value of output. If the Fed doubles the money supply, then nominal output gets doubled. If the Fed triples the money supply, then nominal output gets tripled...so whenever the Fed alters the money supply and nominal output changes, that means that the price level times real output also changes. If Y is determined by production factors and technology, then it must be P, the price level, that changes, because Y, output, doesn't respond to the money supply in the long run. In a nutshell, if the Fed doubles the money supply, the velocity of spending doesn't change, and real output doesn't change, so the only way the system stays in balance is for the price level to double as well. Whatever happens to M happens to P. The point here is, whenever the money supply increases, what we expect to see is inflation; and the faster the money supply increases, the faster the inflation that we're likely to see.

[...]

What I want to look at next is the relationship between inflation and interest rates...The Fischer Effect saus that the nominal interest rate is equal to the interest rate plus expected inflation. The nominal interest rate is the interest rate you get at your bank...The real interest rate isn't what the bank quotes you. The real interest rate is the nominal interest rate the bank quotes minus the impact of inflation on the value of your money. Say that at the beginning of the year it takes $100 to buy the market basket of goods, and at the end of the year it costs $200. Suppose you were to put your money aside for a year and pay 50% interest on that $100. As you can tell, at the end of the year, you'd have $150, but would you feel that had been a good investment?...An idea that addresses this issue comes from Irving Fischer...The Fischer Effect is a very important idea in understanding monetary neutrality. Here's the concept: If the money supply increases at a certain rate, that leads to a particular rate of inflation. And because everybody understands that this process occurs, people are not willing to lend their funds unless they're compensated by the borrower for the decline in the purchasing power that accompanies the increase in the money supply, and of course, the resulting inflation...So if there were no inflation, and you got, say, 10% interest for a one-year deposit, you might feel that that was a pretty good idea and a great return. But if the inflation rate was 7%, you'd only really be getting 3% interest...

William Allen, PhD, "The Midnight Economist," author and radio commentator: You go to a bank and arrange a loan,and all the arrangements are made except for the interest rate. The banker says, if it's around 1980 or so, "Oh, 20%." And when you regain consciousness, you begin to protest. And you say, "My daddy was quite correct—the bankers are out to gouge us! 20% is ridiculous. My daddy told me 5 or 6% is a civilized rate of interest. What is this 20%?" "Well," the banker says, "we, and most people, anticipate that a year from now, prices will be 15-18% higher than they are today. As a matter of fact, for a time there it was more like 20-25%. And I can't lend you at 5% and you pay me back 5% and make any money because, in the ensuing year, prices will have risen, the purchasing power of the dolalrs you pay back will be so low that I'll lose money. I will, in effect, be lending to you at a negative rate of interest, and I won't remain a banker very long that way."

Oh, well, as long as everything balances out, which it will in the long run, there's no harm; we're no worse off than we would have been otherwise. Right? Uh...

Connolly: I think we're ready for a more systematic discussion of the costs of inflation. In the United States, we've only had a couple of periods in the 20th Century where the inflation rate was very high. One of them was in the late 1970s and teh early 1980s, where the inflation rate topped 10% a year, and there was an enormous amount of discussion about inflation and economic policy. Let me get one thing out of the way immediately: Inflation does not, in itself, reduce purchasing power in real terms. Real purchasing power depends on what's happened to nominal income relative to the inflation rate. If my nominal income goes up 20% a year, but inflation goes up 20% a year as well, my real purchasing power hasn't changed. But if my employer only gives me a 15% raise instead of a 20% raise, my wage rate in real terms has actually declined. So again, inflation by itself doesn't lead to a decline in real purchasing power. If my performance on the job is such that I don't get a raise of at least 20%, then the reason for the decline in real purchasing power is that the value of my services to the firm I work for has declined. And if the value of services to the firm declines, then, of course, my real income would decline as well.

In inflationary times, people expend a lot of effort to get rid of money. That's the idea behind the Shoe Leather Cost. It refers to the resources that are wasted when inflation encourages people to reduce their money holdings. There's another cost, sometimes referred to as the Menu Cost. If this sounds to you like a restaurant story's coming up, well, you're right. Here's the idea: If I run a business, then in the presence of an inflation I have to keep changing prices to keep pace with the underlying increase in the costs of my materials. So if I run a restaurant, and the costs of ingredients and labor are increasing, say, ten percent a month, then every month I have to redo the menu prices to raise them 10%, and that's just to keep up. Since it costs money to print menus,that is, to keep changing prices, we actually end up a little worse off, and that's what we refer to as menu costs—the costs associated with changing prices. Another thing that happens which may be even more important is that sometimes people have a hard time distinguishing the reason that a price is different; whether it's because of general inflation or because the relative price of goods is adjusting. We see this in markets where the price of a good tends to change frequently because either the aggregate demand for the good changes or the supply changes...If the change is a result in general inflation, then I wouldn't want to change my business plan because there's been no real change in demand. So this difficulty in telling the difference might lead to potential change in supplier behavior. It might actually lead them to delay entering a market, meaning the customers would pay more in the long run since entry by new producers tends to reduce consumer prices.

There are also tax-related costs. The tax code in the US, for example, is not adjusted for inflation. So, if your income, your nominal income, goes up by some large amount in a particular year, and there's no inflation, generally speaking you should expect to pay more in taxes because your income is higher and we have a progressive tax system in the US. On the other hand, when we have an inflation that raises nominal incomes, the tax bite on individuals will go up just because they're getting pushed into higher tax brackets. In real terms, people will end up worse off because it's only their nominal incomes, not their real incomes, that went up; but now they have to fork over a bigger percentage to the government...This has led many countries, including the US, to consider indexing the tax code to offset the impact of inflation.

The last thing we're going to talk about is the impact of inflation on borrowers and lenders. What we've learned is a kind of good news/bad news thing. Because inflation helps borrowers, but it's not good for lenders. Let me give you an example from my own experience. My parents bought the house that I grew up in in the early 1960s. They went to a bank and financed a mortgage at about 5% interest. And at the end of the 1970s, they still had a few more years to pay on the mortgage. Meanwhile, we had gone through a period of high inflation in the US. The value of money had fallen and monimal interest rates were approaching 17 and 18% on new mortgages...My parents were paying off their house using dollars that were worth significantly less than the dollars that they had borrowed in the early '60s. Another way of looking at it is, they were paying 5% interest on this money, even at a time when other new borrowers were having to pay 16, 17, or 18%. So the mortgage company, the lender, was clearly hurt by that contract, but my parents, the borrowers, were clearly better off. Their experience was repeated, multiplied all over the country.

shanek

19th November 2003, 09:26 PM

All about the open economy, meaning an economy with free trade between countries. A lot of the economic claims people have made here get thrashed in this basic ontroductory Macroeconomics lecture.

Connolly: Let's talk about international trade and how we measure the flow of goods and capital...When we measure GDP, we refer to Net Exports. That's exports - imports. So if exports are greater than imports, then net exports, of course, will be positive. But if a country imports more than it exports, then net exports are going to be negative...Another term we need to introduce is what we refer to as the Trade Balance. The Trade Balance is the value of exports minus the value of imports. In other words, the Trade Balance is the same thing as Net Exports. So it's the same concept, but we're putting a new name on it here. Now, the balance of trade is sometimes referred to as being in surplus, and of course, it can also be in deficit. A trade surplus means that exports are greater than imports...A Trade Deficit means that exports are less than imports. We also want to talk about the flow of capital. That is, what does a nation do with the money it saves? Do the households and the commercial banks in that economy put it into local assets and investments, or do they turn around and send it out to other countries, foreign investments? Because there are so few barriers to capital flow in the US, the flow of capital in and out of the US economy is really very substantial. After all, the US has a great deal of money to invest in other countries; and, of course, political and economic stability in the US attracts a great deal of foreign investing as well...

One important concept we're going to focus on in studying capital flow is called Net Foreign Investment. This is the purchase of foreign assets by domestic residents, minus the purchase of domestic assets by foreigners...If US citizens by large quantities of Japanese government bonds, we'd count that in the first category: foreign assets bought by US citizens. But if Japanese investors bought US Treasury bonds, well, that would fall into the second category, the one that's subtracted out. So if the purchases by the US were smaller than the purchases by Japan, well, NFI would be negative for the US. On the other hand, if NFI is positive for the US, it means US citizens bought foreign assets more than foreign citizens bought US assets. Now, the flow of capital and the flow of goods are very closely related. In fact, one of the things we're going to see is that NFI = Net Exports.

[...]

"In war, the stronger overcomes the weaker. In business, the stronger imparts strength to the weaker." —Frederic Bastiat

Now, it's important to understand what has to happen in order to buy an asset in a foreign country. An American citizen who wants to buy Japanese government bonds has to take US Dollars, use them to buy Japanese Yen, then send them back to Japan in exchange for the bonds. So there's really two transactions: First, dollars go to Japan and Yen come back to the US. Then, in Round 2, the Yen go back to Japan and the bonds come to the US. So what this amounts to is a transfer of money, or financial capital, from the United States to Japan. And it involves not just the bond market, but the foreign exchange market as well, and that's an important point. Conversely, the Japanese investor who wants to buy, say, a golf course, has to exchange Yen for Dollars and then give those dollars to the owner of the golf course, who hands over the title to the property. So the ownership ends up in Japan and the money ends up in the US. What does this come down to? It means that a purchase of US assets by foreign investors actually brings foreign financial capital into the US. We can say that the US is importing financial capital. Likewise, if a US citizen buys a foreigna sset, this is the same as exporting US financial capital to that country. So it's important to recognize that NFI is very similar to the Trade Balance. Where the Trade Balance was about the import and export of goods and services, NFI is about the export and import of financial capital.

[Note: The above argument I made in a thread where pretty much everyone was flat out denying it; one poster even said he'd donate $1000 to the JREF if I could post one financial source supporting that, which he weaseled out of when I did.]

The following is something else in that same thread that pretty much everyone kept denying but I maintained was something so basic you'd learn it in an introductory Macroeconomics class—and lo and behold, here it is!

Now we said earlier that NFI actually has to equal Net Exports. Why is that? The balance starts in the foreign exchange market. Thinking for a moment just about the US and Japan. In the US, for every dollar given up to buy Yen, the Japanese have to be giving up Yen to buy that dollar. It's a trade, and that's why, of course, we call it trade. The Yen acquired and spent by Americans has to be balanced by the dollars acquired and spent by Japanese. If there were no such thing as capital, if there were only goods being traded, then that would mean that the value of exports and imports would have to balance each other just perfectly. Each country would get hold of foreign currency and get it back in exchange for foreign goods. And we'd have perfectly balanced trade. The truth is, you can also buy assets, which we count not as trade, but as NFI. So you can have trade out of balance as long as the overall balance is restored by the sale of assets. It happens automatically...

For each country, there are two types of things a person can buy. First, goods, like Wisconsin cheese or Japanese saki, and second, assets, like hotels or movie studios or government bonds. So there are two things a person can buy: goods and assets. Now if an American wants to buy saki, that would count as trade, and we would include their purchase in the Net Export calculation. But if a Japanese citizen wants to buy American assets, well, then that's going to count in NFI. Let's say that anything bought in Japan has to be paid for in Yen, and anything bought in the US has to be paid for with Dollars. That's, of course, the way it works in the real world. What we need to do is get an exchange rate between Yen and Dollars. So what we'll do here, to make our example work, is set up an exchange rate of 100 Yen to the Dollar...Let's suppose we've got an American—call him "Sam"—who has a taste for saki. Now, 100 bottles of saki which cost 1000¥ per bottle, Sam is going to have to find himself 100,000¥. With an exchange rate of 100 yen to the dollar, that's going to cost Sam $1000. So what he does is goes and finds someone who's Japanese, let's call her "Yoshi," and Yoshi is willing to trade 100,000¥ to Sam's $1000. Why does Yoshi do this? Because she wants to buy some American products and she needs dollars to do it. So we've got Sam and his 100,000¥ and Yoshi with her $1000. Sam buys his 100 bottles of saki from Japan; that's all he wants, and he's a happy guy. Now, Yoshi's got this $1000 she can't spend in Japan. She can only buy American goods with it. So let's say she buys some Wisconsin cheese, 400lbs worth at $2/lb. So the total is $800, and that's all she wants. She doesn't want any more cheese, or any other American goods. That means that she has $200 left over and the US has a $200 trade deficit. It exported $800 worth of cheese but imported $1000 worth of saki. In other words, American Net Exports are -$200 and Japan...has a trade surplus, or positive Net Exports of $200.

But that's not the end of the story. What is Yoshi going to do with the $200 she has left? She doesn't want to buy any more American goods with it, but she must have wanted the dollars for some reason or she wouldn't have given up her yen to get them. So what does she buy? Well, the only other things available are American assets. So let's say she buys $200 of US government bonds. Look at what's happened: Sam didn't buy any Japanese bonds. He didn't invest in Japan at all. He just wanted the saki. But Yoshi invested $200 in the US. That means US NFI is -$200. That's the exact same amount as US net exports, and that's not a coincidence. Every dollar the Japanese spend on US governmetn bonds is a dollar they can't spend on American goods. It's all a matter of arithmetic. The money that Yoshi spends on assets instead of goods contributes to the US trade deficit; and it contributes that exact same amount to the US NFI. When you take into account all the Yoshis in the world, you get the total trade deficit—a total for net exports—that is exactly the same as NFI.

What's the conclusion to be drawn here? It's that net exports of goods and services have to have an exact mirror image in the NFI account. Another way of saying this is, it's impossible to separate the flow of goods and services from the flow of capital. They have to balance one another. So, when we're doing macroeconomics in an open economy setting, we have to remember this link between trade and capital. It's also important to be aware that demand in an economy may come partly from foreign sources. From Japan's perspective, if a saki craze swept the world, then the saki industry in Japan would expand radically. This would lead to higher Japanese Net Exports, greater employment for Japanese workers, and increased GDP in Japan. In addition, there have to be corresponding capital flows unless all the exports and imports balance exactly...Now, I'd like to make one other connection in this open economy. It turns out if we do a little accounting that savings = investment + NFI. We could say this in another way: the amount that can be invested in an economy is equal to savings - NFI. Now, your head might be spinning a little, so let's see if we can make some sense of what's going on here. We've got some money, which we choose not to use for consumption. We save it. We can do two things with this money we save: we can invest it at home, which we call Investment, or we can invest it abroad, which we call NFI...Americans have taken a portion of their savings and used it to buy foreign assets. So it would be unavailable for domestic investment: investments at home. So whatever money Americans have saved can be used to invest in the country, unless, of course, Americans send it overseas. And whatever capital foreigners have sent to us, of course, well, that's available for investment in the US. This means that Investment in the US is the total of whatever Savings occur in the US minus whatever capital is sent overseas, plus whatever capital foreigners send to the US. Investment = Savings - NFI.

In the 1980s, the government ran an enormous budget deficit. This deficit had to be financed from some source, and for the most part, it turned out to be foreign citizens who chose to buy US government bonds in great quantities. But remember, if foreign citizens are buying US assets, that's going to increase the US NFI deficit, and that means there will be a corresponding increase in the US trade deficit...The US budget deficit &cong; to the trade deficit, which = NFI.

My! How horrible that economics students are being taught "crackpot economic theories" right off the bat!

Here's more good information on exchange rates, PPP, and the so-called "Big Max Index":

Now, let's explore what we mean when we talk about Exchange Rates. The Nominal Exchange Rate is the rate at which a person can trade the currency of one country for the currency of another country. You can find these nominal exchange rates in the daily newspaper...The more Yen it takes to buy a dollar, the more valuable the dollar is. This brings us to another important term: appreciation. Exchange Rate Appreciation is an increase in the value of a currency, as measured by the amount of foreign currency it can buy. In the case of Yoshi and Sam, you'll recall the exchange rate was 100 Yen = 1 US Dollar. Of the dollar appreciated, it wouldn't take just 100¥ to buy it anymore; it might take 120¥ to buy $1. Or, we could say the dollar used to buy 100 yen, but now it buys 120 yen. This means that every dollar can buy more Japanese goods than before, and that's why we consider it more value. The opposite situation is depreciation. This means a decrease in the value of a currency, as measured by the amount of foreign currency it can buy. If a currency depreciates, it falls in value against another currency. So if the US Dollar depreciated, instead of getting 100¥ it would only get 80¥. The dollar depreciated so the yen appreciated...an appreciation in one is the same as a depreciation of the other.

"No nation was ever ruined by trade." —Benjamin Franklin

Now, there's another kind of exchange rate that's also important to talk about: the Real Exchange Rate. The Real Exchange Rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. In that respect, it's very different from the Nominal Exchange Rate. With the Nominal Exchange Rate, it's all about exchanging money for money. But the real rate is concerned with exchanging goods. The real and nominal rates are related to one another, so the easy way to see this is to look at it as an equation: Real Exchange Rate = Nominal Exchange Rate × Domestic Price of Goods / Foreign Price of Goods. So what the Real Exchange Rate gives us is essentially a way to adjust the Nominal Exchange Rate for differences in the prices of goods. We'll set up our nominal exchange rate at 80¥ = $1. So that means if you've got 80¥, you can buy $1, or if you have $1 you can buy 80¥. Let's think about a product like rice. As you know, rice is produced in the US and Japan. Suppose a bushel of rice costs $100 in the US and 16,000¥ in Japan. So we've got three numbers here: the exchange rate, the US price of rice, and the Japanese price of rice. In that case, our computation of the real exchange rate is: (80¥ / $1) × $100 per bushel / 16,000¥ per bushel. It comes down to ½ bushel of Japanese rice / 1 bushel of American rice. That means that the amount it would take to buy one bushel of rice in the US ($100) would buy 8,000¥, or just half a bushel of rice in Japan. That means in real terms that rice is twice as expensive in Japan as it is in the US. You only get half as much for your money. Alternatively, the amount it takes to buy 1 bushel in Japan (16,000¥) would buy $200 which would buy 2 bushels of rice in the US. And again, we see that rice is twice as expensive in Japan as in the US; you only get half as much for your money.

Now, there are several implications. Real Exchange Rate clearly depends on the Nominal Exchange Rate. Suppose the nominal rate increased to 120&yen/$1. Then clearly the real rate would have to be different. But it's also true that what happens to the local price, say the dollar price of American rice, has an effect on the Real Exchange Rate. The Real Exchange Rate of a country is a very significant determinant of its net exports of goods and services. After all, where would you want to buy your rice in the example we just looked at? Most of the world would rather buy it from the US, because the rice is cheaper there. This, of course, leads to an important question: What makes the exchange rate rise or fall? So let's talk about a very important figure in exchange rate determination: Purchasing Power Parity (PPP). PPP theory is a very old idea in exchange rate economics. Parity means "equality," and the basic premise behind PPP is that the nominal exchange rate adjusts so that a particular good has the same price in every country...

Conrad: Exchange rates are supposed to adjust so that if we have, in the absence of lots of constraints on imports and exports and things like that, that I ought to be able to, for essentially the same dollar, buy the same product in different markets, so that the amount of bell peppers I can buy in Italy for a price is the same as I could buy in Los Angeles for the price.

[...]

Connolly: The Central Market is a place where demand for a product can be met in a matter of hours, no matter where on the globe that might take you. Given a produce company that pays in dollars, the notion of PPP is totally unabiguous. But when people pay in a foreign currency, then the difference between nominal and real exchange rates needs to be factored in. So the idea behind PPP is that if a good is cheaper in one country than it is in another, then the exchange rate between the two countries will adjust so that there's no advantage to buying in one country as opposed to another. Now, this is a very useful and powerful idea. It means that the nominal exchange rate has to reflect differences in the price level: nominal exchange rate is equal to the ratio of the price levels in the two countries...If we look at some specific goods, say, chewing gum, lumber, or fish, and we compare the prices of these products in, say, the US and Canada, we might ask the question, "Does the exchange rate adjust so that goods have the same prices in both countries?" Actually, there's a fair amount of statistical evidence that it really doesn't work that way; said another way, there's a lot of evidence that the nominal exchange rate does not reflect the prices of specific goods in the two countries. So, as a story at the micro level, PPP isn't a completely accurate description of exchange rate determination.

To bring this home, we can look at what some economists have called "The Big Mac Index." For Americans, the golden arches of McDonalds are part of the culture. Now, it is the same worldwide. The Big Mac you eat in America is the same Big Mac you wat in Great Britain, Hong Kong, France, Spain, Tokyo, or Brazil. Because a Big Mac is made with the same ingredients and the same production process wherever it is put together, the real consumer cost everywhere should be eaul to the US. This is not always the case, however, and surprisingly, the price of the Big Mac hamburger has become an informal but rather accurate measure for nominal international exchange rates.

Conrad: This is something that was pioneered by Economist Magazine, and they have what they call the Big Mac Index. They compare what the price of the Big Mac is across different parts of the world to see if, in fact, the exchange rates do suggest that there is PPP.

Connolly: Some experts even say that using the Big Mac Index to compare the different prices of Big Macs in US Dollars can actually help determine whether a currency is over or under valued. but even though PPP doesn't work out perfectly, it actually does tell us something very useful. It turns out that PPP works pretty well at explaining the behavior of exchange rates during hyperinflations. Hyperinflations occur when the money supply goes up at a terrific rate, with price levels following closely behind...In the long run, there is very clear evidence that PPP is a very important idea or theory that helps us to understand long run movements in exchange rates.

shanek

29th November 2003, 11:27 AM

Not that much new in this episode. It's kind of heavy on the documentary side, and has a lot of reviewing going on. But it does provide good information for tying together the various markets to see how they relate together in an open economy.

But first, in the review of the market for lonable funds, there is a very good point that wasn't made in the earlier episode, so I thought I'd quote that part as well:

Connolly: From the perspective of US consumers, we can say that they have a certain amount of income, paid to them in dollars, and they have basically four ways to use it. The first way, of course, is to consume domestic goods. The second thing consumers can do with their money is buy US domestic assets. Examples of these assets include property, loke hotels and houses, and financial instruments, like treasury bonds or shares of stock. The thid thing they can do is buy foreign goods. to do this, they have to take their dollars and use them to buy foreign currency. Finally, consumers can buy foreign assets, that is, assets which are located or bought and sold in other countries, like Japanese government bonds, a chateau in France, or a cattle ranch in Argentina. Here, too, they have to use their dollars to buy foreign currency first. It's from these last two items that we get the demand for foreign currency. If Net Exports are positive, this means that Americans are exporting more than they're importing; they're taking more money in than they're sending out. That means that Americans now have this extra foreign currency in their possession. What do they do with it? Well, if they don't want foreign goods or services, the only other thing they can do is use it to add to their holdings of foreign assets. If it's not goods, it must be assets. There's no third option. So Net Exports tells us how much extra foreign currency US citizens have, and that's the amount of currency that's used to accumulate NFI.

This I think reinforces and clarifies the earlier lecture very well.

Now, for tying the three markets—the market for loanable funds, the NFI schedule, and the exchange market—together in an open economy:

Supply and demand in the loanable funds market determines the real interest rate; the real interest rate determines the amount of NFI; NFI determines the supply of dollars available in the currency exchange market; and that supply of dollars combined with the demand for dollars gives us the real exchange rate...We have a demand and supply of loanable funds. This market determines an equilibrium real interest rate. That, in turn, will determine the level of NFI.

Remember, NFI is downward-sloping with respect to real interest rates. So when US interest rates are very high, the demand for foreign assets by US citizens is very low. At the same time, the demand for US assets by foreign investors is very high. Why? If US financial assets, like bonds, offer a high interest rate, then people from all over the world, including the US, will want to buy them. People go where they can get the highest interest rate. A high US interest rate means that we would import a lot of capital and export very little capital. As the domestic interest rate declines, then US bonds don't pay as much. So demand for US assets by foreign investors also falls, and the demand for foreign assets by US investors will increase. In that case, we're actually exporting a lot of capital. So the NFI is downward-sloping. So we've got this downward-sloping NFI curve and we've got a real interest rate determined by the loanable funds market. These two things together give us the equilibrium level of NFI—exactly the amount of NFI that takes place.

Now that we know NFI, we can pull in our last step. We know that the supply of dollars into the foreign currency exchange market is given by the equilibrium level of NFI. Earlier, in our first look at this market, we pulled this supply curve out of nowhere. Now we can see exactly where it comes from. The real interest rate combined with the NFI schedule gives us the supply of dollars in the foreign currency market. And this supply curve, when combined with the demand curve, gives us an equilibrium real exchange rate.

So, here's how we tie the markets together: the demand and suppy of loanable funds gives us an equilibrium real interest rate, which in turn determines a level of NFI, and that in turn gives us an equilibrium real exchange rate.

If people begin to save more (remember, savings is the source of loanable funds), we'd shift the supply of loanable funds schedule out. And, of course, the first thing that happens as a result of that increased supply of savings is that the equilibirum interest rate declines. We find that NFI will be larger than before. Why? If the US interest rate declines, American savers will want to buy foreign bonds more than they did before, because American bonds don't offer as high an interest rate as before. At the same time, there is a reduced incentive for foreign savers to buy US dollar assets because the rate of interest on those assets is now relatively lower than before. So on both counts. we find NFI increasing. Now, this increase in NFI means that there's a larger supply of dolalrs being pushed into the foreign exchange market. The supply of dollars increases in the foreign exchange market, and in order for the market to get back to equilibrium, we have to have a decline in the real exchange rate. So if US consumers choose to save more, that leads to a lower interest rate in the US, an increase in NFI, and a decrease in the real echange rate.

Of course, this all helps with the diagram. This is the best I can do in ASCII text:

<pre>Market for
Loanable Funds: NFI Schedule:

r | \ /S r | \
| \ / | \
|---X-------------|---\
| /|\ | |\
| / | \D | | \
-------- ----+---
Q | NFI
|
Currency Exchange e | \ |
Market: | \|
| |
| |\
| | \D
--------
Q</pre>

Finally, one brief comment on the idea of "capital flight," which is when a country's currency moves out of its own market into another country due to the above effect:

William Seidman, former FDIC chairman: Well, for a long time, people thought they could pass a law and say you can't take the money out of the country. Many countries have tried it. It's never worked very well for very long. Really, the only way you can prevent capital flight is to run the country in a way that people have confidence that you don't need to take your money out.

Short and sweet this week, but very useful, too. Look at our foreign economic policy and see how badly we're mangling it up!

QuarkChild

29th November 2003, 11:22 PM

Great thread, shanek. Tho' I probably shouldn't have read all of it in one sitting.

Could you give an example or two of this:

Finally, one brief comment on the idea of "capital flight," which is when a country's currency moves out of its own market into another country due to the above effect:

quote:William Seidman, former FDIC chairman: Well, for a long time, people thought they could pass a law and say you can't take the money out of the country. Many countries have tried it. It's never worked very well for very long. Really, the only way you can prevent capital flight is to run the country in a way that people have confidence that you don't need to take your money out. I've never heard of this concept before. What countries tried it?

shanek

30th November 2003, 06:12 AM

Originally posted by QuarkChild
I've never heard of this concept before. What countries tried it?

Capital Flight is not something that countries "try." It's something that they try to avoid.

When a currency becomes devalued, people don't want to hold that currency even if they're living in that country. So they'll convert more of their country's currency to that of another's and buy stuff from foreign sources, since the prices are lower. Capital Flight means that this happens to such a degree that it affects the national market.

In the early 1980s, currency worth tens of billions of dollars fled Mexico and didn't return until 1990, when Mexico finally implemented a more open trade policy and privatized its banking system. That restored the confidence Mexicans had in their local currency.

Compare that to the 1960s, when the US experienced a moderate Capital Flight. They tried to fix it with capital controls, which only further reduced the confidence Americans had in their own currency and just made the problem worse. An extreme example is the Weimar Republic, who in 1931 made capital exports a crime punishable by death; all that resulted was an increased black market for foreign currency and a further erosion of confidence.

They can try to stave it off by raising interest rates, but this has the side effect of reducing investment, which is necessary for the creation of capital. So instead of the capital leaving the country, it just isn't being created when it ordinarily would and you have pretty much the same effect.

So, as usual, government meddling just makes the problem worse.

QuarkChild

30th November 2003, 06:35 PM

Originally posted by shanek

Capital Flight is not something that countries "try." It's something that they try to avoid.
When I said "try" I was referring to Well, for a long time, people thought they could pass a law and say you can't take the money out of the country. Many countries have tried it. It's never worked very well for very long.
Thanks for your explanation. I was aware of devaluation of currency in the Weimar Republic but I didn't know it was associated with a black market for foreign currency.

shanek

8th December 2003, 08:24 AM

Great episode jam packed with important stuff. We're going into the short run now, which means we're taking out first real look at the Business Cycle. The Business Cycle is very important to understand, and again this is something that has shown to be a major issue in several threads (yes, this is another of those "crackpot economic theories"). There's a lot to this (which is why it took me so long to transcribe) and gives you the essentials of the two major components that drive the Business Cycle: aggregate supply and demand.

Short Run: Aggregate Supply & Demand

Connolly: We're going to shift our focus to the short run and try to figure out why the economy can change so much from month to month, and particularly from quarter to quarter.

First off: a Business Cycle is a fluctuation in the economy over time. We measure business cycles using Real GDP, which is essentially the total quantity of goods and services produced by an economny. It's also the same thing as Total National Income. Sometimes this income is rising, which means the economy is expanding. And sometimes National Income is falling, which means the economy is contracting. So an expansion is a period where Real GDP is increasing. On the other hand, if Real GDP declines, businesses are having trouble because customers aren't buying as much and that's what we would refer to as a recession, a period in which Real GDP is declining. Now, during recessions, firms experience decreasing sales and profits, and unemployment rises. So we can think of the Business Cycle as having a couple of different phases. There's an expansion phase when the economy has expanded as far as it's going to in that particular cycle. At that point, we hit the peak of the cycle, which is when Real GDP is at its largest value. After the economy hits its peak and starts contracting, we move into a phase called the downturn, or the recession. When the economy hits its lowest point, we're at the trough, when Real GDP is at its lowest value, after which expansion begins again.

[...]

Let's look now at three basic facts about Business Cycles: the word "cycle" makes it sound as if there's something regular about it all; and, in fact, we can trace cycles back for hundreds of years. The key thing we've learned over all this time is that Business Cycles are, for the most part, unpredictable and very irregular...It's impossible to know how long a Business Cycle will last, and it's impossible to tell in advance how much GDP will decline. For example, in the 1930s, during the Great Depression, there was a tremendous drop in Real GDP. But we've had other recessions in the post-war period when the decline was fairly small; we call those mild recessions. We've also had expansions that were very mild, and others that were fairly strong. But it's very hard to see what's coming in advance; you see, business cycles are unpredictable and irregular.

Fact #2: Most macroeconomic quantities move together. By "macroeconomic quantities," I mean the components of GDP: Consumption, Investment, Government Purchases, and Net Exports. They all tend to move together. When one goes up, the others probably are, too. And if one of them is falling, it's likely that the others are falling as well. There are other important indicators, like personal income, corporate profits, industrial production, retail, home and auto sales, well, all of these tend to move together as well. To use a bit of statistical language, we would say the correlation of all these items is positive and fairly large; they all tend to move together.

The third fact we need to recognize is the connection between GDP and unemployment. Specifically: There is an inverse relationship between Real GDP and unemployment. As GDP falls, unemployment rises, and as GDP increases, unemployment decreases...Okun's Law states that the change in the unemployment rate = (% change in GDP - 3%) ÷ 2. Now, if GDP grows at 3% a year, then that's (3% - 3%) ÷ 2, or 0% ÷ 2, which of course is 0. So if GDP grows at 3%/year, this means that the change in unemployment rate is 0. Whatever it starts out at, that's where it's going to say. If Real GDP grows by 7% from one year to the next, then Okun's Law tells us that the unemployment rate should fall by (7% - 3%) ÷ 2, which is 4% ÷ 2, or 2%. Now, this is important because it helps us to chart movements over the business cycle in the unemployment rate.

Okun's Law describes the statistical connection between GDP and unemployment, but it doesn't explain why the relationship works this way. It's not really a behavioral explanation; it's just a quick, simple way to describe the connection. Now, in the long run, we know that unemployment is related to productivity and growth in the entire economy, which is, in turn, dependent on factors like technological improvement, education, the difficulty of job search, and so on. These forces help to determine a natural rate of unemployment. But now what we want to do is to focus more on the short run, and we're asking, given some natural rate, what explains the fluctuations in employment that we actually see? We're trying to get after cyclical unemployment, changes in unemployment over the Business Cycle.

We're going to create a basic model of economic fluctuations. In this model, we'll think about an aggregate demand, or total economy-wide demand, for goods and services. We're also going to develop the aggregate supply of goods and services in the short run, and we're going to use this model to talk about how the general price level and quantity of output produced in the economy changes over the Business Cycle. We can look at it like this: We're going to put Price Level on the vertical axis. Not the price of any individual good, but the overall level of prices across the entire economy. We'll measure the quantity of output on the horizontal, and again, that's not output of any one specific good, but total output of everything we produce in the economy. Our aggregate supply schedule wipp be upward-sloping from left to right; our aggegate demand schedule will be downward sloping. Now, what does this actually show? It shows the quantity of goods and services that households, governments, and firms want to buy at any price level. And the aggregate supply curve shows the quantity of goods and services that firms produce and sell at different price levels in the whole economy. The intersection between the curves gives us an equilibrium output and equilibrium price level.

Let's look more closely at aggregate demand. Basically there are three things that explain the downward-sloping nature of aggregate demand. The first is what's referred to as the "wealth effect." This is associated with Arthur Pigou, and is sometimes referred to as the Pigou Effect. The second point is the "exchange rate effect." It was developed by Robert Mundel and Marcus Fleming, and is known as the Mundel-Fleming Effect. Finally, there is an "interest rate effect," and the famous John Maynard Keynes is responsible for the analysis that underlines this effect.

The idea behing the Pigou Effect is this: Think of the wealth you have, the money in your bank account and your wallet, maybe stuffed in your mattress, the value of yoru stock portfolio, or your house, and all the other assets that you own. The nominal value, the dollar amount, is fixed. Of course, over long periods as the price of assets change, the value of your wealth can change, too, but remember, we're in the short run. So let's just think about a single point in time. At that point in time, the nominal value of your wealth is fixed. But suppose the price level in the whole economy rises. What good is the wealth in the first place? Wealth is useful because it allows you to convert it to money and buy goods and services. But if the price level increases, the nominal value of your assets doesn't have the same command over real goods and services that it once did. So an increasing price level means that your wealth doesn't go as far. And if your demand for goods and services depends in part on your wealth, then as the price level rises, aggregate demand will fall. And as the price level declines, the real value of your wealth increases. This means you can afford to buy larger amounts of goods and services. The Pigou Effect is: A decrease in the price level leaves consumers more wealthy, causing them to spend more, creating a larger aggregate demand.

Here's the basic idea of the Mundel-Fleming Effect: if the real exchange rate depreciates, this means that US goods will now be cheaper relative to foreign goods. In turn, this will stimulate Net Exports. So the idea here is, if the US price level declines, the real exchange rate depreciates, stimulating net exports, and creating a larger aggregate demand.

Keynes's interest rate effect can be very important. The idea here is that when the price level rises, people nesd to hold more money, more cash in their pockets or wallets. This means there is less money in the bank and especially potentially in long-term deposits. This reduces the amount of money available for lending in the banking system, and that in turn leads to a higher interest rate. You know that when interest rates go up investment spending goes down, and that in turn will reduce aggregate demand. Prices go up, people keep more cash in hand, they keep less in the bank, bankers have less to lend, that drives up interest rates, investments go down, and that leads to lower aggregate demand. And it works the other way around for a decline in prices. So the idea behind Keynes's interest rate effect is: If the price level declines, the real interest rate declines, encouraging higher spending or investment goods, creating a larger aggregate demand.

Each of these three effects deals with the relationship between aggregate demand and the price level, but other factors can come into play, too. And when they do, we may see a shift in the position of the curve itself. These shifts are crucial to understanding recessions, expansions, and inflations...Let's think first about the consumption component of aggregate demand and the behavior of consumers. When people save more, the amount of consumption is reduced. The change here is not motivated by the price level, but at any price level if people decide to save more, they're going to consume less than they did before. What this means, then, is that the quantity of goods and services demanded in the aggregate will be lower at every price level than before, and that's represented by a leftward-shift in the aggregate demand schedule. A second reason is related to investment spending. If something changes the productivity of new capital, this will lead to a change in the demand for investment goods. This leads to an increase in investment spending, which means the aggregate demand schedule will shift to the right. Now let's think about government purchases of goods and services. A reduction in government purchases leads to a reduction in aggregate demand for goods and services... The important thing to recognize is that changes in government spending in either direction have a major impact on the aggregate demand schedule. Finally, the impact of monetary policy: Suppose the Fed expands the money supply. People spend the new money, and the aggregate demand for goods and services, at whatever the price level happens to be, is going to increase. This means the aggregate demand schedule shifts out to the right. Further, if some of that money is saved, this will increase the supply of funds available for lending, which reduces the interest rate and leads to an increase in investment spending, and that also shifts the aggregate demand schedule out to the right.

Our next step is to develop an analysis of the aggregate supply schedule...Why would the short run aggregate supply curve be upward-sloping? There are three basic reasons. The first is what we call the Misperception Theory. The idea is whenever there are changes in the general price level, individual suppliers may have a hard time distinguishing between a change in relative prices and a change in the overall level of prices. Say I make machine tools, and I see the price of machine tools going up. I might think this means demand for machine tools is rising, and if this happens, I might choose to produce more machine tools. But maybe what's really going on is, prices for all goods and services are going up, including the labor and inputs that I have to buy to make my tools. This means the relative price of machine tools hasn't changed at all. So demand hasn't increased at all, and I shouldn't change production. However, I might not be able to tell what situation I'm in. So changes in the overall price level can temporarily mislead suppliers about what's happening in the markets where they sell their products. When this happens to lots of different firms in the economy at the same time, we get an upward-sloping aggregate supply schedule.

A second idea about why this might be an upward slope is commonly referred to as the Sticky Wage Theory. In microeconomics, we usually think about the price of a product adjusting fairly rapidly to a change in supply or demand. But we find in real-world markets, and in the macro economy, that there are times when prices adjust slowly, including the price for labor. In the long run, we don't really care much about that; but in the short run, that can happen...If the price level falls below what we expected, and the nominal wage is still fixed by contract, then the real wages, in fact, increase. Real Wage = Nominal Wage Rate ÷ General Price Level. So if you make $10/hour, and it goes up 10% to $11/hour, but we also have a 10% increase in prices, it turns out your real wage didn't change at all. Wages tend to be a significant proportion of production costs. So, higher real wage will mean that the firm's real costs have increased, and this means they'll hire a smaller amount of labor and produce a smaller quantity of goods and services. Here's the connection to aggregate supply: If the price level goes up more than expected, real wages go down. And when real wages go down, the real costs of production falls as well. That leads firms to expand and output goes up. On the flip side, if the price level falls more than expected, real wages have gone up, and production costs go up, and output goes down. Now, you might ask, "Wouldn't the nominal wage adjust to this change?" Well, yeah, but it doesn't happen right away. There may be contracts that limit flexibility in the short run.

There's one final idea that we have to consider about why the aggregate supply schedule would be upward-sloping. This is what's referred to as the Sticky Price Theory. The idea is that it costs money for a business to change its prices. We often call these "menu costs," because they include things like the cost of reprinting the menu at a restaurant, or reprinting new catalogs. Firms may find it in their best interests not to adjust their prices in the short run, because prices can be expensive. But if the general level of prices increases, while the price of an individual product does not, then the real price of the product falls. It's now less expensive relative to other goods, whose prices are going up. These firms then experience a boost in their sales, and in production and employment as well. If the overall price level declines, they have prices that are too high, but they have high menu costs, what happens to them? Their sales decline. The real price of their product will go up. That will lead these firms to cut back on production and employment. When the price level rises, firms with sticky prices increase their production for awhile, until it's worth their while to change prices. When the price level falls, firms with sticky prices decrease for awhile. Either way, we get a short run aggregate supply schedule that's upward-sloping. One way technology can give businesses an edge is by making sticky prices come, if you will, unglued. This is especially true for companies who focus heavily on internet sales.

[...]

The positive slope to the aggregate supply schedule is clearly only a short-run phenomenon. So let's talk now about long run aggregate supply. If none of the explanations for the short run aggregate supply curve hold in the long run, the question is, what does long run aggregate supply look like? Here's the answer: In the long run, the aggregate supply curve is a vertical line. The aggregate supply of goods and services depends on a supply of capital, labor, and other inputs to the production process. It also depends on the available production technology that we use to convert inputs (like labor, capital, and raw materials) into finished goods and services. In the long run, the price level doesn't affect any of these. Further, all the misperceptions and stickiness we talked about earlier gets worked out. So that means the price level has no impact in the long run on the quantity of goods and services that the economy can and does produce. That's why the long run aggregate supply curve is a vertical line: no matter what the price level, the long run output level doesn't change.

We now want to ask, what would move them? The long run aggregate supply schedule's position depends on the quantity of technology and inputs that are available. So, if there were a significant improvement in production technology, what happens to the aggregate supply schedule? In that case, at every price level we would be able to produce more than before, so that would lead to a rightward shift in both the short run and the long run aggregate supply curves. There is one other thing that affects the short run aggregate supply schedule which doesn't move the long run aggregate supply schedule: people's expectations of the price level. If, at negotiation time, workers expect prices to go up quite a bit over the next few years, they'll push for a higher nominal wage than they otherwise would have asked for. This means, no matter what would have happened actually to the price level, firms will have higher labor costs. But if workers expect lower inflation, this will lead to lower production costs and this means the short run aggregate supply curve to the right. Our long run aggregate supply curve doesn't move, though, because nothing has happened to the economy's basic capacity to produce goods.

Future episodes should cover the other aspects of the Business Cycle.

Drooper

8th December 2003, 08:45 AM

Ooops,

Just a cursory glance reveals one error.

"In the long run unemployment is related to productivity and the growth in the economy. "

Not the case.

It is in the short run.

In the long run unemployment will be independent of productivity and growth.

Also, FYI. Okun's law appears to have broken down in the US.

Tony

8th December 2003, 08:47 AM

ShaneK, your dedication to bringing education to the ignorant is admirable.

shanek

8th December 2003, 10:01 AM

Originally posted by Drooper
Ooops,

Just a cursory glance reveals one error.

"In the long run unemployment is related to productivity and the growth in the economy. "

Not the case.

Actually, yes it is. Check the transcripts from the other episodes. He's talking about the natural unemployment rate, as opposed to the cyclical unemployment rate.

It is in the short run.

That's cyclical unemployment.

In the long run unemployment will be independent of productivity and growth.

No, it won't. In fact, natural unemployment will be largely determined by those factors.

Also, FYI. Okun's law appears to have broken down in the US.

It hasn't really "broken down," but the US has become such a large economy that the effects are miniscule and easily overpowered by other factors. But in smaller economies, it does have a very real and important effect.

Victor Danilchenko

9th December 2003, 09:26 AM

shanek

A small, libertarian government would spend practically all of its money on infrastructure.hey shane, does this mean that you are willing to concede that infrastructure support is a proper domain of government? That would certainly be an improvement on your stance as i last remember it!

Drooper

9th December 2003, 10:21 AM

Originally posted by shanek

Actually, yes it is. Check the transcripts from the other episodes. He's talking about the natural unemployment rate, as opposed to the cyclical unemployment rate.

Sorry Shanek. I didn't learn my economics over a fewTV documentaries.

In the long-run unemployment is independent of productivity or growth.

any rate of unemployment can coexist with any rate of growth of rate of productivity growth in a dynamic or static steady state.

That's cyclical unemployment.

yes, that is another commonly used term for it.

No, it won't. In fact, natural unemployment will be largely determined by those factors.

I reiterate.

The natural rate of unemployment, or even the NAIRU will be independent of the rate of growth or productivty level or rate of growth in a dynamic or static steady state.

It hasn't really "broken down," but the US has become such a large economy that the effects are miniscule and easily overpowered by other factors. But in smaller economies, it does have a very real and important effect.

Yes it has broken down, given the national accounts estimates published over the last number of years. And size is pretty irrelevant to OKun's Law anyway.

It doesn't matter so much, because this is a pretty archaic concept that was left behind with the advent of macroeconomics from micro foundations.

shanek

9th December 2003, 05:02 PM

Originally posted by Victor Danilchenko
hey shane, does this mean that you are willing to concede that infrastructure support is a proper domain of government?

Saying that all of the proper functions of government are infrastructure-based is not the same thing as saying that all infrastructure-based spending is proper. It depends on which infrastructure you're trying to support.

shanek

9th December 2003, 05:03 PM

Originally posted by Drooper
The natural rate of unemployment, or even the NAIRU will be independent of the rate of growth or productivty level or rate of growth in a dynamic or static steady state.

Do you have any information as to why?

Drooper

10th December 2003, 04:58 AM

Originally posted by shanek

Do you have any information as to why?

I usually avoid talking technically about economics at all costs on this forum. However, given the level of interest I know you have in the subject, I expect that you would accept nothing less. ;)

What appears to be described in this program is the Tobin "wage--price mechanism". This is effectively an aggregate supply model and was formulated in 1972 by James Tobin. It is a product of the Keynesian era of macroeconomics. This was a model that had two elements. One was a "price mark-up" equation, that related price inflation to wage inflation, productivity and unemployment. The second was the "Phillips Curve", something I am sure you are familiar with.

From these two relationships Tobin derived his "wage-price mechanism" (I will exclude the algebra here, but provide it if you ask). This was just an equation that related the rate of change of prices to the expected rate of change of prices, labour productivity growth, the level and rate of change of unemployment. Setting long run conditions (rate of change in unemployment is zero, actual=expected inflation) gave a univariate function in unemployment. i.e. it gave a long run solution for unemployment, solely as a function of (labour) productivity growth.

In general terms:

f(u) + g(u) = a

Where
a=labour productivity growth,
u =unemployment
g() is the underlying function from the Phillips' curve that relates unemployment to wage growth (so g'<=0)
f() is the underlying function in the price "mark-up" equation that drives the relationship between changes in unemployment and changes in prices. (f'<=0)

So even using Tobin, the long run unemployment rate was a function of productivity growth (not economic growth).

There is the first piece of my point. Unemployment is independent of growth in a steady state (long run). This seems to be an out and out error in the program.

Now we can turn to productivity. The reason why the program was wrong on this count is because the Tobin wage-price mechanism is pretty much obsolete, due to failures in its microeconomic underpinnings.

What I outlined above was the model that I am certain was being used in the program. However, this model is pretty much economic history these days. Let me put it this way. Most economists don't believe this model is completely accurate. It could hold under certain conditions, but should not be used to make general inference.

The reason why, is because it was a product of an era when Macro and microeconomics were completely different disciplines. Models such as these were derived in a macro framework, with little or no reference to the (more rigorously understood) microeconomic foundations that supposedly underpinned the macro economy.

During the late 1980s macroeconomics became pretty frustrated at the continuing failure of their models and their need to reinvent models to help describe and understand what was going on. Someone would come up with something that made sense a priori, appeared to fit facts well and was a useful analytical tool. Then it would all fall apart. The advent of stagflation is a classic example, which led economists to accept that a Keynesian demand model was not a good general model of a macroeconomic and was probably a special case (which it is now believed to be).

Economists thought that the solution was to turn back to microeconomics that has never had this problem (mostly) and use that as a basis to build a more rigorous macro approach.

One up-shot of this was the thinking, from a microeconomic point of view that transitory shock do not lead to permanent changes in the real wage. However, this is one of the features of the Phillips' curve that underpins the wage-price mechanism.

A second problem that emerged from microeconomics, was the fact that in the Phillips' curve, real wages do no respond to changes in productivity growth. This meant that the wage price mechanism demanded a rise in long run unemployment in order for steady state real wage growth to slow.

There is also a problem with the expectations augmented into the Phillips' curve that give rise to significant problems as well (if you want to known more it is related to the Lucas Critique).

For these failings, Tobin's wag-price mechanism is not now the accepted model of aggregate supply.

So what is? Well there isn't one now. However, most models you can use to analyse the issue do not relate long run unemployment to productivity.

Instead, the factors that are relevant are issues in information, real and nominal price and wage rigidity, the type of wage bargaining (encompassing efficiency wages, insider/outsider effects, membership effects).

If you really want to get into it, read Layard and Nickell (1986,1987), a series of papers that give a more current (but not definitive) approach to this. In their model long run unemployment was a function of a number of factors including; union membership, ratios of benefits to wage levels, tax rate, levels of employment protection, employers labour taxes, sectoral mismatch - no productivity!!!

shanek

16th December 2003, 09:16 PM

Sorry I keep getting behind on the transcripts, but they keep doing such good episodes with such a lot of information.

Here we see a lot about the business cycle and the relationship between money supply, fiscal policy, and aggregate supply and demand on the short and long term economy. I just don't see that this series is using the Tobin effect that Drooper describes, and I think if you'll read the transcript you'll see why. It talks about the different effects these variables have in the short run and the long run. See for yourself:

Connolly: First, we'll use our aggregate supply and aggregate demand model to look at some causes of the Business Cycle...Let's imagine for the moment that we begin with an equilibrium in the economy, with an equilibrium price level and a natural long-run level of output being produced. Let's consider what might happen if consumers suddenly increased the fraction of their income that they saved. If savings go up, consumption goes down, and that means that the aggregate demand curve shifts to the left...In other words, at every price level people are consuming less than before, which means that aggregate demand falls. In the short run, we get a reduction in prices and we also get an equilibrium output level that's lower than before. These are the typical characteristics of a recession. You see falling output, and sometimes you may actually see a falling price level. We're at an output level that's below the long-run equilibrium supply curve. So how do we get back to equilibrium? The short run aggregate supply schedule will shift to the right, because prices have fallen, and when prices fall, people build that decline of prices into their expectations about future prices; that is, based on their experience, people come to expect that prices will continue to fall...and this is what restores equilibrium in the economy to the long run output level given by the long run aggregate supply schedule. What we ended up with is simply a lower price level.

Of course, it's also possible that market conditions change because something happens to aggregate supply. In fact, that's actually happened in recent decades.

Richard Sylla, PhD, Professor of Economics and Financial History, New York University: The big change came in 1973 when the Israelis and the Egyptians and the Jordanians had their war, and this was used by the middle eastern oil producers to punish the west for supporting Israel, and by cutting off the flows of oil and, at the same time they took control away from thes seven sisters and began to make it more in the government offices of the middle east.

Connolly: Between 1973 and 1974, the price of a barrel of oil more than doubled. But it wasn't just international politics that caused problems for the US.

Sylla: We shot ourselves in the foot because we had excessive price controls and government allocation schemes.

Connolly: President Nixon had instituted price controls to curb inflation, putting a cap on the price oil companies could charge for gas. These price controls stopped American oil companies from passing OPEC's price hikes on to the consumer, and this led to a shortage of gas at the pump.

Michael Darby, PhD, Under Sec. Commerce, Bush Administration, Asst. Sec. Treasury, Reagan Administration: So we ended up with the supply price shifting up, a lid on the prices that consumers were allowed to pay, and that leads to all these long lines and shortages of gasoline as long as that policy was continued.

I just want to interject here and say that this is precisely the same reason why there were all of those power outages in California, and why it's ridiculous to blame "deregulation" for them. Regulations kept the supply of power artificially low, causing the price of power to rise, but price caps kept the power companies from passing these prices on to consumers. Hence, shortages and rolling blackouts. Same principle, same effect.

Conrad: And since oil is a major input into a large array of industries, as a result of that increase in the price, companies had to cut back on their output and that meant that they cut back on the number of people they employed. And so there were layoffs and reductions in employment, and as a result of that income contracted and so the workers couldn't spend that money on other goods and services. So there were reverberations throughout the economy.

[...]

Connolly: It's important to understand that the increase in the price of oil is quite different than any other kind of price hike. Energy is required to produce virtually every kind of product or service, and to transport them as well. So a change in energy prices can single-handedly impact aggregate supply. The aggregate supply curve shifts to the left. We can expect to see a terrible combination where the equilibrium price rises and the equilibrium output in the economy declines. This goes by a special term coined in the 1970s: stagflation. Output is declining, a stagnation of the growth process, and we're getting an increase in prices; that's inflation. Prices increase while growth is stagnant. Output falls and the price level rises...One solution to this predicament is to increase aggregate demand. If aggregate demand is stimulated, and shifts to the right, we get an increase in prices, so we have an inflation; but we also see an increase in equilibrium output. So an increase in aggregate demand actually stimulates production in the economy...Back in the 1970s, when OPEC doubled the price of oil, it led to a reduction in aggregate supply. The inflation rate in the US went way up and unemployment rose to about 8.5%. These increases in inflation and unemployment are exactly what our model predicts: the price level rises, and output goes down. When OPEC doubled the price of oil again, inflation went up once more to more than 10%, and unemployment went up to about 10%...

Let's step back from history for a bit and focus on fiscal and monetary policy...We'll go from money to interest rates to investment spending to aggregate demand and finally to the whole economy. The money supply has a significant effect on long run prices, but its impact on output is purely a short run phenomenon. Money is neutral in the long run; output is driven by the availability of resources and the nature of production...The money supply and money demand schedules determine an equilibrium interest rate. If the money supply increases, we get a lower equilibrium interest rate...This makes it cheaper for consumers to borrow money for consumption purposes, and for firms to borrow money to make investments. therefore, we see an increase in consumption and investment spending at any given price level. That's the same thing as the aggregate demand curve shifting out to the right. Equilibrium prices increase, and, at least temporarily, we can expect to see an increase in equilibrium output.

Say we're at the peak of employment, an output level that corresponds to the long run aggregate supply schedule. Could this increase in the money supply actually boost equilibrium in the long run? The answer is no. That's because, in the long run, equilibrium output is determined by the ability of the economy to produce goods and services. There's nothing that the monetary system does which affects the ability of the economy to produce goods and services. Money doesn't do anything to the real economy in the long run. So if we start out at equilibrium, that increase in the money supply leads to a higher aggregate demand, and higher prices. In turn, that leads to higher expected prices, and that delivers a short run aggregate supply schedule that's shifting back to the left. So what we ultimately get is the same level of output as before. In the long run, increasing the money supply only leads to increasing prices; that is, it leads to inflation. In the short run, however, we can see that increasing the money supply can lead to an increase in aggregate demand. But in the long run, we don't get to keep any of the gain. In the long run, if you want a higher output level, you have to find a way to increase the productive capacity of the economy.

Let's talk now about fiscal policies, or the government's decisions on how much to spend and tax. If government spending goes up, aggregate demand increases, and this shifts the aggregate demand schedule to the right...If the government raises its spending, if it buys new airplanes from a defense contractor, or pays for the production of new bridges or railways, or even if it's just buying office supplies, that money is really only the first round of spending. The merchants who receive the money turn around and spend a portion of it on other things, the second round. How big a portion? We need to introduce the Marginal Propensity to Consume. The Marginal Propensity to Consume is the fraction of each extra dollar of income that a consumer chooses to spend. For some consumers, this is 1; they spend virtually every extra dollar. However, some people usually save a portion of their income, so it's usually less than 1. Let's say it's .9. This means that out of every dollar, the average consumer will spend 90¢ and save 10¢. So if the government spends $30 billion, then the recipients themselves will choose to spend $27 billion. That $27 billion of second-round spending is now income for other people. What are they going to do with it? Well, they're going to spend 90% of it, and it goes on, round after round, getting smaller each time. It turns out that we can come up with a formula that tells us how much income was created in this process. This is the Spending Multiplier, which equals 1 / (1 - MPS). So if the MPC is .9, the Spending Multiplier is 1/ (1-.9), or 1/.1, and that's 10. This means that every dollar of additional spending by the government generates a total of $10 of spending all across the economy. This is the basic idea behing Expansionary Fiscal Policy. The government is able, by changing its own spending, to have a very large impact on total spending, and, therefore, aggregate demand throught the entire economy.

This change in government spending has another important effect on aggregate demand. We refer to this a sthe Crowding Out Effect. What's the impact on the money market of an increase in government spending? It turns out that the answer is actually pretty straightforward: Every time people get an increase in their income, they're going to hold some of it in the form of money. That, in turn, means that the demand schedule in the money market shifts out to the right. This means that the short term interest rate has to increase. We're talking about fiscal policy here, not monetary policy, so whent he government increases its expenditures there's more income and spending in the economy, but the money supply hasn't changed at all. We have a greater demand for currency, but no greater supply...Any time the interest rate goes up, borrowing costs increase. And when borrowing costs increase, the demand for these types of goods and services decreases...An increase in government spending will lead to an increase in the interest rate; and the increase in the interest rate tends to choke off a portion of the demand for goods and services by individuals and firms...And that, in turn, leads to a slowdown in growth. It's called the Crowding Out Effect because what happens is that government expenditures reduce, or crowd out, private investment expenditures...

So, the net effect of an increase in government spending has two parts: The net effect of an increase in government spending is the spending multiplier effect minus the crowding out effect. What actually happens is that an increase in government spending will, in fact, raise aggregate demand—but not by the full amount of the multiplier...It's really very hard to measure precisely what's going on here. The key point I want you to see is this: of the government chooses to spend more, then it tends to raise short run aggregate demand. It's just that the magnitude of the effect isn't very clear, and in the long run it gets even trickier because we know that today's investment expenditures by private businesses shape the long run aggregate supply schedule. So if government spending today crowds out investment, we may have to pay for it with lower long run output that we might otherwise have had.

[...]

If someone gets $1 in income, and we say they spend 90% of it, what they're really spending is 90% of after-tax income. So if the tax rate is 30%, they get to keep 70¢ of the dollar. But if the tax rate falls to 20%, then people get to keep 80¢ on the dollar. Let me stress this point: In this case, with an MPC of .9, they're not spending 9/10ths of 70¢, but 9/10 of 80¢. Clearly a reduction in the tax rate leads to more spending and higher aggregate demand...So when congress cut taxes but not spending [in the 1980s], what was the net impact? The government was taking in a smaller amount of tax revenue than it was spending, so it was running a budget deficit.

Sylla: The mistake [Reagan] made, was feeling that what sounded on paper like a consistent set of policies in 1981 would actually work politically.

Reagan (file footage): So it doesn't make much sense to blame the deficit on tax cuts and even less to ask for economy-busting tax hikes as a cure. The deficit is quite clearly caused by over-spending.

Sylla: The result was that the National Debt went from abotu $1 trillion when Reagan came in to about $3 trillion by the time he left office; in other words, roughly 190 years of American history had built up $1 trillion, and then Reagan tripled that in 8 years.

Connolly: The debt accumulated during Reagan's presidency was unprecedented in the history of the country. This was a very strong stimulus for the economy, but it took awhile for the tax cut to kick in. It took awhile for hte tax cut to affect aggregate demand. So [Federal Reserve Chairman Paul] Volcker's monetary policy was contractionary, but the tax cut led to more spending by consumers, and that was expansionary. The net effect was hard to predict in advance; it really depends on which influence is stronger. But hte kicker to the story is what happened to expected prices: Volcker and the rest of the Fed understood that in order to get expected prices to fall, and therefore shift the short run aggregate supply schedule out, the Fed had to change inflationary expectations. By then, people had come to expect that inflation would continue. We had at that point 10-12 years of continued inflation, including a couple episodes of very high inflation. So Volcker's strategy of cutting back on the money supply took advantage of the fact that people understood that, in the long run, inflation depends on the money supply. So cutting back on the money supply would lead people to expect price levels to stabilize. Remember, the impact of a drop in expected prices shifts the aggregate supply schedule to the right. The problem began when an increase in oil prices shifted aggregate supply to the left. Eventually, people did come to expect lower inflation; at that point, we saw aggregate demand shift to the right, because of expansionary fiscal policy. We say aggregate supply shift to the right because the Fed had broken the cycle of inflationary expectations. This led to the second longest economic boom in the postwar period of the US...

Now, this might raise the question, was it a good thing or a bad thing? See, the answer really depends on your perspective. If you think about this from the viewpoint of someone who's older, someone who isn't going to be around to cope with the consequences of the accumulated debt, this was a great thing. For younger taxpayers who will have to deal with the enormous expansion of government debt, it's sort of a mixed bag. On the one hand, the debt has to be paid, or at least the interest has to be paid, and that means future taxes. On the other hand, employment and output are higher than they would have been otherwise...

Now here's the short run vs. long run analysis:

Let's focus on output, interest rates, and the price level. What we know in the long run is that the level of output depends on the supplies of labor and capital and the production technology that's available for turning capital and labor into output. We also know that at any given level of output we will see the interest rate adjust to balance the supply and demand of loanable funds. Finally, in the long run, changes in the supply of money lead to proportionate changes in the price level. This is the Quantity Theory of Money. In the short run, we know that these propositions don't hold in the same way. In the short run, we work it all in reverse. The price level is sticky, and in the short run it just doesn't respond very much to changing economic conditions. This implies that it's the interest rate that has to adjust. Finally, in the short run, the level of output responds to changes in aggregate demand, and that's determined in part by the interest rate that balances the money market. This helps determine the level of investment spending. So in the long run, fiscal and monetary policy tend to affect the price level and not the level of output, while in the short run they can have a strong influence on output but less influence on the price level.

shanek

5th January 2004, 06:55 PM

The Phillips Curve, and why it works...except when it doesn't:

Let's start by looking at the short run Phillips Curve. We have aggregate demand, which is downward sloping, and of course we have an upward-sliping aggregate supply schedule in the short run. So the idea is that if we have an equilibrium output level, and we have some price level that's determined in the economy, the question is, what happens if there's an increase in aggregate demand? From our diagram, we know that the AD schedule has shifted out to the right, and this, of course, leads to a higher price level, and a higher output level, at least in the short run. The price level has gone up, so we have an inflation. Output has gone up and that means that uneployment goes down, according to Okun's Law...

So we're going to have a new diagram here. Let's put the unemployment rate in percent along the horizontal axis and the inflation rate along the vertical. The Phillips Curve is downward-sloping. The idea is that as we move from one inflation rate that's fairly low, and a relatively high unemployment rate, we see aggregate demand increasing and so the unemployment rate declines but the inflation rate goes up. The idea that Phillips discovered was that, in the short run, as unemployment declines inflation increases.

The question is whether unemployment could be brought down permanently at the expense of higher inflation. So part of the reason this tradeoff between inflation and unemployment was interesting is that it promised a way for policy makers to think about how significant unemployment problems could be resolved. Perhaps nowhere in recent times was this balancing act more keenly challenged than in the wildly dramatic economic history of Brazil. In the 1980s, inflation turned the richest country in Latin America into an economic wreck. The inflation rate hit hundreds or even thousands of percent per year. Prices, wages, and interest rates were rising by up to 2% every day.

Alex Castro, Brazilian National: I used to go to grovery stores, and I could never knew what I was going to find there. The cost of bread one day was not going to be the same the second day. Lots of times, people get change in coins and just throw them away, because it's not worth carrying a lot of change in your pocket when it is worth nothing.

Connolly: By the mid-80s, inflation was built into Brazil's economic system. A policy called "indexation" pegged wages to the rate of inflation.

Jose de la Torre, DBA, former Senior Policy Analyst, US Department of Commerce: All you had to do was calculate the rate of inflation for the last month, and then everything that was paid out would be indexes accordingly the next month. Which, of course, had a tendency to build into the system a continuation of the forces of inflation.

Castro: I remember once my salary was over one million and a half a month. That's pretty good, eh?

Connolly: As the inflation rate soared, Brazil's economy continued to grow. Middle-class workers with indexed wages faced inflation of up to 80% a month. Bank interest rates kept pace with inflation, sometimes paying 70% interest a month. But the poor and unemployed were in a desperate situation. By 1990, one-fifth of Brazil's 150 million people were malnourished. Brazil's inflation-ravaged industries couldn't compete in international markets. By 1994, the Brazilian people were so frustrated with the economy, they elected Fernando Cardoso. Cardoso was committed to tackling inflation at its source, and his first move was to get abolish indexation. He also announced massive cuts in government spending. Unemployment soared.

Marta Ribiero, Brazilian National: Nobody believed it was going to work. We'd been with inflation for over 20 years and got used to it, so we said it's not going to happen, but it worked.

Connolly: Adapting to the new reality of an economy with normal levels of inflation wasn't easy. But the stability benefitted the majority of Brazilians...Brazil's battle with inflation provides important lessons for the future. Think about what happens in the labor market. As AD is increasing and firms want more capital goods and consumers want more consumer goods, businesses, of course, try to meet that demand. To meet that demand, they need to run longer hours and hire more people and buy more materials. The idea is that as AD increases, the demand for individual inputs increases, including the demand for labor. This directly reduces unemployment. As we get farther and farther along in the business cycle, moving towards the peak, what we notice is that employment goes up, unemployment of course goes down, and labor markets begin to tighten.

Let's put the quantity of labor along the horizontal and the wage rate, the price of labor, on the vertical. There's a downward-sloping demand for labor, and an upward-sloping supply. This gives us an equilibrium quantity of labor and an equilibrium wage rate. What we expect as we get father and farther along in the business cycle is the demand curve shifts out further and further and the wage rates tend to increase. That increase in wage rates leads to an increase in costs for businesses and so eventually that has to force the businesses to raise prices. The increase in AD leads to an increase in the demand for labor. Eventually, that forces up wage costs, and that forces up the cost of production. So they have to raise their prices for consumers and so the inflation rate begins to increase. As employment increases the inflation rate is, in fact, increasing.

The question is, what else could happen? Why is this not the end of the story? There are other factors that impact the Phillips Curve. The first is people's expectations. What happens when people expect that prices will rise? When people begin to expect inflation, isn't there an adjustment that takes place in behavior? In the long run, that's precisely the point. The problem with the early analysis of the Phillips Curve was that it assumed there was no adjustment in expected inflation by buyers and sellers of labor and products. If people saw higher inflation in one year, they had no reason to expect higher inflation the next year. but, of course, what we know is that there is every bit of evidence that when we see inflation now, people begin to adjust their expectations and expect that they'll see more inflation later. Nominal wages increase, at the same time real wages really weren't increasing at all. It might have even declined. It depends on how fast the wage goes up relative to the price level. Real Wage = Wage Rate ÷ Price Level. If I expect the price level to go up, then I want my wage rate to go up simply because I have to be compensated for this higher cost of living. Nominal wages have to go up at least as fast as inflation in order for workers to have the same real wage. It's real wages that matter to workers, not nominal wages.

[...]

The secret to controlling inflation, especially over long periods of time, is to reduce the rate of growth of the money supplt. But what was going on [during the Johnson and Nixon years] was that the money supply was increasing rapidly because the government was running a significant budget deficit, and the Fed was increasing the money supply, what we call, "Monetizing to death." The Fed was pumping reserves into the banking system, and that made it possible to absorb the increase in government bonds that were being sold to finance the deficit. The bottom line is that by 1973 the inflation rate had risen significanty, [Nixon's] wage and price controls had turned out not to have been terribly effective, in fact, all they had done really was suppress the underlying inflation for a short period of time.

Through the 60s and the beginning of the 70s, these shifts in AD were pushing us along the Phillips Curve. But in 1973 with the oil crisis, we had a series of shocks to the economy which made it impossible for suppliers to produce the same amount of goods at the same prices. The AS curve in the short term is dependent upon a certain expected rate of inflation. What happened in the early 70s is that the expected inflation rate increased and the AS schedule was shifting back to the left. This is stagflation. Unemployment was going up, inflation was going up, and aggregate output has in fact fallen. The Phillips Curve says there's an inverse relation between unemployment and inflation, and yet what we began to see was evidence that inflation was going up and unemployment was going up, and that's a positive relation. This goes against the Phillips Curve. Professional economists were having a lot of difficulty trying to figure out what was going on, but what was going on is exactly what had been predicted in other work done by Milton Friedman and Edmund Phelps. The Friedman-Phelps analysis argued that in the long run, money supply increases would dominate the explanation of inflation, the ond classical quantity theory of money. In addition, increases in the money supply have no direct connection to the amount of real output that can be produced in the long run. If the money supply increase only affects inflation, then it can't possibly change long run AS. The Phillips Curve may involve a short run tradeoff between inflation and unemployment, and that's what had been exploited in the late 1960s. But in the 1970s, people began to expect inflation, and we ran into supply shocks in the form of the oil prices. These factos shifted AS back, so we experienced higher prices and lower output. The long run Phillips Curve looks quite different; rather than being downward-sloping, is vertical, and it's vertical at what we call the "natural rate of unemployment." There's a certain amount of output that can be produced, and that amount of output implies a certain unemployment rate. There's no claim here that the natural rate of unemployment is a good thing or a bad thing; what we know is that the natural rate of unemployment isn't constant over time, and there are some very specific social implcations of higher vs. lower natural rates of unemployment.

The Friedman-Phelps story is: Actual Unemployment Rate = Natural Rate - [Actual - Expected Inflation]. Suppose the natural rate is 5%. Suppose the actual rate of inflation is 7%, and the expected rate is 3%. The actual rate of unemployment will be 5% - [7% - 3%] = 5% - [4%] = 1%. If we see that actual inflation is above the expected level of inflation, this leads to a decreas in unemployment. That's exactly the idea we've been persuing in our AS-AD analysis in the short run. Friedman/Phelps in the long run says that actual and expected inflation will converge because their expectations will adjust to their own experience. In the long run, if you want to get unemployment down, the real trick is to get the natural rate down. If we get an increase in expected inflation, Friedman-Phelps says that the short run Phillips Curve actually moves; it shifts to the right when expected inflation goes up. We get higher inflation at the same unemployment rate, and that gives us the long run Phillips Curve as a vertical line...In the long run, the trade-off between inflation and unemployment doesn't really exist, so in the 1970s we began to get a great deal of instability in inflation and unemployment.

shanek

27th January 2004, 09:18 AM

Finally, the last episode, dealing with the controversies behind government policies. Heavy on the documentary side, giving lots of examples; again, I've just transcribed the lecture portion here. No answers, just outlaying the questions:

Connolly: Let's jump in to Stabilization Policy....Monetary and fiscal policy are both able to affect aggregate demand, and thereby influence both output and price level in the short run. Now, just because policy makers can affect output doesn't necessarily mean that they ought to be doing it. So the question is, what should policy makers be attempting to do here?

Kyser: I prefer a passive role because government will come in and say, "We're going to deal with this problem," but by the time they have dealt with the problem, it's like a Christmas Tree—they have all kinds of ornaments, and the tree collapses...Government starts out with good intentions, but these people have never worked in business and they're going to take actions that they don't quite understand will have literally counterproductive outcomes.

Allen: By and large, the post efficient way, of course, is for the government to keep its cotton picking fingers off of people!...You dabble, you diddle, you subsidize, you control, you restrict, when we would have been much better off if you had just backed off.

Connolly: We know that, left alone, economies tend to fluctuate. Real incomes tend to rise and fall, unemployment goes up and then comes down, we get more or less inflation and sometimes we actually get prices falling (although not in my lifetime). But we also have experience that proves the economy, on its own, can and does produce major recessions. And a recession constitutes a tremendous waste of resources for society. Workers are unemployed because there isn't enough demand for the output they produce.

[...]

Large, publicly-financed projects...tend to get built because of their short-term and their long-term benefits...But it can also be argued that tese projects tend to crowd out investments from the private sector; in fact, there are strong arguments on both sides of the debate. Here's the case for taking an active role in stabilizing an economy: By jumping in when the economy goes into a downturn, the government might reduce the downward trend, put a limit on increased unemployment, and in the process, make society better off. Certainly, these policies can make many individuals better off. So, those in favor of action argue that, in our nation's history, and in the history of other countries as well, we've seen that intervention can help alleviate some of the terrific human costs of recessions and depressions. In other words, the sacrifice associated with economic difficulties is sometimes so great that the cost of inaction is too much for society to bear.

On the other side, people say that monetary and fiscal policy really don't have an immediate impact on the economy. There is a substantial time lag between the time the policy is decided on and when it actually starts to move the economy in a particular direction. We know that monetary policy has very different effects, too, in the short run, as opposed to the long run. In the short run, it can raise aggegate demand; but in the long run, we know that the output level is, in fact, unrelated to monetary policy. Fiscal policy, of course, also works with a lag. After all, it takes most of the year to get the Federal budget passed. And fiscal policy basically involves a change in either the Federal budget or the tax laws. It can take months and months for the government to enact a policy, and then, of course, it takes awhile for the spending to start or the change in taxes to take effect. By the time the government gets around to doing what needs to be done, the economy can be in a very different stage; we've already worked through the recession and we're on the way up. That's the point at which the government begins the expansion, and it's not really needed anymore.

The second issue involves Monetary Policy. There are two ways to run monetary policy: one way is to establish a rule or regulation that says, "the money supply will expand at a certain rate each year," or "the interest rate will be held at a certain level," or "the exchange rate will be pegged to a certain level." Now, with that rule in place, there's no reason to change policy. It's like putting the airplane on autopilot. But the Fed has a lot of discretion over monetary policy, and the issue at stake is whether the Fed should be allowed to retain that discretion and decide what monetary policy out to be, and whether or not it should be changed...If we have no rules, we may have inconsistent policy, but at least we'll have the flexibility to react to shocks to the system. Now, you might ask, why not simply follow a set of rules until something happens and then adjust? Well, the difficulty here is this: policy makers can always find some particular shock that justifies abandonding a rule. A rule that can be abandoned really isn't a rule at all. To get the advantages of rules, you have to stick to them.

[...]

Our next topic is one of the most controversial: whether or not to balance the Federal budget. Here, the question is, should the Federal government aim at parity between tax revenue and government spending, or should the Federal government be allowed to run a deficit or surplus? Let's look at the arguments in favor of a balanced budget. Between 1980 and 1995, the Federal debt rose from $710 billion to $3.6 trillion. You might ask, with numbers as unreal as these, what's the problem? Well, the debt burden is very real. It falls not on the people who are paying taxes now, but on future generations. In fact, the Federal debt generally isn't repaid, just rolled over, that is, refinanced, over and over and over again. So an increasingly large share of government spending is interest on the Federal debt. There's no reason why we should saddle future generations with such a heavy burden, they say; furthermore, the budget deficit can and does create very difficult problems for the economy. In the short run, the increase in aggregate demand can, for a time, reduce unemployment and raise output. In the long run, though, that can lead to higher inflation, and because long run output is determined by long run aggregate supply, there is no reason to expect that the economy would be any better off in the long run, except we'd have higher inflation. So supporters of a balanced budget believe that the government should not be allowed to run a deficit, because in the long run, all it leads to is higher inflation. Another argument for balancing the budget is that the debt can affect budget priorities in ways that no one is happy about. For example, currently about 1/3rd of the budget goes to paying interest, so all of that money is unavailable for spending on many things...

On the other hand, the arguments against a mandatory balanced budget are very vociferous, and the feelings they generate are very intense. These people believe that repaying a deficit isn't as important as the benefits to be gained by government spending. Their point is, fiscal policy is just one feature of government policy, and the government may need to make further investments, in education, for example, and investment in education in turn can lead to higher productivity and a higher standard of living in the long run. They often argue that the government shouldn't be prohibited from running a deficit in order to make those investments.

"Many bad policies are simply good policies taken too far." —Thomas Sowell

And that's it! Could some kind moderator archive this thread or whatever needs to be done to prevent it expiring? This will be very useful to refer back to in future discussions.